The Value with a Dividend: Five-Year Horizon in VS .NET

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The Value with a Dividend: Five-Year Horizon
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Assume a firm has $100 that it can either invest or pay a dividend The investor can earn a return of 0604 after investor tax on investments in the market The investor nets $6040 after tax from the $100 dividend and after five years the investor who invests in the market will have $8098:
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6040(10604)5 = $8098
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The Value with Retention and Sale
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Now assume the firm reinvests the $100 for five years and earns 10 per year After five years the firm will have $16105:
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100(110)5 = $16105 Assume the firm is sold at time 5 for $16105 and the investor is taxed at 20: (1-20)(16105) = $12884 This strategy is consistent with the manner in which private equity is managed The advantage of the retention strategy compared to a dividend is $4786 for the example or an increase of 59 above the future value with the annual dividend Most corporations have a mixed strategy of paying out a percentage of their earnings and retaining the remainder Thus the actual difference in value for a typical dividend-paying corporation will not be as dramatic as for the example But if we consider the change in value for the dividend component only, the example is accurate With the corporation retaining all the $100 of earnings the investor gives up $6040 at time 0 and gets $12884 at time 5 This is an IRR for the investor of 164 6040(1 + IRR)5 = $12884 IRR = 164 The advantage of the retention strategy is highlighted by the fact that in a situation where the corporation can earn only 10 (after corporate tax and before investor tax), the investor earns 164 from the corporation after all taxes following a retention strategy rather than a dividend strategy Next, we want to consider the effect of lengthening the planning horizon from five years to 10 years
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A Ten-Year Horizon with Sale of Corporation
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First assume the firm pays out the $100 as a dividend and the investor nets $6040 after the 396 tax After 10 years the investor will have $10858
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42 ______________________________________________ PRIVATE EQUITY
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6040(10604)10 = $10858
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If the firm retains $100 for 10 years earning 10 per year and then the firm is sold, the investor nets
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100(110)10(1-20) = $20750 The advantage of retention is $9892, which is a 91 increase over $10850, the future amount with a dividend If the corporation retains, the investor gives up $6040 at time 0 and then nets $20750 after tax at time 10 This is an IRR of 131 6040(1 + IRR)10 = 20750 IRR = 131 This IRR is smaller than with the shorter time horizon But let us consider the present value With a five-year horizon the present value of the $4786 advantage of retention is $3570 PV = (10604)-5 4786 = $3570 With a 10-year horizon the present value of the $9822 advantage of retention is $5503: PV = (10604)-10 9822 = $5503 The present value of the advantage of retention increases as the horizon is increased, but the IRR earned by the investor decreases if the corporation retains rather than pays a dividend and the horizon is increased
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In the preceding example we consider only the dividend of one year But assume a $100 dividend for five years (first dividend is at time 0) The future value for five years is: Future value = [100(10604)5 + 100B(4, 0604)(10604)5 ](1 - 396)
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TABLE 41 Time Value at Time 5
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Value at Time 5 100(110)5 l00(ll0)4 100(110)3 100(110)2 l00(ll0)1 Value $16105 14641 13310 12100 11000 $67156
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0 1 2 3 4
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Future value = [13408 + 34619(13408)]604 = $36133 If the corporation retains $100 a year for five years and earns 10 per year it will have $67156 at time 5 (see Table 41) The investor will net after tax $53725: (1-2)67156 = $53725 The advantage of retention compared to dividends is now $17592 or an increase of
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CONCLUSIONS__________________________
Private equity is not likely to attract investors who want the corporation to pay cash dividends The advantages of retention and then capital gains compared to immediate cash dividends are very large for investors paying a high tax rate Private equity allows a corporation to follow a 100 percent retention policy without harming those investors who want cash