Dividend Policy: Theory

1
Dividend Policy Theory

• 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

1. The issue of new stock (to replace excess
   dividends) is costless and can, therefore, cover
   the shortfall caused by paying excess dividends.
2. Firms that face a cash shortfall do not respond
   by cutting back on projects and thereby affect
   future operating cash flows.
3. Stockholders are indifferent between receiving
   dividends and price appreciation.
4. 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
Dividend Capture

• 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. 

11
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.

12
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.

13
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.

14
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.

15
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.