DIVIDEND POLICY I: The Theory

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DIVIDEND POLICY I The Theory

• Saeid Samiei

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Overview

• Intro
• Theories
• Irrelevance MM
• Low Payout Taxation
• High Payout
• Real World
• Alternative Approaches Stock Repurchase

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First Principles

• Invest in projects that yield a return greater
  than the minimum acceptable hurdle rate.
• The hurdle rate should be higher for riskier
  projects and reflect the financing mix used -
  owners funds (equity) or borrowed money (debt)
• Returns on projects should be measured based on
  cash flows generated and the timing of these cash
  flows they should also consider both positive
  and negative side effects of these projects.
• Choose a financing mix that minimizes the hurdle
  rate and matches the assets being financed.

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First Principles (cont)

• If there are not enough investments that earn the
  hurdle rate, return the cash to stockholders.
• The form of returns - dividends and stock
  buybacks - will depend upon the stockholders
  characteristics.
• Objective Maximize the Value of the Firm

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Dividends are sticky
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Dividends follow the Life Cycle
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More companies are buying back stock..
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Measures of Dividend Policy

• Dividend Payout
• measures the percentage of earnings that the
  company pays in dividends
• Dividends / Earnings
• Dividend Yield
• measures the return that an investor can make
  from dividends alone
• Dividends / Stock Price

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Dividend Payout Ratios in US
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Dividend Yields in US
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Standard Method of Cash Dividend Payment
Cash Dividend - Payment of cash by the firm to
its shareholders.
Ex-Dividend Date - Date that determines whether a
stockholder is entitled to a dividend payment
anyone holding stock before this date is entitled
to a dividend.
Record Date - Person who owns stock on this date
received the dividend.
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Basic Dividend Valuation Model

• The value of a share is generally defined as the
  capitalised value of its stream of future
  dividends
• where
• g - is the growth rate of the firm
• rs - cost of equity

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Procedure for Cash Dividend Payment
25 Oct.
1 Nov.
2 Nov.
6 Nov.
7 Dec.

Ex-dividend Date
Declaration Date
Cum-dividend Date
Record Date
Payment Date
Declaration Date The Board of Directors declares
a payment of dividends.
Cum-Dividend Date The last day that the buyer of
a stock is entitled to the dividend.
Ex-Dividend Date The first day that the seller
of a stock is entitled to the dividend.
Record Date The corporation prepares a list of
all individuals believed to be stockholders as of
6 November.
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Price Behavior around the Ex-Dividend Date

• In a perfect world, the stock price will fall by
  the amount of the dividend on the ex-dividend
  date.

-t -2 -1 0 1 2
P
P - div
The price drops by the amount of the cash dividend
Ex-dividend Date
Taxes complicate things a bit. Empirically, the
price drop is less than the dividend and occurs
within the first few minutes of the ex-date.
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Three Schools Of Thought On Dividends

• 1. If
• (a) there are no tax disadvantages associated
  with dividends
• (b) companies can issue stock, at no cost, to
  raise equity, whenever needed
• Dividends do not matter, and dividend policy does
  not affect value.
• 2. If dividends have a tax disadvantage,
• Dividends are bad, and increasing dividends will
  reduce value
• 3. If stockholders like dividends, or dividends
  operate as a signal of future prospects,
• Dividends are good, and increasing dividends will
  increase value

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The Miller-Modigliani Hypothesis

• Dividends do not affect value
• Basis
• If a firm's investment policy (and hence cash
  flows) don't change, the value of the firm cannot
  change with dividend policy. If we ignore
  personal taxes, investors have to be indifferent
  to receiving either dividends or capital gains.

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Underlying Assumptions

• Perfect Capital Markets
• (a) There are no tax differences between
  dividends and capital gains.
• (b) If companies pay too much in cash, they can
  issue new stock, with no flotation costs or
  signaling consequences, to replace this cash.
• Investment Policy
• (c) If companies pay too little in dividends,
  they do not use the excess cash for bad projects
  or acquisitions.
• Homogenous Expectations
• (d) All individuals have the same beliefs
  concerning future investments, profits, and
  dividends

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Implications

• No change in value of equity due to dividend
  policy
• No correlation between dividend policy and stock
  returns

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Low Payout

• The Tax Response Dividends are taxed more than
  capital gains
• Basis
• Dividends are taxed more heavily than capital
  gains. A stockholder will therefore prefer to
  receive capital gains over dividends.

