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DIVIDEND POLICY
Chapter 17
Alex Tajirian
Dividend Policy 17-2
© morevalue.com, 1997
1. OUTLINE
# What to do with excess cash?
# Types of dividends
# Theories of optimal dividend policy: dividend puzzle
# Some practical considerations
Alex Tajirian
Dividend Policy 17-3
© morevalue.com, 1997
Graphics: WHAT TO DO WITH EXCESS CASH
Alex Tajirian
Dividend Policy 17-4
© morevalue.com, 1997
2. OBJECTIVE & DEFINITION
Definition: Dividend is the distribution of value to shareholders.
Dividend Policy: What happens to the value of the firm as dividendis increased, holding everything else (capitalbudgets, borrowing) constant. Thus, it is a trade-offbetween retained earnings on one hand, anddistributing cash or securities on the other.
Alex Tajirian
Dividend Policy 17-5
© morevalue.com, 1997
3. TYPES3.1 CASH DIVIDEND1
Example: $.5 for every share you hold
Regular, regular + "extra" , special
Dates:
|_____________|______________|___________|____1/15 1/26 1/30 2/15Declaration Ex-dividend Record PaymentDate Date Date Date
Only investors who hold the security prior to the ex-dividenddate receive the dividend.
Alex Tajirian
Dividend Policy 17-6
© morevalue.com, 1997
3.2 STOCK DIVIDENDExample: 1 new stock for each 10 you hold
3.3 STOCK REPURCHASE2
3.1 Methodin the open markettender offerdirect negotiation with major shareholders
3.2 Reasons! Alternative to "extra" or special dividend.
Example. A company just sold a division and cannot use theproceeds 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 attractiveprice.
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.
Alex Tajirian
Dividend Policy 17-7
© morevalue.com, 1997
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 SPLITExample. (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.
Alex Tajirian
Dividend Policy 17-8
© morevalue.com, 1997
4. DIVIDEND CONTROVERSYTHEORIES
Irrelevant, rightists (high dividend), leftists (low payoff), Middle ofthe Road
k = capital gains + dividend yield
4.1 IRRELEVANTM & M in the case of perfect markets.
Reasoning: There is nothing the firm can do that investorscannot duplicate. Firm and investors have identicalopportunities.
Alex Tajirian
Dividend Policy 17-9
© morevalue.com, 1997
4.2 RIGHTISTS! Bird in the hand fallacy. "Paying out some cash today reduces
risk of future payoff uncertainty"
Alternatives CF1 CF2 CF CFT
1 0 0 ... 100 ...
2 20 20 ... 60 ...
What about return?
! Grand Ma's argument: "I need the regular cash dividend to liveon!"
4.3 LEFTISTSTax argument:
Tax on dividends = tax on income $ tax on capital gains.But tax on dividends must be paid now, while on capital gainswould be in the future.
Alex Tajirian
Dividend Policy 17-10
© morevalue.com, 1997
Illustration. Invest $100, ks = 10% , T = 40%Case 1. Stock held for 20 years.
FV20 = $100(1+.1)20 = 672.75after 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
ˆ̂ Case 1 is better. Thus, Optimal dividend policy is zero/verylow.
Alex Tajirian
Dividend Policy 17-11
© morevalue.com, 1997
hg; dividend and tax
Alex Tajirian
Dividend Policy 17-12
© morevalue.com, 1997
4.4 MIDDLE OF THE ROADSignaling. 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 ifno investment opportunities exist. They have to distribute themas dividends.
!! Institutional Restrictions:Many trust portfolios are required to protect the investmentprinciple and can only spend investment income. Thus, theytend to invest in companies with high dividends.
! Market Reaction to Dividend `̀:Price usually ̀̀ . Investors interpret it as a negative signal, in thatthe firm's future opportunities are not good.
Alex Tajirian
Dividend Policy 17-13
© morevalue.com, 1997
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.
Alex Tajirian
Dividend Policy 17-14
© morevalue.com, 1997
1. On recent trends, see LAT 1/27/93 p. E158. On DividendReinvestment Plans (DRIPs) see LAT 2/16/93 p. E56.
2. See LAT 6/12/92 p. E164.
7. ENDNOTES
Alex Tajirian
Dividend Policy 17-15
© morevalue.com, 1997
8. QUESTIONS
True\False-Explain
1. If a company has excess cash, then it should acquire another.
2. Given U.S. tax laws, the optimal dividend policy should be zero dividends.
3. Stock repurchase is a form of dividend.
4. Stock splits should have no effect on the value of a company.
5. If XYZ Inc. announces an increase in its dividends and the price of the stock increases onthe same day, then you can conclude that investors prefer dividend income over capital gains.
6. The 1993 tax changes (tax on dividend $ tax on capital gains) make high dividend payingstocks more attractive to the average investor.
7. SPDRs can have no disadvantages over an S&P500 mutual fund.
8. If splitting a stock increases its liquidity, then the firm necessarily benefits.
9. 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.
Alex Tajirian
Dividend Policy 17-16
© morevalue.com, 1997
Value of Firm ' Price× (# of Shares)
Value After Split:Price
2× (# of shares × 2)
Y Value unchanged
9.0 ANSWERS TO QUESTIONS
True\False-Explain
1. False. If the company does not have any positive NPV projects to invest in, then itshould pay shareholders dividend (either extra dividends or repurchase stock). Note,acquiring another company in the same line of business is also considered a project.
2. True. See notes for explanation
3. True. Since dividends are defined as a distribution of wealth. Stocks have to be re-purchased at a price higher than then market price. Thus, additional value has to bedistributed to shareholders.
4. True.
5. False. A possible explanation for the price increase might be than investors interpret theincrease as a strength in the company's future earnings prospects. Thus, they buy thestock, this increases the demand for the stock, and thus its price goes up. An alternativeexplanation, which has nothing to do with dividends, might be that the general stock
Alex Tajirian
Dividend Policy 17-17
© morevalue.com, 1997
market went up, and so did XYZ Inc!
6. False. Actually the opposite is true. The new lax laws make high paying dividend stockseven less attractive to the average investor.
7. False. One disadvantage of SPDRs is that dividends, from the underlying stocks, aredistributed to shareholders. An index fund, on the other hand, can devise a dividend re-investment plan to reduce the dividend tax effect.
8. 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 primarymarket that is more of a concern to the firm.
9. False. With a 3-to-1 split you end up with 3 shares for each that you held. Moreover, thenew price ought to be a third of the original price.
Alex Tajirian