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The Dividend Controversy

 Principles of

Corporate

 Finance

Seventh Edition

Richard A. Brealey

Stewart C. Myers

Slides by

Matthew Will

Chapter 16

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Topics Covered

How Dividends Are Paid

How Do Companies Decide on DividendPayments?

Information in Dividends and StockRepurchases

The Dividend Controversy

The Rihtists Ta!es and the Radica" #eft

The $idd"e of the Roaders

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Types of Dividends

Cash Div

Reu"ar Cash Div

Specia" Cash Div

Stock Div

Stock Repurchase %& methods'

() *uy shares on the market+) Tender ,ffer to Shareho"ders

&) Private -eotiation %.reen $ai"'

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Dividend ay!ents

Cash Dividend / Payment of cash 0y the firm

to its shareho"ders)

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Dividend ay!ents

Cash Dividend / Payment of cash 0y the firm

to its shareho"ders)

"#$Dividend Date / Date that determineswhether a stockho"der is entit"ed to a dividend

 payment1 anyone ho"din stock 0efore this

date is entit"ed to a dividend)

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Dividend ay!ents

Cash Dividend / Payment of cash 0y the firm

to its shareho"ders)

"#$Dividend Date / Date that determineswhether a stockho"der is entit"ed to a dividend

 payment1 anyone ho"din stock 0efore this

date is entit"ed to a dividend)

Record Date / Person who owns stock on this

date received the dividend)

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Dividend ay!ents

Stoc% Dividend / Distri0ution of additiona"shares to a firm2s stockho"ders)

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Dividend ay!ents

Stoc% Dividend / Distri0ution of additiona"shares to a firm2s stockho"ders)

Stoc% Splits / Issue of additiona" shares tofirm2s stockho"ders)

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Dividend ay!ents

Stoc% Dividend / Distri0ution of additiona"shares to a firm2s stockho"ders)

Stoc% Rep&rchase / 3irm 0uys 0ack stock

from its shareho"ders)

Stoc% Splits / Issue of additiona" shares tofirm2s stockho"ders)

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The Dividend Decision

() 3irms have "oner term taret dividend payout

ratios)

+) $anaers focus more on dividend chanes than on

a0so"ute "eve"s)

&) Dividends chanes fo""ow shifts in "on/run4

sustaina0"e "eve"s of earnins rather than short/runchanes in earnins)

5) $anaers are re"uctant to make dividend chanes

that miht have to 0e reversed)

 Lintner’s “Stylized Facts” (How Dividends are Determined)

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The Dividend Decision

Attitudes concernin dividend tarets vary

Dividend Chane

(

(

EPSratiotaret

dividendtaretDI6

×=

=

(

(

EPSratiotaret

dividendtaretDI6

×=

=

7(

7(

DI6/EPSratiotaret

chanetaretDI6/DI6

×=

=

7(

7(

DI6/EPSratiotaret

chanetaretDI6/DI6

×=

=

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The Dividend Decision

Dividend chanes confirm the fo""owin

( )7(

7(

DI6/EPSratiotaretratead8ustment

chanetaretratead8ustmentDI6/DI6

××=

×=

( )7(

7(

DI6/EPSratiotaretratead8ustment

chanetaretratead8ustmentDI6/DI6

××=

×=

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Dividend olicy

$1'

$1(

$'

(

'

1(

1'

Div Rise

Div Cut

 Source: Healy & Paleu (!"##)

   C   h  a  n  )  e

   "      S   *     r   i  c  e  a   t   t  +

   (  a  s   ,

-ear

 Impact of Dividend Changes on EPS 

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Dividend olicy is rrelevant

Since investors do not need dividends toconvert shares to cash they wi"" not pay

hiher prices for firms with hiher dividend

 payouts) In other words4 dividend po"icy wi""have no impact on the va"ue of the firm)

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Dividend olicy is rrelevant

"#a!ple / Assume Rationa" Demiconductor has no e!tra cash4 0ut dec"ares a

9(4777 dividend) They a"so re:uire 9(4777 for current investment needs);sin $share 312 

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Dividend olicy is rrelevant

"#a!ple / Assume Rationa" Demiconductor has no e!tra cash4 0ut dec"ares a

9(4777 dividend) They a"so re:uire 9(4777 for current investment needs);sin $share 9(+ 311

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Dividend olicy is rrelevant

"#a!ple / Assume Rationa" Demiconductor has no e!tra cash4 0ut dec"ares a

9(4777 dividend) They a"so re:uire 9(4777 for current investment needs);sin $share 9(+ 9(( 311

