Wk50 Dividend Policy

8/10/2019 Wk50 Dividend Policy

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Dividend Policy

Finance 1 Text- and Workbook:

Chapter 18

Berk & DeMarzo:Chapter 17


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Payout Policy

when a firms investments generate

free cash flow, how to use the cash?1. NPV > 0 opportunities

then reinvest the cash: V

investment projects

e.g. young, rapidly growing firms

acquisitions / takeovers

2. no attractive investment opportunities

e.g. mature, profitable firms

retain cash, i.e. hold the funds

as part of cash reserves pay the cash out to shareholders

- pay a dividend

- repurchase shares


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Dividend payout

announcement date

commonly being the declaration date,

when the board of directorsauthorizes the dividend

e.g. 5 months before the payable date

the stock is said to trade cum-dividend

until the ex-dividend date: Pcum

ex-dividend dateon or after this date, anyone who

purchases the stock will not receive

the dividend: Pexusually two days before the record date

the stock is said to trade ex-dividend record date

the date on which the shareholders

have to be registered in order to receive

a usually regular dividend per share

(special dividend = a one-time dividendpayment a firm makes, usually larger)

payable / distribution date

the date on which the dividend checks

are mailed to the registered shareholders

usually a month after the record date


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Example 1: pay dividend with excess cash

in a perfect market, a firm

is all-equity financed, ru= 12%

has 10 million shares outstanding

has 20 million in excess cash, so

it can pay out a dividend of 2 per share

immediately

expects to generate 48 million free CFs

per year in subsequent years, therefore

it anticipates paying a dividend of

48/10 = 4,80 per year each year thereafter

Pcum= Current Dividend + PV(Future Dividends)

= 2 + 4,80 / 0,12 = 2 + 40 = 42

Pex= PV(Future Dividends)= 4,80 / 0,12 = 40


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On the ex-dividend date the share

price falls exactly by the amount

of the dividend = 2 leaving the shareholders

with stock worth 40 and 2 in cashfrom the dividend, for a total of 42,

that is, they do not incur a loss overall.

No opportunity for arbitrage exists. So

in a perfect capital market, the dividendcovers the capital loss on the stock exactly

i.e., an investor cannot earn a profit by

buying the stock just before it goes ex-dividend

and selling it just thereafter, or vice versa


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Excess Cash = 20

Enterprise Value = PV(FCFs) = 48 / 0,12 = 400

Total Market Value = 20 + 400 = 420

Cum-Dividend date

Assets Liabilities

Cash 20 E 420

Other assets 400

420 N = 10 million

P = 42

Dividend Payout = 20 V

Total Market Value = 400

Ex-Dividend date

Assets Liabilities

Cash 0 E 400

Other assets 400400 N = 10 million

P = 40


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If an investor doesnt want the cash,

he can undo the dividend payout

by using the proceeds of the dividend

to purchase additional shares at theex-dividend price (reinvesting dividends

is a NPV = 0 transaction)

e.g. an investor j

before the dividend payout

Pcum= 42

Nj= 1680

Vj= 42 1680 = 70.560

after the dividend payout

Divj= 1680 2 = 3.360

Pex= 40Nj = 1680

Vj= 40 1680 + 3.360 = 67.200 + 3.360

Divj= 3.360 is used to buy

84 additional shares (84 40 = 3.360)

Pex= 40Nj= 1680 + 84 = 1764

Vj = 40 1764 = 70.560

NPV = 0 transaction


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If there is no dividend payout,

by selling equity (NPV = 0 transaction)

the investor can raise the cash himself

= homemade dividend

e.g. an investor

initial position

P = 42

Nj= 1680Vj= 42 1680 = 70.560

by selling 80 shares

homemade dividend = 80 42 = 3.360

P = 42

Nj= 168080 = 1600Vj= 42 1600 + 3.360 = 67.200 + 3.360

NPV = 0 transaction


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Example 2: high dividend (equity issue)

the firm raises 28 million by issuing

equity, so it can start paying 48 millionin dividends now

number of shares sold = 28 / 42 = 0,67 million

number of shares outstanding = 10,67 million

dividend per share = 48 / 10,67 = 4,50

Pcum= 4,50 + 4,50 / 0,12 = 42

the initial share price is unchanged

by this policy and increasing the dividend

has no benefit to shareholders

Alternative P = 42 constant

1: dividend=2 at t=0 2 + 4,80 / 0,12 = Pcum

2: dividend=4,50 at t=0 4,50 + 4,50 / 0,12 = Pcum

Question: Pex? Answer:

Pex= 4,50 / 0,12 = 37,50

Pex= 424,50 = 37,50


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Because by buying or selling shares

which are zero-NPV transactions (so,

there is no benefit to shareholders),

investors can replicate or undoanychoice of dividend policy by a firm, which

therefore must also be a zero-NPV transaction

MM Dividend Irrelevance Proposition

In perfect capital markets, holding fixed

the investment policy of a firm, the firms

choice of dividend policy is irrelevant and

does not affect the initial share price


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Share repurchase

= a buyback of shares by a firm

of its own outstanding stock

open market repurchasein about 95% of all repurchase transactions

often, the intention to do so, is announced

tender offer

usually, the price is set at a substantial

premium to the current market price

(10% - 20% is typical)

Dutch auction

different prices are listed for different

numbers of shares; the firm then paysthe lowest price at which it can buy

back its desired number of shares

targeted repurchase

buyback directly from a major shareholder

where the purchase price is negotiateddirectly with the seller

- major shareholder wants to sell

maybe at a discount

- to reduce the threat of a takeover

often at a large premium (greenmail)


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Example 3: share repurchase (no dividend)

the firms does not pay a dividend

this year, but instead uses the 20 million

to repurchase its shares on the open market

Before Repurchase

Assets Liabilities

Cash 20 E 420Other assets 400

420 N = 10 million

P = 42

firm repurchases 20 / 42 = 0,476 million sharesleaving 9,524 million shares outstanding

After Repurchase

Assets LiabilitiesCash 0 E 400

Other assets 400

400 N = 9,524 million

P = 42


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Firm expects to generate 48 million

free CFs per year in subsequent years,

and anticipates paying a dividend of

48 / 9,524 = 5,04 per share each year thereafter

Prep= 5,04 / 0,12 = 42

Thus, by not paying a dividend today and

repurchasing shares instead, the firm is able

to raise its dividends per share in the future


1: dividend=2 at t=0 2 + 4,80 / 0,12 = Pcum2: dividend=4,50 at t=0 4,50 + 4,50 / 0,12 = Pcum3: share repurchase 5,04 / 0,12 = Prep

The increase in future dividends compensates

shareholders for the dividend they give up today.

Therefore, the share repurchase has no effect on

the stock price, and Prep= Pcum= Div + Pex


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Perfect capital markets

Regardless of the amount of cash the firm

has on hand, it can pay a smaller dividend(and use the remaining cash to repurchase

shares or pay out a larger dividend by selling

equity to raise the necessary cash).

Shareholders can create a homemade

dividend of any size by buying or selling

shares themselves and, in such a way,

replicate either payout methodon their own.

Since equity is fairly priced, these buys and

sells are zero-NPV transactions and therefore

do not add or destroy value. If this holds forthe shareholders achieving the same result

as the firm obtains, its payout choices must

leave the current share price unchanged.


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Notice that, if possible, an alternative policy is

to invest the excess cash in an equal risk project

which produces the same present value per share

as in the case of a share repurchase: P = Prep

Example 4: purchase financial assetsThat is, 20 million immediately is equivalent to

an investment in financial assets producing 2,4

million each year thereafter, discounted at 12%:20 = 2,4 / 0,12 or, likewise, 2 per share is

equivalent to an investment in financial assets

producing 0,24 per share each year thereafter,

discounted at 12%: 2 = 0,24 / 0,12


1: dividend=2 at t=0 2 + 4,80 / 0,12 = Pcum2: dividend=4,50 at t=0 4,50 + 4,50 / 0,12 = Pcum3: share repurchase 5,04 / 0,12 = Prep

4: purchase securities 0,24 / 0,12 + 4,80 / 0,12


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As a rule, a firm only goes to the capital market

for financing purposes or risk management

and does not make it its object to trade insecurities.

f a firm retains cash, it holds the cash in the

bank or purchases Treasury bills, which are

zero-NPV financial investments.The firm can then pay the money (+ interest) to

shareholders at a future time or invest it when

positive-NPV investment opportunities become

available.


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Example 5: retaining cash

That is, 20 million immediately is equivalent to

an investment in Treasury bills producing 0,80

million interest each year thereafter, discounted

at 4%: 20 = 0,80 / 0,04 or, likewise, 2 per share

is equivalent to an investment in Treasury bills

paying 0,08 interest per share each year

thereafter, discounted at 4%: 2 = 0,08 / 0,04


1: dividend=2 at t=0 2 + 4,80 / 0,12 = Pcum

2: dividend=4,50 at t=0 4,50 + 4,50 / 0,12 = Pcum3: share repurchase 5,04 / 0,12 = Prep

4: purchase securities 0,24 / 0,12 + 4,80 / 0,125: retaining cash 0,08 / 0,04 + 4,80 / 0,12

MM Payout Irrelevance Proposition

In perfect markets, if a firm invests excess cash

in financial securities, the firms choice of payout

versus retention is irrelevant and does not affect

the initial value of the firm [holding fixed the

investment policy of the firm]


