|CHAPTER 18. DIVIDEND POLICY
How dividends are paid out.
Dividend policy is defined as the tradeoff between retaining earnings on the one hand and paying out cash on the other hand.
You can't pay out your "par" capital as a dividend...
State law protects the firm's creditors (i.e., bondholders) from paying excessive dividend.
[Extreme case : selling all the assets and payout all the proceeds as a dividend]
Paying a dividend reduces the amount of R/E.
Many firms have automatic dividend reinvestment plan (so call DRIP), under which the new shares are issued at a 5% discount from the market price.
It saves the underwriting costs of a regular share issue.
Share repurchases as an alternative to dividends...
Happens when cash resources have generally outrun good capital investment opportunities.
[i.e., a firm has accumulated large amounts of unwanted cash]
Happens when the firm wants to change the capital strucuture by replacing equity with debt.
Major methods of repurchases
Acquisition in the open market
By a general tender offer to shareholders.
By direct negotiations with a major shareholder.
[ i.e., Greenmail : Shares are repurchased by the target of the takeover at a price which makes the hostile bidder happy to agree to leave the target alone]
Deprive the shareholders of the value.
Reasons for repurchases
Information or Signalling Hypothesis
No Profitable use for internally generated funds.
Firm believe that stock is undervalued.
Mixed results (positive or negative)
Dividend or Personal Taxation Hypothesis
In order to let the S/Holders benefit from the preferential tax treatment of repurchases relative to dividend.
-Tax subsidy connected with the deductibility of interest payments. This subsidy is passed on to the shareholders.
Bondholder Expropriation Hypothesis.
Repurchase reduces the assets of the firm and therefore the value of the claims of the bondholders.
This plausibility of this hypothesis is weakened by the existence of the law and by the bond covenants.
How firms decide on dividend payments.
Procedure for Dividend Payment [Page 461, Figure 18.1]
Ex-Dividend date : traded ex-dividend on and after 2nd business day before record date.
Lintner's finding on dividends : (page 481. 18.9)
Firms have long-run target dividend payout ratios
Changes much more important than levels
Transitory earnings don't lead to dividend changes
Managers are reluctant to reverse a recent change in dividends
Partial adjustment model : Explained in the Text book in page 482.
The Information Contents of the Dividend
Dividend increases are good news signal managerial optimism.
Dividend increases usually lead to stock price increases
That is not because dividend increases create value but because they signal future prosperity.
Clientele Effect : Individual with different tax brackets and Corporation.
1. Right wing: increasing payouts raise value [Bird-in-the-hand Theory]
2. Middle of the road: who cares about dividend policy? [MM dividend theory-Homemade div]
3. Left wing: increasing payouts lowers value [Tax Preference Theory]
MIDDLE OF THE ROAD : Franco Modigliani and Merton Miller [MM Model]
The firm value is determined by its basic earning power [or by the income produced by its assets], not by how this income is split between dividends and R/E.
Ex.) if a firm does not pay dividends, a S/Holders who wants a 5% dividend can “create” it by selling 5% of his stock.
If companies could increase their value by increasing dividends, wouldn't they have done so already?
THE RIGHT WING:
Investors value a dollar of expected dividends more highly than a dollar of expected capital gains because the dividend yield component is less risky than the “g” component in the Gordon’s model.
Dividends carry information that the firm truly is healthy.
Investors don't fully trust managers to handle the firm's free cash flow--but here dividend policy has an impact because it eliminates negative NPV investments.
THE LEFT WING:
Effects of a shift in dividend policy when dividends are taxed more heavily than capital gains.
[ The high payout stock must sell at a lower price to provide the same after-tax rate of return ]
No-Dividend Firm High-Dividend Firm
Next Year's Price $112.50 $102.50
Dividend $0 $10.00
Total Pretax Payoff $112.50 $112.50
Today's Stock Price $100 $X : $96.67
Captal Gain $12.50 $(102.5-X)
Tax on Div.(50%) $0 $5.00
Tax on C.Gain (20%) $2.50 $(102.5-X)*0.2
After-Tax Income $10.00 $(10)*0.5+(102.5-X)*0.8
After-Tax R.of Ret. $10/100 x 100=10% $[ (10)*0.5+(102.5-X)*0.8 ] / X = 10%
Moral: Cut your dividends and expropriate a piece of the government's share of the corporation by playing the angles of the tax system.
But the tax reform act of 1986 equalized the tax rates (now only a small gap exists).
Suggested Homework Problems
Q1 – Q7