dividend policy - lakehead universityflash.lakeheadu.ca/~pgreg/assignments/3019chapter16_… ·...

Dividend Policy

Lakehead University

Winter 2005

Types of Dividend

Dividends are usually paid in cash, and this four times a year.

A company may also pay a stock dividend:

• A 2% stock dividend, for instance, is such that shareholders

receive 1 share for each 50 shares they own.

• A 2-for-1 stock split is a 100% stock dividend.

2

Dividend Payment Procedure

Dividends are normally paid quarterly and, if conditions permit,

the dividend is increased once a year.

Suppose for example that a corporation paid $0.50 per quarter in

2003. Its annual dividend is then $2.00.

If the corporation decided to increase the annual dividend to

$2.08, say, then the quarterly dividend would be $0.52.

3


The procedure for paying dividends is as follows:

Declaration Date: On January 15, say, corporation XYZ announces

that it will pay a dividend on February 16 of the same year.

Holder-of-Record Date: At the close of business on the

holder-of-record date, January 30, say, XYZ clsoes its stock

transfer book and makes a list of shareholders to that date. If XYZ

is not notified of the purchase of its stock by an individual before 5

PM on the record date, the individual does not get the dividend.

4


Ex-Dividend Date: To avoid conflict, the convention is that the

right to the dividend remains with the stock until two days

before the holder-of-record date. Whoever buys the stock on

or after the ex-dividend date does not receive the dividend.

In the present example, the ex-dividend date would be

January 28.

5


Feb 16

Jan 30

Jan 28

Jan 27

Jan 15 Declaration date

Dividend goes with the stock

Ex-dividend date

Holder-of-record date

Payment date

6

Fall in Stock Price on the Ex-Dividend Date

d0≡ dividend announced

p̃0≡ stock price one day before the ex-dividend date

p0≡ stock price on ex-dividend date

p0 =∞

∑t=1

dt

(1+ rs)t

p̃0 = p0 + d0 ⇒ p̃0− p0 = d0.

Without taxes, the stock price should fall byd0 on the

ex-dividend date.

7

Fall in Stock Price on the Ex-Dividend Date (Taxes)

Suppose dividends are taxed at the ratetd, and suppose capital

gains are taxed at the ratetcg.

The day prior to the ex-dividend date, shareholders expect to

receive(1− td)d0 andtcg(p̃0− p0) if capital losses are tax

deductible. Then

p̃0 = p0 + (1− td)d0 + tcg(p̃0− p0),

and thus

p̃0− p0 =1− td1− tcg

×d0.

8

Dividend Irrelevance Theory

XYZ, an all-equity firm has 100 shares outstanding and a cash

flow of $10,000 (including liquidation) over the next two years.

The firm can then pay a dividend of $100 per shares in each of

these two periods, which gives a stock price

P0 =D1

1+ rs+

D2

(1+ rs)2 =1001.10

+100

(1.10)2 = $173.55

wherers = 10%is the return required by shareholders (XYZ’s

cost of capital when an all-equity firm).

9


Suppose that XYZ wants to change its dividend policy. Instead

of paying $100 per year to each shareholder, it will pay $120 per

share the first year and whatever remains after liquidation of the

firm on the second year.

To finance the greater dividend, XYZ has to either raise debt or

equity.

10


Equity Is Issued

If equity is issued new shares have to be issued in exchange of

100×20= $2,000after one year.

There is no increase in leverage and thus the new shareholders

will also require a return of 10%, i.e. a payment of $2,200 at the

end of the second year.

This means that there will be10,000−2,200= $7,800available

to the old shareholders at time 2.

11


Equity Is Issued

The new stock price is then

P′0 =1201.10

+78

(1.10)2 =1201.10

+100−22(1.10)2

=1201.10

+100

(1.10)2 − 22(1.10)2

=1201.10

+100

(1.10)2 − 20×1.10(1.10)2

=1201.10

+100

(1.10)2 − 201.10

=1001.10

+100

(1.10)2

= $173.55

12


Debt Is Issued

Note that the price did not change when equity was issued to

finance the dividend.

What happens if, instead, the firm issues debt to pay the extra

$20 dividend per share?

Suppose the firm borrows $2,000 in year 1 and repay

$2,000× (1+ rd) at the end of year 2.

