Dividend Policy

I. 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 la w 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 A. Information or Signalling Hypothesis - No Profitable use for internally generated funds. - Firm believe that stock is undervalued. - Mixed results (positive or negative) B. Dividend or Personal Taxation Hypothesis - In order to let the S/Holders benefit from the preferential tax treatment of repurchases relative to dividend. C. Leverage Hypothesis. -Tax subsidy connected with the deductibility of interest payments. This subsidy is passed on to the shareholders. D. 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. CHAPTER 18. Dividend Policy 1 II. 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. 2. 3. 4. 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. III. 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. CHAPTER 18. Dividend Policy 2 • 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 ] Next Year's Price Dividend Total Pretax Payoff Today's Stock Price Captal Gain Tax on Div.(50%) Tax on C.Gain (20%) After-Tax Income After-Tax R.of Ret. No-Dividend Firm $112.50 $0 $112.50 $100 $12.50 $0 $2.50 $10.00 $10/100 x 100=10% High-Dividend Firm $102.50 $10.00 $112.50 $X : $96.67 $(102.5-X) $5.00 $(102.5-X)*0.2 $(10)*0.5+(102.5-X)*0.8 $[ (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 3