Dividend Decision: Imperial College Business School

Dividend Decision
Jamie Coen
Imperial College Business School
Autumn 2022
Jamie Coen Dividends 1 / 71

The Dividend Decision
Maximise the Value of the Firm
The Investment Decision The Financing Decision The Dividend Decision

Which assets should a How should a firm How and when should a firm
firm invest in? finance itself? return cash to shareholders?

Firms choose what to do with their earnings:

1 Retain the cash?
1 Invest in new projects.
2 Increase cash reserves.
2 Pay the cash to shareholders.
1 Dividends.
2 Stock buybacks.

This week’s lectures
1 Facts & practicalities.
2 How much cash to return to shareholders?
3 How to return cash to shareholders?
4 Evaluating firms’ decisions.

Dividends: Practicalities
Dividend: money paid by a firm to its shareholders.
Public company’s board determines dividend policy: will one be

paid, how much per share, and when?
Announced on the declaration date.
Dividend paid to those holding shares on a specific date: the

record date.
3 business days for shares to be registered → to get dividend

shareholders need to buy stock ≥ 3 days prior to record date.

Dividends: Practicalities
Ex-dividend date: 2 days before record date → investors buying

now or later will not get the dividend.
Cum-dividend: dates before ex-dividend date (but after

declaration date).
Regular dividend: paid at regular intervals.
Special dividend: one-time dividend that is usually much larger

than regular dividend.
Payable date/distribution date: dividend is paid.

General Motors Dividend History (1983-2008)

Buybacks: Practicalities
Alternative way to pay cash to investors is through a share

repurchase or buyback.
Firm uses cash to buy shares of its own outstanding stock.
These shares are generally held in corporate treasury (non-voting

and don’t receive dividends).
Three ways of repurchasing shares:

1 Open market repurchase.
2 Tender offer.
3 Targeted repurchase.

Open Market Repurchase
Firm announces its intention to buy the shares in the open

market, and then does so over time like any other investor.
May take a year or more to buy the shares, and isn’t obliged to
purchase the full amount it stated
Firm must not buy shares in a way that might appear to
manipulate the price.
Open market repurchases ≈95% of all repurchase transactions.

Tender Offers and Targeted Repurchase
Tender Offer
Firm offers to buy shares at pre-specified price during a short
timeframe (usually ≤ 20 days).
Price usually set at substantial premium (often 10-20%) to the
current market price.
Offer often conditional on shareholders tendering a sufficient
number of shares.
→ if not, firm may cancel the offer.
Targeted Repurchase
Firm purchases shares directly from a major shareholder, with price
negotiated directly with the seller.

1 How much cash (if any) to return to shareholders?
2 How to return it to them?

Jamie Coen
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Fact I: Dividends are sticky
2003
2004
2005
2006
Dividends
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
Increase
Decrease
No change
12 / 71
Fact I: Dividends are sticky
Why are dividends so sticky?
1 Inertia: firms hate to cut dividends.

2 Peer comparisons: firms want to match other firms in their
area.

Fact II: Stock buybacks becoming more popular
900.00 80%
800.00
70%
700.00
60%
600.00
50%
500.00
$ billions
40%
400.00
30%
300.00
20%
200.00
10%
100.00
0.00 0%
Buybacks Dividends Proportion from Buybacks

Measures of Dividend Policy
Dividend payout = Dividends/Net Income

• Percentage of earnings paid in dividends.
• NB: can’t be computed if net income negative.
Dividend yield = Dividends per share/Stock price

• Return that an investor can make from dividends alone
• Part of the expected return on the investment.
Total payout = (Dividends + Buybacks)/Net Income

• Percentage of earnings paid in dividends or buybacks.
• NB: can’t be computed if net income negative.

How much cash to return to shareholders?

Road map
1 Perfect capital markets.

2 Dividends are bad: taxes.
3 Reasons for paying dividends:
1 Clientele effects.
2 Signalling.
3 Discipline.
4 Wealth appropriation.

Perfect Capital Markets (again)
1 No taxes.
2 Firms can raise external financing from debt or equity, with no

issuance costs.
3 No costs – direct or indirect – associated with bankruptcy.
4 No agency costs: managers maximise stockholder wealth,

bondholders don’t have to worry about stockholders
expropriating wealth via their decisions.
5 Investors and firms can trade the same set of securities at

competitive market prices equal to the present value of their
cash flows.