13


Debt Is Issued

The argument is more complex here but the increase in debt will

increase the return required by shareholders, i.e.

P′0 =120

1+ r ′s+

100−20(1+ rd)(1+ r ′s)2 ,

wherer ′s > 10%.

It can be shown thatP′0 = P0.

14


Note that we have assumed

• No taxes, no brokerage fees

• Individuals have homogeneous beliefs

• Investment policy is not affected by the dividend policy

15

Homemade Dividends

Another argument in favour of the dividend irrelevance theory is

that an investor not satisfied with the proposed stream of

dividends can always create her own personalized stream of

income by borrowing or lending.

16

Homemade Dividends

Suppose that

p̃0 = d0 +d1

1+ rs,

but the investor wants to receive all her dividends in period 1, i.e.

d′0 = 0.

17

Homemade Dividends

If d0 can be saved at the rater, this gives

p̃′0 = 0 +(1+ r)d0 +d1

1+ rs.

If r = rs, thenp̃′0 = p̃0.

18

Bird-in-the-Hand Theory

Myron Gordon and John Lintner have argued thatrs decreases as

the dividend payout increases because investors are less certain

of receiving the capital gains supposed to result from retaining

earnings than they are of receiving dividend payments. That is,

take

rs =D1

P0+ g.

D1/P0 being more certain thang, rs will decrease asD1

increases.

19

Bird-in-the-Hand Theory

M&M called this theory the bird-in-the-hand fallacy since

investors tend to reinvest their dividends in securities that have

the same risk characteristics as the stock paying the dividend.

20

Taxes Preference Theory

Dividends have greater tax consequences than capital gains.

Investors in high tax brackets may prefer capital gains, and thus a

low payout ratio, to dividends.

Also, taxes on capital gains are paid only when the stock is sold,

which means that they can be deferred indefinitely.

21

Optimal Dividend Policy

On the board.

22

Empirical Evidence on Dividend Policy

Empirical tests of dividend policy theories have not been too

conclusive because of two reasons:

• For a valid statistical test, things other than dividend policy

must be held constant across the firms in the sample, i.e. one

must have a sample of firms that differ in their dividend

policy only, which is not possible.

• We must also be able to measure with a high degree of

accuracy each firm’s cost of equity, another difficulty.

23

Other Dividend Policy Issues

Signaling Hypothesis

The M&M dividend irrelevance theory assumes that all investors

have the same information regarding the firm’s future earnings.

In reality, however, different investors have different beliefs and

some individuals have more information than others.

More specifically, the firm managers have better information

about future earnings than outside investors.

24


Signaling Hypothesis

It has been observed that dividend increases are often

accompanied by an increase in the stock price and dividend

decreases are often accompanied by stock price declines.

These facts can be interpreted in two different ways:

• Investors prefer dividends to capital gains;

• Unexpected dividend increases can be seen as signals of the

quality of future earnings (signaling theory).

25


Clientele Effect

Different groups (clienteles) of stockholders prefer different

dividend policies.

This may be due to the tax treatment of dividends or because

some investors are seeking cash income while others want

growth.

Changing the dividend policy may force some stockholders to

sell their shares.

26


Clientele Effect

This is not a problem if stockholders can switch without costs but

there are

• brokerage costs;

• the likelihood that the shareholders who sell pay capital

gains taxes;

• a possible shortage of investors who like the firm’s newly

adopted dividend policy.

27

Dividend Stability

Since profits vary over time, dividends should also vary.

Many stockholders, however, rely on dividends to meet expenses.

Cutting dividends may also send the wrong signal to investors

who would then bid the stock price down.

Maximizing the stock price requires a firm to balance internal

needs of funds with stockholders’ needs.

28

Dividend Stability

• Public company usually make five- to ten-year financial

forecast of earnings.

• When inflation is not persistent, “stable dividend” means

approximately the same dollar amount each year. With

inflation, “stable dividend” means a dividend that grows in

line with inflation.

• There are two components to dividend stability:

– The dividend growth rate;

– How the last dividend can help predict the next one.

29

Dividend Policy in Practice

The Residual Dividend Model

Under this model, dividends are determined as follows:

1. The firm determines its optimal capital budget;

2. The firm determines the amount of equity needed given the target

capital structure;

3. Retained earnings are used to meet equity requirements to the

extent possible;

4. Dividends are paid only if more earnings are available than what is

needed.

