The Dividend Decision

1
The Dividend Decision

• P.V. Viswanath

Based on Damodarans Corporate Finance
2
Theories of Dividend Payout

• Dividend Irrelevance
• Dividend Clienteles
• Signaling
• Catering to Psychological Investor Preferences
• Disciplinary Effects on Managers

3
Dividend Irrelevance

• Investors can create their own dividends.
  Consequently, firm value will not be affected by
  dividend payments.

4
Example of Dividend Irrelevance

• Stellar, Inc. has decided to invest 10 m. in a
  new project with a NPV of 20 m., but it has not
  made an announcement.
• The company has 10 m. in cash to finance the
  new project.
• Stellar has 10 m. shares of stock outstanding,
  selling for 24 each, and no debt.
• Hence, its aggregate value is 240 m. prior to
  the announcement (24 per share).

5
Example of Dividend Irrelevance

• Two alternatives
• One, pay no dividend and finance the project with
  cash.The value of each share rises to 26
  following the announcement. Each shareholder can
  sell 0.0385 ( 1/26) shares to obtain a 1
  dividend, leaving him with .9615 shares value at
  25 (26 x 0.9615). Hence the shareholder has one
  share worth 26, or one share worth 25 plus 1
  in cash.

6
Example of Dividend Irrelevance

• Two, pay a dividend of 1 per share, sell 10m.
  worth of new shares to finance the project.
• After the company announces the new project and
  pays the 1 dividend, each share will be worth
  25.
• To raise the 10 m. needed for the project, the
  company must sell 400,000 (10,000,000/25)
  shares. Immediately following the share issue,
  Stellar will have 10,400,000 shares trading for
  25 each, giving the company an aggregate value
  of 25 x 10,400,000 260 m.
• If a shareholder does not want the 1 dividend,
  he can buy 0.04 shares (1/25).
• Hence, the shareholder has one share worth 25
  and 1 in dividends, or 1.04 shares worth 26 in
  total.

7
Assumptions for Dividend Irrelevance

• The issue of new stock (to replace excess
  dividends) is costless and can, therefore, cover
  the shortfall caused by paying excess dividends.
• Firms that face a cash shortfall do not respond
  by cutting back on projects and thereby affect
  future operating cash flows.
• Stockholders are indifferent between receiving
  dividends and price appreciation.
• Any cash remaining in the firm is invested in
  projects that have zero net present value. (such
  as financial investments) rather than used to
  take on poor projects (i.e. there are no agency
  costs of outside equity).

8
Implications of Dividend Irrelevance

• A firm cannot resurrect its image with
  stockholders by offering higher dividends when
  its true prospects are bad.
• The price of a company's stock will not be
  affected by its dividend policy, all other things
  being the same. (Of course, the price will fall
  on the ex-dividend date.)

9
Dividend Clienteles Tax Effects

• For individual investors, dividends are more
  heavily taxed than capital gains because of the
  tax-timing option--the ability for individual
  investors to postpone the tax liability on
  capital gains income. Hence individuals may
  prefer capital gains.
• Corporate shareholders pay income tax at a 34
  peak marginal rate, but are permitted to claim a
  70 dividends-received deduction. Hence the top
  marginal tax rate on dividend income for a
  corporation is only (1-.7) x 34 10.2. They
  have a greater preference for dividends.
• Tax-exempt institutions, such as pension funds,
  do not have a bias in favor of capital gains or
  dividends.

10
Stockholder Marginal Tax Rate Estimation

• Suppose to represents the tax rate on ordinary
  dividends and tcg represents the tax rate on
  capital gains. Let PB denote the cum-dividend
  stock price, and PA the ex-dividend stock price,
  and P the price at which the stock was acquired.
• For the marginal investor,PB-(PB-P)tcg
  PA-(PA-P)tcg D(1-to)where the LHS is the
  after-tax gain from selling the stock
  cum-dividend and the RHS is the after-tax gain
  from selling the stock ex-dividend.

11
Stockholder Marginal Tax Rate Estimation

• From this, we get the relationship
• By examining the empirical price drop, one may
  then infer the marginal tax bracket for holders
  of the firm's stock.
• However, this opens up the possibility of
  dividend capture.

12
Dividend Mechanics

• Declaration date The board of directors declares
  a paymentRecord date The declared dividends are
  distributable to shareholders of record on this
  date.Payment date The dividend checks are
  mailed to shareholders of record.
• Ex-dividend date A share of stock becomes
  ex-dividend on the date the seller is entitled to
  keep the dividend.   At this point, the stock is
  said to be trading ex-dividend. 

13
Dividend Capture

• On Aug 2, 2005, XYZ declares a dividend payable
  on October 3, 2005. XYZ announces that
  shareholders of record on or before Sept 30, 2005
  are entitled to the dividend. The stock goes
  ex-dividend Sept 28, 2005, two days before the
  record date.
• Anyone who bought the stock before September 28,
  2005 or after would get the dividend.
• The stock price will fall after the dividend
  payment, but usually less than the div amount.
  If the trader is tax-neutral, selling right after
  the stock goes ex-dividend, i.e. on Sept 28, can
  net the trader a profit.

14
Dividend Clienteles Transactions Costs

• A shareholder who desires a high income stream
  would prefer real cash dividend payments over
  homemade dividends if the firm can sell new
  shares more cheaply than the shareholder can sell
  his/her own shares. Hence such shareholders might
  prefer firms with a high payout ratio, while
  other shareholders may prefer firms with a low
  payout policy.
• Consequently, some investors prefer equity income
  in the form of dividends, while others prefer
  capital gains.

