Transcript Dividend policy - BU Main Page

Dividend policy
Concepts and exemplification
Objective
Understand the role of dividend policy in the context of the firm’s
overall financial policy.
Outline
• Types of dividends
• The dividend time line
• Stock price reaction
• Dividend policy irrelevance
• Theories explaining dividend policy
Dividends come in many forms:
 Regular cash dividend
 Extra dividends
 Liquidating dividends
 Shares repurchases
• Stock dividends
Dividend time Line
• Declaration date
• Cum-dividend date
• Ex-dividend date
• Record date
• Payment date
Ex-dividend day: Stock price reaction
The stock price will drop by the amount forgone by the average
investor
Clarification:
Pcum
= D0 + D1/(1+ r)2 + D2/(1+r)3 + ……
Pex
=
D1/(1+ r)2 + D2/(1+r)3 + ……
Stock price reaction (con't)
With taxes, the price drop ~ D(1-Td)/(1-Tcg)
Td = tax on dividend (average investor)
Tcg = tax on capital gain (average investor)
Dividend Policy: Does it matter? Is there an optimal
dividend policy?
If no, focus on the investment decision
If yes, what is the optimal policy?
View # 1: Dividend policy is irrelevant
Shareholders are able to undo firm's dividend policy.
M&M: firm value is independent of the dividend decision.
View # 1: Dividend policy is relevant
Bird-in-hand story
A $1 in dividend now is worth more than $2 in dividend later on.
Signaling
Dividend increase = Good times ahead
The free cash-flow hypothesis
$1 in dividend is $1 less to spend on M&A
View # 1: Dividend policy is relevant (cont’d)
Clientele effect
Some want dividends while others want capital gains
Tax effect
Tax effect
REC Company has $1,000 in extra cash. It can invest this cash in a 5year T-bill at 8%, or it can pay the cash to the shareholders as a dividend.
Shareholders can also invest in T-bills. Assume a 44% corporate tax, a
40% individual tax on interest, and 30% individual tax on dividend income.
If dividend is paid now, shareholders get
1000(1-0.3)[1+ (0.08)(1-0.4)]5=$884.9
If dividend is invested, shareholders get
1000[1+ (0.08)(1-0.44)]5(1-0.3) =$871.5
Shareholders would be indifferent between receiving the dividend now as
opposed to receiving it later if and only if:
(1-TE)[1+r(1-TP)] = [1+r(1-TC)](1-TE)
Tax effect (cont’d)
Investors would like a dividend according to their tax preferences:
•
Tax-exempt investors, investors in low tax brackets, etc. prefer
high current dividend
•
Investors in high tax brackets prefer capital gains
Agency costs explanation of dividends
Paying dividends can result in a need for external financing.
Raising equity and/or debt more often intensifies market’s scrutiny
of the company.
Reality check
• Earnings increase one year before dividend initiation.
• Earnings decrease one year before dividend omission.
• Following dividend initiation, earnings increases appear to be
permanent.
• Following dividend omission, earnings decreases appear to be
temporary.
• Weak reaction to earnings changes following dividend changes.
Overview of financial policy: Why is it important?
Capital structure policy, long-term financing policy, dividend policy,
etc.…do have some impact on market valuation.
Remember, however:
Capital budgeting is the bread and butter of wealth maximization.
Financial policy is only fine-tuning.