Dividend Policy

FIN3701
National University of Singapore

Reference: RWJJ Chapter 19

Last Update: 12 October 2022

1
What do firms do with cash?

– Retain earnings
• Invest in new projects
• Keep the cash sit on the cash

– Return to shareholders
• Dividends
• Share repurchase

2
 Different Types of Dividends

• Many companies pay a regular cash dividend.

– No legal right to dividends
– Most companies pay quarterly.
– Others pay semi-annually or annually.
– Plus some special (extra) cash dividend.
– The extreme case would be a liquidating
dividend (return of capital)
– Restrictions on dividend (covenants)
– Mostly pay constant dividends

3
 Procedure for Cash Dividend Payment

25 Oct. 1 Nov. 2 Nov. 6 Nov. 7 Dec.

…

Declaration Last Cum- Ex- Record Payment

Date dividend dividend Date Date
Date Date

Declaration Date: The Board of Directors declares a payment of

dividends.
Last Cum-Dividend Date: The last day that the buyer of a stock is
entitled to the dividend.
Ex-Dividend Date: The first day that the buyer of a stock is not
entitled to the dividend.
Record Date: The corporation prepares a list of all individuals believed
to be stockholders as of 6 November. why is there a gap between record date and cum dividend date
4 for the
brokerage firm knows who owns stock but it takes time to
information to be transferred to the firm. hence theres time delay for
record date from cum dividend date
Price Behavior around the Ex-Dividend Date

• In a perfect world, the stock price will

fall by the amount of the dividend on
the ex-dividend date.
-t … -2 -1 0 +1 +2 …

$P

$P - div
The price drops Ex-
by the amount of dividend
the cash Date
dividend Taxes complicate things a bit. Empirically, the
price drop is less than the dividend and occurs
within the first few minutes of the ex-date. 5
 Modigliani-Miller Proposition

• Perfect Capital Markets:

– Perfect competition
– Investment and dividend are
independent
– Equal access to all relevant information
– No agency costs
– No transaction costs
– No taxes
• è dividend policy is irrelevant

6
 Dividend Discount Model (DDM)

• The value of a common share is the PV

of all future expected dividends.
𝐸(𝐷" ) 𝐸(𝐷$ ) 𝐸(𝐷% )
𝑃! = + $
+ %
+⋯
1 + 𝑟# 1 + 𝑟# 1 + 𝑟#
(
𝐸(𝐷& )
=+
1 + 𝑟# &
&'"
– where 𝑟# is the required return of
shareholders.
• In practice, it is difficult to project all the future
dividends.
• Hence, we need some simplifying assumptions.
– Zero growth model 7
– Constant growth model
 DDM: Constant Growth Model

• If the dividends are expected to grow

forever at a constant rate, g:
𝐸 𝐷" = 𝐷! 1 + 𝑔
𝐸 𝐷$ = 𝐷! 1 + 𝑔 $
𝐸 𝐷% = 𝐷! 1 + 𝑔 %
𝐸 𝐷& = 𝐷! 1 + 𝑔 &
• Then, the share will be worth:

𝐸(𝐷" ) 𝐷! (1 + 𝑔)
𝑃! = =
𝑟) − 𝑔 𝑟) − 𝑔

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 Example: Singa Inc
Balance Sheet: Singa Inc

Cash $20million
Shares Outstanding 10 million
Cost of Capital 12%
Future Cash Flow $48million/year forever

Firm will be able to pay $20 million in dividends immediately ($2

per share).
Future Dividend = $48million or $48mil/10mil = $4.80 per share
forever.
What is the share price with and without dividend?

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 Dividend Payout
Balance Sheet: Singa Inc
(before dividend) (after dividend)
Cash
Other Assets
Total Market
Value
Shares 10 million 10 million
Outstanding
Share Price 42 40

Cost of Capital 12% 12%

Future Cash $48million forever $48million forever
Flow

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 Homemade Dividends
• Singa Inc. is a $42 stock about to pay
a $2 cash dividend.
• Bob Investor owns 80 shares and
prefers $3 cash dividend. yes $3 cash dividend is possible, he needs to
sell ex dividend share

• How many ex-dividend shares to sell?

