Dividend policy

1
Dividend policy

• Concepts and exemplification

2
Objective

• Understand the role of dividend policy in the
  context of the firms overall financial policy.

3
Outline

• Types of dividends
• The dividend time line
• Stock price reaction
• Dividend policy irrelevance
• Theories explaining dividend policy

4
Dividends come in many forms

• Regular cash dividend
• Extra dividends
• Liquidating dividends
• Shares repurchases
• Stock dividends

5
Dividend time Line

• Declaration date
• Cum-dividend date
• Ex-dividend date
• Record date
• Payment date

6
Ex-dividend day Stock price reaction

• The stock price will drop by the amount forgone
  by the average investor
• Clarification
• Pcum D0 D1/(1 r)2 D2/(1r)3
• Pex D1/(1 r)2 D2/(1r)3

7
Stock price reaction (con't)

• With taxes, the price drop D(1-Td)/(1-Tcg)
• Td tax on dividend (average investor)
• Tcg tax on capital gain (average investor)

8
Dividend Policy Does it matter? Is there an
optimal dividend policy?

• If no, focus on the investment decision
• If yes, what is the optimal policy?

9
View 1 Dividend policy is irrelevant

• Shareholders are able to undo firm's dividend
  policy.
• MM firm value is independent of the dividend
  decision.

10
View 1 Dividend policy is relevant

• Bird-in-hand story
• A 1 in dividend now is worth more than 2 in
  dividend later on.
• Signaling
• Dividend increase Good times ahead
• The free cash-flow hypothesis
• 1 in dividend is 1 less to spend on MA

11
View 1 Dividend policy is relevant (contd)

• Clientele effect
• Some want dividends while others want capital
  gains
• Tax effect

12
Tax effect

• REC Company has 1,000 in extra cash. It can
  invest this cash in a 5-year T-bill at 8, or it
  can pay the cash to the shareholders as a
  dividend. Shareholders can also invest in
  T-bills. Assume a 44 corporate tax, a 40
  individual tax on interest, and 30 individual
  tax on dividend income.
• If dividend is paid now, shareholders get
• 1000(1-0.3)1 (0.08)(1-0.4)5884.9
• If dividend is invested, shareholders get
• 10001 (0.08)(1-0.44)5(1-0.3) 871.5
• Shareholders would be indifferent between
  receiving the dividend now as opposed to
  receiving it later if and only if
• (1-TE)1r(1-TP) 1r(1-TC)(1-TE)

13
Tax effect (contd)

• Investors would like a dividend according to
  their tax preferences
• Tax-exempt investors, investors in low tax
  brackets, etc. prefer high current dividend
• Investors in high tax brackets prefer capital
  gains

14
Agency costs explanation of dividends

• Paying dividends can result in a need for
  external financing.
• Raising equity and/or debt more often intensifies
  markets scrutiny of the company.

15
Reality check

• Earnings increase one year before dividend
  initiation.
• Earnings decrease one year before dividend
  omission.
• Following dividend initiation, earnings increases
  appear to be permanent.
• Following dividend omission, earnings decreases
  appear to be temporary.
• Weak reaction to earnings changes following
  dividend changes.

16
Overview of financial policy Why is it important?

• Capital structure policy, long-term financing
  policy, dividend policy, etc.do have some impact
  on market valuation.
• Remember, however
• Capital budgeting is the bread and butter of
  wealth maximization.
• Financial policy is only fine-tuning.