The valuation of franking credits in Australia's imputation-based tax system has been a topical and contentious issue in recent years, due to the significant implication it has in both academic and commercial settings. A myriad of methods have emerged in an attempt to assign a value to 'gamma' or ' r', which is the value of franking credits that should be incorporated into the determination of firms' costs of capital, as demonstrated by Officer (1994).
This thesis builds upon the body of literature relating to the use of dividend drop-off estimation to value franking credits. Specifically, the focus is on why past studies have obtained a drop-off estimate less than one for unfranked dividends, when U.S. evidence suggests that cash dividends are fully valued by investors trading around the ex-dividend date. This study contributes to the existing literature with the implementation of the Boyd and Jagannathan (1994) method of dividend drop-off estimation. This econometric technique is yet to be directly applied to the Australian imputation setting, despite its apparent superiority to past drop-off estimation methods.
Although a definitive solution is not found to the 'puzzle' regarding the ex-dividend behaviour of Australian cash dividends, a detailed analysis of the dividend sample casts significant doubt over the use of this estimation technique for valuing franking credits. Specifically, it is shown that the investors who have the greatest int1uence over the ex-dividend drop-off estimates are inconsistent with the investor group of interest for the valuation of franking credits in a cost of capital context.