Dividend Policy - PowerPoint PPT Presentation

About This Presentation
Title:

Dividend Policy

Description:

If they sell new stock today, the new shareholders will miss out on the time 0 ... Agency Models Evidence. Bondholder wealth expropriation: ... – PowerPoint PPT presentation

Number of Views:48
Avg rating:3.0/5.0
Slides: 26
Provided by: jzen1
Category:
Tags: dividend | policy

less

Transcript and Presenter's Notes

Title: Dividend Policy


1
Dividend Policy
  • More Properly
  • Payout Policy

2
Historical View
  • Illustrated by the arguments of Gordon (1959) -
    more dividends more value.
  • Follows from the discounted dividend approach to
    valuing a firm

3
Historical View
  • Gordon argued that retained earnings rather than
    current dividends made the cash flow stream for
    the shareholder riskier.
  • This would increase the cost of capital.
  • The future dividend stream would presumably be
    higher due to the investment of retained earnings
    (NPV).
  • He argued that the first effect would be the
    dominant one.
  • Now called the bird in the hand fallacy.

4
Along Came MM
  • Basic Point Firm value is determined by its
    investment policy, net dividends are simply the
    residual of earnings after investment.
  • Dividend Irrelevance
  • No Taxes or Transactions Costs
  • Symmetric Information
  • Complete Contracting Possibilities
  • Perfect Capital Markets

5
Dividend Irrelevance Example
  • Consider the case of Ralph Inc.
  • Currently (time 0) Ralph Inc. is expected to
    survive another year in business (till time 1).
    At which time the firm will liquidate and all
    value will be distributed to claimants.
  • The firm is presently all equity financed with
    50,000 shares outstanding. The cash flow of the
    firm is risk free and it is common knowledge that
    Ralph Inc. will receive 1 million immediately
    and another 1 million at time 1.
  • The current dividend policy is for Ralph Inc. to
    payout its entire cash flow as dividends as it is
    received. So 20 per share now and at time 1.
  • The risk free rate in the economy is 5. And the
    firm has no positive NPV projects available.

6
Dividend Irrelevance Example
  • Ralph, the CEO of Ralph Inc. is convinced that an
    alternative dividend policy would increase the
    current stock price.
  • The current value of the firm and the price per
    share is V0 Div0 Div1/(1.05) 1m
    1m/(1.05) 1,952,380.95 or P0 39.05
    per share.
  • The share price will drop to 19.05 after the
    time 0 dividend is paid.
  • Ralph wants you to evaluate the impact on the
    current stock price of an increase or a decrease
    of the current dividend of 2 per share.

7
Dividend Irrelevance Example
  • 2 per share dividend increase
  • A 2 per share dividend requires 1,100,000 in
    total so the firm must raise 100,000 to
    accomplish this policy change.
  • If they sell new stock today, the new
    shareholders will miss out on the time 0 dividend
    but will receive a time 1 dividend. With a 5
    risk free rate the new shareholders are only
    willing to contribute a total investment of
    100,000 today if they will receive 105,000 at
    time 1.
  • This will leave only 895,000 in total dividends,
    or 17.90 per share, for the existing
    shareholders at time 0.
  • The time zero stock price will then be P0
    22 17.90/(1.05) 39.05 (??) the price will
    drop to 39.05 - 22 17.05 when the time 0
    dividend is paid.

8
Dividend Irrelevance Example
  • 2 per share dividend increase
  • Because the new shareholders receive only the
    time 1 dividend they will be willing to pay a
    price reflective of this 17.90/(1.05) 17.05.
  • To raise 100,000 the firm must sell
    100,000/17.05 5,865.1 shares of stock today
    to implement this increase in dividends.
  • Finally, with 55,865.1 shares outstanding, the
    1,000,000 in cash the firm has to distribute at
    time 1 works out to 17.90 per share.

9
Dividend Irrelevance Example
  • 2 per share dividend decrease
  • With an 18 per share dividend today this leaves
    an extra 100,000 in cash within the firm.
  • Because the firm has no positive NPV projects it
    does the next best thing and makes a zero NPV
    investment, buying t-bills.
  • With a risk free rate of 5, the t-bills will
    return 105,000 at time 1. This implies a total
    dividend of 1,105,000 or 22.10 per share at
    time 1.
  • The current stock price is P0 18
    22.10/(1.05) 39.05

10
Dividend Irrelevance Example
  • What made this example work?
  • Two things were critical
  • We fixed the cash the firm will receive and
    assumed they had no positive NPV projects. This
    is a version of the assumption that the dividend
    policy will not alter the investment policy of
    the firm.
  • We assumed no taxes or transactions costs.
  • Several were not
  • The one year time frame.
  • The risk free cash flows.
  • The fact that the firm was all equity financed.

