The impact of secondary tax

Abstract

The intention of the introduction of a secondary tax on companies (STC) and the lowering of the normal income tax rate in 1993 was to encourage companies to re-invest profits to make use of capital investment opportunities. The 2007 budget again raised questions about how the proposed changes in STC would impact the value of companies. This study investigates the effect of these tax changes and all subsequent changes since 1993 on the cost of capital. An up-to-date analysis of payout ratios of listed SA companies indicates a steady decline from a median of 40% in 1993 to a median of 26% in 2006, vindicating STC to a certain extent. However, instead of lowering the cost of capital of companies in South Africa, it appears as if these tax measures actually increased the WACCs, all other things being equal, by more than 0.5%. As typical free cash flow valuations have WACC in the denominator, and considering the number of companies affected, the destruction of shareholder wealth is considerable. Needless to say, there is no stronger disincentive for increased capital investment than value destruction. The most important insight coming to the fore in this study is that if an opportunity cost approach is followed, the cost of equity is unaffected by both the STC and the dividend payout ratio. The cost of preference shares is actually increased by the STC, even if its impact is limited because of the low average weight and use of preference shares in capital structures. The after-tax cost of debt is negatively impacted by decreases in the normal tax rate.