Relation between franking credits and the market risk premium: a comment

Abstract

Based on the Officer (1994) model, Gray and Hall (2006) derive a relation between franking credits and the market risk premium. On the basis of this relation, the authors show that traditional estimates of the value of franking credits imply dividend yields that are inconsistent with historical equity market data. This inconsistency arises from assumptions about the franking credit payout ratio and the value of franking credits retained. With less than a 100 per cent payout ratio some franking credits are retained within the firm. Assuming that the retained franking credits have no value leads to the inconsistency in dividend yields. Current practice in the application of Officer's model makes this assumption and, therefore, leads to inconsistent results. Gray and Hall suggest resolving the inconsistency by setting the value of all franking credits to zero. An alternative solution is to recognize that retained franking credits might have a positive value. Copyright (c) The Authors.

Fifty years of finance research in the Asia Pacific Basin

“…The issue of dividend imputation and its relevance to cost of capital computations is raised by Officer (, ), Wood (), Truong et al . (), Gray and Hall (), Dempsey and Partington (), Truong and Partington (), Lally (), Gray and Hall () and Chu and Partington (). The primary issue here is the value of dividend imputation tax credits and its relevance to cost of capital computation.…”

Cost of capital equations under the Australian imputation tax system

“…They argue that the inconsistency may be eliminated by allocating franking credits a value of zero. Exemplifying the 'allocation' problem, however, Truong and Partington (2007) contend that such inconsistency can also be resolved by attributing a positive value to the franking credits retained within the firm.…”

Relationship between franking credits and the market risk premium: a reply

“…Truong and Partington (2008) note that the calculation of the required dividend yield comes from the Officer model, which assumes that all cash flows are a level perpetuity. They also note that the actual dividend yield comes from a market in which firms do grow and generate capital gains.…”

“…We demonstrate that if the Officer/regulatory model is to be maintained, the inconsistency can be resolved by following commercial practice in setting γ = 0. Truong and Partington (2008) and Lally (2008) propose alternative ways to resolve the inconsistency. These proposals involve maintaining the regulatory assumption that γ = 0.5 and abandoning the Officer framework.…”

“…In the present paper, we spell out precisely how the Officer model must be changed under the proposals of Truong and Partington (2008) and Lally (2008). We also show that regardless of whether the documented inconsistency is resolved by keeping the Officer model and setting γ = 0 (Gray and Hall, 2006), or abandoning the Officer model and maintaining γ = 0.5, the estimated after‐tax cost of equity must increase.…”