PAYING BACK: DIVIDEND POLICY

Empirical evidence about Dividends

• Dividends are Sticky• Dividends tend to follow earnings• Dividends tend to follow smoother path than

earnings• Dividends follow life cycle

Stage 2Rapid Expansion

Stage 1Start-up

Stage 4Mature Growth

Stage 5Decline

Figure 21.7: Life Cycle Analysis of Dividend Policy

Years

Years

Capacity to paydividends

Revenues

Earnings

None None Increasing High

External fundingneeds

High, but constrained by infrastructure

High, relative to firm value.

Moderates, relativeto firm value.

Low, as projects dryup.

Internal financing

Low, as projects dryup.

Very low

Stage 3High Growth

Negative orlow

Negative orlow

Low, relative to funding needs

High, relative tofunding needs

More than funding needs

Growth stage

$ Revenues/Earnings

Source :A Damodaran

Measures of Dividend Policy4

• Dividend Payout = Dividends/ Net Income– Measures the percentage of earnings that the company

pays in dividends– If the net income is negative, the payout ratio cannot be

computed.

• Dividend Yield = Dividends per share/ Stock price– Measures the return that an investor can make from

dividends alone– Becomes part of the expected return on the investment.

Facts about Payout

• Cash Dividend versus Stock Repurchase– Cash Dividend

• Dividends are rarely cut back, managers do not increase dividends unless confident that dividend can be maintained

– Stock Repurchase or Buyback• Repurchases are more flexible and repurchases are tax-

advantaged

Facts about Payout

• Dividend Payments– Cash Dividend

• Payment of cash by firm to shareholders

– Ex-Dividend Date• Date that determines when stockholder is entitled to

dividend payment

– Record Date • Person who owns stock on this date receives dividend

Tata Steel’s Dividend

Facts about Payout

• Dividend Payments– Stock Dividend

• Distribution of additional shares to firm’s stockholders

– Stock Splits• Issue of additional shares to firm’s stockholders

– Buyback• Firm buys back stock from its shareholders

Stock Split

• Stock splits are akin to optical illusions – they give the impression that things have changed. In reality, splits are only adjustments in the number of shares outstanding, while the company's equity and the value of shareholders' holdings remain unchanged. Although most investors view stock splits as inherently bullish, do not be swayed by this fact alone. The effects of stocks splits are only temporary in nature. Ultimately, the company's business fundamentals will be the true drivers of the stock's value and its future direction.

Buffet Doing The Splits

• In January 2010, Class B shares of Berkshire Hathaway – the holding company owned by legendary investor Warren Buffett – underwent a 50-for-1 split, bringing the stock price down from about $3,500 to approximately $70. The stock split was not undertaken merely to attract a bigger retail investor following. Warren Buffett was not concerned with attracting retail investors. Berkshire Hathaway's Class A shares trade in the low six figures, and the Class B shares were only introduced in 1996. Rather, Berkshire Hathaway said that the stock split was needed to facilitate its acquisition of railroad company Burlington Northern Santa Fe. The split allows even small holders of Burlington shares to exchange them for Berkshire Hathaway shares if they prefer the latter to cash.

What's the Point of a Stock Split?

• Psychology:: Splitting the stock brings the share price down to a more "attractive" level. The effect here is purely psychological

• Increase Liquidity

Dividend Policy Survey 2004

Information Content of Dividend and Repurchases

• Payout Decision– Managers are reluctant to make dividend

changes that may be reversed

– Managers worry about rescinding dividend increases and raising new funds to maintain payout

Information Content of Dividend and Repurchases

• Payout Decision– To avoid risk of reduction in payout, managers

“smooth” dividends

– Dividend changes follow shifts in long-run sustainable earnings

– Transitory earnings changes unlikely to affect dividend payouts

Information Content of Dividend and Repurchases

• Payout Decisions – Managers focus on dividend changes over absolute

levels

– Paying a dividend of Rs.2.00 per share is important if last year's dividend was Rs.1.50

– Paying a dividend of Rs.2.00 is not important if last year's dividend was Rs.2.00

Information Content of Dividend and Repurchases

• Information in Payouts– Varying attitudes toward dividend targets

• DIV1 = target dividend

= target ratio × EPS1

– Dividend change

• DIV1 – DIV0 = target change

= target ratio × EPS1 – DIV0

Information Content of Dividend and Repurchases

• Information in Payouts – Dividend changes confirm the following: – DIV1 – DIV0

= adjustment rate × target change

= adjustment rate × target ratio × EPS1 – DIV0

Lintner Model

1. The primary determinants of changes' in dividends paid out were the most recent earnings and the past dividends paid

2. Management focused on the change in the dividends rather than the amount

3. Changes were made only when management felt secure that the new level of dividends could be maintained and firms very reluctantly cut or eliminated dividends

4. There was propensity to move toward some target payout ratio for most firms, but the speed of adjustment toward the level differed greatly among companies

5. Investment requirements generally had little effect on dividend behaviour.

Three Schools Of Thought On Dividends

1. If there are no tax disadvantages associated with dividends & companies can issue stock, at no issuance cost, to raise equity, whenever needed

Dividends do not matter, and dividend policy does not affect value.