7"W S8AR"S AR" SS9"D

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Dividend olicy is rrelevant

 

"#a!ple / continued / Shareho"der 6a"ue

  Record

Stock (+4777Cash 7

Tota" 6a"ue (+4777

Stock (4777 sh B 9(+ (+4777

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Dividend olicy is rrelevant

 

"#a!ple / continued / Shareho"der 6a"ue

  Record Pmt

Stock (+4777 ((4777Cash 7 (4777

Tota" 6a"ue (+4777 (+4777

Stoc% + 1/(((sh 5 311 + 11/(((

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Dividend olicy is rrelevant

 

"#a!ple / continued / Shareho"der 6a"ue

  Record Pmt ost

Stock (+4777 ((4777 12/(((Cash 7 (4777   (

Tota" 6a"ue (+4777 (+4777 12/(((

Stoc% + 1/(01sh 5 311' + 12/(((

Assume stockho"ders purchase the new issue with the cash

dividend proceeds)

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Dividends ncrease :al&e

Mar%et !perfections and Clientele "ffect

There are natura" c"ients for hih/payout stocks4

 0ut it does not fo""ow that any particu"ar firm can

 0enefit 0y increasin its dividends) The hihdividend c"iente"e a"ready have p"enty of hih

dividend stock to choose from)

These c"ients increase the price of the stock

throuh their demand for a dividend payin stock)

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Dividends ncrease :al&e

Dividends as Si)nals

Dividend increases send ood news a0out cash

f"ows and earnins) Dividend cuts send 0ad news)

*ecause a hih dividend payout po"icy wi"" 0e

cost"y to firms that do not have the cash f"ow to

support it4 dividend increases sina" a company2s

ood fortune and its manaer2s confidence in

future cash f"ows)

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Dividends Decrease :al&e

Ta# Conse;&ences

Companies can convert dividends into capita"ains 0y shiftin their dividend po"icies) Ifdividends are ta!ed more heavi"y than capita"ains4 ta!payin investors shou"d we"come such amove and va"ue the firm more favora0"y)

In such a ta! environment4 the tota" cash f"owretained 0y the firm and>or he"d 0y shareho"derswi"" 0e hiher than if dividends are paid)

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Ta#es and Dividend olicy

Since capita" ains are ta!ed at a "ower ratethan dividend income4 companies shou"d pay

the "owest dividend possi0"e)

Dividend po"icy shou"d ad8ust to chanes inthe ta! code)

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Ta#es and Dividend olicy

7)(7(777)(7(77%'returnof rateAfter ta!

)'5)75%'+)5(7%(7F7)+'F7)(+7%ta!es'/aincap%div

incomeTa!AfterTota"

5)7+)5)+7+)F7(+)F7)+7+7B.ainCaponTa!

5)77(7)577F7BdivonTa!

7F)(F(77F)(+(77%'returnof ratePreta!

5)+(+)F7ainCapita"

)(77 pricestocksTodayG((+)F7((+)F7 payoff  preta!Tota"

(77Dividend

(7+)F7((+)F7 pricesyearG -e!tdividend'%hih

*3irm

dividend'%no

A3irm

))

(77(7

)(5)+

(77(+)F

=×=×

=+−−=−+

+

=×=×

=×

=×=×

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Ta#es and Dividend olicy

2000 Marginal Income Tax Bracets

 $ncome %arac&et 

Mar)inal Ta# Rate Sin)le Married 4

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Ta#es and Dividend olicy

'as( Flow

,peratin Income (77

Corporate ta! at &F &F

After Ta! income %paid as div' HF

Income ta! paid 0y investors at &?)H +F)D

Cash to Shareho"der &?)&

In ;)S)4 shareho"ders are ta!ed twice %fiures in do""ars'

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M G Hill/I i

Ta#es and Dividend olicy

 )ate o* $ncome ta+ 

1', =(, >?,

,peratin Income (77 (77 (77

Corporate ta! %Tc)&7' &7 &7 &7

After Ta! income 7 7 7

.rossed up Dividend (77 (77 (77

Income ta! (F &7 5

Ta! credit for Corp Pmt /&7 /&7 /&7

Ta! due from shareho"der /(F 7 (

Cash to Shareho"der F 7 F&

;nder imputed ta! systems4 such as that in Austra"ia4 Shareho"dersreceive a ta! credit for the corporate ta! the firm pays %fiures in

Austra"ian do""ars'