dividend policy concepts and exemplification objective understand the role of dividend policy in the...

Dividend policy

Concepts and exemplification

Objective

Understand the role of dividend policy in the context of the firm’s overall financial policy.

Outline

• Types of dividends

• The dividend time line

• Stock price reaction

• Dividend policy irrelevance

• Theories explaining dividend policy

Dividends come in many forms:

Regular cash dividend

Extra dividends

Liquidating dividends

Shares repurchases

• Stock dividends

Dividend time Line

• Declaration date

• Cum-dividend date

• Ex-dividend date

• Record date

• Payment date

Ex-dividend day: Stock price reaction

The stock price will drop by the amount forgone by the average investor

Clarification:

Pcum = D0 + D1/(1+ r)2 + D2/(1+r)3 + ……

Pex = D1/(1+ r)2 + D2/(1+r)3 + ……

Stock price reaction (con't)

With taxes, the price drop ~ D(1-Td)/(1-Tcg)

Td = tax on dividend (average investor)

Tcg = tax on capital gain (average investor)

Dividend Policy: Does it matter? Is there an optimal dividend policy?

If no, focus on the investment decision

If yes, what is the optimal policy?

View # 1: Dividend policy is irrelevant

Shareholders are able to undo firm's dividend policy.

M&M: firm value is independent of the dividend decision.

View # 1: Dividend policy is relevant

Bird-in-hand story

A $1 in dividend now is worth more than $2 in dividend later on.

Signaling

Dividend increase = Good times ahead

The free cash-flow hypothesis

$1 in dividend is $1 less to spend on M&A

View # 1: Dividend policy is relevant (cont’d)

Clientele effect

Some want dividends while others want capital gains

Tax effect

Tax effect

REC Company has $1,000 in extra cash. It can invest this cash in a 5-year T-bill at 8%, or it can pay the cash to the shareholders as a dividend. Shareholders can also invest in T-bills. Assume a 44% corporate tax, a 40% individual tax on interest, and 30% individual tax on dividend income.

If dividend is paid now, shareholders get

1000(1-0.3)[1+ (0.08)(1-0.4)]5=$884.9

If dividend is invested, shareholders get

1000[1+ (0.08)(1-0.44)]5(1-0.3) =$871.5

Shareholders would be indifferent between receiving the dividend now as opposed to receiving it later if and only if:

(1-TE)[1+r(1-TP)] = [1+r(1-TC)](1-TE)

Tax effect (cont’d)

Investors would like a dividend according to their tax preferences:

• Tax-exempt investors, investors in low tax brackets, etc. prefer high current dividend

• Investors in high tax brackets prefer capital gains

Agency costs explanation of dividends

Paying dividends can result in a need for external financing.

Raising equity and/or debt more often intensifies market’s scrutiny of the company.

Reality check

• Earnings increase one year before dividend initiation.

• Earnings decrease one year before dividend omission.

• Following dividend initiation, earnings increases appear to be permanent.

• Following dividend omission, earnings decreases appear to be temporary.

• Weak reaction to earnings changes following dividend changes.

Overview of financial policy: Why is it important?

Capital structure policy, long-term financing policy, dividend policy, etc.…do have some impact on market valuation.

Remember, however:

Capital budgeting is the bread and butter of wealth maximization.

Financial policy is only fine-tuning.