 A question arises that what amount of cash a firm should distribute among its shareholders or it should retain in the business. Now before going into the answer of this question, one must think that what purpose of XX cash the firm can have with itself. We know that the firm can use XX cash in projects or other financial instruments. Now under perfect market conditions, once a firm takes all the positive NPV projects, it becomes indifferent between the XX cash it can save or it can pay out to the shareholders. However, with certain market imperfections, there is a trade-off that is the XX cash retained by the firm can reduce the cost of issuing new capital in the future, but it also increases the taxes and the agency cost of the firm. Now we see that the new projects are financed by the cash retained by the firm with itself and the positive NPV projects undertaken by the firm are responsible for creating the shareholders value whereas the negative NPV projects do not create any value for the firm. However, once the firm takes all positive NPV projects, it becomes indifferent between the saving of the XX cash with itself or paying it out as dividend. This means that under perfect market conditions, the XX cash has no effect on the value of the firm. This means that retention versus payout decisions is similar to the dividend versus share repurchase decisions as both have no relation with the firm value because these are irrelevant to the value of the firm. Now to understand this relationship, let take an example in which we have a perfect market condition. The firm has access cash holding of 100,000. Now the firm has two options of using this access cash. The first option is that to buying off one year treasury bills and earn 6% rate of interest thereon retain it and pay to the shareholders after one year as the dividend. The second option is that the firm can immediately give out this access cash to the shareholders as dividend and these shareholders will be at liberty to invest this amount at their own. So, what will be the best option for the shareholders under perfect market condition? You see that the present value of option 1 using the proceeds of tables by the firm has an amount equal to 100,000 whereas the immediate dividend payment to the shareholders is also equal to the amount of 100,000. So, we see the implication of this access cash under perfect market conditions that this access cash holding or its immediate payment to the shareholders has nothing to do with the firm value. Now we have another example with the imperfect market condition and that imperfect market condition is the existence of the corporate taxes. Again we will be repeating the same example with the addition that now there is the corporate tax rate of 35%. So, what will be the best option for the shareholders under this imperfect market conditions and we assume that this shareholder is a pension fund investor. Now our example solution says that the future value of the first alternative is equivalent to 100 and 3000 whereas the present value, a future value of the second option in which the immediate amount is paid to the shareholder and the shareholder invest that amount at the rate of 6%. The future value of second option is equal to 106,000. Now in the conditions of imperfect market in the form of existence of taxes, we see that now shareholder is at the benefit as he is earning more future value than the company itself. What is the effect of investors' taxes on the firm value? See that the decense on dividend payments versus cash retentions may also affect the taxes paid by the shareholders. Now let's see an example. We have a firm who has only one asset of $100 and that is the cash. We assume identical tax rates for the investors. Now the firm has two options on this $100 cash. At first, the firm can immediately pay this amount as dividend to the shareholders and second option is that the firm can retain this cash and earn interest to pay a dividend to the shareholders next year. As a first option, if the firm pays dividend immediately and shuts down, then the share price will be equal to the price where we assume the X price is equal to 0 because the firm is shutting down. So the firm value will be equal to 0 plus 100 as dividend into 1 minus tax on dividend over 1 minus tax on the capital gain. Now tax on dividend or the TD is basically the tax that shareholder is paying on the dividend. Whereas TG is the tax credit allowed to the shareholders on the capital loss due to the shutdown by the firm. The second and the alternative option with the firm is that the firm can retain this cash and earn interest there on through the investment in T-bills. And after paying the corporate tax on the interest earned, the firm can pay the rest amount to the shareholders as a perpetual dividend every year. So in this case, the dividend that is going to the shareholder is basically the after tax cost of interest to the firm. This means that the shareholders or the investors cost of capital in this case will be equal to investing in T-bills at her own. And if the investor is investing this amount at its own, her cost of capital will be equal to after tax interest cost of capital which in this equation TI is the tax on the interest income earned by the investor. Now in these conditions, how the firm value can be determined to see that the price of the firm then will be equal to the combined effect of the corporate tax rate and tax on the dividend in relation to the tax on the interest income earned by the shareholder. And that relationship is basically representing the effective tax disadvantage to the shareholders. Now we see that the interest on cash returned by a firm is taxed twice as we have seen in our earlier equation. It takes in two ways. At first, the firm pays tax on the cash retention at the rate of tax C or the corporate tax and then the investor pays tax on the increased value of the firm at the rate of G or the capital gain tax. The earnings made by the shareholders at their own are taxed once, so there is the difference between the earnings by the firm and the earnings by the shareholder, the cash retained by the firm and the firm is earning interest there on and then it distributes the amount to the shareholders. The firm is earning, the firm is paying tax twice whereas if the shareholder is alone investing the amount and paying tax, he is paying tax only once, so the cost of retaining cash depends upon the combined effect of the corporate tax, tax on dividend and the tax on interest earned by the shareholder. Let's see an example to understand this effect. We have a corporate tax rate of 35%, dividend tax rate of 39.6% and the capital gain tax of 20%. The effective takes disadvantage in this case for the shareholder on retained cash is equal to 13.9%. So we see that after adjusting for the investor's taxes, there is still a large tax disadvantage for the shareholder of the firm and that is due to the excess cash retained by the firm.