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Low Payout

• Reasons why Dividends are Bad
• Taxes
• Transactions Costs

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Implications

• More Individual Investors
• gt Lower Dividends
• The Higher the Income/Tax rates of Investors
• gt Lower Dividends
• Tax Disadvantage Increases
• gt Dividends decrease

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Evidence

• Examining ex-dividend dates should provide us
  with some evidence on whether dividends are
  perfect substitutes for capital gains.

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Price Behavior on Ex-Dividend Date

• Let Pb Price before the stock goes ex-dividend
• Pa Price after the stock goes ex-dividend
• D Dividends declared on stock
• to, tcg Taxes paid on ordinary income and
  capital gains respectively

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Cashflows from Selling around Ex-Dividend Day

• The cash flows from selling before then are
• Pb - (Pb - P) tcg
• The cash flows from selling after the ex-dividend
  day are-
• Pa - (Pa - P) tcg D(1-to)

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• Since the average investor should be indifferent
  between selling before the ex-dividend day and
  selling after the ex-dividend day
• Pb - (Pb - P) tcg Pa - (Pa - P) tcg D(1-to)

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Price Change, Dividends and Tax Rates

• Moving the variables around, we arrive at the
  following.

If Pb - Pa D then to tcg Pb - Pa lt D then
to gt tcg Pb - Pa gt D then to lt tcg
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The Evidence on Ex-Dividend Day Behavior
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High Payout - Investors Like Dividends

• Long (1978) CitizenUtility
• Class A (Stock Dividend) Class B (Cash
  Dividend)
• Class B sold _at_ premium
• Reasons
• Pay Little Tax
• Desire for Current income
• Trusts Endowments
• Transaction Costs

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Clientele Effect

• Some Investors like Low Dividends (e.g.
  Microsoft)
• Def Clustering of stockholders in companies with
  dividend policies that match their preferences
• Older and poorer investors more likely to hold
  high-dividend-paying stocks than younger and
  wealthier investors.
• gt safer companies, with older and poorer
  investors, tended to pay more in dividends than
  companies with wealthier and younger investors.

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Clientele Effect - Implications

• Firms get the Investors they deserve
• "Sticky Dividend Policies"
• Supports the Irrelevance Theory

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Information Signalling

• Positive Signal Information Content
  Expectation of Larger Future Earnings, Palepu
  (1986)
• Empirical Evidence
• Stock Price Rise following Dividend Increase,
  Asquith Mullins (1983)
• Stock Price Falls following Dividend Omissions,
  Healy Palepu (1988)

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Unrealistic Reasons for Paying Higher Dividend

• The Birds in the Hand Fallacy
• Temporary Excess Cash

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Pros Cons of Paying Dividends
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Reality- What do we know?

• Lintner (1956)
• Follow Earnings
• Sticky
• Smooth Dividends
• Corporate Dividends are Substantial
• Fewer Companies are Paying Dividends
• Information Content

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Alternative Approaches of Returning Cash to
Stockholders

• Equity Repurchases
• Forward Contracts
• Stock Dividends Stock Splits
• Spin-offs Split-Offs

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Equity Repurchases

• Instead of declaring cash dividends, firms can
  rid itself of excess cash through buying shares
  of their own stock.
• Recently share repurchase has become an important
  way of distributing earnings to shareholders.

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Stock Repurchase versus Dividend
Consider a firm that wishes to distribute
100,000 to its shareholders.

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Stock Repurchase versus Dividend
If they distribute the 100,000 as cash dividend,
the balance sheet will look like this
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Stock Repurchase versus Dividend
If they distribute the 100,000 through a stock
repurchase, the balance sheet will look like this
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Share Repurchase The Rationale

• One-time return of cash
• Greater Flexibility
• Tax Advantages
• Give to the Needy
• Increase Insider Control
• Support Stock Price

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To Do

• Review Questions
• Case Study Apple Computers
• Article Why is the Dividend Yield So Low