FNCE30011 Essentials of Corporate Valuation Class 11

Professor John Handley

VALUATION & IMPUTATION

Class Outline

• Adjusting Equity Returns For Imputation

• Adjusting The WACC For Imputation
• Adjusting The CAPM For Imputation
• Estimating Theta
• Market Practice
• Do We Need To Worry About Adjustments For Imputation ?

References

Officer, 1994, The Cost of Capital Under An Imputation Tax System, Accounting and Finance, 34, 1-17

Handley, 2014, Advice on the Value of Imputation Credits, Report Prepared for the Australian Energy
Regulator, 29 September available from www.aer.gov.au
OBJECTIVES FOR TODAY

• Does imputation change the way we define the cost of equity ?

• What is theta and how do you estimate it ?

• What is gamma ?

• How do you adjust the WACC for imputation ?

• How do you adjust the CAPM for imputation ?

• Do we really need to adjust our valuation approach for imputation ?

Extension Note: There is more than type of imputation tax system and different countries at different times have adopted
different systems. An excellent review appears in: US Department of the Treasury (1992), Integration of the Individual
and Corporate Tax Systems: Taxing Business Income Once. US Government Printing Office, Washington, DC.
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1. ADJUSTING EQUITY RETURNS FOR IMPUTATION

A Quick Recap About Imputation

An Australian company can pay two types of cash dividend to its shareholders …

• a franked dividend – paid out of earnings which has been subject to

Australian company tax

• an unfranked dividend – paid out of earnings which has not been subject to
Australian company tax

A franked dividend comes with a tax credit – called a franking credit or

imputation credit – which represents the amount of tax paid by the company on
the earnings out of which the dividend is paid

… franked dividends are usually fully franked which means each dollar of
𝑇𝑇
dividend comes with dollars of franking credits where 𝑇𝑇 is the corporate
1−𝑇𝑇
tax rate
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Franking credits are not paid in cash but rather may be used by some shareholders
to reduce the amount of personal tax they pay on the dividend …
W1

• the tax rules are complex but franking credits are normally valuable to resident
investors but not to non-resident investors

• resident investors are normally taxed on both the dividend and the franking
credit (called the grossed-up dividend) and then the amount of personal tax
payable by the investor is reduced by the amount of the franking credit

This means …

• tax paid by a company can be interpreted as a mixture of corporate tax and

personal tax

• the source of value of a franking credit is the reduction in personal tax paid
by the investor
W2

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 As Officer (1994 p.2) states …

“The proportion of company tax that can be fully rebated against personal tax
liabilities is best viewed as personal income tax collected at the company level.
In effect, the tax collected at the company level is a mixture of personal tax and
company tax, the company tax being that proportion of the tax collected which is
not credited (rebated) against personal tax.”

• dividends have a value before personal tax and a value after personal tax and
so too do franking credits

… we will see that the distinction between the before personal tax value of a
franking credit and the after personal tax value of a franking credit is
important in understanding the impact of imputation on equity returns

Example

Assume ABC Pty Limited generates earnings before tax of $100, pays corporate
tax at 30% and pays a fully franked dividend of $70 to Jimmy who is the only
shareholder in the company. Jimmy is an Australian resident for tax purposes and
has a personal tax rate of 40%.
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This means Jimmy …
W3
0.30
• also receives × 70 = $30 of franking credits
1−0.30

• is taxed on the grossed-up dividend of 70 + 30 = $100

• pays personal tax of only 100 × 0.40 − 30 = $𝟏𝟏𝟏𝟏

• ends up with an after-personal-tax dollar return of 70 − 10 = $60

which effectively represents …

• the after-personal-tax value of the dividend of 70 × (1 − 0.40) = $42

• the after-personal-tax value of franking credits of 30 × (1 − 0.40) = $18

• If there was no imputation tax system, then Jimmy would have paid personal
tax of 70 × 0.40 = $𝟐𝟐𝟐𝟐

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How Should We Measure The Return On Equity ?