Dividend now or dividend later?
Barston mining has $100k in excess cash.
It is considering investing in one-year Treasury bills paying 6%

interest, and then using the cash to pay a dividend next year.
Alternatively, it could pay one immediately and the firm’s

shareholders could invest the cash themselves.
Which option will shareholders prefer?

Dividend now or dividend later?
Immediate dividend: shareholders receive $100k today.
Retain the cash: Barston can pay dividend of 1.06×$100k=$106k

next year.
Payoff is the same as if shareholders had invested the $100k

dividend they received in Treasury bills themselves.
Shareholders are indifferent between payout and retention.

Payout policy in perfect capital markets
More broadly, the decision of whether to return cash to

shareholders is a choice between:
• Keeping cash to accrue in the firm.
• Giving it out to shareholders.
After a dividend has been paid, there has been a decrease in the
value of the firm.
→ Money has left the firm.
→ But the dividend benefited the shareholders.
How do these two forces add up?

Payout policy in perfect capital markets: example
Genron Corporation. The firm’s board is meeting to decide how to

pay out $20 million in excess cash to shareholders.
Genron has no debt, 10 million shares outstanding, and its cost of

equity is 12%.
The firm expects to generate future free cash flows of $48 million
per year, thus it anticipates paying a dividend of $4.80 per share
each year thereafter.

Genron is considering two policies:

1 Pay a $2 dividend now.
2 Raise cash and pay higher dividend ($4.80) now.

Genron policy 1
The cum-dividend price of Genron will be:
PCUM = Current dividend + PV(future dividends)

4.80
=2+
0.12
= $42
After the ex-dividend date, new buyers will not receive the current
dividend and the share price of Genron will be:
4.80
PEX =
0.12
= $40
Share price drops by amount of dividend.

Genron policy 2
Now Genron wants to pay dividend larger than $2 per share right
now, but it only has $20mn in cash today.
→ Genron needs an additional $28mn to match future cash flows.
Given current share price of $42, Genron could raise $28 mn by
selling $28mn/$42 per share =0.67 million shares.
The new dividend per share will be $48mn/10.67m shares =$4.50
per share.
What is the new price?
4.50
PCUM = 4.50 +
0.12
= 4.50 + 37.50 = $42

Two policies resulted in exactly the same initial share price.
Trade-off between dividends per share now vs later.
Trade-off resolved such that shareholder value unaffected.

Modigliani-Miller (again)
With perfect capital markets, holding fixed a firm’s investment

policy, its dividend policy is irrelevant.
When a dividend is paid, the share price drops by the amount of

the dividend.
→ Shareholders like receiving the dividends but dislike the fall in
price, so are indifferent.
What determines a firm’s value is its investment policy.

→ Dividend policy is just changing how you divide up the cash
flows.

Homemade Dividends
Suppose a firm doesn’t pay a dividend, but I as a shareholder

would like cash each period. What can I do?
→ I can just sell a bit of the stock each period, and get exactly the
same cash flows.
Suppose a firm pays a dividend, but I as a shareholder wish it had

not. What can I do?
→ I can just re-invest the dividend in the firm’s shares, and get
exactly the same cash flows.

The Irrelevance Result
As with the capital structure irrelevance result, there are two issues
with this theory:
• Its assumptions do not hold.
• Its conclusions seem too stark.
Nonetheless, it still provides a useful framework, and helps

understand the following:
• A firm with bad projects can’t resurrect its value by paying
higher dividends.
• A firm with a history of good investments will still be liked by
investors, even if it pays out less than it could afford.

Frictions and payout policy
As in our discussion of capital structure, we now turn to market

frictions as the driver of payout policy.
1 Taxes.
2 Signalling.
3 Discipline.


1 Taxes.
2 Signalling.
3 Discipline.

US tax rates on dividends & capital gains

The effective dividend tax rate
Consider an investor who buys a stock just before it goes

ex-dividend, and sells it just after.
If the dividend is DIV and the investor’s dividend tax rate is τd ,

her after-tax cash flow from the dividend is (1 − τd ) × DIV .
Because the price just before the stock goes ex-dividend, PCUM ,
exceeds the price just after, PEX , the investor will expect to incur a
capital loss on her trade.
If her tax rate on capital gains is τg , her after-tax loss is

(PCUM − PEX ) × (1 − τg ).
If the gains exceed the losses, there is an arbitrage opportunity.

The effective dividend tax rate
(PCUM − PEX ) × (1 − τg ) = (1 − τd ) × DIV

Rearranging gives:
PCUM − PEX = DIV (1 − τd∗ )

where
τd − τg
τd∗ =
1 − τg
is the effective dividend tax rate.
→ the additional tax paid by the investor per dollar of after-tax
capital gains income that is instead received as a dividend.

