Chapter 6 from the syllabus

Dividend policy
BMA, chap. 17; RWJJ, chap. 18

279

Dividends
Unless a dividend is declared by the board of directors of a
corporation, it is not a liability of the corporation.
A corporation cannot default on an undeclared dividend.

The payment of dividends by the corporation is not a

business expense.
Therefore, they are not tax-deductible.

Dividends received by individual shareholders are fully

taxable at the same rate as capital gains for most people
15%.
Since the Jobs and Growth Tax Relief Reconciliation Act of 2003

Portugal: taxa liberatria de 28%

281

Dividends and Stock Repurchases

Cash Dividend
Regular Cash Dividend
Special Cash Dividend

Stock Dividend
Stock Repurchase
Buy shares on the market
Tender Offer to Shareholders
Private Negotiation (Greenmail)
282

Different Types of Dividends

Many companies pay a regular cash
dividend
Public companies often pay quarterly

Sometimes firms will throw in an extra cash

dividend
The extreme case would be a liquidating
dividend
283

Different Types of Dividends

Often companies will declare stock
dividends.
Very similar to a stock split (but usually smaller)
No cash leaves the firm.
The firm increases the number of shares
outstanding.

Some companies declare a dividend in kind.

Wrigleys Gum sends around a box of chewing gum
(Would be better to be a BMW shareholder)

284

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 the date when the firm records
all the shareholders that are receiving
dividends.

285

Cash Dividend Payment Process

31 Jan.07

6 Feb07 7 Feb07

9 Feb07

9 Mar07

Declaration
Date

Cumdividend
Date

Exdividend
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 buyer of a stock is NOT entitled to the dividend
Record Date: The corporation prepares a list of all individuals believed to be
stockholders as of 6 February
Payment Date: The company mails dividend checks to the registered shareholders
286

Ex-Dividend and Record Date

The procedure of paying dividends to all shareholders as
of the record date would be unfair if:
Some brokerage houses are able to notify the corporation by Feb.
9th of a purchase made on Feb. 8th
Other brokerage houses might not be that efficient, and the
purchase notification would only reach the company by Feb. 10th

To eliminate that problem, all brokerage firms entitle

stockholders to receive the dividend if they purchased the
stock three business days before the date of record
287

Price Behavior around the ExDividend Date

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

-2

-1

+1

+2

$P
$P - div
The price drops by
the amount of the
cash dividend

Exdividend
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.

288

Repurchase of Stock
Also known as stock buyback
Instead of declaring cash dividends, a firm can
get rid of excess cash through buying shares of
its own stock
The shares are generally held in the corporate
treasury until they are cancelled. They might be
resold if the company needs to raise money in
the future
Share repurchase has become an important
way of distributing earnings to shareholders
289

Open Market Repurchase

Most common method.
Firm announces its intention to buy shares in
the open market, and then proceeds to do so
over time like any other investor
It may take a year or more to buy the shares,
and the firm is not committed to do so at all.
The firm must not buy its shares in a way that
might appear to manipulate the price.
291

Novartis buyback
Pharmaceuticals company Novartis AG of Switzerland launched a
new share-buyback program valued at up to three billion Swiss
francs, and said it will remain on the lookout for suitable takeover
targets despite the cash outflow.
Novartis said the new buyback plan is in line with its strategy of
compensating shareholders with around 50% of the companys
annual free operational cash flow.
Since 1999, Novartis has launched three major share-buyback
programs valued at a total of 12 billion francs.
In the last buyback, for four billion francs, Novartis bought 69.7
million of its own shares by the week ended Aug. 6th of this year.
Around 30% of these shares, equaling around 0.8% of the
companys capital, are to be canceled after Novartiss annual
general meeting in 2005
Wall Street Journal, Aug 10th, 2004
292

Tender Offer
The firm commits to buying all the shares in the
buyback program very quickly generally
within 20 days.
Rather than buying the shares in the market,
the firm offers to buy the shares at a fixed
price, which is usually at a substantial premium
(20% is typical).
Often the tender offer is conditional on
shareholders tendering a sufficient number of
shares.
293

Targeted Repurchase
Buy directly from a major shareholder.
Price is directly and privately negotiated with
the seller.
If the major shareholder is threatening to take
over the firm and remove its management, the
firm may decide to eliminate the threat by
buying out the shareholder often at a large
premium over the current stock price. This type
of transaction is often referred to as
greenmail.
294

Lintners Stylized Facts

(How Dividends are Determined)
1. Firms have long-term target dividend payout ratios.
2. Managers focus more on dividend changes than on
absolute levels.
3. Dividend changes follow shifts in long-run,
sustainable levels of earnings
4. Managers are reluctant to make dividend changes
that might have to be reversed.

Dividend Smoothing
295

What is Dividend Policy?

