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Financial Decisions

8a. Dividend RelevanceDoes Dividend Polcy matter?

1. Dividend Policy is irrelevant 2. Dividend Polciy is relevant

Instructor: A. Ashta

References: Ross, Westerfield Jordan: Ch. 14Emery, Finnerty & Stowe: Ch. 17

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1. MM Dividend Irrelevance Proposition

In perfect capital markets, in the

absence of taxes and transaction

costs, dividend policy is

irrelevant in the sense that it

cannot effect shareholder value.

The effect of any dividend policy

can be offset by management

adjusting the sale of new stock

or by investors adjusting their

dividend stream through stock

purchases or sales.

Dans un March parfait, en

absence des impts et aucun

cot de transaction, la politique

de dividende est inutile : aucun

effet sur le valeur dactionnaire.

Leffet de toute politique du

dividende peut tre compense

par lemission des nouvelles

actions par la socite ou par

lachat et vente des actions par

les actionnaires

Modigliani-MillerInutilit de dividende

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Dividend irrelevance

Three cases to explain M-M irrelevancy proposition: dividends do not effects firmvalue:

1.Firm has necessary cash for dividend

2.Firm sells new shares to generatethe cash needed to pay the dividends

3.Firm does not pay any dividendsand the shareholder wants cash

First two cases are from firm view-point and last one from shareholderview-point

3 faons dexpliquer le proposition de M-M : la politique de dividende est inutile :

1.La socit a des disponibilits

2.La socit met des nouvelles actions

3. La socit ne paie pas de dividende mais lactionnaire a besoin de cash.

Les premiers deux cas sont de point de vue de la socit tandis que le dernire est celui de lactionnaire

Inutilit de dividende

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Case1.Firm has necessarycash to pay the dividend

Cash balance decreaseswhen dividend is paid

Equity account is alsoreduced

Only financial asset and financial liability changes

Net Operating assetsremain unchanged

Therefore, firm value remains unchanged

Trsorie diminue quand dividede pay

Capitaux propres rduit autant

Que les actifs financiers et passifs financirs ont t modifs

Les actifs dexploitation nont pas t modifi

Donc, la valeur de la socit est le mme

Cas1: Le dividende est vers de la trsorie

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Case 2: A firm issues new sharesto finance the dividend

The sale of new sharesincreases the firmsfinancial value

The payment of dividends decreases the firms financial value

As long as shares are sold at their fair marketvalue, the two effectsoffset each other

Firm value remainsunchanged

Les nouvelles actions augmentes la valeur financier

Le paiement des dividendes rduit le valeur financier

Tant que les actions ont t mit a leur valeur intrinsique correcte, les deux effets sont compensatoires

La valeur de la socitest le mme

Cas 2: Le dividende est fainancpar lemission des nouvelles

actions

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Dividend Irrelevance: Case 2 illustrated MicroGeneral

Balance Sheet (Market Values)

Cash $ 2,000 Debt $ 4,000Fixed Assets $ 5,000Growth Opportunities* $ 3,000 Equity $ 6,000

Total Assets $10,000 Value of Firm$10,000

*The value of future opportunities to invest in posi tive NPV projects

Equity consists of 100 shares

Dividende Inutile: Cas 2 illustrMicroGeneral

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Dividend Irrelevance -MicroGeneral

MicroGeneral needs $2,000 in cash to invest

in growth opportunities. Each share is worth

$___. Suppose management decides to pay

a dividend of $10 a share for a total of $____.

Total assets drop to $_____ giving the firm a

net worth of $_____. The new price of the

stock is $___ a share, a decline of $____ a

share.

Dividende Inutile: MicroGeneral

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Dividend Irrelevance - MicroGeneral

Holding capital structure constant, MicroGeneral

must raise $______ in new equity by issuing ____

new shares at ____ a share for a total of $_____.

MicroGenerals new balance sheet will look identica l

to the old except that the equity account will list

____shares. MicroGenerals old stockholders

wealth position remains the same since the value of

their shares $_____ plus the dividend of $______

equals their original position.

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Case 3: HomemadeDividends

If the firm does not issue dividends and the shareholder wants cash The shareholder can sell

her shares to anotherinvestor

This creates homemadedividends

If the shares are sold atfair market value, neitherthe buyer nor seller gain

Firm value is unchanged

Cas 3: Dividendes fabriqus

Si la socit ne distribue pas de dividende et lactionnaire en veux Lactionnaire peut vendre

ses actions une autre personne

Ceci cre des dividendes fabriqus maison

Si les actions sont vendu leur prix correct, ni le vendeur ni lacheteur nont profit.

La valeur de la socitna pas chang

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Quiz: True or False

If there is perfect competition and thereare no taxes

Dividends are irrelevant

Dividend policy is irrielevant

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2. In the real world, dividendsare Relevant

A. Taxes

B. Transactions Cost

C. Legal Constraints

D. Risks

E. Agency Theory

2. En pratique, les dividendes sont utiles

A. Impts

B. Cots de transaction

C. Contraintes lgales

D. Risque

E. Thorie dagence

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A. Dividends and Taxes - An Example

Suppose that tax on dividend income for the highest earning individual is 40%, whereas, capital gains are taxed at 20%. What are the differences in valuation for a firm that pays no dividends, and one that pays out all of its earnings in dividends?

Si le taux dimpt sur les dividendes est de 40% tandis que les plus values sont impos 20%, quelle sera la diffrence en valeur dune socitqui ne paie pas de dividende dune socitqui versent tout en dividendes.

