Here at Shmoop, we don’t let Frank do too much. He’s the kind of guy who always jams the copier or always spills coffee all over the important contracts. Anything goes wrong, we say it got “franked.”
Luckily for you dividend recipients, our Frank has nothing to do with a franked dividend. Instead, it’s a tax policy meant to prevent dividends from getting taxed twice. (Most prominently in place in Australia.)
A company earns a profit for the year. It wants to return some of the profit to its shareholders. So, it wants to issue a dividend. Meanwhile, the company’s profits are taxed. Once it pays its tax bill, it uses its remaining after-tax profits to pay for the dividend. Without the franked policy, the shareholders would then get taxed on the dividend they receive. Double taxation. The pot of money that makes up the company’s profits are taxed once as corporate tax, and then again when those funds get sent out as dividends.
Governments with franked dividends (like in Australia) want to avoid this. So they have the franked dividend policy. In this structure, the tax rate of the company paying the dividend helps inform the dividend tax paid by the shareholders who receive them. The government keeps in mind the taxes already paid on the money when determining the tax rate for the shareholders receiving the dividend.
Related or Semi-related Video
Finance: What is Dividend Coverage/the D...7 Views
finance a la shmoop what is dividend coverage and what is the dividend payout
ratio? whatever.com has earnings big earnings a hundred million dollars worth
of earnings this year from sales of a whole lot of whatever's the board green [People working in a factory]
lights a dividend payment of 40 million bucks that is the company will pay 10
million dollars to its common shareholders of record four times in
this next year the payout is 40 million because well
you know it's paid out and yeah clever titling know is never a thing on Wall
Street and the payout ratio is 40 over a hundred that hundred million of earnings [Payout ratio calculation appears]
or forty percent well why does the payout ratio even matter?
well companies hate having to cut their dividends and they love raising them if
the former well stock prices usually crash if the latter well they usually go
up and companies love it when their stock prices go up duh so what would [Whatever.com share price rises]
happen if whatever dot-com stumbled in its earnings tumbled and then
shareholders mumbled that the earnings payout ratio had crumbled that is... okay
stop with the rhyming bad timing okay now we're stopping and yeah that is what
if the earnings of whatever.com went down next year to only 50 million
remember they were a hundred million now they're only 50....hmm
problem because now the payout ratio is 80 percent 40 over 50 yeah very
difficult situation the company thought it would have tons of earnings to cover
its dividend at the forty million dollar level more or less forever
but clearly it did not so now what well if earnings recover and go back to a [Man discussing whatever.com's earnings]
hundred million dollars on their way to the 300 million they projected well,
then life is grand no sweat no heavy decisions to be made
but what if earnings fall further to be only thirty million the following year
well then whatever dot-com has to either borrow money or deplete its cash
reserves just to cover its dividend in which case the payout ratio would then
be over a hundred percent meaning that the earnings were 30 million and the [Earnings appear]
dividend was to be forty well then the payout ratio would be 40 over 30
133% ouch can't do that for very long without going bankrupt so payout ratios [Wheel spins and lands on bankrupt]
matter because they give a sense for the safety or certainty that that dividend
will continue at its present rate if the ratio is low well odds are good the
company could certainly afford to raise the dividend over time or at least not
cut it yeah for a very long time ideally and if the ratio is high well your [Dividend cut with scissors]
bottom line may soon be bottoming out back-end load there if i ever saw it...
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