296

Companies can pay out some of their earnings

either through a dividend or through share
repurchases
The strategy on how to distribute earnings to
shareholders is called Dividend Policy

297

What is Dividend Policy?

Dont mix up firms decision about dividends with other
financing and investment decisions.
Isolate dividend policy from other problems of financial
management
What is the effect of a change in cash dividends paid,
given the firms capital budgeting and borrowing
decisions?
Dividend policy is the trade-off between retaining
earnings on the one hand and paying out cash and
issuing new shares on the other.
299

An imprecise statement
After a change in management, Dreamers Inc.
new CEO immediately announced an increase in
the dividend of 15%. The stock market reacted
positively to this announcement, and the share
price of Dreamers Inc. rose by 7%.
So, dividends have a positive effect here
but we might be missing something what is it?

300

The Irrelevance of Dividend

Policy

301

10

Modigliani and Miller

Franco Modigliani (1918-2003)

Nobel Prize 1985

Merton H. Miller (1923-2000)

Nobel Prize 1990
302

M&M Dividend Irrelevance

Modigliani & Millers dividend policy

proposition

Dividend policy is irrelevant in perfect

capital markets
303

11

M&M Dividend Irrelevance

Interpretations
If companys investment policy is fixed, its NPV is
fixed. The pattern of dividend payments doesnt
affect NPV
In perfect capital markets, investors dont care how
they get their money, as long as they get it. They can
get it through stock price changes or dividends
Since investors do not need dividends to convert
shares to cash, they will not pay higher prices for
firms with higher dividend payouts.
304

M&M Dividend Irrelevance

Some key assumptions:
The investment policy of the firm is set ahead of
time and is not altered by changes in dividend
policy.
No transaction costs (e.g. no repurchasing premium
for company, no cost of mailing dividend checks)
No taxes, or dividends and capital gains are taxed at
same rate

305

12

M&M Dividend Irrelevance

Clearly, capital markets are not perfect.

BUT:
If you claim dividends do matter, one or more
of these assumptions must be violated. That
is the real power of the theorem: it clarifies
how dividends could matter.
306

An Illustration of the Irrelevance of

Dividend Policy
A compelling case can be made that dividend policy
is irrelevant.
Since investors do not need dividends to convert
shares to cash they will not pay higher prices for
firms with higher dividend payouts.
In other words, 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.
307

13

Homemade Dividends
Bianchi Inc. is a $42 stock about to pay a $2 cash dividend.
Bob Investor owns 80 shares and prefers $3 cash dividend.
Bobs homemade dividend strategy:
Sell 2 shares ex-dividend

homemade dividends
Cash from dividend
$160
Cash from selling stock
$80
Total Cash
$240
Value of Stock Holdings $40 78 =
$3,120

$3 Dividend
$240
$0
$240
$39 80 =
$3,120

308

Irrelevance of Cash Dividends

Since investors do not need dividends to convert
shares to cash, dividend policy will have no impact
on the value of the firm.
In the above example, Bob Investor began with total
wealth of $3,360:

$3,360 80 shares

$42
share
309

14

Irrelevance of Cash Dividends

After a $3 dividend, his total wealth is still $3,360:
$3,360 80 shares

$39
share

$240

After a $2 dividend, and sale of 2 ex-dividend

shares, his total wealth is still $3,360:
$3,360 78 shares

$40
share

$160 $80
310

Irrelevance of Stock Dividends

Shimano USA has 2 million shares currently
outstanding at $15 per share. The company
declares a 50% stock dividend. How many shares
will be outstanding after the dividend is paid?
A 50% stock dividend will increase the number of
shares by 50%:
2 million1.5 = 3 million shares
311

15

Irrelevance of Stock Dividends

After the stock dividend what is the new price per
share and what is the new value of the firm?
The value of the firm was 2m shares $15 per share = $30
m. After the dividend, the firm value will remain the same

Price per share = $30m/ 3m shares = $10 per share

Investor who owned one share at $15 before the stock split
now owns 1.5 shares at $10.
312

Stock Repurchase vs. Dividend

Consider a firm that wishes to distribute $100,000 to its
shareholders

A. Original balance sheet

Assets
Cash
Other assets

Liabilities & Equity

$150,000 Debt
850,000 Equity

0
1,000,000

Value of Firm 1,000,000 Value of Firm 1,000,000

Shares outstanding
Price per share

= 100,000
= $1,000,000/100,000 = $10
313

16

Stock Repurchase versus Dividend

If they distribute the $100,000 as cash dividend, the
balance sheet will look like this:
B. After $1 per share cash dividend
Assets
Liabilities & Equity
Cash
$50,000 Debt
0

Other assets

850,000

Value of Firm 900,000

Equity

900,000

Value of Firm 900,000

Shares outstanding = 100,000

Price per share
= $900,000 / 100,000 = $9
Wealth of shareholder = $9 + $1 div.
= $10

