Dividend Policy

1
Dividend Policy
8-1
2
Overview

• Practical Aspects
• Benchmarking Irrelevance revisited
• Policy
• Low dividends
• High dividends
• Policy refers to the tradeoff between paying
  dividends at a particular date versus paying on a
  different date - not about the level of dividends

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Types of Dividends

• Regular cash dividends
• extra cash dividend
• liquidating dividend
• Stock dividends
• increases number of outstanding shares
• no cash flow
• Stock split
• similar yet larger than stock dividend

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Important Dates

• Declaration date
• Date of record
• Ex-dividend date
• Date of payment

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Irrelevance Example

• Consider a firm that exists 1 year and consists
  of only an expected cash flow of 10,000 at the
  end of the year and 10,000 immediately. The firm
  is all-equity financed with rE10. The firm will
  match its dividend payments with the cash flows.
  The firm has 1,000 shares outstanding.
• V0 D1 D2 / (1rE) 10,000 10,000 / (1.1)
  19,090.91
• Share price 19,09 (cum dividend)
• Share price 9.09 (ex dividend1)
• Proposed new dividend policy is to pay 11 per
  share immediately. The excess cash needed is
  financed through an equity issue, again yielding
  a 10 return.
• What is the value of the firm under the new
  policy?
• At what price can the new shares be issued and
  how many?

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Answer

• New shareholders require 10 and hence require
  1,100 at the end of the year, leaving 8,900, or
  8,90 per share, in dividends for the existing
  shareholders.
• Share price for existing shareholders (cum
  dividend) 11 (8.90/1.1) 19.09
• Issue price new shares 19.09118.09 (or
  8.90/1.1)
• Number of new shares offered 1,000 / 8.09
  123.61 shares
• Assumptions for this irrelevance to hold
• no taxes or transactions costs (perfect markets)
• homogeneous expectations
• investment policy is independent of dividend
  policy

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Dividends and Taxes

• Effective tax rate is higher on dividends than on
  capital gains
• Firm with insufficient cash
• transaction costs of financing price pressure
  effect
• tax effect of paying dividends
• stability issue of maintaining a constant level
• Firms with sufficient cash
• Agency costs of free cash flow
• Investing in financial assets (Tcorporate versus
  Tpersonal)

8
Dividends versus Repurchases

• Irrelevant under perfect markets
• Tax benefit of share repurchases
• Targeted Repurchases
• Investment opportunity and signaling

9
Expected returns and dividend yield

• Pretax returns are increasing in the dividend
  yield
• Dividend yieldannual dividends per share/share
  price
• Empirical evidence is mixed
• Dividend yield is highly correlated with
  Book-to-Market
• Should firms have High or Low Dividend policies?
• Current income
• Uncertainty
• Tax arbitrage
• Agency costs

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The Information Content of Dividends

• Results so far
• Irrelevance because of homemade dividends
• Low dividends because of taxes
• High dividends because of current income etc.
• Empirical evidence
• Stock price is positively related to changes in
  dividends
• Consistent with . . . .?
• Or . . . .?
• Signaling and the information content of dividends

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Other issues

• Clientele effect
• Different tax brackets result in demand for
  different levels of dividends
• Value creation can only occur if dissatisfied
  clientele exists - unlikely!
• Despite taxes - dividends are substantial
• Decline in the number of dividend paying
  companies
• Dividend smoothing