2. If dividends create a tax disadvantage for investors (relative to capital gains)

Dividends are bad, and increasing dividends will reduce value

3. If dividends create a tax advantage for investors (relative to capital gains) and/or stockholders like dividends

Dividends are good, and increasing dividends will increase value

The balanced viewpoint20

• If a company has excess cash, and few good investment opportunities (NPV>0), returning money to stockholders (dividends or stock repurchases) is good.

• If a company does not have excess cash, and/or has several good investment opportunities (NPV>0), returning money to stockholders (dividends or stock repurchases) is bad.

The Dividends don’t matter schoolThe Miller Modigliani Hypothesis

21

The Miller-Modigliani Hypothesis: Dividends do not affect value Basis:

If a firm's investment policies (and hence cash flows) don't change, the value of the firm cannot change as it changes dividends.

If a firm pays more in dividends, it will have to issue new equity to fund the same projects. By doing so, it will reduce expected price appreciation on the stock but it will be offset by a higher dividend yield.

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 to investors 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.

Taxes and Dividends: What do investors in your stock think about

dividends? Clues on the ex-dividend day!22

• Assume that you are the owner of a stock that is approaching an ex-dividend day and you know that dollar dividend with certainty. In addition, assume that you have owned the stock for several years.

P = Price at which you bought the stock a “while” backPb= Price before the stock goes ex-dividendPa=Price after the stock goes ex-dividendD = Dividends declared on stockto, tcg = Taxes paid on ordinary income and capital gains respectively

Ex-dividend day

Dividend = $ D

Initial buyAt $P

Pb Pa

Cashflows from Selling around Ex-Dividend Day

23

The cash flows from selling before ex-dividend day are:Pb - (Pb - P) tcg

The cash flows from selling after ex-dividend day are:Pa - (Pa - P) tcg + D(1-to)

Since the average investor should be indifferent between selling before the ex-dividend day and selling after the ex-dividend day -Pb - (Pb - P) tcg = Pa - (Pa - P) tcg + D(1-to)

Some basic algebra leads us to the following:

Intuitive Implications24

• The relationship between the price change on the ex-dividend day and the dollar dividend will be determined by the difference between the tax rate on dividends and the tax rate on capital gains for the typical investor in the stock.

Tax Rates Ex-dividend day behavior

If dividends and capital gains are taxed equally

Price change = Dividend

If dividends are taxed at a higher rate than capital gains

Price change < Dividend

If dividends are taxed at a lower rate than capital gains

Price change > Dividend

The empirical evidence…25

• Ordinary tax rate = 70%• Capital gains rate = 28%• Price change as % of Dividend = 78%

1966-1969

• Ordinary tax rate = 50%• Capital gains rate = 20%• Price change as % of Dividend = 85%

1981-1985

• Ordinary tax rate = 28%• Capital gains rate = 28%• Price change as % of Dividend = 90%

1986-1990

But higher or new dividends may signal bad news (not good)

26

-4 -3 -2 -1 1 2 3 40.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

45.00%

Dividend Initiations and Earnings Growth

Year relative to dividend initiation (Before and after)

Annu

al E

arni

ngs G

row

th R

ate

Dividends Initiated here

Running out of Investment opportunities

Dividend increases may be good for stocks… but bad for bonds..

-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 STOCKS AND BONDS AROUND DIVIDEND CHANGES

Day (0: Announcement date)

CAR

Bond price drops

Stock price rises

Taxes and Radical Left

• Taxes and Dividend Policy – Capital gains taxed at lower rate than dividend

income so companies should pay lowest dividend possible.

• No long-term capital gains if STT paid • Short-term capital gains tax rate is 15%• Dividend Distribution tax rate is around 17%.

– Dividend policy should adjust to changes in tax code

Taxes Dividend Policy

• Returns to Shareholders Taxed Twice

Taxes Dividend Policy

• Australian Tax Credit to Shareholders

Dividend Theories

• Apple's Growth 2002-2012

Indian Scenario

In 2013 a study conducted by Business Today of more than 6,000 stocks came up with a startling finding: only six companies have paid dividends of more than 30 per cent of their net profit in the past decade, as well as outperformed the benchmark index for eight of those 10 years.

Colgate-Palmolive, Hawkins Cookers, Emami, Eicher, HDFC and GRUH Finance - are all high-growth companies

One-fifth of the BSE 500 Index companies share more than 30 per cent of their profits with investors.

Indian Scenario

• In financial year 2014, dividends from the listed companies have grown by 20 per cent, the highest in the past four years.

• Dividend Payout ratio rose to a record 32 per cent which is the highest in the past seven years.

• Indian corporates had a record level of cash surplus which was lying idle due to lack of investments and expansion opportunities.

• Top Indian companies are taking on more debt to pay dividends to their shareholders

• 57 of the 500 biggest companies listed on BSE borrowed a total of Rs.19,170 crore to fund dividend payments, according to a study that India Ratings and Research Pvt. Ltd

Comparison

• US households are holding 27% in cash and deposits, 25% in fixed income and 42% in equities

• European households are holding 53% in cash and deposits and only 29% in equities.

• Developed Asian households, which are in Hong Kong, Singapore, Taiwan and Korea, are holding 55% in cash and deposits.

• In comparison, emerging Asia households are holding 77% in cash, 13% in fixed income and only 10% in equities.