Dividend Policy
Chapter 18 – 7,11,13,17
DIVIDEND POLICY: OVERVIEW
I. Mechanics.
II. Why do firms pay dividends?
1. Dividends don't matter (Modigliani Miller, 1961).
2. Introduction of personal taxes:
Dividends are taxed heavier than capital gains
(arguments against dividend payments).
Dividend policy is tailored to meet clientele needs.
3. Dividends are more certain than capital gains.
(bird in hand fallacy)
4. Dividends are signals.
5. Dividends reduce the agency problems.
III.Framework for analyzing dividend policy
I.
Mechanics
Cash dividends
Stock dividends / stock splits
Stock repurchases:
Open market purchases
Targeted share repurchase
Dutch auction share repurchase
Significant dates:
11/15
Declaration
date
12/13
Ex-dividend
date
12/15
Holder-of-record
date
1/2
Payment
date
II. Why do firms pay dividends?
1. The Modigliani-Miller Hypothesis:
Dividends do not affect value.
If a firm's investment policy (and hence cash
flows) doesn't change, the value of the firm
cannot change with dividend policy.
Home-made dividends
Assume no taxes, transactions costs,
investment policy held constant
2. Personal taxes.
Basis: Dividends are taxed more heavily than capital
gains.
Extreme response - stockholders will prefer capital
gains to dividends, and firms should pay no
dividends.
Moderate response – personal taxes discourage but
are not sufficient to lead firms to eliminate dividends.
Evidence:
1) Examine dividend yield vs. expected return.
2) Examine ex-dividend date stock price behavior to
see whether dividends are perfect substitutes for
capital gains.
Ex dividend day price effects:
Let:
Pb = price before the stock goes ex-dividend
Pa = price after the stock goes ex-dividend
Pc = original purchase price
D = dividend declared on stock
to,tcg = tax on ordinary income and capital gains
Compare two strategies:
Sell the stock the instant before it goes ex-dividend:
Pb - tcg(Pb - Pc)
Sell the stock after it goes ex-dividend:
D(1-to) + Pa - tcg(Pa - Pc)
Setting the two equal: ( Pb - Pa ) = 1 - t O
D
1 - t cg
The marginal investor will be indifferent between the two strategies.
The price drop on the ex-dividend date is related to investor tax rates.
Example: Ex-dividend day price
effects
• CP Corp is priced at $50 with dividend. Its
price falls to $46.50 when a dividend of $5
is paid.
• What is the implied marginal rate of
personal taxes for its stockholders?
Assume the capital gains tax rate is 40%
of the personal income tax rate.
Other factors to consider in
setting dividend policy:
3. Dividends are a more reliable form of return
than capital gains (the bird in the hand
fallacy).
Dividends now are more certain than capital gains
and hence are more valuable.
4. The signalling hypothesis.
In a world of asymmetric information, firms have to
convince investors about their future prospects.
5. Dividends reduce agency problems.
Managers do not throw away $ on bad projects.
III. Framework for analyzing
dividend policy.
1) The Lintner model: Firms appear to smooth
dividends; dividends are generally a
weighted average of past earnings, placing
the heaviest weight on most recent years.
D1 - D0 = adjustment rate x (target ratio*EPS1 - D0)
This is inconsistent with a “residual” dividend
policy (pay out all cash after investing in
positive NPV projects).
2) How can we evaluate a firm's
dividend policy?
• If a company has excess cash, and few good
projects, returning money to stockholders is good.
• If a company does not have excess cash, and/or has
several good projects, returning money to
stockholders is bad.
Example:
if
FCFE > dividends
ROE < required return on equity
then
increase dividends
cut bad projects
Definition:
FCFE = FCF – payments to debt holders
(interest and net principal repayment)
Or,
FCFE = NI - (capex - depr) - D(net working
capital) + (new debt issued - debt
repayments)
Dividends/opportunities matrix:
FCFE - Dividends
I. Increase dividends
II. No change
Cash Flow
Surplus
ROE - Req return
Good projects
Bad projects
Cash Flow
Deficit
III. Decrease dividends
Reevaluate projects
IV. Decrease dividends
Example: Limited, 1992
restructuring
Net income
+ depreciation
- capex
- WC change
FCFE
$403
223
523
200
-97
Dividends and share repurchases
101
ROE
Required rate of return from CAPM
23.4%
8.9%