The usual definition of the return on a stock is …

Δ𝑃𝑃𝑡𝑡 + 𝑑𝑑𝑡𝑡
𝑟𝑟𝑡𝑡 =
𝑃𝑃𝑡𝑡−1

where Δ𝑃𝑃𝑡𝑡 is the capital gain for the period, 𝑑𝑑𝑡𝑡 is the dividend paid during the
period and 𝑃𝑃𝑡𝑡−𝑙𝑙 is the price at the start of the period

This definition is common across countries but the way it is interpreted depends on
the tax system in place at the time

𝑟𝑟𝑡𝑡 is commonly called the return on the stock or the return on equity or the cost of
equity under a classical tax system – but a more precise description is the after-
company-before-personal-tax return on the stock since …

• dividends are paid out of earnings after company tax

• the return is measured before deducting personal taxes paid by the investor
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𝑟𝑟𝑡𝑡 is also commonly called the return on the stock or the return on equity or the cost
of equity under an imputation tax system – but a more precise description is the
after-company-after-some-personal-tax return on the stock since …

• dividends are paid out of earnings after company tax

• the return is measured before deducting personal taxes paid by the investor

but

• some of the company tax effectively represents personal tax paid by the
company on behalf of its shareholders

This means we need to adjust the usual definition of a return if we want to measure
the after-company-before-personal-tax return on the stock under imputation

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Specifically, the after-company-before-personal-tax return on a stock under
imputation is …

Δ𝑃𝑃𝑡𝑡 + 𝑑𝑑𝑡𝑡 + 𝜽𝜽𝑪𝑪𝒕𝒕

𝑟𝑟𝑡𝑡∗ =
𝑃𝑃𝑡𝑡−1

where

Δ𝑃𝑃𝑡𝑡 , 𝑑𝑑𝑡𝑡 , 𝑃𝑃𝑡𝑡−𝑙𝑙 are as previously defined and 𝜃𝜃𝐶𝐶𝑡𝑡 is the value of franking credits
distributed during the period where

… 𝑪𝑪𝒕𝒕 is the amount of franking credits distributed during the period and 𝜽𝜽 (theta)
is the value of a distributed franking credit

𝑟𝑟𝑡𝑡∗ is commonly called the grossed-up return on equity

In effect, the adjustment is to add back that part of company tax which represents
personal tax so that the return is then expressed before all personal tax regardless
of whether it is paid by the company or is paid by the investor

W4 W5
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What Is The Value Of A Distributed Franking Credit ?

The value of a distributed franking credit – also called the utilisation value of a
distributed franking credit – represents the extent to which distributed franking
credits are used by investors to reduce their personal taxes

𝜃𝜃 is sometimes expressed in dollar terms such as 50 cents in the dollar or as a

proportion such as 0.50 which means …

• $1.00 of franking credits reduces personal taxes by $0.50.

Recall, the value of a franking credit can be expressed in two ways – before
personal tax or after personal tax – and …

• since Δ𝑃𝑃𝑡𝑡 is the after-company-before-personal-tax capital gain and 𝑑𝑑𝑡𝑡 is the

after-company-before-personal-tax dividend then the only sensible
interpretation of 𝜽𝜽 is that it represents the after-company-before-personal-tax
value of a distributed franking credit
Extension Note: If instead you interpret theta as the after-company-after-personal tax value of a distributed franking
credit then 𝑟𝑟𝑡𝑡∗ will no longer represent the after-company-before-personal-tax return on the stock but rather will have
a very usual interpretation since the dividend (and capital gain) components are measured before personal tax but the
franking credit that is distributed with the dividend is measured after personal tax.
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Different investors can have different personal tax rates which means …

• each investor 𝑖𝑖 has their own utilisation value 𝜃𝜃𝑖𝑖

• but since franking credits are normally valuable to resident investors but not to
non-resident investors then we often simply assume that …

