Dividend and Stock Price

7/24/2019 Dividend and Stock Price

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Dividend Policy and

Stock Price



Stock Return Has Two Components

Dividend Yield(% Gained

FromDividend

Cash Flow)

Capital Gain

Yield (% thatstock grows)



The firm uses earnings plus the additionalfinancing that the increased equity can support to

finance any expected positive-NPV projects.

Any unused earnings are paid out in the form ofdividends. This describes a passive dividendpolicy.

Can the payment of cash dividends affectshareholder wealth?

If so, what dividend-payout ratio willmaximize shareholder wealth?



Ir relevance of Div idends

M&M contend that the effect of dividendpayments on shareholder wealth isexactly offset by other means offinancing.

The dividend plus the “new” stock price

exactly equals the stock price prior to thedividend distribution.

A. Current dividends versus retentionof earnings



Ir relevance of Div idends

M&M and the total-value principle ensures

that the sum of market value plus currentdividends of two firms identical in allrespects other than dividend-payout ratioswill be the same.

Investors can “create” any dividend policythey desire by selling shares when thedividend payout is too low or buying shareswhen the dividend payout is excessive.

B. Conservation of value



Relevance o f Div idends

Uncertainty surrounding future company

profitability leads certain investors toprefer the certainty of current dividends.

Investors prefer “large” dividends.

Investors do not like to manufacture“homemade” dividends, but prefer the

company to distribute them directly.

A. Preference for dividends




Capital gains taxes are deferred until the

actual sale of stock. This creates a timingoption.

Capital gains are preferred to dividends,everything else equal. Thus, high dividend-

yielding stocks should sell at a discount togenerate a higher before-tax rate of return.

Certain institutional investors pay no tax.

B. Taxes on the investor




Corporations can typically exclude 70% of dividend

income from taxation. Thus, corporations generallyprefer to receive dividends rather than capital gains.

The result is clienteles of investors with differentdividend preferences. In equilibrium, there will be

the proper distribution of firms with differingdividend policies to exactly meet the needs ofinvestors.

Thus, dividend-payout decisions are irrelevant.

B. Taxes on the investor (continued)



Implications of 3 Theories for Managers

Theory Implication

Irrelevance Any payout OK

Bird-in-the-hand Set high payout

Tax preference Set low payout



Other Dividend Issues

Flotation costs

Transaction costs anddivisibility of securities

Institutional restrictions Financial signaling



Empir ical Tes t ing

of Div idend Pol icy

Tax Effect

Dividends are taxed more heavily (in PV terms) thancapital gains, so before-tax returns should be higherfor high-dividend-paying firms.

Empirical results are mixed -- recently the evidenceis largely consistent with dividend neutrality.

Financial SignalingExpect that increases (decreases) in dividends lead

to positive (negative) excess stock returns.

Empirical results are consistent with these

expectations.



Impl icat ions for

Corpo rate Po l icy

Establish a policy that will maximizeshareholder wealth.

Distribute excess funds to shareholdersand stabilize the absolute amount ofdividends if necessary (passive).

Payouts greater than excess fundsshould occur only in an environmentthat has a net preference for dividends.



Impl icat ions for

Corpo rate Po l icy

There is a positive value associatedwith a modest dividend. Could be due

to institutional restrictions orsignaling effects.

Dividends in excess of the passive

policy does not appear to lead toshare price improvement because oftaxes and flotation costs.



Facto rs In f luencing

Dividend Pol icy

Funding Needs of the Firm

Liquidity

Ability to Borrow

Restrictions in Debt Contracts(protective covenants)

Control

Legal Rules



Factors Affecting Payout

PolicySignaling

Agency ProblemsTaxes

Capital Structure AdjustmentsExcess Cash Flow

Provide Liquidity



Dividend Stab i l ity

Stability -- maintaining the position of the firm’s

dividend payments in relation to a trend line.

D o l l a r s P

e r S h a r e

3

4

2

1

Earnings per share

Dividendsper share

Time

50% of earningspaid out as dividends




Dividends begin at 50% of earnings, but are stable andincrease only when supported by growth in earnings.

D o l l a r s P

e r S h a r e

3

4

2

1

Earnings per share

Dividends per share

Time

50% dividend-payoutrate with stability



Valuat ion o f


Information content -- management may be able toaffect the expectations of investors through theinformational content of dividends. A stable dividend

suggests that the company expects stable orgrowing dividends in the future.

Current income desires -- some investors who desirea specific periodic income will prefer a company withstable dividends to one with unstable dividends.

Institutional considerations -- a stable dividend maypermit certain institutional investors to buy thecommon stock as they meet the requirements to beplaced on the organizations “approved list.”



What’s the “residual

distribution model”?

Find the reinvested earnings

needed for the capital budget.Pay out any leftover earnings

(the residual).

This policy minimizes flotationand equity signaling costs,hence minimizes the WACC.



Using the Residual Model to CalculateDistributions Paid

Distr. = – .Net

incomeTargetequityratio

Totalcapitalbudget[ ]))((



Case-1-

Driver Corporation has plans calling for a capitalbudget of $60 million. Its optimal capitalstructure is 60 percent equity and 40 percentdebt. Its earnings before interest and taxes

(EBIT) were $98 million for the year. The firm has$200 million in assets, pays an average of 10percent on all its debt, and faces a marginal taxrate of 35 percent. If the firm maintains a residualdistribution policy (with all distributions in theform of dividends) and will keep its optimalcapital structure intact, what will be the amount ofthe dividends it pays out after financing its capitalbudget?



Calculate interest cost:

Total assets = $200M; 40% debt $200M = $80 million in debt.

Interest cost = $80M 0.10 = $8.0 million.

Calculate net income (in millions):

EBIT $98.0

less: Interest - 8.0EBT $90.0

less: Taxes (@35%) - 31.5

Net income $58.5

The portion of projects financed with retained earnings:

Capital budget calls for $60 million in positive NPV projects.

Retained earnings portion: $60M * 0.60 = $36.0 millionDebt portion: $60M * 0.40 = $24.0 million

Calculate residual available for dividends:

$58.5M - $36.0M = $22.5 million in dividends.

The dividends payout ratio=38%



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Dividend and Stock Price

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