dividend policy

DIVIDEND POLICY

Chapter 17

Alex Tajirian

Dividend Policy 17-2

© morevalue.com, 1997

1. OUTLINE

# What to do with excess cash?

# Types of dividends

# Theories of optimal dividend policy: dividend puzzle

# Some practical considerations

Alex Tajirian



Graphics: WHAT TO DO WITH EXCESS CASH

Alex Tajirian



2. OBJECTIVE & DEFINITION

Definition: Dividend is the distribution of value to shareholders.

Dividend Policy: What happens to the value of the firm as dividendis increased, holding everything else (capitalbudgets, borrowing) constant. Thus, it is a trade-offbetween retained earnings on one hand, anddistributing cash or securities on the other.

Alex Tajirian



3. TYPES3.1 CASH DIVIDEND1

Example: $.5 for every share you hold

Regular, regular + "extra" , special

Dates:

|_____________|______________|___________|____1/15 1/26 1/30 2/15Declaration Ex-dividend Record PaymentDate Date Date Date

Only investors who hold the security prior to the ex-dividenddate receive the dividend.

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3.2 STOCK DIVIDENDExample: 1 new stock for each 10 you hold

3.3 STOCK REPURCHASE2

3.1 Methodin the open markettender offerdirect negotiation with major shareholders

3.2 Reasons! Alternative to "extra" or special dividend.

Example. A company just sold a division and cannot use theproceeds for favorable investments.

! If management believes the stock is under-valued.

! As an obstacle to takeovers.Q If management re-purchases stocks, then the price increases,

thus prevents raiders from acquiring company at an attractiveprice.

Q Greenmail

! EPS increases, thus value of firm increases !?

3.3 Advantages(! Shareholders have a choice: sell shares or keep.! Firm has no obligation to make future repurchases.

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2.3.4 Disadvantages;! May signal to investors that the firm's investment opportunities

are limited.

! The firm may pay too high a price for the repurchase.Example: Greenmail

2.4 STOCK SPLITExample. (2-1 split), i.e., for every share you own, now you own

two.

! Argument for splits: To make stock "more attractive" to investors?!

! Value of firm is not expected to change.

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4. DIVIDEND CONTROVERSYTHEORIES

Irrelevant, rightists (high dividend), leftists (low payoff), Middle ofthe Road

k = capital gains + dividend yield

4.1 IRRELEVANTM & M in the case of perfect markets.

Reasoning: There is nothing the firm can do that investorscannot duplicate. Firm and investors have identicalopportunities.

Alex Tajirian



4.2 RIGHTISTS! Bird in the hand fallacy. "Paying out some cash today reduces

risk of future payoff uncertainty"

Alternatives CF1 CF2 CF CFT

1 0 0 ... 100 ...

2 20 20 ... 60 ...

What about return?

! Grand Ma's argument: "I need the regular cash dividend to liveon!"

4.3 LEFTISTSTax argument:

Tax on dividends = tax on income $ tax on capital gains.But tax on dividends must be paid now, while on capital gainswould be in the future.

Alex Tajirian



Illustration. Invest $100, ks = 10% , T = 40%Case 1. Stock held for 20 years.

FV20 = $100(1+.1)20 = 672.75after tax FV20 = final value - tax paid

= 672.75 - (T)(capital gains)= 672.75 - (.4)(672.75 - 100) = 443.65

Case 2. Assume that all earnings are paid as dividends.Investor takes money and buys back stock

FV20 = $100 (1 + After tax rate of return )20

= 100 [1 + ks (1 - T)]20

= 100 [ 1 + .1(1 - .4)]20 = 320.7

ˆ̂ Case 1 is better. Thus, Optimal dividend policy is zero/verylow.

Alex Tajirian



hg; dividend and tax

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4.4 MIDDLE OF THE ROADSignaling. Regular dividend can be used by managers to

provide information/signal about future prospects.

In practice, it is too expensive to signal with dividends.

5. PRACTICAL ISSUES

! Legal Requirements:Companies cannot keep "excess" cash as retained earnings ifno investment opportunities exist. They have to distribute themas dividends.

!! Institutional Restrictions:Many trust portfolios are required to protect the investmentprinciple and can only spend investment income. Thus, theytend to invest in companies with high dividends.

! Market Reaction to Dividend `̀:Price usually ̀̀ . Investors interpret it as a negative signal, in thatthe firm's future opportunities are not good.

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6. DIVIDEND POLICY IN PRACTICE! Constant $ pay-off! Constant payoff: fixed % of earnings! Residual Theory: Pay out $ that cannot be re-invested in the

firm at the required rate of return ks.

Alex Tajirian



1. On recent trends, see LAT 1/27/93 p. E158. On DividendReinvestment Plans (DRIPs) see LAT 2/16/93 p. E56.

2. See LAT 6/12/92 p. E164.

7. ENDNOTES

Alex Tajirian



8. QUESTIONS

True\False-Explain

1. If a company has excess cash, then it should acquire another.

2. Given U.S. tax laws, the optimal dividend policy should be zero dividends.

3. Stock repurchase is a form of dividend.

4. Stock splits should have no effect on the value of a company.

5. If XYZ Inc. announces an increase in its dividends and the price of the stock increases onthe same day, then you can conclude that investors prefer dividend income over capital gains.

6. The 1993 tax changes (tax on dividend $ tax on capital gains) make high dividend payingstocks more attractive to the average investor.

7. SPDRs can have no disadvantages over an S&P500 mutual fund.

8. If splitting a stock increases its liquidity, then the firm necessarily benefits.

9. A 3-to-1 stock split means that for every 3 shares you currently own you end up with one.Moreover, the new price, after the split, would be 3 times the original price.

Alex Tajirian



Value of Firm ' Price× (# of Shares)

Value After Split:Price

2× (# of shares × 2)

Y Value unchanged

9.0 ANSWERS TO QUESTIONS

True\False-Explain

1. False. If the company does not have any positive NPV projects to invest in, then itshould pay shareholders dividend (either extra dividends or repurchase stock). Note,acquiring another company in the same line of business is also considered a project.

2. True. See notes for explanation

3. True. Since dividends are defined as a distribution of wealth. Stocks have to be re-purchased at a price higher than then market price. Thus, additional value has to bedistributed to shareholders.

4. True.

5. False. A possible explanation for the price increase might be than investors interpret theincrease as a strength in the company's future earnings prospects. Thus, they buy thestock, this increases the demand for the stock, and thus its price goes up. An alternativeexplanation, which has nothing to do with dividends, might be that the general stock

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market went up, and so did XYZ Inc!

6. False. Actually the opposite is true. The new lax laws make high paying dividend stockseven less attractive to the average investor.

7. False. One disadvantage of SPDRs is that dividends, from the underlying stocks, aredistributed to shareholders. An index fund, on the other hand, can devise a dividend re-investment plan to reduce the dividend tax effect.

8. False. Liquidity in the secondary market benefits the investors not the company. Remember the secondary market is for the exchange of ownership. It is the primarymarket that is more of a concern to the firm.

9. False. With a 3-to-1 split you end up with 3 shares for each that you held. Moreover, thenew price ought to be a third of the original price.

Alex Tajirian

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