Chapter 18' Dividend policy

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Chapter 18. Dividend policy

• Dividend policy Firms policy about the
  distribution of cash to shareholders
• Historically, firms have on average paid out 50
  of their earnings to shareholders
• Dividend payout ratio (Div/Earn) tends to
  decrease in years when earnings increase and
  increase when earnings decrease
• Firms tend to smooth dividends
• Managers adjust dividends to earnings very slowly

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• Year After-tax earnings Dividends Div/Earn.
• ( billions) ( billions) ()
• 1971 53 24 45
• 1982 88 70 79
• 1983 135 81 60
• 1984 170 83 49
• 1985 184 92 50
• 1986 165 110 67
• 1987 193 106 55
• 1988 228 115 51
• 1989 221 135 61
• 1990 242 153 63
• 1991 240 137 57
• 1992 261 150 57

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• Company Div.Yld() Payout ratio ()
• ATT 2.51 44.92
• Boeing 2.31 27.34
• Boston Edison 5.71 64.90
• Deere 2.7 92.74
• Disney 0.54 18.35
• HP 1.14 19.32
• McDonalds 0.74 13.82
• Microsoft 0 0
• Philip Morris 4.67 63.91
• Walmart 0.52 12.81

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• Alternative to paying dividends that achieves the
  same result
• Share repurchases
• Increased in popularity after the wage and price
  controls (dividend controls) of 1971
• First major repurchase was the 1.4 billion
  repurchase by IBM in 1977
• In the 80s large firms distributed about 70 as
  much cash through repurchases as through
  dividends

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Modigliani-Miller again

• In the absence of taxes and transactions costs
• Dividends versus Repurchases
• Choice is irrelevant
• Example Consider two firms Signetics Inc and
  Comgen, both of which are identical except for
  their dividend payout policies. Signetics Inc.
  has announced that it will pay a 10 million
  dividend next year. Comgen announces that it
  will repurchase 10 million in outstanding
  shares. The firms will be worth somewhere
  between 100 million and 200 million at the end
  of the year depending on industry conditions.
  Their future values are assumed to be identical
  V. Both firms currently have a million shares
  outstanding. If you are a shareholder of
  Signetics, are you better off than your
  counterpart at Comgen?

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• Comgens shareholders
• Price per share next year, P
• P x N 10,000,000 where N is the of shares
  repurchased
• V P x (1,000,000 - N)
• Hence solve for P and N in terms of V
• P ( V 10,000,000) / 1,000,000 V/1,000,000
  10
• Hence if V 150,000,000, P 160 and N 62,500
• So Comgens shareholders either receive 160 or
  they have a share worth 160

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• Signetics shareholders
• Dividend of 10 per share
• Price per share next year V/1,000,000
• If V 150,000,000, P 150
• Hence each shareholder receives
• Dividend 10
• Share 150
• Total 160

8

• The tax story
• Irrelevance changes with taxes If dividends are
  taxed at 38 and capital gains at 20
• Comgens shareholders pay a tax of 20 on the
  difference between 160 and the price at which
  they purchased the shares
• Signetics shareholders pay 38 on the 10
  dividend
• As long as the price at which Comgens
  shareholders purchased the shares originally was
  not less than 141 the repurchase results in a
  lower tax burden
• Dividend clienteles
• Investors in the higher tax brackets prefer
  stocks with lower dividend yields and vice versa

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• Example NBM Inc. has 2 million in extra cash.
  They have two alternatives they can invest the
  cash in financial assets for 3 years and then pay
  it out as a dividend or they can pay dividends
  today and let investors invest it themselves. If
  NBM invests it, they have the following choices
  Invest in T bills yielding 7 or in preferred
  stock yielding 11. The corporate tax rate is
  35 . Only 30 of the dividends from preferred
  stock will be taxed. The individual tax rate is
  31. If investors invest on their own the yields
  are the same. What is the best choice?

