DIVIDEND POLICY I: The Theory

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DIVIDEND POLICY I The Theory

• Lecture 7
• Saeid Samiei
• Portsmouth Business School

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Overview

• Intro
• Theories
• Irrelevance MM
• Low Payout Taxation
• High Payout
• Real World
• Alternative Approaches Stock Repurchase

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Measures of Dividend Policy

• Dividend Payout
• measures the percentage of earnings that the
  company pays in dividends
• Dividends / Earnings
• Dividend Yield
• measures the return that an investor can make
  from dividends alone
• Dividends / Stock Price

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Standard Method of Cash Dividend Payment

Cash Dividend - Payment of cash by the firm to
its shareholders.
Ex-Dividend Date - Date that determines whether a
stockholder is entitled to a dividend payment
anyone holding stock before this date is entitled
to a dividend.
Record Date - Person who owns stock on this date
received the dividend.
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Procedure for Cash Dividend Payment
25 Oct.
1 Nov.
2 Nov.
6 Nov.
7 Dec.

Ex-dividend Date
Declaration Date
Cum-dividend Date
Record Date
Payment Date
Declaration Date The Board of Directors declares
a payment of dividends.
Cum-Dividend Date The last day that the buyer of
a stock is entitled to the dividend.
Ex-Dividend Date The first day that the seller
of a stock is entitled to the dividend.
Record Date The corporation prepares a list of
all individuals believed to be stockholders as of
6 November.
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Price Behavior around the Ex-Dividend Date

• In a perfect world, the stock price will fall by
  the amount of the dividend on the ex-dividend
  date.

-t -2 -1 0 1 2
P
P - div
The price drops by the amount of the cash dividend
Ex-dividend Date
Taxes complicate things a bit. Empirically, the
price drop is less than the dividend and occurs
within the first few minutes of the ex-date.
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Three Schools Of Thought On Dividends

• 1. If
• (a) there are no tax disadvantages associated
  with dividends
• (b) companies can issue stock, at no cost, to
  raise equity, whenever needed
• Dividends do not matter, and dividend policy does
  not affect value.
• 2. If dividends have a tax disadvantage,
• Dividends are bad, and increasing dividends will
  reduce value
• 3. If stockholders like dividends, or dividends
  operate as a signal of future prospects,
• Dividends are good, and increasing dividends will
  increase value

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The Irrelevance of Dividend Policy

• MM (1961) Dividend Policy, Growth the
  Valuation of Shares Journal of Business, October
• A compelling case made that dividend policy is
  irrelevant.
• Homemade leverage Since investors do not need
  dividends to convert shares to cash they will not
  pay higher prices for firms with higher dividend
  payouts.
• Conclusion dividend policy will have no impact
  on the value of the firm because investors can
  create whatever income stream they prefer by
  using homemade dividends.

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The Underlying Assumptions

• For this argument to work we have to assume the
  following
• Perfect Markets
• Homogeneous Expectations
• Investment Policy

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Implications

• No change in value of equity due to dividend
  policy
• No correlation between dividend policy and stock
  returns

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Low Payout

• Reasons why Dividends are Bad
• Taxes
• Transactions Costs

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Implications

• More Individual Investors gt Lower Dividends
• The Higher the Tax Rates gt the lower the
  dividend
• Tax Disadvantage Increases gt dividends decrease

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High Payout- Investors Like Dividends

• Long (1978) Citizen Utility
• Class A (Stock Dividend) Class B (Cash
  Dividend)
• Class B sold _at_ premium
• Reasons
• Pay Little Tax
• Desire for Current income
• Trusts Endowments
• Transaction Costs

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High Payout Clientele Effect

• Some Investors like Low Dividends (e.g.
  Microsoft)
• Def Clustering of stockholders in companies with
  dividend policies that match their preferences
• Older and poorer investors more likely to hold
  high-dividend-paying stocks than younger and
  wealthier investors.
• gt safer companies, with older and poorer
  investors, tended to pay more in dividends than
  companies with wealthier and younger investors.

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Clientele Effect -Implications

• Firms get the Investors they deserve
• "Sticky Dividend Policies"
• Supports the Irrelevance Theory

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Information Signalling

• Positive Signal Information Content
  Expectation of Larger Future Earnings, Palepu
  (1986)
• Empirical Evidence
• Stock Price Rise following Dividend Increase,
  Asquith Mullins (1983)
• Stock Price Falls following Dividend Omissions,
  Healy Palepu (1988)

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Unrealistic Reasons for Paying Higher Dividend

• The Birds in the Hand Fallacy
• Temporary Excess Cash

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Pros Cons of Paying Dividends
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Reality- What do we know?

• Lintner (1956)
• Follow Earnings
• Sticky
• Smooth Dividends
• Corporate Dividends are Substantial vs. Fewer
  Companies are Paying Dividends
• Information Content

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Alternative Approaches of Returning Cash to
Stockholders

• Equity Repurchases
• Forward Contracts
• Stock Dividends Stock Splits
• Spin-offs Split-Offs

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Equity Repurchases

• Instead of declaring cash dividends, firms can
  rid itself of excess cash through buying shares
  of their own stock.
• Recently share repurchase has become an important
  way of distributing earnings to shareholders.

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Stock Repurchase versus Dividend
Consider a firm that wishes to distribute
100,000 to its shareholders.

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Stock Repurchase versus Dividend
If they distribute the 100,000 as cash dividend,
the balance sheet will look like this
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Stock Repurchase versus Dividend
If they distribute the 100,000 through a stock
repurchase, the balance sheet will look like this
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Share Repurchase The Rationale

• One-time return of cash
• Greater Flexibility
• Tax Advantages
• Give to the Needy
• Increase Insider Control
• Support Stock Price

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To Do

• Review Questions
• Case Study Apple Computers
• Article Why is the Dividend Yield So Low