1. Dividend Policy Chapter 18 – 7,11,13,17

4. DIVIDEND POLICY: OVERVIEW I.Mechanics. II.Why do firms pay dividends? 1. Dividends don't matter (Modigliani Miller, 1961). 2. Introduction of personal taxes: Dividends are taxed heavier than capital gains (arguments against dividend payments). Dividend policy is tailored to meet clientele needs. 3. Dividends are more certain than capital gains. (bird in hand fallacy) 4. Dividends are signals. 5. Dividends reduce the agency problems. III.Framework for analyzing dividend policy

5. I.Mechanics Cash dividends Stock dividends / stock splits Stock repurchases: Open market purchases Targeted share repurchase Dutch auction share repurchase Significant dates: 11/15 12/13 12/15 1/2 DeclarationEx-dividendHolder-of-record Payment date date

6. II. Why do firms pay dividends? 1. The Modigliani-Miller Hypothesis: Dividends do not affect value. If a firm's investment policy (and hence cash flows) doesn't change, the value of the firm cannot change with dividend policy. Home-made dividends Assume no taxes, transactions costs, investment policy held constant

7. 2. Personal taxes. Basis: Dividends are taxed more heavily than capital gains. Extreme response - stockholders will prefer capital gains to dividends, and firms should pay no dividends. Moderate response – personal taxes discourage but are not sufficient to lead firms to eliminate dividends. Evidence: 1) Examine dividend yield vs. expected return. 2) Examine ex-dividend date stock price behavior to see whether dividends are perfect substitutes for capital gains.

8. Ex dividend day price effects: Let: P b = price before the stock goes ex-dividend P a = price after the stock goes ex-dividend P c = original purchase price D = dividend declared on stock t o,t cg = tax on ordinary income and capital gains Compare two strategies: Sell the stock the instant before it goes ex-dividend: P b - t cg (P b - P c ) Sell the stock after it goes ex-dividend: D(1-t o ) + P a - t cg (P a - P c ) Setting the two equal: The marginal investor will be indifferent between the two strategies. The price drop on the ex-dividend date is related to investor tax rates.

10. Example: Ex-dividend day price effects CP Corp is priced at $50 with dividend. Its price falls to $46.50 when a dividend of $5 is paid. What is the implied marginal rate of personal taxes for its stockholders? Assume the capital gains tax rate is 40% of the personal income tax rate.

11. Other factors to consider in setting dividend policy: 3. Dividends are a more reliable form of return than capital gains (the bird in the hand fallacy). Dividends now are more certain than capital gains and hence are more valuable. 4. The signalling hypothesis. In a world of asymmetric information, firms have to convince investors about their future prospects. 5. Dividends reduce agency problems. Managers do not throw away $ on bad projects.

12. III. Framework for analyzing dividend policy. 1) The Lintner model: Firms appear to smooth dividends; dividends are generally a weighted average of past earnings, placing the heaviest weight on most recent years. D 1 - D 0 = adjustment rate x (target ratio*EPS 1 - D 0 ) This is inconsistent with a “residual” dividend policy (pay out all cash after investing in positive NPV projects).

13. 2) How can we evaluate a firm's dividend policy? If a company has excess cash, and few good projects, returning money to stockholders is good. If a company does not have excess cash, and/or has several good projects, returning money to stockholders is bad. Example: if FCFE > dividends ROE < required return on equity then increase dividends cut bad projects

14. Definition: FCFE = FCF – payments to debt holders (interest and net principal repayment) Or, FCFE = NI - (capex - depr) - D(net working capital) + (new debt issued - debt repayments)

15. Dividends/opportunities matrix: FCFE - Dividends I. Increase dividendsII. No change III.Decrease dividends Reevaluate projects IV. Decrease dividends Bad projects Good projects ROE - Req return Cash Flow Surplus Cash Flow Deficit

16. Example: Limited, 1992 restructuring