The Dividend Controversy
Should firms pay high dividends?
Review item
 An
asset A is being added to the market
portfolio M.
 What variable indicates whether A will
raise or lower the risk of the portfolio?
 Explain briefly.
Answer: beta of A is the variable
 Beta
of A is covariance of A with M
divided by variance of M.
 Beta of A > 1 implies A varies more with
M than M itself does (possible diagram).
 Beta of A > 1 implies A raises the risk of
M.
 Beta of A < 1 implies A lowers risk of M.
Normal dividends (pages 461-462)
 declaration
date
 ex-dividend date
 record date
 payment date
Why is the ex-dividend date early?
 To
avoid disputes, exchanges control
the right to the dividend.
 Early date reduces costs of
administering the rule.
 Now 2 days lead time. Formerly 5
days.
Dependence of value on dividends
 Notation:
 Pt,
Pt+1, Pt+2, ... are
 prices of shares at time t, t+1, t+2
 Dt, Dt+1, Dt+2, ... are dividends
Derivation
 Pt
= Dt+1/(1+r) + Pt+1/(1+r)
 Pt+1=

Dt+2/(1+r) + Pt+2/(1+r)
Pt = Dt+1/(1+r) + Dt+2/(1+r)2
+ Pt+2/(1+r)2
By induction
 Pt
= Dt+1/(1+r) + Dt+2/(1+r)2 +
Dt+3/(1+r)3 + …
 Expected
dividends determine value,
 even when the share changes hands.
Trap question one:
 An
investor buys a share.
 It never pays a dividend.
 Is it valueless?
No.
 The
investor resells it before any
dividends are paid.
 The buyer gets dividends.
Trap question two:
 A firm
never pays dividends to any
investor and is never expected to do so.
 Is it valueless?
No. Think of Webservice.com
 The
typical start-up firm is bought by
another.
 Its investors get cash or shares in the
acquiring firm.
Dividend policy alternatives:
 Either
high dividends now, low later, or
 Low now, high later.
Dividend policy is irrelevant!
 The
firm has done all projects with NPV
> 0.
 It has some cash.
 What are the alternatives?
Alternatives:
 Distribute
cash as a dividend now.
 Invest the cash in financial markets and
 pay out as a dividend later.
Separation theorem interpreted for
dividends (Figure 18.4)
C1
L o w -d iv id e n d firm
F u tu re
r e tu rn
or
s lo p e = - ( 1 + r )
H ig h - d iv id e n d
firm
d iv id e n d n o w
C0
Separation theorem
 NPV
is relevant.
 Investors time preferences are not.
Homemade dividends
 Investors
who want higher dividends
sell some shares to get cash.
 Those who want lower dividends use
high dividends to buy more shares.
Upshot
 Investors
do not reward firms for doing
what investors can do for themselves.
Taxes and dividends
 The
alternatives are
 (1) dividends or
 (2) capital gains.
Tax-class clienteles
 Investors
with similar tax exposure.
 Some prefer dividends.
 Some prefer capital gains.
Some prefer dividend income
 because
they have tax exemptions,
e.g.,
 non-profit institutions, pension funds,
corporations etc.
Some investors prefer capital gains
 because
they can't shelter dividends
from taxes,
 but they can shelter capital gains.
 High income investors, for instance.
Example of partial tax sheltering by
capital gains
 Alternative
one: dividend of $10,000.
 Pay taxes on all of it.
 Compare to capital gains of the same
amount.
Tax shield continued, homemade
dividend
 Alternative
two: capital gains of
$10,000.
 Sell stock worth $10,000.
 The stock was bought when the price
was half the current price.
 Realized capital gains = $5,000
 Pay taxes on $5,000.
Implications of clienteles
 Some
cash flows in the high-dividend
channel.
 Some in the low-dividend channel.
 Like the Miller channels model.
Dividend equilibrium
H iD iv
value
per $1
LoD iv
value
per $1
V *=1/Rh
V *=1/RL
E quilibriu m
H iD iv
E q u ili b riu m
L o D iv
$ of operating
cash flow s
...
Value is invariant to dividend policy.
 In
equilibrium
 i.e., almost all the time
Out of equilibrium
 i.e.,
after tax law changes,
 firms can increase value by
appropriately changing their dividend
policy.
Example of disequilibrium
 Suppose
that the capital gains tax rate
is lowered.
 LoDiv cash flows are more valuable.
 Demand for LoDiv cash flows
increases.
Cut in capital gains tax rates
HiDiv
value
LoDiv
value
Increased value
of old equity
More LoDiv
firms
$ of operating
cash flows in
the economy
Result of capital gains tax cut
 Value
of old equity rises (instantly)
 Firms increase value by switching to
lower dividends
 until equilibrium is restored.
Real-world evidence
 for
not changing dividend policy
 and for existence of tax-class clienteles.
Evidence
 Actual
dividends are highly smoothed
 Earnings fluctuate much more.
 Smooth means constant or increasing
at a constant rate.
A problem for the low-dividend firm
 The
firm has a quantity of spare cash
 after all NPV>0 projects are done.
Dilemma
 Pay
dividends: Shareholders pay extra
taxes.
 Invest in financial markets: Firm
becomes a mutual fund.
Solution: use the cash to buy stock
 Investors
who sell are those who want
cash.
 Stock price is unaffected ...
 because the value of the firm falls
 in proportion to the shares repurchased.
Example: Firm is worth $10M. $1M
is spare cash.
 There
are 1M shares, at $10 per share.
 Buy back .1M shares at $10 apiece.
 Cost is $1M.
After the buyback,
 Remaining
value of the firm is $9M
 because there are no financial illusions.
 There are .9M shares remaining
 still at $10 apiece.
Stock buybacks
 are
associated with rising share value in
the financial press.
 Can this be correct?
Outsider's model before the buyback
 Pr{underpriced}
= .5
 Pr{overpriced} = .5
If insiders think the stock is
overpriced
a
buyback would reduce the value of
the firm.
 Therefore, no buyback occurs.
Since the buyback occurs
 Outsiders
know that insiders think
 the stock is underpriced (or fairly
priced).
Therefore, the buyback
 signals
the knowledge of insiders
 that the stock is underpriced
 and outsiders raise their estimates of its
value.
 Thus, share price rises on the buyback.
The IRS understands this game.
 Stock
buyback for tax avoidance is
illegal.
 Therefore...
Excuses, excuses
 always
another reason for a stock
buyback,
 usually ... our shares are a good
investment
 or...we disburse cash to prevent
takeover.
Summary
 Dividend
policy is like capital structure.
 It probably doesn’t matter.
 If it does, it matters because of taxes,
and even that is temporary.
 In equilibrium, firms cannot increase
value by changing capital structure or
dividend policy.
Review item
 A share
paid a dividend of $5 last year.
 The dividend is expected to grow at 3%
forever.
 The discount rate is 13%.
 What is the value of the share?
Answer:
 Next
year’s dividend is $5.15
( = 1.03 x 5)
 Value is $5.15/(.13-.03) = $51.50.
 Not $50.