𝜃𝜃 = 1 for resident investors

𝜃𝜃 = 0 for non-resident investors

In addition, we use the value of distributed franking credits 𝜽𝜽𝑪𝑪𝒕𝒕 rather than the
amount of distributed franking credits 𝑪𝑪𝒕𝒕 in calculating returns because franking
credits are not cash …

• instead franking credits are effectively “converted” into a cash (by reducing
the amount of personal tax paid by the investor) and this amount depends on
the tax status and domicile of the shareholder who receives the credit

• in other words, the value of a franking credit is not the amount of franking
credit received but rather it is the reduction in personal tax that is paid
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Example (ABC continued)

Assume there is no capital gain on the stock during the period. Then …

• the after-company-after-some-personal-tax dollar return on the stock is

𝑑𝑑𝑡𝑡 = $70

• the after-company-before-personal-tax dollar return on the stock is

𝑑𝑑𝑡𝑡 + 𝜃𝜃𝐶𝐶𝑡𝑡 = 70 + 1 × 30 = $100

• the after-company-after-personal-tax dollar return on the stock is

100 × (1 − 0.4) = $60

W3
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The Key Idea is …

Under an imputation tax system, returns based on …

• dividends, capital gains and franking credits

are expressed on an after-company-before-personal-tax basis

• dividends and capital gains

are expressed on an after-company-after-some-personal-tax basis

Extension Note: In addition, returns are measured not only before personal taxes but also before any personal costs
incurred by investors which are associated with the receipt of the capital gain, dividend and franking credit.

Extension Note: The seminal paper dealing with valuation under an imputation tax system is Officer (1994) who:
(i) shows under an imputation tax system, the way we measure after-company-before-personal-tax returns needs to
change; (ii) extends the WACC valuation framework (in a perpetuity setting) to an imputation tax system; and (iii)
suggests an extension of the CAPM suitable for an imputation tax system.

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2. ADJUSTING THE WACC FOR IMPUTATION

How Should We Deal With Personal Taxes ?

DCF valuation models commonly used in practice include corporate taxes but
not personal taxes. For example …

• the cash flows – 𝐹𝐹𝐹𝐹𝐹𝐹𝑡𝑡𝑢𝑢 , 𝐹𝐹𝐹𝐹𝐹𝐹𝑡𝑡 , 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝑡𝑡 , 𝐷𝐷𝑡𝑡 – are measured after company tax but
before personal taxes

• the discount rates – 𝑘𝑘𝑠𝑠 , 𝑘𝑘𝑣𝑣 , 𝑘𝑘𝑒𝑒 , 𝑘𝑘𝑢𝑢 – are similarly measured after company tax
but before personal taxes

The reason for this is simple – it avoids the complexity of having to model the
structure of investors’ personal taxes

Importantly, this approach does not assume there are no personal taxes …

• rather, we simply do not explicitly include personal taxes in the analysis

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• and this is OK because we have matched the cash flow (which is after-
company-before-personal-tax) to the discount rate (which is after-company-
before-personal-tax)

There are other valuation approaches that could be used in practice but rarely are
including …

• discounting before-corporate-before-personal-tax cash flows at a before-

corporate-before-personal-tax rate

• discounting after-corporate-after-personal-tax cash flows at an after-corporate-

after-personal-tax rate

… which if applied consistently would give the same value

W6

Extension Note: Taggart, 1991, Consistent Valuation and Cost of Capital Expressions With Corporate and Personal
Taxes, Financial Management, 20, 8-20 presents valuation formulae where both corporate and personal taxes are
explicitly taken into account. Importantly, he matches the cash flow (after company and personal taxes) to the discount
rate (after company and personal taxes).

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How Do You Adjust The Standard WACC Model For Imputation ?

Let’s examine this within the framework of the one period standard WACC model

Consider a firm which is expected to generate (and distribute) a single unlevered free
cash flow of 𝐹𝐹𝐹𝐹𝐹𝐹 𝑢𝑢 and a franking credit of 𝐶𝐶 at the end of the period. The firm is
financed by two sources of capital – debt and equity. The debt has a principal of 𝑃𝑃,
an interest rate of 𝑟𝑟 per period and matures at the end of the period.

