The Dividend Decision

P.V. Viswanath Based on Damodaran’s Corporate Finance

Theories of Dividend Payout

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Dividend Irrelevance

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Dividend Clienteles

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Signaling

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Catering to Psychological Investor Preferences

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Disciplinary Effects on Managers

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Dividend Irrelevance

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Investors can create their own dividends. Consequently, firm value will not be affected by dividend payments.

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Example of Dividend Irrelevance

    Stellar, Inc. has decided to invest $10 m. in a new project with a NPV of $20 m., but it has not made an announcement.

The company has $10 m. in cash to finance the new project. Stellar has 10 m. shares of stock outstanding, selling for $24 each, and no debt. Hence, its aggregate value is $240 m. prior to the announcement ($24 per share).

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Example of Dividend Irrelevance

Two alternatives: One, pay no dividend and finance the project with cash.

The value of each share rises to $26 following the announcement. Each shareholder can sell 0.0385 (= 1/26) shares to obtain a $1 dividend, leaving him with .9615 shares value at $25 (26 x 0.9615). Hence the shareholder has one share worth $26, or one share worth $25 plus $1 in cash.

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Example of Dividend Irrelevance

Two, pay a dividend of $1 per share, sell $10m. worth of new shares to finance the project.  After the company announces the new project and pays the $1 dividend, each share will be worth $25.    To raise the $10 m. needed for the project, the company must sell 400,000 (=10,000,000/25) shares. Immediately following the share issue, Stellar will have 10,400,000 shares trading for $25 each, giving the company an aggregate value of 25 x 10,400,000 = $260 m. If a shareholder does not want the $1 dividend, he can buy 0.04 shares (1/25). Hence, the shareholder has one share worth $25 and $1 in dividends, or 1.04 shares worth $26 in total.

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Assumptions for Dividend Irrelevance

1. The issue of new stock (to replace excess dividends) is costless and can, therefore, cover the shortfall caused by paying excess dividends. 2. Firms that face a cash shortfall do not respond by cutting back on projects and thereby affect future operating cash flows. 3. Stockholders are indifferent between receiving dividends and price appreciation. 4. Any cash remaining in the firm is invested in projects that have zero net present value. (such as financial investments) rather than used to take on poor projects (i.e. there are no agency costs of outside equity). P.V. Viswanath 7

Implications of Dividend Irrelevance

  A firm cannot resurrect its image with stockholders by offering higher dividends when its true prospects are bad. The price of a company's stock will not be affected by its dividend policy, all other things being the same. (Of course, the price will fall on the ex-dividend date.) P.V. Viswanath 8

Dividend Clienteles: Tax Effects

   For individual investors, dividends are more heavily taxed than capital gains because of the tax-timing option--the ability for individual investors to postpone the tax liability on capital gains income. Hence individuals may prefer capital gains.

Corporate shareholders pay income tax at a 34% peak marginal rate, but are permitted to claim a 70% dividends-received deduction. Hence the top marginal tax rate on dividend income for a corporation is only (1-.7) x 34 = 10.2%. They have a greater preference for dividends.

Tax-exempt institutions, such as pension funds, do not have a bias in favor of capital gains or dividends.

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Stockholder Marginal Tax Rate Estimation

  Suppose t o represents the tax rate on ordinary dividends and t cg represents the tax rate on capital gains. Let P B denote the cum-dividend stock price, and P and P the price at which the stock was acquired. A the ex-dividend stock price, For the marginal investor, P B -(P B -P)t cg = P A -(P A -P)t cg + D(1-t o ) where the LHS is the after-tax gain from selling the stock cum-dividend and the RHS is the after-tax gain from selling the stock ex dividend.

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Stockholder Marginal Tax Rate Estimation

 From this, we get the relationship:   By examining the empirical price drop, one may then infer the marginal tax bracket for holders of the firm's stock.

However, this opens up the possibility of dividend capture.