314

Stock Repurchase versus Dividend

If they distribute the $100,000 through a stock repurchase,
the balance sheet will look like this:

C. After stock repurchase

Assets
Cash
Other assets

Liabilities & Equity

$50,000 Debt
0
850,000 Equity
900,000

Value of Firm 900,000 Value of Firm 900,000

Shares outstanding
Price per share

= 90,000
= $900,000/90,000 = $10
315

17

Dividends and Investment

Policy
Firms should never forgo positive NPV projects
to increase a dividend (or to pay a dividend for
the first time).
Recall that one of the assumptions underlying
the dividend-irrelevance arguments was The
investment policy of the firm is set ahead of
time and is not altered by changes in dividend
policy.
316

The Dividend Controversy

317

18

Topics Covered
Views on dividend relevance
The Rightists (dividends increase value)
The Radical Left (dividends decrease value)
The Middle-of-the-Roaders (little or no
effect)
318

Dividends Increase Value

A rightist (high-payout) view

the considered and continuous verdict of the stock

market is overwhelmingly in favor of liberal dividends as
against small ones
Benjamin Graham and David Dodd
Security Analysis (1951) (1st ed. 1934)

319

19

Dividends Increase Value

Rightist argument: M&M ignore risk
Dividends are cash in hand, but capital gains are not
Bird in hand versus bird in bush
So isnt the dividend to be preferred?

Questionable argument
Declaring high dividend makes (residual) capital gain component
riskier, overall risk to shareholders does not change
Can get dividend-like bird in hand whenever you like, just by
selling some of your stock
M&M assume efficient capital market: $1 in dividend would
otherwise be capitalized at $1 in share price. So long as this is
true, the bird in hand argument is invalid. If this is not true (as
Graham and Dodd imply), argument is valid.

320

Dividends Increase Value

Rightists say: There are clienteles that prefer
dividends
Some financial institutions cannot hold stocks that do not have
established dividend records
Trusts and endowments may be discouraged from spending capital
gains (which may be viewed as principal) but allowed to spend
dividends (may be viewed as income)
Retirees(?)/Small investors(?) may prefer to spend from their AT&T
dividend checks rather than sell a few shares every month. (Reduces
transaction costs, inconvenience)
The demand of these dividend clienteles may increase the price of
a dividend-paying stock

But
Unclear whether any particular firm can benefit by increasing
dividends. There may already be enough high-dividend stocks to
choose from.

321

20

Dividends Increase Value

Rightist argument: Dividends cant be wasted
Investors may not trust managers to invest retained
earnings wisely
Firms that refuse to pay out cash may sell at a
discount

Comments
In this case dividend decision is tied to investment
decision
May have particular merit in countries with poor
corporate governance systems

322

Dividends Decrease Value

Leftist (low-payout) argument: Taxes
If dividends are taxed more heavily than
capital gains, investors dislike dividends.
Firms should pay low dividend, retain cash or
repurchase shares
Investors should require higher pre-tax
return on dividend-paying stocks (i.e,
dividend-paying stocks sell at a discount
price)
323

21

Middle of the Road

Maybe M&M conclusion of irrelevance is right even
when some of the assumptions are relaxed:
High- or low-payout clienteles may exist, but they
are already satisfied, so no firm can increase its
value by changing dividends
This middle of the road view argues that
dividends have little or no effect on value
329

Dividends Increase Value

Market Imperfections and Clientele Effect
There are natural clients for high-payout stocks, but it
does not follow that any particular firm can benefit by
increasing its dividends. The high dividend clientele
already have plenty of high dividend stock to choose
from.
These clients increase the price of the stock through
their demand for a dividend paying stock.
330

22

Dividends as Signals
A firms dividend policy may convey information to
investors.
When a firm raises its dividend, it is a positive signal
to investors that the management expects to be able to
afford the higher dividend for the foreseeable future
(because managers are very reluctant to make dividend
changes that might have to be reversed).
Conversely, when a firm cuts its dividend, it signals
that management has given up hope that earnings will
rebound in the near term and so need to reduce
dividends to save cash.
331

Florida Power and Light

Company BMA p. 421
FPL Group announced a 32 percent reduction in
its dividend
FPL was very careful spelling out the strategy
behind their move, and it was economically valid
The market did not care the share price dropped
by 14% on the announcement
It took several weeks for the market to realize
that FPL was doing well and following a valid
strategy
332

23

Microsofts Starter Dividend

On January 16, 2003, Microsoft announced what
CFO John Connors called a starter dividend
initiating its first dividend ever in the amount of 8
cents per share.
This surprise led to a variety of reactions on Wall
Street.
Goldman Sachs analyst Rick Sherlund removed
Microsoft from its place of honor on Goldmans
recommendation list, seeing the dividend as the
companys declaration that its best growth years
are behind it, and that now it has nothing better to
do with its capital than to mail it back to
333
shareholders.