80 share and prefer $3 cash dividend = 80*3 = 240
normally (80*2) = 160
240 - 160 = 80
80'2 = 4

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 Dividend Policy is Irrelevant
• Since investors do not need dividends to
convert shares to cash, dividend policy will
have no impact on the value of the firm.

12
Repurchase of Stock

• Instead of declaring cash dividends,

firms can rid itself of cash through
buying shares of their own stock.
• Recently share repurchase (or
buyback) has become an important
way of distributing earnings to
shareholders.
• Suppose Singa Inc uses stock
repurchase instead of paying $20
million in dividends.

13
Stock Repurchase (zero dividend)
Partial Balance Singa Inc
Sheet: (before repurchase) (after repurchase)
Cash
Other Assets
Total Market
Value
Shares 10 million 9.524million
Outstanding
Share Price
Cost of Capital 12% 12%
Future Cash $48million forever $48million forever
Flow

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What about future dividends per share?

• What are the dividends per share for

years 0, 1, and 2 for dividend payout
policy?
• What are the dividends per share for
years 0, 1, and 2 for dividend payout
policy? repurchase

Dividend per share Paid

Policy Initial Year 0 Year 1 Year 2
Price
Dividend
Repurchase

15
 Methods of Stock Repurchase

1. Open market (most common)

2. Tender Offer at Fixed price within a
certain period – should it be above or
below current price? above

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Dividend Policy is Irrelevance in Perfect World

• Dividend policy will have no impact on the value of

the firm because investors can create whatever
income stream they prefer by using homemade
dividends.
• The type of payout is also irrelevant: does not
affect initial share price.
• Firm value derives solely from profitability of assets
and management competence.
• The investment policy of the firm is set ahead of
time and is not altered by changes in dividend
policy.
• Firms should never forgo positive NPV projects to
increase a dividend (or to pay a dividend for the
first time). 17
 Imperfect Market: Taxes

In a tax-free world, cash dividends are a wash between the

firm and its shareholders.

Cash: stock issue

Stock
Firm
Holders
Cash: dividends

Taxes In a world with taxes, the

government gets a cut.
Gov.

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 Taxes and Dividends

• In the presence of personal taxes:

– If dividend is effectively taxed at a
higher rate than capital gains, then
there is a tax disadvantage to
dividends
– If same tax rate on both dividend and
capital gains, repurchase allows
deferment of capital gains tax.
– Share repurchase is preferred to
dividends

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 Effective Tax Rate on Dividends
Suppose you buy the stock just before it goes ex-dividend
and sell the stock immediately after.
Pcum = cum dividend price; Pex = ex-dividend price
tcgains = capital gains tax rate; tdiv = dividend tax rate

In equilibrium, you should not make any profits:

after-tax capital loss on price drop = after-tax div
Pcum *(1-tcgains) = Pex *(1-tcgains) + Div (1-tdiv)
(Pcum – Pex )*(1-tcgains) = Div (1-tdiv)
(1−!!"# )
(Pcum – Pex ) = Div = Div * (1 - t*)
(1−!$%&"' )
if there is tax

Pex = Pcum – Div * (1 - t*)

!!"# "!$%&"'
where t* = #"! = effective tax rate on dividends
$%&"'
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 Dividends vs Repurchases (US firms)

Source: Pearson Addison-Wesley 17

• Big payers in 2018: Shell, Apple, Exxon-Mobil,
Microsoft
22
Apple 2018 dividend= $13b

23
Apple buyback in 2018 = $23b
24
Apple dividend plus buyback in 2012-2018 is $210bn

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 Dividend Puzzle
• In perfect M&M world, dividend is irrelevant
• Tax effect does not seem to favor paying
dividends
è why firms pay dividends?
• Other Deviations from M&M assumptions

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 Clientele Effect
• Clientele Effect
– Dividend policy attracts different investors
– High tax individuals may prefer low dividend
paying stocks
– Institutions, and pension funds and others
may prefer dividends that match their income
needs
– Behavioral reasons: prefer regular income (e.g.
pensioners)

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 Agency cost of cash

• Agency Cost: when firms have excessive

cash, managers may use the funds
inefficiently e.g. pay excessive executive
perks, over-pay for acquisitions, etc.
– Paying out cash through dividends or
share repurchases, rather than retaining
cash, reduces agency costs
– Maximize stock price by reducing
managers’ ability and temptation to
waste resources.
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 Dividend Signaling Hypothesis

