DIVIDEND POLICY Chapter 17

Alex Tajirian

Dividend Policy

17-2

1. OUTLINE
# # # # What to do with excess cash? Types of dividends Theories of optimal dividend policy: dividend puzzle Some practical considerations

morevalue.com, 1997
Alex Tajirian

Dividend Policy

17-3

Graphics: WHAT TO DO WITH EXCESS CASH

morevalue.com, 1997
Alex Tajirian

Dividend Policy

17-4

2. OBJECTIVE & DEFINITION

Definition: Dividend is the distribution of value to shareholders.

Dividend Policy:

What happens to the value of the firm as dividend is increased, holding everything else (capital budgets, borrowing) constant. Thus, it is a trade-off between retained earnings on one hand, and distributing cash or securities on the other.

morevalue.com, 1997
Alex Tajirian

Dividend Policy

17-5

3. TYPES
3.1 CASH DIVIDEND1
Example: $.5 for every share you hold Regular, regular + "extra" , special Dates: |_____________|______________|___________|____ 1/15 1/26 1/30 2/15 Declaration Ex-dividend Record Payment Date Date Date Date Only investors who hold the security prior to the ex-dividend date receive the dividend.

morevalue.com, 1997
Alex Tajirian

Dividend Policy

17-6

3.2 STOCK DIVIDEND

Example: 1 new stock for each 10 you hold

3.3 STOCK REPURCHASE2

3.1 Method in the open market tender offer direct negotiation with major shareholders 3.2 Reasons ! Alternative to "extra" or special dividend. Example. A company just sold a division and cannot use the proceeds for favorable investments. ! ! If management believes the stock is under-valued. As an obstacle to takeovers. Q If management re-purchases stocks, then the price increases, thus prevents raiders from acquiring company at an attractive price. Q ! Greenmail

EPS increases, thus value of firm increases !?

3.3 Advantages( ! Shareholders have a choice: sell shares or keep. ! Firm has no obligation to make future repurchases.

morevalue.com, 1997
Alex Tajirian

Dividend Policy

17-7

2.3.4 Disadvantages; ! May signal to investors that the firm's investment opportunities are limited. ! The firm may pay too high a price for the repurchase. Example: Greenmail

2.4 STOCK SPLIT

Example. (2-1 split), i.e., for every share you own, now you own two. ! ! Argument for splits: To make stock "more attractive" to investors?! Value of firm is not expected to change.

morevalue.com, 1997
Alex Tajirian

Dividend Policy

17-8

4. DIVIDEND CONTROVERSY THEORIES

Irrelevant, rightists (high dividend), leftists (low payoff), Middle of the Road k = capital gains + dividend yield

4.1 IRRELEVANT
M & M in the case of perfect markets. Reasoning: There is nothing the firm can do that investors cannot duplicate. Firm and investors have identical opportunities.

morevalue.com, 1997
Alex Tajirian

Dividend Policy

17-9

4.2 RIGHTISTS
! Bird in the hand fallacy. "Paying out some cash today reduces risk of future payoff uncertainty" Alternatives 1 2 CF1 0 20 CF2 0 20 CF ... ... CFT 100 60 ... ...

What about return? ! Grand Ma's argument: "I need the regular cash dividend to live on!"

4.3 LEFTISTS
Tax argument: Tax on dividends = tax on income $ tax on capital gains. But tax on dividends must be paid now, while on capital gains would be in the future.

morevalue.com, 1997
Alex Tajirian

Dividend Policy

17-10

Illustration. Invest $100, ks = 10% , T = 40% Case 1. Stock held for 20 years. FV20 = $100(1+.1)20 = 672.75 after tax FV20 = final value - tax paid = 672.75 - (T)(capital gains) = 672.75 - (.4)(672.75 - 100) = 443.65 Case 2. Assume that all earnings are paid as dividends. Investor takes money and buys back stock

FV20 = $100 (1 + After tax rate of return )20 = 100 [1 + ks (1 - T)]20 = 100 [ 1 + .1(1 - .4)]20 = 320.7

Case 1 is better. Thus, Optimal dividend policy is zero/very low.

morevalue.com, 1997
Alex Tajirian

Dividend Policy

17-11

hg; dividend and tax

morevalue.com, 1997
Alex Tajirian

Dividend Policy

17-12

4.4 MIDDLE OF THE ROAD

Signaling. Regular dividend can be used by managers to provide information/signal about future prospects.

