David French | 18/02/2009 3:34:38 PM

This article was originally published in The Morning Bulletin on 14th February 2004

If you like Jargon, look no further than the financial pages of the newspaper. Let’s look at some common terms and their effect on your wealth.

Dividends are distributions paid to shareholders from company profits. The profits can be current year profits or profits accumulated from prior years. Directors decide what level of dividends will be paid, usually twice per year.

A profitable company will generally pay company tax. When directors declare a dividend, it is paid from after-tax income. In the bad old days, shareholders again paid tax on the dividend again. Assuming a 30 per cent company tax rate, and a 31.5 per cent personal tax rate, the investor would be paying 61.5 per cent of their share of company earnings to the tax-man. It’s easy to see how that would lead people to favour capital gain over dividends, and thus distort investment decisions. Such bias is now avoided through the use of franking credits. The cash component of the dividend now comes with a notice stating how much tax the company has already paid. The shareholder declares both amounts as income, and is then taxed at his or her marginal rate. It is commonly said that franking credits reduce your tax bill. This is not true, franking credits increase your pre-tax income. The amount of tax you paid is then determined by your taxable income (which includes the franking credits).

Capital returns are another way for a company to distribute money to shareholders. They occur when a company is carrying more shareholders funds than it needs to operate efficiently. Say you paid $1.00 for a share and the company announced a capital return of $0.10, you would receive a one-off non-taxable payment of $0.10. At this point a capital return is essentially a return of your own money. The value of a capital return lies in the mismatch between rates of income tax and the calculation of capital gains tax. In the preceding example, you pay no income tax on the $0.10 you received. At the same time however, the cost base of the shares is lowered from $1.00 to $0.90. If you sold the shares a year after you purchased them, then you would pay capital gains tax on the $0.10, at half your income tax rate. Capital returns are excellent if the company’s share price is robust.

Share splits and bonus issues occur when Directors feel that more people will be interested in their shares if the dollar price is low. They will issue more shares in the company, without making any alterations to the company itself. The result is more shares representing the same assets, and thus a lower share price. While share splits and bonus issues are sometimes followed by a rally in the share price (making shareholders better off), the improvement in wealth is usually to do with other factors – like higher profits or an expected acquisition. The reality is that alone, share splits and bonus issues leave the shareholder no better off. Imagine two shares trading at $10.00 and $1.00 respectively. Both shares have an expected return of 10 per cent. The person who buys the $10.00 share will get exactly the same return as the person who buys 10 individual $1.00 shares. The amount of dollars you pay for a share is unimportant, while the return you get from your spend is critical.

Rights issues occur when a company wants to raise more money. Existing shareholders are given the opportunity to buy more shares, usually at a discount to the market price. If the discount is not large, or the company has not been performing well, the value of the discount might be lost (the logic is much the same as for share splits). Rights can be renounceable or non-renounceable. The value of renounceable rights can be realized by selling the rights on the share market to a third party. Non-renounceable rights cannot be sold.

For those interested in finding out more I can recommend, “The Language of Money” by Edna Carew.

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