The after-company-before-personal-tax cost of equity is 𝑘𝑘𝑒𝑒∗ , the cost of debt is 𝑘𝑘𝑑𝑑 ,

the corporate tax rate is 𝑇𝑇 and 𝜃𝜃 is the value of a distributed franking credit.

The enterprise value today is then equal to the present value of the expected future
unlevered free cash flow and franking credit discounted at a rate 𝑘𝑘𝑠𝑠∗ …

𝐹𝐹𝐹𝐹𝐹𝐹 𝑢𝑢 + 𝜃𝜃𝜃𝜃
𝑉𝑉0 =
1 + 𝑘𝑘𝑠𝑠∗
… where
𝐷𝐷0
𝑘𝑘𝑠𝑠∗ = (1 − 𝐿𝐿)𝑘𝑘𝑒𝑒∗ + 𝐿𝐿𝑘𝑘𝑑𝑑 (1 − 𝑇𝑇) and 𝐿𝐿 =
𝑉𝑉0
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Note that we have matched …

• the cash flow – 𝐹𝐹𝐹𝐹𝐹𝐹 𝑢𝑢 + 𝜃𝜃𝜃𝜃 includes the value of franking credits and so is
measured after-company-before-personal-tax

• to the discount rate – 𝑘𝑘𝑒𝑒∗ and therefore 𝑘𝑘𝑠𝑠∗ includes the value of franking
credits and so is measured after-company-before-personal-tax

We can interpret 𝑘𝑘𝑠𝑠∗ as the standard WACC based on grossed-up equity returns

Extension Note: Officer (1994) shows how to adjust the WACC for imputation in a perpetuity setting. This corresponds
to after tax case (iv) in Officer (1994 p.8). Monkhouse, 1996, The Valuation of Projects Under the Dividend Imputation
Tax System, Accounting and Finance, 36, 185–212 extends Officer’s results to a non-perpetuity setting and allows for
less than full payout of cash flow and franking credits each period.

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Where Does The Formula For 𝑘𝑘𝑠𝑠∗ Come From ?

As in the one period standard WACC model, the current value of debt is …
𝑌𝑌+𝑃𝑃
𝐷𝐷0 = and 𝑌𝑌 = 𝑘𝑘𝑑𝑑 𝐷𝐷0
1+𝑘𝑘𝑑𝑑

But the current value of equity is now …

𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 + 𝜃𝜃𝜃𝜃
𝐸𝐸0 =
1 + 𝑘𝑘𝑒𝑒∗

… where 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 is the expected FCFE generated by the firm during the period

Again, we have matched …

• the cash flow – 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 + 𝜃𝜃𝜃𝜃 includes the value of franking credits and so is
measured after-company-before-personal-tax

• to the discount rate – 𝑘𝑘𝑒𝑒∗ includes the value of franking credits and so is
measured after-company-before-personal-tax
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The derivation is then similar to what we did in class 3. We start with …

𝐹𝐹𝐹𝐹𝐹𝐹 𝑢𝑢 = 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 + 𝑌𝑌 + 𝑃𝑃 − 𝑌𝑌𝑌𝑌

Add the value of franking credits to each side …

𝐹𝐹𝐹𝐹𝐹𝐹 𝑢𝑢 + 𝜃𝜃𝜃𝜃 = 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 + 𝜃𝜃𝜃𝜃 + 𝑌𝑌 + 𝑃𝑃 − 𝑌𝑌𝑌𝑌

𝐸𝐸0
Divide both sides by 𝑉𝑉0 , multiply the first two terms on the RHS by and work
𝐸𝐸0
through the algebra to give …

𝑘𝑘𝑠𝑠∗ = (1 − 𝐿𝐿)𝑘𝑘𝑒𝑒∗ + 𝐿𝐿𝑘𝑘𝑑𝑑 (1 − 𝑇𝑇)

