MIF.G.

F278 CORPORATE FINANCE

Session 18 Dividend Policy

Barbara S. Pcherot Petitt

Objectives

To discuss the theories of dividend policy: The irrelevance theory The tax-preference theory The bird-in-the-hand theory The signaling theory The agency theory

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Definitions (1)

The dividend policy includes: Dividends, whether they are: Cash dividends (cash leaves the firm) Stock dividends (no cash leaves the firm) Share buy-backs

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Definitions (2)

When it comes to dividends, there are two key characteristics of the dividend policy: The dividend payout, which is equal to the annual dividend divided by the firms earnings. The dividend yield, which is equal to the annual dividend divided by the firms stock price.

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The Theories of Dividend Policy (1)

There are several theories of dividend policy: Theory 1: The Irrelevance Theory When there are (1) no taxes and (2) no frictions, dividends are irrelevant, and increasing dividends does not affect the value of the firm. Modigliani and Miller (MM) (1961)

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Homemade Dividends

For an investor, it should be equivalent: To get the cash dividend, or To sell some shares to get the cash equivalent to the cash dividend. Pricing by arbitrage

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The Theories of Dividend Policy (2)

Theory 2: The Tax-Preference Theory (1) is relaxed. As income tax rates are higher than capital gains tax rates, or income tax rates and capital gains tax rates are equal but capital gains taxes are deferred compared to income taxes, dividends are bad, and increasing dividends decreases the value of the firm.

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The Clientele Effect

There is a clientele effect: Some people (e.g., older people, people in low income tax brackets) prefer high dividends. Other people (e.g., younger people, people in high income tax brackets) prefer low dividends. But the clientele effect does not affect the value of the firm.

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The Theories of Dividend Policy (3)

Theory 3: The Bird-in-the-Hand Theory As dividends are more certain than capital gains, dividends are good, and increasing dividends increases the value of the firm.

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The Theories of Dividend Policy (4)

Value of the firm Bird-in-the-Hand Theory

Irrelevance Theory

Tax-Preference Theory Dividend Payout

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The Theories of Dividend Policy (5)

Theory 4: The Signaling Theory (2) is relaxed. There is asymmetric information between the managers and the shareholders, and dividends are viewed as a signal of firm value: A decrease in dividends signals firms with bad prospects. An increase in dividends signals firms with good prospects.

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The Theories of Dividend Policy (6)

Theory 5: The Agency Theory (2) is relaxed. There are agency conflicts between: The managers and the shareholders. Dividends are good, as they decrease these agency conflicts (Easterbrook, 1984). The shareholders and the debtholders. Dividends are bad, as they increase these agency conflicts (there is a wealth transfer between debtholders and shareholders).

Covenants
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The Empirical Evidence

Investors prefer a stable dividend policy. In absolute terms, the dividend policy does not matter. However, in relative terms, the dividend policy does matter. Indeed, a change in the dividend policy conveys information about the firm. Information conveyed by decreases in dividends is stronger than information conveyed by increases in dividends.

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Dividends vs. Share Buy-Backs (1)

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Dividends vs. Share Buy-Backs (2)

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Dividends vs. Share Buy-Backs (3)

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Dividends vs. Share Buy-Backs (4)

Source: Brav, Graham, Harvey and Michaely (2005)

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Free Cash Flows (1)

The free cash flows (FCFs) measure how much cash is left once the firm has taken care of all its operating and investing decisions. Therefore, they measure how much cash is available for the financing decisions, i.e., for the providers of funds (e.g., debtholders, preferred shareholders and common shareholders).

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Free Cash Flows (2)

Sales Cost of Sales Selling, General and Administrative (SG&A) Depreciation = Earnings Before Interest and Tax (EBIT) Tax (i.e., EBIT times the effective tax rate) = Net Operating Profit After Tax (NOPAT) + Depreciation = Operating Cash Flow +/- Change in Gross Fixed Assets (CapEx) +/- Change in Net Working Capital (NWC) = Free Cash Flow
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Free Cash Flows to Common Equity (1)

The free cash flows to common equity (FCFCEs) measure how much cash is left once the firm has taken care of (1) all its operating and investing decisions and (2) all its financing decisions related to the debtholders and the preferred shareholders.

Therefore, they measure how much cash is available for the common shareholders.

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Free Cash Flows to Common Equity (2)

Free Cash Flow Interest After Tax (i.e., Interest (1Effective Tax Rate)) +/- Net Change in Debt (Issuance Repayment) Preferred Dividend +/- Net Change in Preferred Equity (Issuance Repayment) = Free Cash Flow to Common Equity

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Free Cash Flows to Common Equity (3)

FCFCE < Dividends
Firms should deal with its investment problem first and then cut dividends. FCFCE > Dividends Force managers to justify holding cash or return cash to stockholders.

EVA < 0

EVA > 0

Firm should cut dividends and reinvest more.

Give managers the flexibility to keep cash and set dividends.

Source: Damodaran

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References

A. Brav, J. Graham, C. Harvey and R. Michaely, Payout Policy in the 21st Century, Journal of Financial Economics, 77(3), September 2005, p. 483527. F. Easterbrook, Two Agency-Costs Explanations of Dividends, American Economic Review, 74(4), September 1984, p. 650-659. M. Miller and F. Modigliani, Dividend Policy, Growth, and the Valuation of Shares, Journal of Business, 34(4), October 1961, p. 411-433.

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