A growing body of literature has attempted to determine the market value of a dollar of imputation credits (theta). By observing the market prices of securities around the ex-dividend date, these studies have consistently estimated that theta is significant and positive. Another subset of literature however, has consistently found that imputation credits do not affect a firm’s cost of capital, and are not capitalised into stock prices. These conflicting results provide a puzzle within the literature. We theorise, and then empirically show, that the values of theta observed in prices around the ex-dividend date are inflated upwards by the activity of short-term traders and arbitrageurs. Once we exclude their activity from our analysis, we use a considerable sample of 200,000 observations, to show that the market value of imputation credits is insignificantly different from zero. These results provide us with evidence that, consistent with the cost-of-capital literature, long-term providers of equity place no value on imputation credits. Our results therefore act to bridge the gap between these two areas of research, and solve the puzzle that exists within the literature. The fact that these imputation credits are priced into futures contracts at a value far below their face value also raises the question: are domestic investors able to exploit this low value by simultaneously entering into two opposing positions – a long position in the company’s stock, and a short position in a futures contract to sell the stock after the ex-dividend date – and successfully generate arbitrage profits? We find that this dividend-capturing arbitrage strategy has been able to consistently produce significant, abnormal returns over our 19 year sample period. We find that even after incorporating explicit transaction costs and collateral requirements, a small domestic investor is able to generate between 0.86% and 2.83% monthly abnormal returns with the top 10 percent of profitable observations in financial year 2014.

/pdf/the-impact-of-dividend-capturing-arbitrage-on-the-market-cyq1cg3ipz.pdf

The impact of dividend-capturing arbitrage on the market value of imputation credits

Estimating the market value of dividend imputation tax credits is an important component of cost of capital estimation for companies operating within a dividend imputation tax system. There is a divergence of views about what represents an appropriate estimate of this value, and the different values that have been proposed have a substantial impact on the estimates of the cost and value of equity. This thesis provides a range of empirical evidence on the appropriate estimate of the value of imputation credits by conducting three major studies, each approaching the issue from a different angle. In the first study we infer the value of cash dividends, and the imputation tax credits that are attached to them, from simultaneous trades of ordinary shares (which entitle the holder to dividends and imputation credits) and individual share futures contracts (which provide no such entitlement). Our sample contains more than 30,000 observations from the period subsequent to the year 2000 change in tax laws that allowed a rebate for unused credits. Over this sample we find that the value of the combined bundle of one dollar of cash dividend and imputation credit is close to one dollar. We also show that the value of cash dividends and the value of imputation credits are estimated jointly and that it is important that they are interpreted jointly.The second study provides a complementary approach to the first by utilizing the prices of alternative derivative securities to infer the embedded value of dividends. We infer the value of the dividend package that is comprised of cash dividends, and the imputation tax credits that are attached to them, from simultaneous trades of ordinary shares (which entitle the holder to dividends and imputation credits) and exchange traded call options (which provide no such entitlement). Our sample contains more than 370,000 observations from the period subsequent to the year 2000 change in tax laws that allowed a rebate for unused credits. Over this sample, we estimate the value of the dividend package tobe approximately equal to the  face value of the cash dividend.The third study examines the market impact of various significant changes to the dividend tax system to draw conclusions about the value of imputation credits incorporated in equity prices. The results of the third study suggest that the introduction of dividend imputation had no significant impact on equity prices in Germany and Australia. Our pricing model for Germany reveals no detectable difference in returns for the period of the introduction of dividend imputation and those of control period. Likewise our pricing model for Australia finds no difference between returns in the introduction period and those in the control period.The results of all three studies are consistent with dividend imputation having an immaterial effect on the cost of capital of Australian firms. This evidence is also consistent with the dominant commercial and market practices of making no adjustment in relation to dividend imputation when estimating the cost of capital or performing any other valuation exercises.

Dividend imputation tax credits: Valuation implications

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Dividend imputation tax credits: Valuation implications