19
How Do You Adjust The Vanilla WACC Model For Imputation ?

The one period vanilla WACC model is adjusted in a similar way …

The enterprise value today is equal to the present value of the expected future free
cash flow and franking credit discounted at a rate 𝑘𝑘𝑣𝑣∗ …

𝐹𝐹𝐹𝐹𝐹𝐹 + 𝜃𝜃𝜃𝜃
𝑉𝑉0 =
1 + 𝑘𝑘𝑣𝑣∗
… where
𝐷𝐷0
𝑘𝑘𝑣𝑣∗ = (1 − 𝐿𝐿)𝑘𝑘𝑒𝑒∗ + 𝐿𝐿𝑘𝑘𝑑𝑑 and 𝐿𝐿 =
𝑉𝑉0

Extension Note: This corresponds to after tax case (iii) in Officer (1994 p.7).

The Key Idea is …

We adjust the standard WACC model and vanilla WACC model

for imputation by including the value of franking credits
in both the cash flow and the discount rate
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3. ADJUSTING THE CAPM FOR IMPUTATION

Recall, the usual formula for the CAPM (which is commonly called the Sharpe-
CAPM) states that in equilibrium the expected return on a stock is given by …

𝐸𝐸�𝑟𝑟𝑗𝑗 � = 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝑗𝑗 �𝐸𝐸(𝑟𝑟𝑀𝑀 ) − 𝑟𝑟𝑓𝑓 �

… where 𝐸𝐸�𝑟𝑟𝑗𝑗 � is the expected return on stock 𝑗𝑗, 𝑟𝑟𝑓𝑓 is the risk-free return, 𝛽𝛽𝑗𝑗 is
the beta of stock 𝑗𝑗 and 𝐸𝐸 (𝑟𝑟𝑀𝑀 ) − 𝑟𝑟𝑓𝑓 is the market risk premium

The Sharpe-CAPM was derived without any explicit assumption concerning taxes
but is usually applied in a classical tax system to estimate after-company-before-
personal-tax returns.

Extension Note: Brennan, 1970, Taxes, Market Valuation and Corporate Financial Policy, National Tax Journal, 23,
417–427, extends the Sharpe-CAPM to incorporate the effects of personal taxes on income and capital gains.

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Officer (1994) suggests that the Sharpe-CAPM would take the following form under
an imputation tax system …

𝐸𝐸�𝑟𝑟𝑗𝑗∗ � = 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝑗𝑗∗ �𝐸𝐸 (𝑟𝑟𝑀𝑀∗ ) − 𝑟𝑟𝑓𝑓 �

where 𝐸𝐸�𝑟𝑟𝑗𝑗∗ � is the expected after-company-before-personal-tax return on stock 𝑗𝑗 ,

𝐸𝐸 (𝑟𝑟𝑀𝑀∗ ) is the expected after-company-before-personal-tax return on the market
𝐶𝐶𝐶𝐶𝐶𝐶�𝑟𝑟𝑗𝑗∗ ,𝑟𝑟𝑀𝑀
∗
�
portfolio, 𝑟𝑟𝑓𝑓 is the risk-free return and 𝛽𝛽𝑗𝑗∗ = ∗� is the beta of stock 𝑗𝑗 (based
𝑉𝑉𝑉𝑉𝑉𝑉�𝑟𝑟𝑀𝑀
on grossed-up returns)

… in other words, we use the Sharpe-CAPM in the usual way but with grossed-
up returns (based on capital gains, dividends and franking credits) instead of
with returns based on capital gains and dividends only

We will call this the Officer CAPM

Extension Note: Officer (1994) conjectures but does not derive the model. Handley (2014) identifies the minimum set
of assumptions that would support the model and importantly derives the key definition of theta in this context.

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4. ESTIMATING THETA

Which Value Of Theta Should We Use In Our Valuation ?

We know that franking credits have different values to different investors and so an
important question is which investor should we choose ?

