Dividend Policy

05/30/07

Ch. 21

Dividend Process

Declaration Date – Board declares the dividend and it becomes a liability of the firm

Ex-dividend Date Occurs two business days before date of record If you buy stock on or after this date, you will not

receive the dividend Stock price generally drops by about the amount

of the dividend Date of Record – Holders of record are determined

and they will receive the dividend payment Date of Payment – checks are mailed / electronic

payment made

Theoretically, stock price should adjust exactly…

Actual ex-dividend day price behavior and tax differences The stock price around the ex-dividend date actually drops by less than

the dividend amount to accommodate the tax preferences of investors.

Certain investors (tax-exempt or very low tax bracket) may be able to make excess returns by trading around this date.

These investors would buy the stock before the ex-dividend day, sell it after it goes ex-dividend, collect the dividend making a profit because the dividend exceeds the price drop. This is referred to as dividend capture or dividend arbitrage.

Ex-dividend day equality where the marginal investor is indifferent between selling the stock before and after the ex-dividend day:

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cg

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D

PP

Empirical evidence on dividends

Dividends tend to lag earnings Dividends are changed to reflect long-term shifts in

earnings

Dividends are sticky

Dividends are less volatile than earnings

Dividend policy tends to follow the life cycle of the firm with mature firms returning more to owners

How does dividend policy affect stock price? Constant growth stock valuation model:

An increase in dividends increases D1 but also decreases g

gr

DP

1

0

Three schools of thought on dividends

If (a) there are no tax disadvantages associated with dividends (b) companies can issue stock, at no cost, to raise equity,

whenever needed Dividends do not matter, and dividend policy does not

affect value. If dividends have a tax disadvantage,

Dividends are bad, and increasing dividends will reduce value

If stockholders like dividends, or dividends operate as a signal of future prospects, Dividends are good, and increasing dividends will

increase value

Dividends are irrelevant… The Miller-Modigliani Hypothesis: Dividends do not affect

value Basis:

If a firm's investment policy (and hence cash flows) does not change, the value of the firm cannot change with dividend policy. If we ignore personal taxes, investors have to be indifferent to receiving either dividends or capital gains.

Underlying Assumptions: (a) There are no tax differences between dividends and

capital gains. (b) If companies pay too much in cash, they can issue new

stock, with no flotation costs or signaling consequences, to replace this cash.

(c) If companies pay too little in dividends, they do not use the excess cash for bad projects or acquisitions.

Dividends are bad…

Individuals in upper income tax brackets might prefer lower dividend payouts, with the immediate tax consequences, in favor of higher capital gains

Additionally, Flotation costs – low payouts can decrease the amount

of capital that needs to be raised, thereby lowering flotation costs

Dividend restrictions – debt contracts might limit the percentage of income that can be paid out as dividends

Dividends are good….not for these reasons The bird in the hand fallacy: Dividends are

better than capital gains because dividends are certain and capital gains are not.

The Excess Cash Argument: The excess cash that a firm has in any period should be paid out as dividends in that period.

The bird in the hand fallacy

Argument: Dividends now are more certain than capital gains later. Hence dividends are more valuable than capital gains.

Counter: The appropriate comparison should be between dividends today and price appreciation today.

The excess cash hypothesis

Argument: The firm has (temporary) excess cash on its hands this year, no investment projects this year and wants to give the money back to stockholders.

Counter: So why not just repurchase stock? If this is a one-time phenomenon, the firm has to consider future financing needs. Consider the cost of issuing new stock If it initiates dividends, it may need to raise

capital through a stock issue just to pay dividends in the future.

Dividends are good….possibly for these reasons The Clientele Effect: There are stockholders who

like dividends, either because they value the regular cash payments or do not face a tax disadvantage. If these are the stockholders in your firm, paying more in dividends will increase value.

Dividends as Signals: Dividend changes act as signals to financial markets about the future sustainable earnings of the firm

Wealth Transfer: By returning more cash to stockholders, there might be a transfer of wealth from the bondholders to the stockholders.

A clientele based explanation

Basis: Investors may form clienteles based upon their tax brackets. Investors in high tax brackets may invest in stocks which do not pay dividends and those in low tax brackets may invest in dividend paying stocks.

Evidence: A study of 914 investors' portfolios was carried out to see if their portfolio positions were affected by their tax brackets. The study found that (a) Older investors were more likely to hold high

dividend stocks and (b) Poorer investors tended to hold high dividend

stocks

Dividends as signals

Dividend increases Stock prices increase significantly around dividend

increase announcements. Management is signaling to the market that earnings

will be sustainable at a higher level thus allowing the company to maintain a higher dividend level

The opposite is true for dividend decreases Signals are most effective for smaller firms Can you think of a negative implication of dividend

increases?

The wealth transfer hypothesis

-2

-1.5

-1

-0.5

0

0.5

t:-15

-12 -9 -6 -3 0 3 6 9 12 15

CAR (Div Up)

CAR (Div down)

EXCESS RETURNS ON STRAIGHT BONDS AROUND DIVIDEND CHANGES

Day (0: Announcement date)

CAR

Dividend policy summary

No definite conclusion can be reached about the optimal dividend policy

Investors in aggregate cannot be shown to uniformly prefer either high or low dividends

Individual investors, however, have strong dividend preferences and will tend to invest in companies whose dividend policies match their preferences

Regardless of the payout ratio, investors prefer a stable, predictable dividend policy