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.