CORPORATE
FINANCIAL
THEORY
Lecture 6
Review
Goal: Maximize Value of the Firm
Past Topics
Investment Decision (spending money)
Financing Decision (raising money)
Future Topics
“Variations on a Theme”
Today’s Topics
Dividends (today)
• Define (Capital Budgeting & Investment variation)
• Dividends & Value of the Firm
Capital Structure
• Define (financing variation)
• Capital Structure & Value of the Firm
Dividends
A payment made by a company to the
shareholders of the company.
Dividend Payments
Stock Dividend - Distribution of additional shares
to a firm’s stockholders.
Stock Splits - Issue of additional shares to firm’s
stockholders.
Cash Dividend - Payment of cash by the firm to its
shareholders.
-Regular
-Special
Dividend Payments
Stock Repurchase - Firm buys back stock from
its shareholders.
Stock Repurchase (4 methods)
1. Buy shares on the market
2. Tender Offer to Shareholders
3. Dutch Auction
4. Private Negotiation (Green Mail)
Dividend Terms

Record Date

Announcement Date

Payment Date

Ex-Dividend
Dividend Payments
Aug 14
Declaration
date
Aug 25
Aug26
Sept 1
Withdividend
date
Ex-dividend
date
Record
date
Share
price
falls
Sept 15
Payment
date
Dividend Policy is Irrelevant
Since investors do not need dividends to
convert shares to cash they will not pay higher
prices for firms with higher dividend payouts.
In other words, dividend policy will have no
impact on the value of the firm.
Dividend Policy is Irrelevant
Example - Assume Rational Demiconductor has no extra cash, but
declares a $1,000 dividend. They also require $1,000 for current
investment needs. Using M&M Theory, and given the following
balance sheet information, show how the value of the firm is not
altered when new shares are issued to pay for the dividend.
Record Date
Cash
1,000
Asset Value 9,000
Total Value 10,000 +
New Proj NPV
2,000
# of Shares
1,000
price/share
$12
Dividend Policy is Irrelevant
Example - Assume Rational Demiconductor has no extra cash, but
declares a $1,000 dividend. They also require $1,000 for current
investment needs. Using M&M Theory, and given the following
balance sheet information, show how the value of the firm is not
altered when new shares are issued to pay for the dividend.
Record Date
Cash
1,000
Asset Value 9,000
Total Value 10,000 +
New Proj NPV
2,000
# of Shares
1,000
price/share
$12
Pmt Date
0
9,000
9,000
2,000
1,000
$11
Dividend Policy is Irrelevant
Example - Assume Rational Demiconductor has no extra cash, but
declares a $1,000 dividend. They also require $1,000 for current
investment needs. Using M&M Theory, and given the following
balance sheet information, show how the value of the firm is not
altered when new shares are issued to pay for the dividend.
Record Date
Cash
1,000
Asset Value 9,000
Total Value 10,000 +
New Proj NPV
2,000
# of Shares
1,000
price/share
$12
Pmt Date
0
9,000
9,000
2,000
1,000
$11
NEW SHARES ARE ISSUED
Post Pmt
1,000 (91
9,000
10,000
2,000
1,091
$11
sh @ $11)
Dividend Policy is Irrelevant
Example - continued - Shareholder Value
Record
Stock
Cash
Total Value
12,000
0
12,000
Stock = 1,000 sh @ $12 = 12,000
Dividend Policy is Irrelevant
Example - continued - Shareholder Value
Stock
Cash
Total Value
Record
Pmt
12,000
11,000
0
12,000
Stock = 1,000sh @ $11 = 11,000
1,000
12,000
Dividend Policy is Irrelevant
Example - continued - Shareholder Value
Stock
Cash
Total Value
Record
Pmt
Post
12,000
11,000
12,000
1,000
0
12,000
12,000
0
12,000
Stock = 1,091sh @ $11 = 12,000
Assume stockholders purchase the new issue with the cash dividend proceeds.
Payout Policies
Dividend & Stock Repurchases
$ Billions
U.S. Data 1995 - 2013
Dividend Theories
Leftists (M&M) - Div does not effect value
Rightists - Dividends increase value
Middle of the roaders - Leftist theory with some reality
thrown in.
Residual Dividend Policy
Dividend Theories
r
MRI = IRR
12 %
COC
QTY $$$
Dividends Increase Value
Market Imperfections and Clientele Effect
There are natural clients for high-payout stocks,
but it does not follow that any particular firm can
benefit by increasing its dividends. The high dividend
clientele already have plenty of high dividend stock to
choose from.
These clients increase the price of the stock
through their demand for a dividend paying stock.
Dividends Increase Value
Dividends as Signals
Dividend increases send good news about cash
flows and earnings. Dividend cuts send bad news.
Because a high dividend payout policy will be
costly to firms that do not have the cash flow to support
it, dividend increases signal a company’s good fortune
and its manager’s confidence in future cash flows.
Dividends Decrease Value
Tax Consequences
Companies can convert dividends into capital
gains by shifting their dividend policies. If dividends
are taxed more heavily than capital gains, taxpaying
investors should welcome such a move and value the
firm more favorably.
In such a tax environment, the total cash flow
retained by the firm and/or held by shareholders will
be higher than if dividends are paid.
Taxes and Dividend Policy
Companies can convert dividends into capital gains by shifting their
dividend policies. If dividends are taxed more heavily than capital
gains, taxpaying investors should welcome such a move and value the
firm more favorably.
In such a tax environment, the total cash flow retained by the firm
and/or held by shareholders will be higher than if dividends are paid.
Since capital gains are taxed at a lower rate than dividend income,
companies should pay the lowest dividend possible.
Dividend policy should adjust to changes in the tax code.
Taxes and Dividend Policy
In U.S., shareholders are taxed twice (figures in dollars)
Rate of Income tax
0%
Operating Income
Corporate tax (Tc=.35)
After Tax income (paid as div)
Income tax
Cash to Shareholder
100
35
65
0
65
39.60%
100
35
65
25.7
39.3
Taxes and Dividend Policy
Under imputed tax systems, such as that in Australia, Shareholders
receive a tax credit for the corporate tax the firm pays (figures in
Australian dollars)
Rate of Income tax
15%
Operating Income
Corporate tax (Tc=.30)
After Tax income
100
30
70
30%
100
30
70
Grossed up Dividend
Income tax
Tax credit for Corp Pmt
Tax due from shareholder
Cash to Shareholder
100
15
-30
-15
85
100
30
-30
0
70
47%
100
30
70
100
47
-30
17
53
Capital Structure
Read Chapter 17 on your own
Overlap with Lecture 3
Exam Review