Corporate Finance

Lecture 13

Corporate Finance

Lecture 13 :
Dividend Policy

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Dividend Policy
! Dividend
! Cash payment made to owners of corporation A form of
profit distribution
! One of the basic financial inducements for individuals to
hold shares
! Fundamental question
! What is the optimal dividend policy for the company?
! Should be aimed at maximising shareholders wealth
! Is dividend policy in a business relevant or irrelevant?
! Depends on whether shareholders wealth is affected
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Corporate Finance

Lecture 13

Dividend Policy
! High or low payout ratio to increase the value of the shares
!

From
As dividend is the numerator, it seems the higher the better
Dividend drains financial resources which may affect
companys short & long term prospects i.e. future dividend
paying ability
A lower or zero g may result, thus offsetting the effect of
high current dividend

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Dividend Policy
Chronology of Dividend Payments
15 Jan

26 Feb

3 Mar

16 Mar

Declaration

Ex-dividend

Record

Payment date

date

date

date

Days

1. Declaration date : The board of directors declares a payment

of dividends
2. Ex-dividend date : A share goes ex-dividend on the date &
seller remains entitled to the dividend
3. Record date : The declared dividends are distributable to
shareholders of record date
4. Payment date : The dividend cheques are mailed to
shareholders of record or their accounts are credited
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Corporate Finance

Lecture 13

MM View on Dividend Policy

! Dividend policy is irrelevant
! Assumptions
! No transaction costs or tax
! No agency costs
! Perfect (symmetric) information
! Investment outcomes independent of financing decisions
! Every investor has equal influence
! Firms have unlimited access to capital markets
! Investors are rational in preferring more wealth than less
wealth & dont mind the composition of wealth
! Efficient market
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MM View on Dividend Policy

! MM Capital Structure Theory implies that the entire
financial policy (capital structure, dividend policy including
risk management activities) of a firm is irrelevant for its
valuation
=> All that matters is the firms portfolios of investment
projects
! Value of firm or shareholders wealth is determined solely by
earning power of firms assets or investment policy & NOT
the manner in which income is split between dividend &
retained earnings
=> Pie Theory No matter how you slice the pie will not
increase its size
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Corporate Finance

Lecture 13

MM View on Dividend Policy

! Effects of MM view
! Firms can alternate between distribution & retention of
profits
! Perfect substitutability between profit retention & new
equity issues
! Shareholders could create dividend by selling some shares
at enhanced price due to capital gain
=> Dividend policy is irrelevant

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Traditional View on Dividend Policy

! Mooted by Graham Dodd then Myron Gordon supported
! Bird in the Hand Theory
! Wealth in the form of cash is more certain than capital gain
! Current cash dividend is worth more than future dividend or
capital gain
=> Lower discount rate because lower risk
! KE is an increasing function of time
=> Higher KE for discounting expected cash flows that are
further in the future

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Corporate Finance

Lecture 13

Empirical Studies on Dividend Policy

! MM view concluded that dividend policy is irrelevant but
some empirical observations seem contrary to the view
! John Lintners Stylized Facts : Research led to the
following facts
! Firms have longer term target dividend payout ratios
! Dividends changes follow shifts in long-run sustainable
levels of earnings rather than short-run changes in earnings
! Managers focus more on dividend changes than on
absolute levels
! Managers are reluctant to make dividend changes that
might have to be reversed
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Empirical Studies on Dividend Policy

! Lintner further developed a simple partial adjustment model
to show the characteristics of dividend behaviour :

where

Dt = Dividend per share at time t

EPSt = Earnings per share at time t
a
= Target payout-out ratio
l
= Parameter governing the degree of dividend
smoothing

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Corporate Finance

Lecture 13

Empirical Studies on Dividend Policy

This model suggests that dividend depends partly on firms
current earnings & partly on the dividend for the previous
year
! Event study
! A wide range of studies for equity from many countries has
demonstrated that dividend cuts & increases on average
lead to drops & rises in the stock prices respectively
! This suggests that the market interprets unexpected
dividend increases or cuts as good or bad news for a stock
respectively
!

