Dividend policies


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Dividend policies

  1. 1. DIVIDEND POLICY Chapter 17 Alex Tajirian
  2. 2. Dividend Policy 17-2 1. OUTLINE# What to do with excess cash?# Types of dividends# Theories of optimal dividend policy: dividend puzzle# Some practical considerations © morevalue.com, 1997 Alex Tajirian
  3. 3. Dividend Policy 17-3Graphics: WHAT TO DO WITH EXCESS CASH © morevalue.com, 1997 Alex Tajirian
  4. 4. Dividend Policy 17-4 2. OBJECTIVE & DEFINITIONDefinition: Dividend is the distribution of value to shareholders.Dividend Policy: What happens to the value of the firm as dividend is increased, holding everything else (capital budgets, borrowing) constant. Thus, it is a trade-off between retained earnings on one hand, and distributing cash or securities on the other. © morevalue.com, 1997 Alex Tajirian
  5. 5. Dividend Policy 17-5 3. TYPES3.1 CASH DIVIDEND1 Example: $.5 for every share you hold Regular, regular + "extra" , special Dates: |_____________|______________|___________|____ 1/15 1/26 1/30 2/15 Declaration Ex-dividend Record Payment Date Date Date Date Only investors who hold the security prior to the ex-dividend date receive the dividend. © morevalue.com, 1997 Alex Tajirian
  6. 6. Dividend Policy 17-63.2 STOCK DIVIDEND Example: 1 new stock for each 10 you hold3.3 STOCK REPURCHASE23.1 Method in the open market tender offer direct negotiation with major shareholders3.2 Reasons! Alternative to "extra" or special dividend. Example. A company just sold a division and cannot use the proceeds 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 attractive price. 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. © morevalue.com, 1997 Alex Tajirian
  7. 7. Dividend Policy 17-72.3.4 Disadvantages; ! May signal to investors that the firms investment opportunities are limited. ! The firm may pay too high a price for the repurchase. Example: Greenmail2.4 STOCK SPLIT Example. (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. © morevalue.com, 1997 Alex Tajirian
  8. 8. Dividend Policy 17-8 4. DIVIDEND CONTROVERSY THEORIES Irrelevant, rightists (high dividend), leftists (low payoff), Middle of the Road k = capital gains + dividend yield4.1 IRRELEVANT M & M in the case of perfect markets. Reasoning: There is nothing the firm can do that investors cannot duplicate. Firm and investors have identical opportunities. © morevalue.com, 1997 Alex Tajirian
  9. 9. Dividend Policy 17-94.2 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 Mas argument: "I need the regular cash dividend to live on!"4.3 LEFTISTS Tax argument: Tax on dividends = tax on income $ tax on capital gains. But tax on dividends must be paid now, while on capital gains would be in the future. © morevalue.com, 1997 Alex Tajirian
  10. 10. Dividend Policy 17-10Illustration. Invest $100, ks = 10% , T = 40% Case 1. Stock held for 20 years. FV20 = $100(1+.1)20 = 672.75 after 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 ˆ Case 1 is better. Thus, Optimal dividend policy is zero/very low. © morevalue.com, 1997 Alex Tajirian
  11. 11. Dividend Policy 17-11hg; dividend and tax © morevalue.com, 1997 Alex Tajirian
  12. 12. Dividend Policy 17-124.4 MIDDLE OF THE ROAD Signaling. 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 if no investment opportunities exist. They have to distribute them as dividends.! Institutional Restrictions: Many trust portfolios are required to protect the investment principle and can only spend investment income. Thus, they tend to invest in companies with high dividends.! Market Reaction to Dividend `: Price usually `. Investors interpret it as a negative signal, in that the firms future opportunities are not good. © morevalue.com, 1997 Alex Tajirian
  13. 13. Dividend Policy 17-13 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. © morevalue.com, 1997 Alex Tajirian
  14. 14. Dividend Policy 17-14 7. ENDNOTES1. 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. © morevalue.com, 1997 Alex Tajirian
  15. 15. Dividend Policy 17-15 8. QUESTIONSTrueFalse-Explain1. 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 on the 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 paying stocks 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. © morevalue.com, 1997 Alex Tajirian
  16. 16. Dividend Policy 17-16 9.0 ANSWERS TO QUESTIONSTrueFalse-Explain1. False. If the company does not have any positive NPV projects to invest in, then it should 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 explanation3. 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 be distributed to shareholders.4. True. Value of Firm Price× (# of Shares) Price Value After Split: × (# of shares × 2) 2 Y Value unchanged5. False. A possible explanation for the price increase might be than investors interpret the increase as a strength in the companys future earnings prospects. Thus, they buy the stock, this increases the demand for the stock, and thus its price goes up. An alternative explanation, which has nothing to do with dividends, might be that the general stock © morevalue.com, 1997 Alex Tajirian
  17. 17. Dividend Policy 17-17 market went up, and so did XYZ Inc!6. False. Actually the opposite is true. The new lax laws make high paying dividend stocks even less attractive to the average investor.7. False. One disadvantage of SPDRs is that dividends, from the underlying stocks, are distributed 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 primary market 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, the new price ought to be a third of the original price. © morevalue.com, 1997 Alex Tajirian