Taxes and payout policy
Does this tally with what we see in the data?

1 Proportion of companies paying dividends increases a little
after tax law changes in 2003.
2 Empirically, the fall in a stock’s price around dividend day
should be greater when dividends and capital gains are taxed
equally.
→ This is true!

Tax differences across investors
The effective dividend tax rate τd∗ for an investor depends on the
tax rates the investor faces on dividends and capital gains.
These rates differ across investors for a variety of reasons,
including:
1 Income level.
→ Investors with different incomes may face different tax
rates.
2 Type of investor.
→ Stocks held by individual investors in a retirement account
are not subject to taxes on dividends or capital gains.
→ US corporations can exclude large share of dividends they
receive from tax.

Clientele effects
Given differences across investors, it makes sense that:

1 Firms try to optimise their payout policy according to their
investor base.
2 Investors migrate to firms with payout policies that suit them.


1 Taxes.
2 Signalling.
3 Discipline.

Signalling via dividends
Two facts:
1 Dividends are smooth through time.
2 A firm can only pay dividends if it can afford them.
Implication: by raising dividends, I can signal that I have

information that my firm is going to have future earnings.
→ can boost share price.

Disciplining managers via dividends
When discussing capital structure we noted that fixed interest

payments can reduce managers’ ability to waste resources on
ill-conceived projects.
If dividends are sticky, the same argument applies (perhaps to a

lesser extent) to dividends.


1 Taxes.
2 Signalling.
3 Discipline.

Wealth appropriation
A surprise dividend – to the extent that it was not already priced

into interest rates – represents a transfer from bondholders to
shareholders.
Consider a firm in distress → shareholders may well desire a

dividend to salvage some payoff before default.
Bondholders thus sometimes restrict dividend payments via

covenants.

This week’s lectures
1 Facts & practicalities.
2 How much cash to return to shareholders?
3 How to return cash to shareholders?
4 Evaluating firms’ decisions.

How to return cash to shareholders?

How to return cash to shareholders?
Firms that decide to return cash to shareholders then have to

decide how: dividends or buybacks?
Traditionally we think of payout policy coming in the form of

dividends, but in recent years buybacks have increased in
popularity.
Before we discuss the benefits of the two policies...

Dividends vs buybacks in perfect capital markets
Recall Genron, a firm looking to return cash to shareholders.
We showed it was indifferent between two policies:

1 Pay a $2 dividend now.
2 Raise cash and pay higher dividend ($4.80) now.
Both left it with a share price of $42.

Suppose instead that Genron does not pay a dividend this year, but
uses the $20mn to repurchase its shares on the open market.
With an initial share price of $42, Genron will repurchase $20mn /

$42 per share =0.476 million shares, leaving only 10-0.476 = 9.524
million shares outstanding.

In future years, Genron expects to have $48mn in free cash flow,

which can be used to pay a dividend of $48mn / 9.524 million
shares = $5.04 per share each year.
Thus, with a share repurchase, Genron’s share price today is:
5.04
P= = $42
0.12
The same as under all the other policies.
In perfect capital markets, this choice is also irrelevant.

Advantages of buybacks: firms
1 Buybacks are one-time payouts.

• Don’t commit a firm to future payments.
• Particularly valuable following windfalls or if future cash flows
and investment needs are uncertain.
2 Easier to reverse.
3 Buybacks can help increase insider control for a firm.
• If insiders don’t tender shares.
4 Can help support stock price.

Advantages of buybacks: investors & managers
Investors
1 May be tax advantages to buybacks rather than dividends
(though not for all investors).
• Even if they’re taxed at the same rate, investors don’t have to
sell if they don’t want to, so don’t have to realise capital gains.
2 Buybacks are more selective: shareholders who really want
cash can sell, whilst those who don’t will not sell.
Managers
• Managers often receive options on the stock of the firms they
manage.
→ option to buy stock.
• This will lead them to favour buybacks.
• Dividends push prices down.
• Buybacks tend to push prices up.
→ options are more valuable when stock price increases.

Evaluating firms’ decisions

Steps to analyse dividend policy
1 How much is available to be paid out?

2 How much cash has the company accumulated over time?
3 How good are existing and new investments?
4 How does it affect the firm’s financing policy?



Free cash flow to equity (FCFE)
To estimate how much cash a firm can afford to return to

shareholders, begin with net income.
Net income is an accounting measure, which needs adjusting.