30



Under the residual dividend model, dividends are determined asfollows:

Dividends = Net Income− Target Equity Ratio×Capital Needed

31



Suppose a firm has a target equity ratio of 60% and needs to

spend $50m on new projects.

The firm needs.6×50= $30m in equity.

If its net income is $100m, its dividend will be

100− 30 = $70m.

If capital requirements were $200m, the firm would not pay any

dividend.

32



Under the residual dividend model, the better the firm’s

investment opportunities, the lower the dividend paid.

Following the residual dividend policy rigidly would lead to

fluctuating dividends, something investors don’t like.

33



To satisfy shareholders’ taste for stable dividends, firms should

1. Estimate earnings and investment opportunities, on average

over the next five to ten years;

2. Use this information to find out the average residual payout

ratio;

3. Set a target payout ratio.

34


Note that one way to maintain a regular dividend payment is to

set a payment sufficiently low to never exceed the expected

payment given by the target payout ratio.

There are other factors influencing the dividend policy:

• Bond indentures

• Preferred stock restrictions

• Availability of cash

35

Dividend Policy and Growth Rate

Let b denote the firm’s retention ratio, and letr denote the rate of

return the firm will earn, on average, on new investments.

Let It denote investment at timet and letEt denote earnings at

time t.

Note thatr can be approximated by the return on equity (ROE).

36


Then

Et = Et−1 + rI t−1 = Et−1 + rbEt−1 = (1+ rb)Et−1.

37


The growth in dividends is then

g =Dt −Dt−1

Dt−1=

(1−b)Et − (1−b)Et−1

(1−b)Et−1

=Et −Et−1

Et−1

= rb.

That is, the expected growth rate in dividends can be

approximated by

Return on Equity (ROE)×Retention Ratio.

38

Repurchases of Shares

Advantages of Stock Repurchases

• Repurchase announcements are viewed as positive signals by investors.

• Stockholders have a choice when a firm repurchases stocks: They can sell

or not sell.

• Dividends are sticky in the short-run because reducing them may

negatively affect the stock price. Extra cash may then be distributed

through stock repurchases.

• The target payout ratio may be achieved with the help of repurchases.

39

Repurchases of Shares

Disadvantages of Stock Repurchases

• Stockholders may not be indifferent between dividends and

capital gains.

• The selling stockholders may not be fully aware of all the

implications of a repurchase.

• The corporation may pay too much for the repurchased

stocks.

40

Repurchases of Shares (vs Dividend Payment)

The day before a dividend payment, the price of a stock is

p̃0 = d0 +∞

∑t=1

dt

(1+ rs)t = d0 +∞

∑t=1

CFt/n0

(1+ rs)t

whereCFt is the cash flow net of debt payments at timet andn0

is the initial number of shares.

Suppose that instead of payingd0, the firm decides to repurchase

n′ shares.

41


Anybody left with a share will receive

∞

∑t=1

CFt/(n0−n′)(1+ rs)t = p̃′0

The firm uses dividend money to repurchase the shares, and thus

n′ is such that

n′ p̃′0 = n0d0

42


This gives us

p̃′0 =∞

∑t=1

CFt/(n0−n′)(1+ rs)t

=n0

n0−n′×

∞

∑t=1

CFt/n0

(1+ rs)t

=n0

n0−n0d0/p̃′0×

∞

∑t=1

CFt/n0

(1+ rs)t

=1

1−d0/p̃′0×

∞

∑t=1

CFt/n0

(1+ rs)t

43


p̃′0 =1

1−d0/p̃′0×

∞

∑t=1

CFt/n0

(1+ rs)t

p̃′0 − p̃′0×d0

p̃′0=

∞

∑t=1

CFt/n0

(1+ rs)t

p̃′0 = d0 +∞

∑t=1

CFt/n0

(1+ rs)t = p̃0.

44

Stock Splits

A stock split takes place when a firm declares that each

outstanding share now becomes more than one share.

A two-for-one split, for example, means that each outstanding

shares now becomes two separate shares.

In efficient markets, the two-for-one split of a $80 stock would

create two $40 stocks.

45

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