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Dividend Mechanics

  Declaration date: The board of directors declares a payment Record date: The declared dividends are distributable to shareholders of record on this date.

Payment date: The dividend checks are mailed to shareholders of record.

Ex-dividend date: A share of stock becomes ex dividend on the date the seller is entitled to keep the dividend. At this point, the stock is said to be trading ex-dividend.

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Dividend Capture

   On Aug 2, 2005, XYZ declares a dividend payable on October 3, 2005. XYZ announces that shareholders of record on or before Sept 30, 2005 are entitled to the dividend. The stock goes ex dividend Sept 28, 2005, two days before the record date.

Anyone who bought the stock before September 28, 2005 or after would get the dividend. The stock price will fall after the dividend payment, but usually less than the div amount. If the trader is tax-neutral, selling right after the stock goes ex-dividend, i.e. on Sept 28, can net the trader a profit.

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Dividend Clienteles: Transactions Costs

  A shareholder who desires a high income stream would prefer real cash dividend payments over homemade dividends if the firm can sell new shares more cheaply than the shareholder can sell his/her own shares. Hence such shareholders might prefer firms with a high payout ratio, while other shareholders may prefer firms with a low payout policy.

Consequently, some investors prefer equity income in the form of dividends, while others prefer capital gains.

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Dividend Signalling

      If investors cannot observe information to distinguish a good firm from a bad firm, both firms will be valued the same.

Firms that pay higher dividends than they would otherwise have, drain cash and thus increase the probability of bankruptcy. This will decrease the value of the firm.

This decrease in firm value will be lower for good firms, because they are less likely to go bankrupt.

Hence if a good firm increases its dividends, bad firms will be less likely to mimic the good firm.

This will allow investors to separate good firms from bad firms and they will price their stock higher.

This benefits stockholders who have to sell in the interim.

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Psychological Investor Preferences

   Dividends and Capital Gains may not be perfect substitutes due to psychological reasons. A lack of self-control may lead an investor to prefer regular cash dividends. If the investor has to sell stock to get income, he might have a tendency to sell too much stock too soon.

Hence an investor might choose to invest in a firm that follows a particular type of dividend policy to minimize the total agency costs of shareholding, including the investor's human frailties. P.V. Viswanath 16

Disciplinary Effects on Managers

   Contracts between the firm and its managers cannot always be designed to take into account all possible contingencies. Hence, managers may sometimes take actions that reduce firm value. For example, it may be in the interest of managers to increase firm size or to unduly reduce the riskiness of the firm in order to reduce the probability of bankruptcy, and increase the present value of their firm specific skills. This may lead them to accept negative NPV projects or to engage in undesirable mergers. P.V. Viswanath 17

Disciplinary Effects on Managers

   This may lead some managers to reduce dividends to a suboptimal level. In contrast, managers, who want to assure the market of their desire to maximize firm value by reducing the amount of disposable resources (free cash flow beyond current investment needs) available to them, may choose to increase dividends. By doing so, they force themselves to submit to the discipline of the markets any time that they wish to raise funds to invest in a project. Such credible proof of a manager's unwillingness to take NPV < 0 projects will be rewarded by the market with an increase in the stock price. P.V. Viswanath 18

Dividends and Firm Life-Cycle

Funding Needs Cash flows generated Dividend Policy Stage 1 Introduction Limited by size and other infrastructure limits Negative as investments are made No dividends New Stock Issues P.V. Viswanath 19

Dividends and Firm Life-Cycle

Stage 2 Rapid expansion Funding Needs Cash flows generated Dividend Policy High relative to firm value Cash flow low relative to firm value No or very low dividends P.V. Viswanath 20

Dividends and Firm Life-Cycle

Funding Needs Cash flows generated Dividend Policy Stage 3 Mature growth Moderate relative to firm value Cash flow increases as percentage of firm value Increase dividends P.V. Viswanath 21