→ Include non-cash charges, like depreciation, but not the cost of
capital investment directly.
Capital expenditures & depreciation

• Depreciation is not a cash expense, but a method used for
accounting purposes to allocate the purchase cost of an asset
over its life.
• We want cash flows, which means we want the actual capital
expenditures when they are made.

Net working capital (NWC)
• A firm’s net working capital is the difference between current
assets and current liabilities, where ‘current’ means it’s due or
can be converted to cash within 1 year.
• Key components:
1 Cash.
2 Inventory.
3 Receivables minus payables.
→ Customers may not pay for their purchases immediately.
→ Also true for the firm.
• Net working capital is not cash that’s ‘available’ to the firm or
to be paid out to shareholders.
→ Changes in net working capital need subtracting from cash
flows.

FCFE measures the cash left over after taxes, reinvestment needs
and debt cash flows have been met.
Adjusting net income for capital expenditures and depreciation

together with changes in working capital gives the simplest formula
for FCFE:
FCFE = net income

− (capital expenditures - depreciation)
− change in working capital
Note: this is true if a firm has no net debt payment, meaning there
are no payments coming due on past debt.

If a firm decides to increase its net borrowing it will increase its

FCFE:
FCFE = net income

− (capital expenditures - depreciation)
− change in working capital
+ (new debt issued - debt repayments)

If a firm decides to target a fixed debt ratio (δ) and uses this ratio
when funding net capital expenditures and working capital:
FCFE = net income

− (capital expenditures - depreciation
+ change in working capital)(1 − δ)

FCFE and dividends
FCFE can be used to measure dividend policy.
We can define the following ratio:
Dividends+Equity repurchases
Cash to stockholders/FCFE =
FCFE
If this is ≈ 100% over time → the firm is paying out all it can
to stockholders.
If it is below 100% it is paying out less than it can afford and using
the difference to increase cash or invest in securities.
It it is above 100% it is paying out more than it can afford and

either drawing on existing cash balances or issuing new securities.

Why not pay out 100%?
Firms might pay out less than 100%:

1 Retain cash to take on future investments.
→ Avoid cost of having to subsequently issue.
2 Buffers for future shocks to earnings.
→ Help smooth dividends and avoid distress costs.
3 Empire building: increase cash to create a big firm.
4 Bondholders may restrict payouts.
Firms might pay out more than 100%:

1 Maintaining dividends despite shocks to earnings.
2 Interaction with financing decision.


2 How much cash has the company accumulated over
time?

Cash balances
A firm’s holdings of cash and cash-like assets (scaled by firm value)

is a stock measure of the firm’s past payout policy.
→ If this is large, it could have paid more dividends in the past if it
had wished.
It is also a measure of potential to pay dividends in the future.

→ If it is large, firms can pay more dividends in the future.
Why build up cash balances?

→ Use to make future investments without costly issuance.
Firms with larger cash balances will face more pressure to

pay out.



Assessing project quality
Investors are happy for firms to retain cash if they have a track
record of undertaking good projects and good future
prospects.
If they have a bad track record or bad prospects, investors will

apply pressure to pay out.
To evaluate a firm’s payout policy, you need a measure of its

project quality. For example:
1 Compare return on equity to cost of equity over recent years.
2 Compare return on invested capital to WACC.
3 Jensen’s alpha.



Dividend and financing interactions
Payout policy affects leverage: we can increase leverage by

increasing dividends or repurchasing stock.
As a result, we cannot analyse dividend policy in isolation.

→ Should also consider if firm is under- or over-levered and
whether they intend to change this.
An over-levered firm with poor projects and a cash flow surplus

may be better spending the cash reducing debt rather than paying
dividends.



Coca Cola in 2018
1 Current Cashflow: returned $9.3 billion in cash but its FCFE

was even higher (almost $12 billion).
2 Cash Balance: had accumulated almost $20 billion in cash,
about 10% of firm value.
3 Project Quality: generated positive excess returns (≈ 12%)
but its core beverage business was stagnant and growth was
scarce.
4 Leverage: The company was under levered, with a debt ratio
well below its optimal debt ratio.

Coca Cola in 2018
1 Current Cashflow: returned $9.3 billion in cash but its FCFE

was even higher (almost $12 billion).
3 Project Quality: generated positive excess returns (≈ 12%)
but its core beverage business was stagnant and growth was
scarce.
well below its optimal debt ratio.
Coca Cola has continued with significant payouts in recent
years, including buybacks.