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Dividends and Taxes - An Example

CompanyA B

Dividend Payout Ratio 0% 100%

Income Available to Shareholder E E

Investors After Tax Return

After-Tax Required Return on Equity r r

Market Value of the Equity

As Equity is valued _______ times higher

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B. Transaction Costs

For a firm Floatation Costs for new

equity to finance dividends This reduces profit and firm

value Firms prefer not to pay

dividends

For individuals Brokerage Costs This reduces capital gains Individual prefers dividends

B. Cots de transaction

Socit Cots dmission des actions Impliquent rduction du

rsultat et du valeur de la socit

Socits prfrent de ne pas payer de dividendes

Individus Courtage Implique rduction des plus-

values Individus prfrent

dividendes

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Dividends, Transaction costs and Taxes

Dividends help those investors who need current income and would incur transaction costs to sell off part of their holdings.

Each investor, therefore, trades off the transaction cost benefits of dividends against the tax disadvantages.

Dividendes, cots de transaction et impts

Les dividendes sont avantageux aux actionnaires qui ont besoin de revenu courant et qui auront de cots de transaction si ils cdent leurs actions.

Chaque investisseur doit valuer les bnfices de moindre cots de transaction associs avec des dividendes contre les pertes fiscales.

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C. Legal Restrictions on Dividend Payments

Restrictive covenants in bond indentures, loan agreements, and preferred stock agreements

Designed to prevent excessive payments of dividends.

No Dividends Unless Earnings or Net Assets reach certain levels

Net profit rule or Capital impairment rule Cant pay out of capital

In some States only par value considered, in others capital surplus (premium) also cannot be eroded

Insolvency rule: insolvent firms cannot pay dividends

C. Restrictions lgales sur versement des dividendes

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D. Risk and Bird-in-the-Hand Argument

An argument for paying dividends based on the

idea that since investors are risk-averse, they pre fer

a stream of relatively certain dividends over

uncertain capital gains.

This argument confuses the investment and

dividend decision.

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E. Agency Theory

This conjecture is based on the notion that the market will oversee otherwise not perfectlyenforceable contracts.

Therefore, taking excess cash (whatever thatmight be) out of the firm will force management to go to the market place and compete for funds.

The idea is then to siphon out as much cash as possible in the form of dividends.

E. Thorie dagence

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Dividends and the Real World

A low payout is better if one considers: Flotation costs Taxes Indenture restrictions

A high payout is better if one considers: The need for current income Uncertainty resolutionthe bird-in-

hand argument Taxes Agency Theory

Who is right? Resolving the issue ---

Clientele effects Signaling or Information Effect

Une distribution basse est prfrablesi on considre: Cots dmission Impts Restrictions des contrats de

dette

Une distribution haute est prfrablesi on considre: Le besoin du revenu courant La rsolution dincertitude Impts Thorie dagence

Qui a raison?

Leffet des Clienteles Leffet des signaux ou

dinformation

Dividendes en pratique

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The Clientele Case for Tax Neutrality of Dividends

Investors sort themselves into three clienteles: those that prefer dividends

those that are indifferent towards dividends

those that are averse to dividends

Thus, companies dont have to worry about their

payout policy since clienteles will select the payo ut

policy that serves them best.

So high-tax bracket individuals would invest in lowor no-

dividend-paying firms, and vice versa.

Le cas clientle pour la neutralit fiscale des

dividendes

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Signaling With Dividends

Dividend changes may have communications value if

investors believe the change contains useful inform ation

Talk is cheap but dividends are backed by cash

Especially in countries where corporate information is

not reliable

A dividend cut would give a negative signal about future earnings

A dividend increase would give a positive signal about future

earnings

Criticism : Dividend cut may reflect growth opportunities.

Dividend increase may reflect firm cant use money!

Signalisation par Dividendes

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Psychological/ Sociological Explanations

hard cold cash has more power than anythingelse.

The dividend payment is a ritual meant to strengthen the bond between the owners and the stewards of the firm, a reinforcementnecessary because of the separation of ownership from management.

Seem to resemble Bird in Hand and AgencyTheory

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Homework

Read Ross ch 14 (sections 14.1 to 14.3)

Try Questions 14.1 16 and 17

Devoir

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References

The Bird in Hand explanation Gordon and Shapiro [1956], Gordon [1963] and Walter [1963].

The tax effect explanation (see, for example, Miller and Scholes [1978], Litzenberger and Ramaswamy [1982],

Lakonishok and Vermaelen [1983], and Masulis and Trueman [1988]).

The clientele effect explanation, which is closely relat ed to the tax effect (see Elton and Gruber [1970], Pettit [1977], Fung [1981], Booth and Johnston [1984], and

Bajaj and Vijh [1990]).

The agency theory explanation (see Rozeff [1982], Easterbrook [1984], Jensen [1986], Crutchley and Hansen [1989], and

Dempsey and Laber [1992]).

The signaling model explanation (see Bhattacharya [1979, 1980], John and Williams [1985], Asquith and Mullins [1986], and

Bar-Yosef and Huffman [1986]).

The psychological/sociological explanation (see Shefrin and Statman [1984], Shiller [1986], and Frankfurter and Lane [1992]).

Source: George Frankfurter, Arman Kosedag, Hartmut Schmidt a nd Mihail Topalov: The Perception of Dividends By Management, The Journal of Psychology and Financial Markets 2002, Vol. 3, No. 4, 202217