Other commentators did not view Microsofts

dividend announcement as new news about its
investment opportunities. The fact that Microsoft
accumulated over $40 billion in cash over the last
several years was already evidence that it had
cash flow that far exceeds its investment needs.
Some viewed the policy as tacit support for Bushs
dividend tax cut proposal, which was being
promoted at the time.
334

24

Dividends Decrease Value

Tax Consequences
Companies can convert dividends into capital gains
by shifting their dividend policies. If dividends are
taxed more heavily than capital gains, taxpaying
investors should welcome such a move and value
the firm more favorably.
In such a tax environment, the total cash flow
retained by the firm and/or held by shareholders
will be higher than if dividends are paid.
335

Dividends and Managerial Income

You might be tempted to increase dividends to
pay yourself some low-tax income
Some examples of boosts to dividend income:
Bill Gates (Microsoft)
Leslie Wexner (Limited Brands)
Sumner Redstone (Viacom)

+80.3 million
+ 9.3 million
+40.2 million
336

25

Exercises
RWJJ, chap. 18
exercises 1, 2, 5, 6, 15, 16, 18

337

The methodology of event-studies

An event study measures the impact of a specific
event on the value of a firm.
In these studies we assume that the market will
immediately incorporate any new information about
the firm.
Event studies have been applied to a variety of
finance-related topics: M&A, earnings
announcements, security issues, etc.
From MacKinlay (1997)

338

26

The methodology of event-studies

Procedure for an event study
Define the event window: (0, +1), (-1, +1), etc.
After identifying the event, we need to define the selection
criteria to include a firm in the sample (market capitalization,
industry representation, time range, etc.)
Calculate abnormal returns: the difference between actual
return and normal returns over the event window.
Several models may be used to calculate normal returns.

From MacKinlay (1997)

339

The methodology of event-studies

...
Define the estimation window, over which the
parameters of normal returns are estimated.

Design the testing framework: define the null

hypothesis and how to aggregate individual firm
abnormal returns.
Present the results following the formulation of
the econometric design.
From MacKinlay (1997)

340

27

The methodology of event-studies

Statistical models for measuring normal
performance:
Constant mean return model

From MacKinlay (1997)

341

The methodology of event-studies

The market model

From MacKinlay (1997)

342

28

The methodology of event-studies

Other statistical models:
Factor models: allow to reduce the variance of abnormal
returns, by explaining more of the variation of the
normal returns.
But, are the improvements relevant?
Evidence has shown that the marginal explanatory gain
from including new factors is relatively small.
Factor models may be relevant when the sample firms
are not diversified; e.g., when the sample is
concentrated in one industry.
From MacKinlay (1997)

343

The methodology of event-studies

Economic models for measuring normal performance:
CAPM: is an equilibrium theory where the expected
return of an asset is determined by its covariance with
the market.
Problem: the restriction that CAPM imposes makes the market
model more appealing.

APT: is an asset pricing theory where the expected

return of an asset is a linear combination of several
risk factors.
Problem: small gains from adding new risk factors.
From MacKinlay (1997)

344

29

The methodology of event-studies

Measuring and analyzing abnormal returns
Consider the market model
Time line for an event study:

Let L1 = T1 T0 and L2 = T2 T1
From MacKinlay (1997)

345

The methodology of event-studies

Estimate the market model over the
estimation window, using OLS.

From MacKinlay (1997)

346

30

The methodology of event-studies

The abnormal return of firm i is given by

Conditional on the event window market returns

the variance of the abnormal returns of firm i is

From MacKinlay (1997)

347

The methodology of event-studies

The null (H0) is that the event has no impact on
the behavior (mean and variance) of the asset
returns.
Under the null, the distribution of abnormal
returns over the event window is

Aggregation of abnormal returns (through time

and across securities).
From MacKinlay (1997)

348

31

The methodology of event-studies

Aggregation through time for an individual
security

Asymptotically the variance of CARi is

Thus,

From MacKinlay (1997)

349

The methodology of event-studies

Tests with one event observation are not useful.
Observations must be aggregated over the event window
and across all firms.
Assume that there is no overlap of the event windows across
firms.
Aggregate CARi across all securities

From MacKinlay (1997)

350

32

The methodology of event-studies

Inferences about CAR can be drawn using

The null that abnormal returns are zero can be tested using

Since 2 is unknown, the appropriate estimator to use is

the sample variance of the market model over the
estimation window.
From MacKinlay (1997)

351

A common plot of cumulative abnormal returns from

event day -21 to event day +21

From MacKinlay (1997)

352

33