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• If dividends are paid out today
• 2 x (1-0.31) x (10.07x(1-0.31))3 1.58 million
• NBM invests the money
• In T bills
• 2 x (10.07 x (1-0.35))3 x (1-0.31) 1.58
  million
• In preferred stock
• 2 x (10.11x(1-0.30 x0.35))3 x (1-0.31) 1.83
  million

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• Dividend policy and expected stock returns
• According to the tax argument, stocks with higher
  dividends should offer higher returns to
  investors to compensate for the higher tax
  effects
• Are expected returns higher for stocks with
  higher dividend yields?
• Price drop at ex-dividend date measures the value
  that the market imputes to the dividend

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• Dates associated with dividend payments
• Declaration date Board declares a dividend
• Ex-dividend date The day on which the share
  trades without the next dividend - on and after
  the second business day before the record date
• Record date Need to be a shareholder on record
  as of this date to receive the next dividend
• Payment date Dividend checks are mailed to
  shareholders of record

Jan. 28
Jan. 30
Jan. 15
Feb 16
Dec.date
Ex-div. date
Record date
Payment date
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• Hence if you purchase shares on the ex-dividend
  date you are not entitled to the next dividend
• Ceteris paribus, price of the share should
  decline on the ex-dividend date
• Decline in price is a reflection of the value
  placed on the dividend
• Empirical studies
• Elton and Gruber (1970) - stock prices declined
  on average by 77.7
• Drop is related to the size of the dividend
• High dividend stocks - price decline is more than
  90 of the value of the dividend
• Low dividend stocks - price decline is about 50
• Supports the clientele hypothesis

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Example

• Deaton Inc. and Grebe Inc. are in the same risk
  class. Shareholders expect Deaton to pay a 4
  dividend next year when the stock will sell for
  20 per share. Grebe has a no-dividend policy.
  Currently Grebes stock is selling for 20 per
  share. Grebes shareholders expect a 4 capital
  gain over the next year. Capital gains are not
  taxed but dividends are taxed at 25.
• What is the current price of Deatons stock?
• If capital gains are also taxed at 25 what is
  the price of Deatons stock?

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• After taxes, the expected return on Grebes stock
  is
• 4/20 0.2 20
• Since Deaton has the same risk, their expected
  return should also be 20
• Expected return for Deaton
• Let P denote their current price
• return (20-P) 4 x (1-0.25)
• P
• This should equal 0.2
• Solve for P
• P 19.17

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• If capital gains are also taxed at 25
• Expected return on Grebe
• 4 x (1-0.25) / 20 0.15 15
• Expected return on Deaton
• (20-P) x (1-0.25) 4 x (1-0.25)
• P
• If this equals 0.15, then P 20

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• Dividends as income story
• Clientele of investors that like the income
  content of dividends
• Investors in lower tax brackets
• Pension funds
• Over the last 30 years, the proportion of market
  value of stocks held by pension funds has
  increased substantially - implications for
  dividend policy?

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• Dividends as information story
• Dividends provide information about the firm
• Firms announcing changes in dividend policy are
  conveying information
• Signalling theory
• Firms frequently make a lot of claims about
  future growth prospects
• Some of these claims may be supported, some not
• Dividends are a way to convey information that
  cannot be imitated by other firms unless they
  have the financial backing to do so
• Empirical studies Dividend increases are viewed
  positively and vice versa

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• Summarize the markets perception about dividends
• Tax story - negative
• Signal story - positive
• How should management set dividend policy given
  these reactions?
• Too high a dividend
• Cash constrained for positive NPV projects
• Clienteles in high tax brackets do not appreciate
  this
• Too low a dividend
• Cash balance increasing over time - free cash
  flow problem
• Agency costs

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Determinants of dividend policy

• Investment opportunities - Negative
• Stability of earnings - Positive
• Financial leverage - Negative
• Stockholder clientele

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• Types of dividends
• Cash dividend
• Stock dividend
• Increase the number of shares and reduce the
  price per share
• Similar to stock splits
• Liquidating dividend
• Larger than retained earnings
• Viewed as return on capital by IRS

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Questions

• 18.1
• 18.3
• 18.6 - 18.8
• 18.13
• 18.16-18.18