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Summarizing :

1. dividend payout financed by cash reserves

V , Div + Pex= Pcum, N = constant

2. dividend payout fully financed

by an equity issue at the same time

(to hold a fixed investment policy)

V =, Pex< Pcum, N

3. share repurchase financed by cash reservesV , Prep= Pcum, N

4. purchase securities financed by excess cash

V = and P =

5. retain cash

V = and P =

There is no difference to shareholders

if the firm pays the cash immediately

if the firm retains the cash (and invests it infinancial securities) and pays it out at a future date

n perfect capital markets, holding fixed the investment

policy of a firm, the firms announcementof a (change

n) payout policy does not affect the initial share price


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Dividend policy

with perfect capital markets

while dividends do determine shareprices, a firms choice of dividend

policy does not

with corporate tax

no dividend irrelevancecash is equivalent to negative leverage;

so, the tax advantage of leverage implies

a tax disadvantage of holding cash;

to retain excess cash and invest it in

financial assets is costly (NPV


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with personal taxes

= capital gains tax rate

= dividend tax rate

if , e.g. , then

personal taxes discriminatebetween

capital gains and dividend payouts

(which make up the investors income)

Pcum

Pnow

Pex

under the assumption that arbitrage

opportunities are absent, the expected

rates of return r* relating to just before

the stock goes ex-dividend and to just

thereafter must be the same

g

d

dg dg

nowgnowcum

* )/P)(1P(Pr

nowdgnowex

* )]/PDiv(1))(1P[(Pr

g

dexcum

1

1DivPP

time


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Similarly, the change from just before

to just thereafter yields no return

(PexPcum)(1g)+ Div(1d) = 0

Thus

So, the price drop is determined by thedividend policy of the firm and by the tax

rates g& dthe market faces, or

more precisely, by

of the firms investor clientele

Suppose investor n is lightly

taxed on dividends: d,nlow, then

Thus, investor n will have a preference

for this stock if it pays a high dividend

g

dexcum

1

1DivPP

))/(1(1 gd

)1()1()1)(( ,nddgexcum DivDivPP


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All investors in the same tax bracket

will have a preference for this stock,

whereas investors which are heavily taxed

on dividends will have a preference forstocks that pay low or no dividend

The process of investors tuning their

tax-determined preferences to the dividend

policy of a firm eventually leads to an

equilibrium:

clientele effects

the dividend policy of a firm reflects

the tax preference of its investor clientele

for every investor, there exists a stock

where the firms dividend policy matches

his preferences

a change in the dividend

policy of one single firm- does not disturb equilibrium

- does not create / add value

- is irrelevant with respect to V


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Six empirical results:

1. Elton & Gruber (1970)

PcumPex= 0,778 Divthis is in support of taxes

having an impact

2. But findings for the Hong Kong

Stock Exchange, among other stock

markets / countries where relevanttaxes are absent, show that

PcumPex< Div

this invalidates a tax-effect

3. The Netherlands: relevant taxes

are absentUS: in 2003 tax rates were cut such

that the discriminative effect of

taxes on dividend payouts and

capital gains was strongly reduced,

so 1))/(1(1 gd


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if so true, PcumPex Div

recall

rewrite

where

effective dividend tax rate

If investor ns

then he should sell the stock before it goes

ex-dividend, thereby avoiding the dividend

which in his case is heavily taxed.

If investor ns

he should buy the stock & capture the dividend

g

dexcum

1

1DivPP

*)(1DivPP dexcum

g

gd

d-1

*

*d

0* nd,

0* nd,


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4. Recent research focuses on order

imbalances around the ex-dividend

date, among other things in view

of a dynamic clientele effect:

the dividend-capture theory

= the theory that absent transaction

costs, investors can trade shares at

the time of the dividend so that

non-taxed investors receive the dividend

empirical implication:

= larges volumes of trade in a stock

around the ex-dividend day, as

high-tax investors sell and low-taxinvestors buy the stock in anticipation

of the dividend, and then reverse those

trades just after the ex-dividend day

practice shows supportive evidence,

but it is also true that many high-taxinvestors continue to hold stocks even

when dividends are paid


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5. If < , then shareholders

will pay lower taxes if a firm uses

share repurchases for all payouts

rather than dividends. The fact thatfirms continue to issue dividends

despite their tax disadvantage is

referred to as the dividend puzzle

- bird in the hand heuristic

- repurchasing stock on a regular

basis as a substitute for dividends

(in order to save stockholders taxes)

is not allowed by the tax authorities

- financial managers do not show much

concern with the tax effects of payout

choices (see hereafter)

6. The costs of retaining excess cash

depend on the combined effect of thecorporate and capital gains taxes,

compared to the single tax on interest.

