Suddenly, the cash from corporate tax cuts may not sound like a problem. However, some companies face a dilemma in deciding how to use the money. A combination of market forces and financial theory would leave them with no truly attractive options.
Fans of the tax cuts and jobs act of 2017 predict an increase in capital spending. Currently, only 78 percent of U.S. factories, mining and utility companies are interested in building more factories and equipment. Capital costs have been historically low over the past few years. People think that most companies are attractive enough to expand.
Some big companies have announced bonuses and wage increases, and trumpeted tax cuts. When Bernard marcus, the co-founder of home depot, recently spoke to fox business about the benefits of the new tax law, he attributed the increase to a tightening of the Labour market. Of course, as an explanation, it makes the economy feel better, even if the company claims to be politically savvy and unselfish in sharing parliamentary and presidential gifts with employees.
The acquisition is another potential exit for companies that can now attract qualified talent without raising wages. Strategic deals driven purely by financial considerations rather than by efficiency are more vulnerable to damage than the creation of shareholder wealth. Directors and executives who really want to create the most value for their owners must find other ways to apply for this year’s tax credit.
Debt repayment is a sensible option for some companies, but what about companies that already have conservative debt/equity ratios? Interest costs are still deductible, but only up to 30 per cent of EBITDA. Therefore, further reduction of leverage, i.e. greater reliance on equity financing, is not tax efficiency.
This leaves the option to return funds to shareholders. The question then becomes whether to do so through dividends or share buybacks. From the perspective of enterprise financing theory, there are problems in both options.
Dividend tax payable on shareholder’s equity. Under the general income tax rate, income from enterprises and dividend income must be collected. Despite the inefficiency of taxation, financial economists find companies paying dividends a dilemma. Shareholders in need of cash flow can receive dividends by selling shares. In the worst case, they will get a return on sales capital, not a higher normal rate of return.
Share buybacks are more tax-efficient than dividends, but in the current circumstances they are not desirable for many companies. The right time to buy back shares is below their intrinsic value. The s&p 500 is trading at 3.59 times earnings, according to multpl.com, down from an average of 2.77 times since 2000. So in general, it’s hard to say that stock prices are unreasonable. Some stocks are overvalued if they are other stocks.
Companies that are too expensive to buy properly may hoard cash and wait for prices to plummet. This strategy has the disadvantage of temporarily suppressing returns on capital, especially near zero returns such as CDS and t-bills. It is inappropriate to donate all funds to worthy charities as an appropriate corporate act.
In short, the financial theory of any company has the following characteristics, as it seeks the right use of the new tax law’s emerging cash:
There is no economically viable basis for a substantial increase in capital spending.
There is no compelling acquisition opportunity.
There is no reason to bring the debt/equity ratio below its current level.
The stock price equals or exceeds its intrinsic value.
Yield-oriented investors are less concerned with the advantages of financial theory. If the company’s chief financial officer wants to ask for their advice, they suggest an immediate dividend. Unfortunately, this will increase the payment rate, indicating that the company has fallen to a low growth market.
More interesting is how the company ended up solving the odd problem of having more cash, rather than knowing how to handle it.