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F 5001 Capital Markets and Corporate Finance
Tutorial Questions and Solutions
Topic 7 – Cost of Capital
Discussion Question 6 (Chapter 8)
Compare and contrast the essential features of the alternative systems of
corporate taxation—classical and dividend imputation.
Under the classical system of taxation, earnings are taxed at the corpora te
and then distributed as dividends. Once received by the shareholder, the
dividend is taxed as al e. This double-taxation reduces the value of
after tax dividends vis a vie capital gains and makes dividends less attractive then
capital gains.
Under the Imputation system of taxation, earnings are taxed at the corporate tax
rate. If a dividend is paid by the from this after tax earnings, the
shareholder receives a credit for the payment. Effectively, the shareholder is
assessed as though he/she had earned the pre-tax amount and that amount
(dividend and trading credit) is assessed for tax purposes in the hands of the
shareholder. The franking credit is then used to offset the tax payable. If a
shareholder is in a marginal tax bracket which is less than the corporate tax rate,
the shareholder is eligible to use the additional tax credit to offset tax payable on
other e or receive a cash refund.
The result of this system is that dividends are only taxed once at a rate
determined by the shareholders marginal tax rate. Imputation results in
dividends being more attractive than under the classical system.
Discussion Question 7 (Chapter 8)
What is a franking credit? How does it impact upon the after-tax returns of a
shareholder?
A franking credit is the amount
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