Chapter 18. Dividend policy how dividends are paid out

1. 
   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.

 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.

1. 
   Acquisition in the open market
   
2. 
   By a general tender offer to shareholders.
   
3. 
   By direct negotiations with a major shareholder.
   

 Deprive the shareholders of the value.

1. 
   Information or Signalling Hypothesis
   

• 
  No Profitable use for internally generated funds.
  
• 
  Firm believe that stock is undervalued.
  
• 
  Mixed results (positive or negative)
  

2. 
   Dividend or Personal Taxation Hypothesis
   

• 
  In order to let the S/Holders benefit from the preferential tax treatment of repurchases relative to dividend.
  

3. 
   Leverage Hypothesis.
   

4. 
   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.
  

2. 
   How firms decide on dividend payments.
   

 Procedure for Dividend Payment [Page 461, Figure 18.1]

1. 
   Declaration date
   
2. 
   Ex-Dividend date : traded ex-dividend on and after 2^nd business day before record date.
   
3. 
   Record Date
   
4. 
   Payment Date
   

 Lintner's finding on dividends : (page 481. 18.9)

1. 
   Firms have long-run target dividend payout ratios
   
2. 
   Changes much more important than levels
   
3. 
   Transitory earnings don't lead to dividend changes
   
4. 
   Managers are reluctant to reverse a recent change in dividends
   

 Partial adjustment model : Explained in the Text book in page 482.

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.

3. 
   Dividend Controversy
   

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.
  
• 
  Homemade dividends.
  
• 
  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.
  
• 
  Homemade dividends.
  
• 
  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:

[ The high payout stock must sell at a lower price to provide the same after-tax rate of return ]

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