• dividend changes reflect managers’ views

about a firm’s future earning prospects
– An increase in its dividend sends a
positive signal to investors that
management expects to be able to afford
the higher dividend for the foreseeable
future.
– A decrease in dividend may signal that
management has given up hope that
earnings will rebound in the near term
and so need to reduce the dividend to
save cash. 29
 Event Study: Dividend Omissions

Cumulative Abnormal Returns for Companies Announcing

Cumulative abnormal returns

Dividend Omissions

0.146 0.108 0.032 0

(%)

-0.244
-8 -6 -4
-0.72 -2 -0.483 0 2 4 6 8
-1
response to “bad news”
-2

anticipated -3
-3.619
-4
-4.563-4.747-4.685-4.49
-5 -5.015 -4.898
-5.183
-5.411
-6
increase dividend only if firms cf is increasing for next few years, not a one time huge increase this year

Days relative to announcement of dividend omission

S.H. Szewczyk, G.P. Tsetsekos, and Z. Santout “Do Dividend Omissions Signal Future Earnings or Past Earnings?”
30 Journal
of Investing (Spring 1997)
 Share Repurchase and Signalling

• Share repurchases are a credible signal that

the shares are under-priced
– If investors believe that managers have
better information regarding the firm’s
prospects and act on behalf of current
shareholders, then investors will react
favorably to share repurchase
announcements.

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 Dividend Smoothing

• Firm change dividends infrequently and

dividends are much less volatile than earnings.
• Management believes that investors prefer stable
dividends with sustained growth.
• Management desires to maintain a long-term
target level of dividends as a fraction of
earnings.
• Thus, firms raise their dividends only when they
perceive a long-term sustainable increase in the
expected level of future earnings, and cut them
only as a last resort.

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 Dividend History for GM Stock,
1983–2006

Source: Pearson Addison-Wesley

GM’s Earnings and Dividends per share,
1985–2006

Source: Pearson Addison-Wesley.

Dividend Policy in Practice: U.S. div
payout (div yield)

Beverage: 23% (0.5%)

Internet: 0% (0%)
Biotechnology: 0.5% (0%)
Bank: 36% (5%)
Elec Utilities: 30% (4.5%)

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Top 5 cash-rich: Apple ($245b), Microsoft, Alphabet,
Amazon, Facebook
What is the cost/benefit of holding lots of cash? 36
US non-financial cash holdings

Cash generating
firms (high
margins, low
capex)

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 Low Dividend

• High-tech and biotechnology firms tend to

retain and accumulate large amounts
of cash (pay zero dividends). Why?
• Generally, firms retain cash balances to
cover potential future cash shortfalls,
despite the agency cost of cash
• This also avoids financial distress costs
and difficulty of raising capital when
capital markets are distressed

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 High Cash Holdings

• In perfect capital markets, retaining cash or

paying out as dividend is irrelevant (investment
in financial securities is zero NPV)
• Negatives
– agency costs
• Positives
– lower financial distress costs
– easier access to capital for future projects;
lower transaction costs; adverse selection costs
of new equity issues; lower refinancing risks
and underinvestment problem

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Scrip Dividend Scheme (e.g. Singapore)

20 Oct. 25 Oct. 7 Dec.

…

Price Declaration Ex- Record Payment

Determination Date dividend Date by
Period Date crediting
shares
Price Determination Period: Average Daily Price (plus
discount)
Shareholder Account credited with appropriate number of
shares
Shareholders choose to have cash dividend, stock dividend or a
mix of the two.
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Summary

• Reasons for Low Dividend

– Low profits
– Personal Taxes (repurchase preferred)
• Dividends are taxed upon payment
• Capital gains taxed only when realized
– High retained earnings (keep cash)
• Lower financial distress costs
• Costly to issue new stock, especially in
distressed financial markets

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 Summary
• Reasons for High Dividend
– Dividends as a signal about firm’s
future performance
• Dividend increases are associated
with stock price increase
• Dividend changes contain
information
– Reduce agency costs of cash
– Clientele effect

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 Summary and Conclusions
• Firms should follow a sensible dividend
policy:
– Don’t forgo positive NPV projects just
to pay a dividend.
– Avoid issuing stock to pay dividends.
– Consider share repurchase when there
are few better uses for the cash.

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