In practice, it is too expensive to signal with dividends.

5. PRACTICAL ISSUES
! Legal Requirements: Companies cannot keep "excess" cash as retained earnings if no investment opportunities exist. They have to distribute them as dividends. Institutional Restrictions: Many trust portfolios are required to protect the investment principle and can only spend investment income. Thus, they tend to invest in companies with high dividends. Market Reaction to Dividend `: Price usually `. Investors interpret it as a negative signal, in that the firm's future opportunities are not good.

morevalue.com, 1997
Alex Tajirian

Dividend Policy

17-13

6. DIVIDEND POLICY IN PRACTICE

! ! ! Constant $ pay-off Constant payoff: fixed % of earnings Residual Theory: Pay out $ that cannot be re-invested in the firm at the required rate of return ks.

morevalue.com, 1997
Alex Tajirian

Dividend Policy

17-14

7. ENDNOTES
1. On recent trends, see LAT 1/27/93 p. E158. On Dividend Reinvestment Plans (DRIPs) see LAT 2/16/93 p. E56. 2. See LAT 6/12/92 p. E164.

morevalue.com, 1997
Alex Tajirian

Dividend Policy

17-15

8. QUESTIONS True\False-Explain
1. 2. 3. 4. 5. If a company has excess cash, then it should acquire another. Given U.S. tax laws, the optimal dividend policy should be zero dividends. Stock repurchase is a form of dividend. Stock splits should have no effect on the value of a company. If XYZ Inc. announces an increase in its dividends and the price of the stock increases on the same day, then you can conclude that investors prefer dividend income over capital gains. The 1993 tax changes (tax on dividend $ tax on capital gains) make high dividend paying stocks more attractive to the average investor. SPDRs can have no disadvantages over an S&P500 mutual fund. If splitting a stock increases its liquidity, then the firm necessarily benefits. A 3-to-1 stock split means that for every 3 shares you currently own you end up with one. Moreover, the new price, after the split, would be 3 times the original price.

6.

7. 8. 9.

morevalue.com, 1997
Alex Tajirian

Dividend Policy 9.0 ANSWERS TO QUESTIONS

17-16

True\False-Explain
1. False. If the company does not have any positive NPV projects to invest in, then it should pay shareholders dividend (either extra dividends or repurchase stock). Note, acquiring another company in the same line of business is also considered a project. True. See notes for explanation True. Since dividends are defined as a distribution of wealth. Stocks have to be repurchased at a price higher than then market price. Thus, additional value has to be distributed to shareholders. True.

2. 3.

4.

Value of Firm ' Price (# of Shares) Value After Split: Price (# of shares 2) 2

Y Value unchanged

5.

False. A possible explanation for the price increase might be than investors interpret the increase as a strength in the company's future earnings prospects. Thus, they buy the stock, this increases the demand for the stock, and thus its price goes up. An alternative explanation, which has nothing to do with dividends, might be that the general stock morevalue.com, 1997
Alex Tajirian

Dividend Policy market went up, and so did XYZ Inc! 6.

17-17

False. Actually the opposite is true. The new lax laws make high paying dividend stocks even less attractive to the average investor. False. One disadvantage of SPDRs is that dividends, from the underlying stocks, are distributed to shareholders. An index fund, on the other hand, can devise a dividend reinvestment plan to reduce the dividend tax effect. False. Liquidity in the secondary market benefits the investors not the company. Remember the secondary market is for the exchange of ownership. It is the primary market that is more of a concern to the firm. False. With a 3-to-1 split you end up with 3 shares for each that you held. Moreover, the new price ought to be a third of the original price.

7.

8.

9.

morevalue.com, 1997
Alex Tajirian