A franking credit is an asset which generates a single cash flow (saving in personal
tax) and so it seems reasonable to assume that franking credits would be valued
like any other asset in the market

… this suggests that we want the utilisation value of distributed franking credits
to the market as a whole rather than the utilisation value to any single
investor or the utilisation value to any single class of investors

Handley (2014) shows, within the framework of the Officer CAPM, the equilibrium
value of a distributed franking credit is given by …

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 𝜔𝜔 𝜃𝜃
∑ 𝑖𝑖 𝑖𝑖
𝜆𝜆𝑖𝑖
𝜃𝜃 = 𝜔𝜔𝑖𝑖
∑
𝜆𝜆𝑖𝑖

where 𝜔𝜔𝑖𝑖 is the proportion (by value) of risky assets in the market held by investor
𝑖𝑖, 𝜆𝜆𝑖𝑖 is a measure of investor 𝑖𝑖‘s relative risk aversion and the summation is taken
over all investors 𝑖𝑖 = 1, . . , 𝑚𝑚 in the market

… in other words, in equilibrium, theta represents a wealth-and-risk-aversion

weighted average of the value of a distributed franking credits to all investors
in the market

Extension Note: The interpretation of theta as a complex weighted average of investor utilisation rates is consistent with
results in Monkhouse, 1993, The Cost of Equity Under the Australian Dividend Imputation Tax System, Accounting and
Finance, 33, 1–18 and Lally and van Zijl, 2003, Capital Gains Tax and the Capital Asset Pricing Model, Accounting
and Finance, 43, 187–210. Monkhouse derives a CAPM under an imputation tax system which allows for personal taxes
on income and capital gains and distinguishes between distributed and retained imputation credits. Lally and van Zijl
derive a CAPM under an imputation tax system which allows for differential personal taxes on income and capital gains
and distributed imputation credits only. Both the Monkhouse CAPM and the Lally-van Zijl CAPM can be regarded as
adaptions of the Brennan CAPM to an imputation tax system.

24
Extension Note: There are several common ways to estimate theta including: the equity ownership approach based on
aggregate foreign ownership data from either the Australian Bureau of Statistics, Australian Taxation Office and or the
Australian Stock Exchange; the historic credit utilisation rate approach based on aggregate taxation statistics from the
ATO and implied market value studies including dividend drop-off studies. All approaches are subject to substantial
uncertainty and so estimation of theta is imprecise. For a detailed discussion of the many issues involved in estimating
the value of franking credits see chapter 11 of Australian Energy Regulator, 2018, Rate of Return Instrument:
Explanatory Statement, Commonwealth of Australia, December available at: www.aer.gov.au

Is Gamma The Same Thing As Theta ?

Officer (1994 p.4) introduces the parameter gamma which he describes as …

“ 𝜸𝜸 can be interpreted as the value of a dollar of tax credit to the shareholder”

Despite sounding similar there is an important distinction between 𝜃𝜃 and 𝛾𝛾 which

comes from considering the three stages in the life of a franking credit …

• franking credits are generated when the company pays tax

• franking credits are distributed when the company pays a franked dividend

• franking credits are utilised when a distributed credit is used to reduce the
personal tax of the investor who received it
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Gamma 𝜸𝜸 refers to the utilisation value of a generated franking credit

Theta 𝜽𝜽 refers to the utilisation value of a distributed franking credit

In a perpetuity framework, 100% of the free cash flow to equity and 100% of the
franking credits generated each period is paid out as franked dividends in that
period, which means …
𝛾𝛾 = 𝜃𝜃

But in a non-perpetuity framework, not all the free cash flow to equity and franking
credits generated in a period is paid out in that period which leads to …

𝛾𝛾 = 𝐹𝐹 × 𝜃𝜃 + (1 − 𝐹𝐹 ) × 𝜓𝜓

where 𝐹𝐹 is the franking credit distribution or payout ratio – representing the

proportion of credits generated that are distributed to shareholders – and 𝜓𝜓 (psi) is
the utilisation value of a retained franking credit

… which means gamma can be interpreted as a weighted average of the value of a

distributed credit and the value of a retained credit

26
Extension Note: Officer (1994) assumes a perpetuity setting and so does not distinguish between credits generated and
credits distributed. He uses gamma to simply refer to the value of imputation credits in this case. We know that a
retained franking credit is worth less than the value of a distributed franking credit 𝜓𝜓 < 𝜃𝜃 due to the time delay in
distribution – but the difficult question is by how much.

