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Chapter 18. Dividend policy how dividends are paid out

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  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.

 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

  1. Acquisition in the open market

  2. By a general tender offer to shareholders.

  3. 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

  1. Information or Signalling Hypothesis

  • No Profitable use for internally generated funds.

  • Firm believe that stock is undervalued.

  • Mixed results (positive or negative)

  1. Dividend or Personal Taxation Hypothesis

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

  1. Leverage Hypothesis.

-Tax subsidy connected with the deductibility of interest payments. This subsidy is passed on to the shareholders.

  1. 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.

  1. 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 2nd 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.

 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. 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?


  • 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.


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

CHAPTER 18. Dividend Policy

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