Suddenly, the cash infused from a corporate tax cut may not sound like a problem. However, some companies face a dilemma in deciding how to use the money. The combination of market forces and financial theory will leave them without a truly attractive option.
Fans of the 2017 Tax Relief and Employment Bill forecast a boom in capital expenditures. At present, only 78% of U.S. factories, mines and utilities companies are interested in building more factories and equipment. Over the past few years, the cost of capital has been at historically low levels. People will think that most companies already have enough attractive opportunities for expansion.
Some big companies have already announced bonuses and wage increases and hyped their tax cuts. When Home Depot co-founder Bernard Marcus recently accepted Fox Business’s talk about the benefits of the new tax law, he attributed the pay rise to a labor market tightening. As an explanation, of course, it would make the economy feel better, even if the company claims they unselfishly shared parliamentary and presidential gifts with employees and is politically savvy.
For companies that are currently able to attract qualified talent without a raise in wages, the acquisition is another potential exit for newly discovered funds. Strategic deals driven purely by financial considerations rather than effective ones are more likely to damage than the creation of shareholder wealth. Directors and executives who really want to create the greatest value for their owners must find other ways to apply for this year’s tax credit.
Debt servicing is a sensible option for some companies, but what about companies that already have a conservative debt / equity ratio? Interest costs can still be deducted, although only up to 30% of EBITDA. Therefore, further reduction of leverage, that is, greater reliance on equity financing, is not tax efficiency.
This left the option of returning funds to shareholders. Then the question becomes whether to achieve through dividends or stock repurchases. From the corporate finance theory point of view, both options are problematic.
Dividend tax payable to equity shareholders. In accordance with the general income tax rate, corporate income and received a dividend income must be collected. Despite tax inefficiencies, financial economists find it a dilemma for companies to pay their dividends. Shareholders in need of cash flow can make their own dividends by selling shares. In the worst case, they will have a return on sales capital, not a higher normal rate of return.
Share repurchases are more tax-efficient than dividends, but in the current case they are not desirable for many companies. The right time to repurchase shares is to trade below its intrinsic value. According to multpl.com, the S & P 500 Index is trading at 3.59x for the current P / E ratio, compared with an average of 2.77x since 2000. Therefore, on the whole, it is hard to say that stock prices are unreasonable. If some stocks are then others will be overestimated.
Companies that are too expensive to buy the shares properly may stock up for cash and wait for the price to plummet. This strategy has the shortcomings of curbing the return of capital temporarily, especially near-zero returns such as CDs and T-Bills. It is not appropriate to donate all the money to a worthwhile charity as an appropriate corporate act.
In short, any company’s financial theory has the following characteristics, as it seeks to properly use the emerging cash of the new tax code:
There is no basis for a substantial increase in capital expenditure that is economically viable.
There is no compelling acquisition opportunity.
There is no reason to lower the debt / equity ratio below the current level.
The stock price is equal to or higher than the intrinsic value.
Income-oriented investors are less concerned with the advantages of financial theory. If the company’s CFO wants to ask their advice, they would suggest an immediate dividend. Unfortunately, this will raise the payout rate, indicating that the company has dropped to the lower growth market.