5. MARKET PRACTICE

Market practice concerning imputation in valuation is mixed.

… broadly, regulators tend to explicitly take imputation into account whilst

valuation practitioners tend not to

For example, according to the most recent survey of valuation practices by KPMG

“Respondents were relatively divided with a third (32%) assuming a utilisation factor of 0%
when imputation benefits were included as an adjustment to cash flow … Almost all
(92%) respondents indicated that they did not use a gamma factor in discount rates”. 1

1
KPMG, Valuation Practices Survey, 2019, p.14
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This is consistent with previous surveys which identifies multiple reasons for not
adjusting for imputation. For example, according to KPMG …

“The range of reasons offered for not adjusting for imputation credits is similar
to that found in Lonergan (2001). The common theme that emerges from most
expert reports is that whilst imputation credits are valuable to investors,
including such value in company valuations or the cost of capital involves more
complex considerations” 2

More recently, Grant Samuel suggests that …

“available tools such as the CAPM involve [amongst other things] …

unresolved issues (such as the impact of dividend imputation)”. 3

But perhaps there is a way out of the complexities of having to estimate the value
of franking credits …

2
KPMG, 2005, Cost of Capital – Market Practice in Relation to Imputation Credits, August., p.14
3
Source: Billabong International Limited, Scheme Booklet, 14 February 2018, page 138
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6. DO WE NEED TO WORRY ABOUT ADJUSTMENTS FOR
IMPUTATION ?

If we wish to use the standard WACC model or the vanilla WACC model adjusted
for imputation then we need to estimate three additional parameters …

• the franking credit distribution ratio 𝐹𝐹

• the utilisation value of a distributed franking credit 𝜃𝜃

• the utilisation value of a retained franking credit 𝜓𝜓

… and this is not an easy task !!

Extension Note: For example, the chapter dealing with the valuation of franking credits in the Australian Energy
Regulator, 2018, Rate of Return Instrument: Explanatory Statement, Commonwealth of Australia is 75 pages long !!.

But there is another way � …

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We can simply continue to use the standard WACC model and the vanilla WACC
model in the usual way …

• that is, we do not include the value of franking credits in either the cash flow
or in the discount rate

• for example, in the case of the one period standard WACC model, the
enterprise value today is still equal to the present value of the expected future
unlevered free cash flow discounted at a rate 𝑘𝑘𝑠𝑠 …

𝐹𝐹𝐹𝐹𝐹𝐹 𝑢𝑢
𝑉𝑉0 =
1 + 𝑘𝑘𝑠𝑠

where
𝑘𝑘𝑠𝑠 = (1 − 𝐿𝐿)𝑘𝑘𝑒𝑒 + 𝐿𝐿𝑘𝑘𝑑𝑑 (1 − 𝑇𝑇)

• but what changes is our interpretation of the cash flow and the discount rate

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Under a classical tax system, the standard WACC model is an after-company-before-
personal-tax approach to valuation.

… but under an imputation tax system, the standard WACC model is an after-
company-after-some-personal-tax approach to valuation.

The Key Idea is …

We can continue to use the standard WACC model and the vanilla WACC model
in the normal way – that is, without having to explicitly recognise
the value of franking credits in either the cash flow or the discount rate

W7

Importantly, this approach avoids having to estimate or make any assumption

about the value of franking credits

Extension Note: This corresponds to after tax case (i) in Officer (1994 p.6) but Officer does not appear to recognise its
significance. Specifically, he does not mention that his formula for the standard WACC adjusted for imputation (equation
(7)) is equivalent to the usual formula for the standard WACC (equation (8)) – and not just, as he points out, when
franking credits have zero value.
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