Using 2012 tax rates, the effective

tax disadvantage of retained cash

appears to be substantial

g d


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Agency costs

Firms should choose to retain cash

for the same reasons they would uselow leverage: to preserve financial

slack for future growth opportunities

and to avoid financial distress costs

e.g. high-tech and biotechnology firms

have little debt & large cash balancesThese needs must be balanced against

the tax disadvantage of holding cash

(which is equivalent to negative leverage

in view of taxes owed on the interest

receipts of a firm) and theagency costs of retaining cash

as a means to increase managers

job security and to avoid the

discipline of the market to fund wasteful investments

e.g. pet projects or overpaying for

acquisitions

e.g. excessive salaries


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To avoid a conflict of interests between

the firms shareholders and managers,

a similar role by taking cash out

of the firm is performed by leverage

share repurchases

dividends

Agency benefits of dividends (V )

Agency costs of dividendsexist when there is financial distress

and the potential conflict of interest

between the debt holders and the

shareholders intensify.


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Asymmetric Information

In practice

dividend smoothing=the practice of maintaining

relatively constant dividends

dividend increases are more

frequent than dividend cuts

So, the firms dividend choice will

contain information, especially when

managers cut the dividend

dividend signaling hypothesis

= the idea that dividend changes

reflect managers views about a

firms future earnings prospects


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Consistent with this hypothesis

average size stock price reaction

- increases with the magnitude

of the dividend change

- is larger for a dividend cut e.g. -3,7%

(costly for managers in terms of their

reputation and the reaction of investors)

than for a dividend raise e.g. + 1,3%

- is smaller than that of leverage changes

e.g. D & E : -7% and D & E : +10%

due to a somewhat weaker information

signal by a dividend change because of

a less strong commitment


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Survey of corporate managers

by Lintner (1956), who suggested

managements desire to maintain a

long-term target level of dividends

as a fraction of earnings

an investors preference for stable

dividends (with sustained growth)

the focus is on dividend changes

= target dividend payout ratio,

percentage of earnings (per share)

s = adjustment rate

e.g. s = 0: Divt= Divt-1 stickys = 1: Divt= EPSt direct adjustment

0 < s < 1: partial adjustment

s close to zero: smoothing

Empirical results: = 50%, s = 30%

Suppose: Divt+1 announced at t+1 such that

Divt+1>> Divt+ 0,30(0,50 EPSt+1Divt)

Interpretation? Favorable info!

)DivEPSs(

DivDiv 1tt1tt


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Survey of financial executives

Brav, Graham, Harvey & Michaely (2005)

Dividend policy

not decreasing Div has top priority

that is, if necessary at the cost of

NPV > 0 project inconsistent with MM

so, Div = very bad signal: P

Div = residual CF decision

in principle, consistent with MM in thesense that firm value is determined

by operating & investments decisions

and not by financing & payout policy

Div only ifpermanent earnings

and if desired by shareholders(as a monitoring and control

mechanism to discipline managers)

preference for stable dividends

Share repurchases= residualCF decision

if earnings only temporarily

and if desired by shareholders:

agency costs and/or under-valuation

no long-term commitment, still P 3%


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Question 30, exam 17 December 2009

Consider a perfect capital market.

On 1 January 2008 investor X buys shares of company Xfor an aggregate amount of1000 and at a price of20,00

per share.

On 1 March 2008 company X implements a stock split,

where shareholders receive three new shares for each

existing (and subsequently withdrawn) share.

On 1 June 2008 the company pays a dividend of1,50 pershare. During the remainder of the year, X holds the

dividend proceeds in cash and therefore receives no

interest.

On 1 September 2008 every investor receives a stock

dividend (dividend in stocks) of 6 percent.

On 31 December 2008 the closing price of the shares of S

is6,70.

Question: Measured from 1 January until 31 December

2008 the total return of investor X on the

shares of S is closest to

a. 14%b. 29%

c. 105%

d. 114%


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Answer 30, exam 17 December 2009

Alternative b

January: N=50, P=20, V=1000

Stock split: N=50x3=150, P=20/3=6,67, V=1000

Cash dividend: N=150, P=6,67-1,50=5,17

V=775 & cash=150x1,50=225

Stock dividend: N=150x1,06=159, P=5,17/1,06=4,87

V=775 & cash=225

December: N=159, P=6,70

V=159x6,70=1065,30 & cash=225

Return=(end-begin)/begin=(1065,30+225-1000)/1000=29%

Another route is by backward computation of the stock

price (=6,70) to an equivalent in Januaryend: 6,70

6,70x1,06

6,70x1,06+1,50

begin: (6,70x1,06+1,50)x3=25,806 versus 20

Wk50 Dividend Policy

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