Dividend Policy 8-1

8-2 Overview Practical Aspects Practical Aspects Benchmarking: Irrelevance revisited Benchmarking: Irrelevance revisited Policy Policy Low dividends Low dividends High dividends High dividends Policy refers to the tradeoff between paying dividends at a particular date versus paying on a different date - not about the level of dividends Policy refers to the tradeoff between paying dividends at a particular date versus paying on a different date - not about the level of dividends

8-3 Types of Dividends Regular cash dividends Regular cash dividends extra cash dividend extra cash dividend liquidating dividend liquidating dividend Stock dividends Stock dividends increases number of outstanding shares increases number of outstanding shares no cash flow no cash flow Stock split Stock split similar yet larger than stock dividend similar yet larger than stock dividend

8-4 Important Dates Declaration date Declaration date Date of record Date of record Ex-dividend date Ex-dividend date Date of payment Date of payment

8-5 Irrelevance: Example Consider a firm that exists 1 year and consists of only an expected cash flow of $10,000 at the end of the year and $10,000 immediately. The firm is all-equity financed with r E =10%. The firm will match its dividend payments with the cash flows. The firm has 1,000 shares outstanding. V 0 = D 1 + D 2 / (1+r E ) = $10,000 + $10,000 / (1.1) =$19, Share price = $19,09 (cum dividend) Share price = $9.09 (ex dividend 1 ) Proposed new dividend policy is to pay $11 per share immediately. The excess cash needed is financed through an equity issue, again yielding a 10% return. What is the value of the firm under the new policy? What is the value of the firm under the new policy? At what price can the new shares be issued and how many? At what price can the new shares be issued and how many?

8-6 Answer New shareholders require 10% and hence require $1,100 at the end of the year, leaving $8,900, or $8,90 per share, in dividends for the existing shareholders. New shareholders require 10% and hence require $1,100 at the end of the year, leaving $8,900, or $8,90 per share, in dividends for the existing shareholders. Share price for existing shareholders (cum dividend): $11 + ($8.90/1.1) = $19.09 Share price for existing shareholders (cum dividend): $11 + ($8.90/1.1) = $19.09 Issue price new shares = $19.09–$11=$8.09 (or $8.90/1.1) Issue price new shares = $19.09–$11=$8.09 (or $8.90/1.1) Number of new shares offered = $1,000 / 8.09 = shares Number of new shares offered = $1,000 / 8.09 = shares Assumptions for this irrelevance to hold: Assumptions for this irrelevance to hold: no taxes or transactions costs (perfect markets) no taxes or transactions costs (perfect markets) homogeneous expectations homogeneous expectations investment policy is independent of dividend policy investment policy is independent of dividend policy

8-7 Dividends and Taxes Effective tax rate is higher on dividends than on capital gains Effective tax rate is higher on dividends than on capital gains Firm with insufficient cash Firm with insufficient cash transaction costs of financing & price pressure effect transaction costs of financing & price pressure effect tax effect of paying dividends tax effect of paying dividends stability issue of maintaining a constant level stability issue of maintaining a constant level Firms with sufficient cash Firms with sufficient cash Agency costs of free cash flow Agency costs of free cash flow Investing in financial assets (T corporate versus T personal ) Investing in financial assets (T corporate versus T personal )

8-8 Dividends versus Repurchases Irrelevant under perfect markets Irrelevant under perfect markets Tax benefit of share repurchases Tax benefit of share repurchases Targeted Repurchases Targeted Repurchases Investment opportunity and signaling Investment opportunity and signaling

8-9 Expected returns and dividend yield Pretax returns are increasing in the dividend yield Pretax returns are increasing in the dividend yield Dividend yield=annual dividends per share/share price Dividend yield=annual dividends per share/share price Empirical evidence is mixed Empirical evidence is mixed Dividend yield is highly correlated with Book-to-Market Dividend yield is highly correlated with Book-to-Market Should firms have High or Low Dividend policies? Should firms have High or Low Dividend policies? Current income Current income Uncertainty Uncertainty Tax arbitrage Tax arbitrage Agency costs Agency costs

8-10 The Information Content of Dividends Results so far: Results so far: Irrelevance because of homemade dividends Low dividends because of taxes High dividends because of current income etc. Empirical evidence: Empirical evidence: Stock price is positively related to changes in dividends Consistent with....? Consistent with....? Or....? Or....? Signaling and the information content of dividends

8-11 Other issues Clientele effect Clientele effect Different tax brackets result in demand for different levels of dividends Different tax brackets result in demand for different levels of dividends Value creation can only occur if dissatisfied clientele exists - unlikely! Value creation can only occur if dissatisfied clientele exists - unlikely! Despite taxes - dividends are substantial Despite taxes - dividends are substantial Decline in the number of dividend paying companies Decline in the number of dividend paying companies Dividend smoothing Dividend smoothing