Dividends and Firm Life-Cycle

Stage 4 Decline Funding Needs Cash flows generated Dividend Policy Low as projects dry up Cash flow high relative to firm value Special dividends Repurchase stock P.V. Viswanath 22

Relevant factors in dividend policy

   Investment Opportunities: A firm with more investment opportunities should pay a lower fraction of its earnings. Stability of earnings: A firm with more volatile earnings should pay, on average, a lower proportion of its earnings, so that it will not have to cut dividends. Alternative sources of capital: To the extent that a firm can raise alternative capital at low cost, it can afford to pay higher dividends. Hence, large firms tend to pay higher dividends.

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Relevant Factors in Dividend Policy

   Degree of financial leverage: If a firm has high leverage, it will probably also have covenants restricting the payment of dividends. Furthermore, to a certain extent, dividends and debt can be considered substitutes for the purpose of manager discipline. Signalling incentives: To the extent that a firm can signal using other less costly means, for example debt, it should pay lower dividends. Stockholder Characteristics: If a firm's stockholders want higher dividends, it should provide them. P.V. Viswanath 24

Computing optimal payout: first step

  Questions: How much cash is available to be paid out as dividends? Answer: The funds available to be paid out as dividends are essentially equal to free cash flow to equity (FCFE) Keep in mind these quantities should be computed prospectively.

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Three definitions of FCFE

   FCFE = Net Income - (Capital Expenditures Depreciation) - (Change in Noncash Working Capital) + (New Debt Issued - Debt Repayments) Preferred Dividends FCFE = Net Income - (Capital Expenditures - Depreciation)*(1- Debt Ratio) - Change in Non-cash Working Capital (1-Debt Ratio).

Cash Flows from Operating Activities - (Capital expenditures) - (preferred dividends) - (New Debt Issued - Debt Repayments).

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Computing optimal payout: second step

    How good are the projects available to the firm? If Dividends greatly exceed FCFE, dividends should be cut. If the rate of return on equity is greater than the cost of equity, the released funds should be invested in new projects and if funds are inadequate, funding should be sought from elsewhere. If projects are unprofitable, investment should be reduced.

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Computing optimal payout: second step

   If FCFE greatly exceed Dividends, the CFO must check to see how funds are being invested. If the actual rate of return (accounting rate of return) on equity is greater than the required rate of return, then the excess funds should be invested in new projects. If necessary, the dividend payout ratio should also be decreased to release funds for new projects.

If the actual rate of return is low relative to the required rate of return, then dividends should be increased.

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Solution to Problem 8, Chapter 22

Year 1991 1992 1993 1994 1995 Net Income 240 282 320 375 441 Cap. Exp.

314 466 566 490 494 Depr. Noncash Change in WC Noncash WC 307 295 284 278 293 35 -110 215 175 250 25 -145 325 -40 75 Dividends FCFE 70 220.8

80 266.4

95 -44.2

110 271.8

124 275.4

Conrail could have paid, on average, yearly dividends equal to its FCFE.

Conrail is earning an average accounting return on equity of 13.5%.

The required rate of return = 0.07 + 1.25(0.125-0.07) = 13.875. Hence Conrail’s projects have done badly on average. It’s average dividends have been much lower than the average FCFE. Conrail should pay more in dividends. P.V. Viswanath 29

Solution to Problem 9, Chap. 22

Year Net Income 1996 $485.10 (Cap Ex - Depr) (1-DR) $151.96 Ch WC (1-DR) $8.75 FCFE $324.39 1997 $533.61 1998 $586.97 $164.11 $177.24 $9.19 $9.65 $360.31 $400.08 1999 $645.67 2000 $710.23 $191.42 $10.13 $206.73 $10.64 $444.12 $492.86 This is the amount that the company can afford to pay in dividends.

The perceived uncertainty in these cash flows implies that the firm should be more conservative in paying out the entire amount of FCFE each year. P.V. Viswanath 30