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Empirical Studies on Dividend Policy

! Putting together the empirical evidence from Lintners
research & event studies would suggest that dividend policy is
relevant
! Possible reasons for invalidity of MM view on dividend
irrelevancy are existence of tax, asymmetric information &
agency costs

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Corporate Finance

Lecture 13

Agency Costs & Dividend Policy

! Agency cost arises when the ownership & control are
separated
! Managers may pay out large levels of dividends (benefiting
equity-holders), financing these payments by rejecting
positive NPV projects or by increasing debt levels
! Hence, excessive dividend payments can lead to lower firm
values
! This, however, contradicts with the implications of the
asymmetric information-based theories, which, as dividend
increases are good news in general, predict that they should
lead to increase in the firm values
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Information Content of Dividend Policy

! Dividend policy can signal information to investors
! Expectations theory
! If dividend > expected then may convey confidence in the
future unexpected by the market resulting in higher share
price
!

Conversely, if Dividend < Expected => Bad signal =>

Share price will fall

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Corporate Finance

Lecture 13

Information Content of Dividend Policy

! High dividend payout will be costly to firm short of cash flow
to support it, hence dividend increase will signal a firms
confidence in its future
! MM argues that such price movement will materialise even
without an increase in dividend when the fundamental about
the prospects of the firm become known to the market

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Dividend Policy & Taxation

! Taxation can affect shareholders wealth
! If marginal tax rate (personal tax rate) > corporate rate
! Dividend will reduce shareholders wealth if there is tax
discrimination on capital gain vs dividend i.e. lower capital
gain tax than income tax
! Shareholders in high income tax brackets prefer low dividend
paying stocks while those in low income tax brackets prefer
high dividend paying stocks

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Corporate Finance

Lecture 13

Clientele Effect
! Each company should decide for itself the dividend policy that
best fits its corporate strategy & funding needs
! Depending on each companys policy, each investor will know
how to select the companies to invest in where the dividend
policy best fit their preference
=> Birds of the Same Feather Flock Together
! Examples :
! High income tax brackets will select high growth stocks
with low dividend payout
! Retirees will select mature stocks with high dividend payout
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Taxation & Clientele Theory - Illustration

! Assume an economy populated by risk-neutral agents
! Three types of stock exist in the economy : High payout,
medium payout stocks & low payout stocks
! Different tax rates for different parties
! Individuals
: 50% tax on dividend & 20% tax on
capital gains
!

Corporations : 10% tax on dividend & 35% tax on

capital gains
Institutions
: No tax

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Corporate Finance

Lecture 13

Taxation & Clientele Theory - Illustration

Payout Policy

High

Medium

Low

Dividend

100

50

50

100

Individuals

50

65

80

Corporations

90

77.50

65

Institutions

100

100

100

1,000

1,000

1,000

Capital Gain
After Tax Payout

Equilibrium Price

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Share Repurchase
! 3 Ways
! Direct purchase from stock market
! Arrangement with shareholders
! Tender offer to all shareholders

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Corporate Finance

Lecture 13

Share Repurchase
! Reasons for share repurchase
! Return surplus cash to shareholders
! Increase EPS => Increase share price
! Buy-out of unwelcome large shareholders (Greenmail)
! Adjustment of capital structure by reducing equity
! Provides alternative to dividend payment
=> Investors may have tax advantages
BUT greater uncertainty than stable dividend policy

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Share Repurchase - Example

An all equity company has a current market value of $100,000,
comprising 2,000 shares outstanding at market price of $50 per
share.
The firm is due to pay a dividend of $10 per share tomorrow.
What would happen to the share price after dividend
payment?

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Corporate Finance

Lecture 13

Share Repurchase - Example

Total dividend payment = $20,000
Firm value after payment of dividend
= $100,000 - $20,000
= $80,000
Ex-dividend share price

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Share Repurchase - Example

Assume there is an investor who originally held 5 shares in this
firm
Original wealth of the investor
= (5)($50) = $250
Wealth of the same investor after payment of dividend
= Worth of Shareholding + Cash Dividend
= ($40)(5) + ($10)(5)
= $200 + $50
= $250
Hence, wealth of this shareholder remains unchanged
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Corporate Finance

Lecture 13

Share Repurchase - Example

Lets assume that the company decides to use the cash it had
originally earmarked for dividend payment for a share repurchase
instead
No of share to repurchase

No of shares remained
= 2,000 - 400 = 1,600 shares

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Share Repurchase - Example

Share price after share repurchase

The post-share repurchase share price remain unchanged

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Corporate Finance

Lecture 13

Share Repurchase - Example

What happen then to the individual investor
Original wealth = $250
Wealth post-share repurchase
= Worth of Shareholding + Cash Received
= ($50)(4) + $50 = $250
This is exactly the same as the case where cash dividends were
received
=> Individual is indifferent between cash dividends &
share repurchase
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