15
Dividend Signalling

• If investors cannot observe information to
  distinguish a good firm from a bad firm, both
  firms will be valued the same.
• Firms that pay higher dividends than they would
  otherwise have, drain cash and thus increase the
  probability of bankruptcy. This will decrease
  the value of the firm.
• This decrease in firm value will be lower for
  good firms, because they are less likely to go
  bankrupt.
• Hence if a good firm increases its dividends, bad
  firms will be less likely to mimic the good firm.
• This will allow investors to separate good firms
  from bad firms and they will price their stock
  higher.
• This benefits stockholders who have to sell in
  the interim.

16
Psychological Investor Preferences

• Dividends and Capital Gains may not be perfect
  substitutes due to psychological reasons.
• A lack of self-control may lead an investor to
  prefer regular cash dividends. If the investor
  has to sell stock to get income, he might have a
  tendency to sell too much stock too soon.
• Hence an investor might choose to invest in a
  firm that follows a particular type of dividend
  policy to minimize the total agency costs of
  shareholding, including the investor's human
  frailties.

17
Disciplinary Effects on Managers

• Contracts between the firm and its managers
  cannot always be designed to take into account
  all possible contingencies.
• Hence, managers may sometimes take actions that
  reduce firm value. For example, it may be in the
  interest of managers to increase firm size or to
  unduly reduce the riskiness of the firm in order
  to reduce the probability of bankruptcy, and
  increase the present value of their firm specific
  skills.
• This may lead them to accept negative NPV
  projects or to engage in undesirable mergers.

18
Disciplinary Effects on Managers

• This may lead some managers to reduce dividends
  to a suboptimal level.
• In contrast, managers, who want to assure the
  market of their desire to maximize firm value by
  reducing the amount of disposable resources (free
  cash flow beyond current investment needs)
  available to them, may choose to increase
  dividends.
• By doing so, they force themselves to submit to
  the discipline of the markets any time that they
  wish to raise funds to invest in a project. Such
  credible proof of a manager's unwillingness to
  take NPV lt 0 projects will be rewarded by the
  market with an increase in the stock price.

19
Dividends and Firm Life-Cycle
20
Dividends and Firm Life-Cycle
21
Dividends and Firm Life-Cycle
22
Dividends and Firm Life-Cycle
23
Relevant factors in dividend policy

• Investment Opportunities A firm with more
  investment opportunities should pay a lower
  fraction of its earnings.
• Stability of earnings A firm with more volatile
  earnings should pay, on average, a lower
  proportion of its earnings, so that it will not
  have to cut dividends.
• Alternative sources of capital To the extent
  that a firm can raise alternative capital at low
  cost, it can afford to pay higher dividends.
  Hence, large firms tend to pay higher dividends.

24
Relevant Factors in Dividend Policy

• Degree of financial leverage If a firm has high
  leverage, it will probably also have covenants
  restricting the payment of dividends.
  Furthermore, to a certain extent, dividends and
  debt can be considered substitutes for the
  purpose of manager discipline.
• Signalling incentives To the extent that a firm
  can signal using other less costly means, for
  example debt, it should pay lower dividends.
• Stockholder Characteristics If a firm's
  stockholders want higher dividends, it should
  provide them.

25
Computing optimal payout first step

• Questions How much cash is available to be paid
  out as dividends?
• Answer The funds available to be paid out as
  dividends are essentially equal to free cash flow
  to equity (FCFE)Keep in mind these quantities
  should be computed prospectively.

26
Three definitions of FCFE

• FCFE Net Income - (Capital Expenditures -
  Depreciation) - (Change in Noncash Working
  Capital) (New Debt Issued - Debt Repayments) -
  Preferred Dividends
• FCFE Net Income - (Capital Expenditures -
  Depreciation)(1- Debt Ratio) - Change in
  Non-cash Working Capital (1-Debt Ratio).
• Cash Flows from Operating Activities - (Capital
  expenditures) - (preferred dividends) - (New Debt
  Issued - Debt Repayments).

27
Computing optimal payout second step

• How good are the projects available to the firm?
• If Dividends greatly exceed FCFE, dividends
  should be cut.
• If the rate of return on equity is greater than
  the cost of equity, the released funds should be
  invested in new projects and if funds are
  inadequate, funding should be sought from
  elsewhere.
• If projects are unprofitable, investment should
  be reduced.

28
Computing optimal payout second step

• If FCFE greatly exceed Dividends, the CFO must
  check to see how funds are being invested.
• If the actual rate of return (accounting rate of
  return) on equity is greater than the required
  rate of return, then the excess funds should be
  invested in new projects. If necessary, the
  dividend payout ratio should also be decreased to
  release funds for new projects.
• If the actual rate of return is low relative to
  the required rate of return, then dividends
  should be increased.

29
Solution to Problem 8, Chapter 22
Conrail could have paid, on average, yearly
dividends equal to its FCFE. Conrail is earning
an average accounting return on equity of
13.5. The required rate of return 0.07
1.25(0.125-0.07) 13.875. Hence Conrails
projects have done badly on average. Its
average dividends have been much lower than the
average FCFE. Conrail should pay more in
dividends.
30
Solution to Problem 9, Chap. 22
This is the amount that the company can afford to
pay in dividends. The perceived uncertainty in
these cash flows implies that the firm should be
more conservative in paying out the entire amount
of FCFE each year.