The Dividend Controversy

Should firms pay high dividends?

Review item

An asset A is being added to the market portfolio M.

What variable indicates whether A will raise or lower the risk of the portfolio?

Explain briefly.

Answer: beta of A is the variable

Beta of A is covariance of A with M divided by variance of M.

Beta of A > 1 implies A varies more with M than M itself does (possible diagram).

Beta of A > 1 implies A raises the risk of M.

Beta of A < 1 implies A lowers risk of M.

Normal dividends (pages 461-462)

declaration date ex-dividend date record date payment date

Why is the ex-dividend date early?

To avoid disputes, exchanges control the right to the dividend.

Early date reduces costs of administering the rule.

Now 2 days lead time. Formerly 5 days.

Dependence of value on dividends

Notation: Pt, Pt+1, Pt+2, ... are

prices of shares at time t, t+1, t+2 Dt, Dt+1, Dt+2, ... are dividends

Derivation

Pt = Dt+1/(1+r) + Pt+1/(1+r)

Pt+1= Dt+2/(1+r) + Pt+2/(1+r)

Pt = Dt+1/(1+r) + Dt+2/(1+r)2

+ Pt+2/(1+r)2

By induction

Pt = Dt+1/(1+r) + Dt+2/(1+r)2 +

Dt+3/(1+r)3 + …

Expected dividends determine value, even when the share changes hands.

Trap question one:

An investor buys a share. It never pays a dividend. Is it valueless?

No.

The investor resells it before any dividends are paid.

The buyer gets dividends.

Trap question two:

A firm never pays dividends to any investor and is never expected to do so.

Is it valueless?

No. Think of Webservice.com

The typical start-up firm is bought by another.

Its investors get cash or shares in the acquiring firm.

Dividend policy alternatives:

Either high dividends now, low later, or Low now, high later.

Dividend policy is irrelevant!

The firm has done all projects with NPV > 0.

It has some cash. What are the alternatives?

Alternatives:

Distribute cash as a dividend now. Invest the cash in financial markets and pay out as a dividend later.

Separation theorem interpreted for dividends (Figure 18.4)

C1

C0

s lo p e = - (1 + r)

L o w -d iv id e n d firm

H ig h -d iv id e n dfirm

w

F u tu rere tu rno r

d iv id e n d n o

Separation theorem

NPV is relevant. Investors time preferences are not.

Homemade dividends

Investors who want higher dividends sell some shares to get cash.

Those who want lower dividends use high dividends to buy more shares.

Upshot

Investors do not reward firms for doing what investors can do for themselves.

Taxes and dividends

The alternatives are (1) dividends or (2) capital gains.

Tax-class clienteles

Investors with similar tax exposure. Some prefer dividends. Some prefer capital gains.

Some prefer dividend income

because they have tax exemptions, e.g.,

non-profit institutions, pension funds, corporations etc.

Some investors prefer capital gains

because they can't shelter dividends from taxes,

but they can shelter capital gains. High income investors, for instance.

Example of partial tax sheltering by capital gains

Alternative one: dividend of $10,000. Pay taxes on all of it. Compare to capital gains of the same

amount.

Tax shield continued, homemade dividend

Alternative two: capital gains of $10,000.

Sell stock worth $10,000. The stock was bought when the price

was half the current price. Realized capital gains = $5,000 Pay taxes on $5,000.

Implications of clienteles

Some cash flows in the high-dividend channel.

Some in the low-dividend channel. Like the Miller channels model.

Dividend equilibrium

$ of operatingcash flows

HiDivvalueper $1

LoDivvalueper $1

mq ili riuo iv

EL

mEquilibriuHiD iv

u bD

V*=1/Rh V*=1/RL

...

Value is invariant to dividend policy.

In equilibrium i.e., almost all the time

Out of equilibrium

i.e., after tax law changes, firms can increase value by

appropriately changing their dividend policy.

Example of disequilibrium

Suppose that the capital gains tax rate is lowered.

LoDiv cash flows are more valuable. Demand for LoDiv cash flows

increases.

Cut in capital gains tax rates

$ of operatingcash flows inthe economy

HiDivvalue

LoDivvalue

Increased valueof old equity

More LoDivfirms

Result of capital gains tax cut

Value of old equity rises (instantly) Firms increase value by switching to

lower dividends until equilibrium is restored.

Real-world evidence

for not changing dividend policy and for existence of tax-class clienteles.

Evidence

Actual dividends are highly smoothed Earnings fluctuate much more. Smooth means constant or increasing

at a constant rate.

A problem for the low-dividend firm

The firm has a quantity of spare cash after all NPV>0 projects are done.

Dilemma

Pay dividends: Shareholders pay extra taxes.

Invest in financial markets: Firm becomes a mutual fund.

Solution: use the cash to buy stock

Investors who sell are those who want cash.

Stock price is unaffected ... because the value of the firm falls in proportion to the shares

repurchased.

Example: Firm is worth $10M. $1M is spare cash.

There are 1M shares, at $10 per share. Buy back .1M shares at $10 apiece. Cost is $1M.

After the buyback,

Remaining value of the firm is $9M because there are no financial illusions. There are .9M shares remaining still at $10 apiece.

Stock buybacks

are associated with rising share value in the financial press.

Can this be correct?

Outsider's model before the buyback

Pr{underpriced} = .5 Pr{overpriced} = .5

If insiders think the stock is overpriced

a buyback would reduce the value of the firm.

Therefore, no buyback occurs.

Since the buyback occurs

Outsiders know that insiders think the stock is underpriced (or fairly

priced).

Therefore, the buyback

signals the knowledge of insiders that the stock is underpriced and outsiders raise their estimates of its

value. Thus, share price rises on the buyback.

The IRS understands this game.

Stock buyback for tax avoidance is illegal.

Therefore...

Excuses, excuses

always another reason for a stock buyback,

usually ... our shares are a good investment

or...we disburse cash to prevent takeover.

Summary

Dividend policy is like capital structure. It probably doesn’t matter. If it does, it matters because of taxes,

and even that is temporary. In equilibrium, firms cannot increase

value by changing capital structure or dividend policy.

Review item

A share paid a dividend of $5 last year. The dividend is expected to grow at 3%

forever. The discount rate is 13%. What is the value of the share?

Answer:

Next year’s dividend is $5.15 ( = 1.03 x 5)

Value is $5.15/(.13-.03) = $51.50. Not $50.