Alphabet in 2018
1 Current Cashflow: had not returned cash to stockholders in

recent years, either as dividends or stock buybacks. In the
most recent year, the company had about $11 billion in FCFE.
3 Project Quality: positive excess returns: RoIC - Cost of
capital ≈ 14%, but almost all from its search engine business.
The rest of its businesses were money losers.
of 2% and an estimated optimal ratio of 30%.

Alphabet in 2018
1 Current Cashflow: had not returned cash to stockholders in

recent years, either as dividends or stock buybacks. In the
most recent year, the company had about $11 billion in FCFE.
3 Project Quality: positive excess returns: RoIC - Cost of
capital ≈ 14%, but almost all from its search engine business.
The rest of its businesses were money losers.
of 2% and an estimated optimal ratio of 30%.
In recent years Alphabet has run major buyback schemes.

Summary
Stylised facts and practicalities
1 Understand what dividends and buybacks are.
2 Be comfortable with terminology.
3 Know stylised facts.
How much cash to return?

1 Perfect capital markets.
1 Modigliani-Miller again.
2 Logic.
3 Homemade dividends.
4 Interpretation and contribution of result.
2 Imperfect capital markets.
• Role of taxes.
• Other frictions.

Summary
How to return cash?

1 Modigliani-Miller once more.
2 Reasons to prefer buybacks.
Analysing dividend policy

1 Computing FCFE.
2 Logic of analysing payout policy: am I happy for this firm to
keep hold of cash it could pay to me?
3 Evaluate real firms’ payout policies.

Dividend Decision: Imperial College Business School

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Dividend Decision: Imperial College Business School

Uploaded by

Copyright:

Available Formats

Dividend Decision

Imperial College Business School

Jamie Coen Dividends 1 / 71

Maximise the Value of the Firm

The Investment Decision The Financing Decision The Dividend Decision

Jamie Coen Dividends 2 / 71

Firms choose what to do with their earnings:

Jamie Coen Dividends 3 / 71

1 Facts & practicalities.

2 How much cash to return to shareholders?

3 How to return cash to shareholders?

4 Evaluating firms’ decisions.

Jamie Coen Dividends 4 / 71

Dividend: money paid by a firm to its shareholders.

Public company’s board determines dividend policy: will one be

Announced on the declaration date.

Dividend paid to those holding shares on a specific date: the

3 business days for shares to be registered → to get dividend

Jamie Coen Dividends 5 / 71

Ex-dividend date: 2 days before record date → investors buying

Cum-dividend: dates before ex-dividend date (but after

Regular dividend: paid at regular intervals.

Special dividend: one-time dividend that is usually much larger

Payable date/distribution date: dividend is paid.

Jamie Coen Dividends 6 / 71

Jamie Coen Dividends 7 / 71

Alternative way to pay cash to investors is through a share

Firm uses cash to buy shares of its own outstanding stock.

These shares are generally held in corporate treasury (non-voting

Three ways of repurchasing shares:

Jamie Coen Dividends 8 / 71

Firm announces its intention to buy the shares in the open

Jamie Coen Dividends 9 / 71

Jamie Coen Dividends 10 / 71

1 How much cash (if any) to return to shareholders?

2 How to return it to them?

Jamie Coen Dividends 11 / 71

Why are dividends so sticky?

1 Inertia: firms hate to cut dividends.

Jamie Coen Dividends 13 / 71

Buybacks Dividends Proportion from Buybacks

Jamie Coen Dividends 14 / 71

Dividend payout = Dividends/Net Income

Dividend yield = Dividends per share/Stock price

Total payout = (Dividends + Buybacks)/Net Income

Jamie Coen Dividends 15 / 71

Jamie Coen Dividends 16 / 71

1 Perfect capital markets.

Jamie Coen Dividends 17 / 71

2 Firms can raise external financing from debt or equity, with no

3 No costs – direct or indirect – associated with bankruptcy.

4 No agency costs: managers maximise stockholder wealth,

5 Investors and firms can trade the same set of securities at

Jamie Coen Dividends 18 / 71

Barston mining has $100k in excess cash.

It is considering investing in one-year Treasury bills paying 6%

Alternatively, it could pay one immediately and the firm’s

Which option will shareholders prefer?

Jamie Coen Dividends 19 / 71

Immediate dividend: shareholders receive $100k today.

Retain the cash: Barston can pay dividend of 1.06×$100k=$106k

Payoff is the same as if shareholders had invested the $100k