11
Dividend Irrelevance Example
  • The insight this example is supposed to bring to
    you is that under the irrelevance assumptions a
    change in dividend policy results in the company
    simply moving money across time.
  • Using the capital markets (so the NPV is zero)
    ensures that no value is created or lost by this
    movement. Thus the current stock prices is not
    changed.
  • Moving money across time is also what the capital
    markets allow individual investors to do.
    Therefore, a change in dividend policy doesnt do
    anything for the investors they couldnt do
    themselves. Again no price change is the result.

12
Empirical Observation 1
  • Corporations typically payout a significant
    percentage of their after-tax profits as
    dividends.
  • Examination of dividend payouts over time shows
    that on average firms paid out between 40 and
    50 of their profits.
  • This percentage has been rising.
  • Recently, a smaller percentage of all firms are
    paying dividends. Seems in part due to a lot of
    new firms (who traditionally dont pay dividends)
    and in part to the fact that fewer firms of all
    types are paying dividends. Some evidence
    suggests that firms are beginning to substitute
    repurchases for dividends.

13
Empirical Observation 2
  • Historically, dividends have been the predominant
    form of payout. Share repurchases were
    relatively unimportant until the mid 1980s.
  • Before 1984 repurchases amounted to between 2
    and 11 of corporate earnings. Since 1984 they
    have accounted for between 30 and 40 and have
    been on the rise.
  • It is interesting to note that in the mid 80s
    the other major form of payout from the corporate
    sector, MA activity, also dramatically increased.

14
Empirical Observation 3
  • Individuals in high tax brackets receive large
    amounts of dividends and pay large taxes on these
    dividends.
  • That they choose to do so is referred to by Black
    as the Dividend Puzzle.
  • Study by Peterson, Peterson, Ang (1985) showed
    that individuals received 33 B in dividends in
    1979 (2/3rds of total paid) and the marginal tax
    rate paid on the dividends was 40 (versus 20 on
    capital gains).

15
Empirical Observation 4
  • Corporations smooth dividends.
  • Lintner in a survey of companies noted that
  • Firms are primarily concerned with the stability
    of their dividends.
  • Changes in earnings are the most important
    determinant of changes in dividends.
  • Dividend changes lag earnings changes.
  • Dividend policy is set first then the investment
    and financing decisions are made, taking
    dividends as given.
  • Firms with many valuable investment projects are
    likely to set a low target payout ratio and those
    with few a higher target.

16
Empirical Observation 5
  • There are positive stock price reactions to
    dividend increases and big negative reactions to
    dividend decreases.
  • Pettit(1972), Charest(1978), Aharony
    Swary(1980).
  • Consistent with asymmetric information models
    (dividends relay information) and with incomplete
    contracting models (dividends solve agency
    problems).
  • Inconsistent with a large tax differential (or at
    least the tax effects are swamped by other
    effects).

17
Taxes
  • A large part of the literature on dividends has
    focused on the impact of taxes on dividend policy
    and tried to reconcile the first three empirical
    observations.
  • Firms payout a lot, payout is in form of
    dividends not repurchases, and high tax bracket
    individuals receive most of these dividends.
  • Basic aim of the tax literature is to determine
    if there is a tax effect do firms with high
    dividends have lower value than otherwise
    equivalent firms that pay low dividends?

18
Taxes
  • Is there a tax effect?
  • Fundamental question but not an easy one.
  • Do tax clienteles exist?
  • Simplest representation says pay no dividends.
  • More clever ideas say firms target groups of
    investors.
  • Is there dividend capture?
  • Examine trading volume around dividend
    announcements.
  • Managerial prescription?

19
Asymmetric Information
  • Dividend signaling models.
  • High (or higher) dividends signal good news.
  • Good news about what?
  • What is the signal cost?
  • If the goal is to signal information to the
    market, why use dividends?
  • Given the cost to the firm (transactions costs)
    and the cost to investors (taxes) there should be
    cheaper ways to credibly communicate information
    about expectations.

20
Asymmetric Information Evidence
  • The information content of dividends.
  • In a statistical sense, dividends have relatively
    little information content beyond that contained
    in past and present earnings.
  • Large dividend changes seem to have some
    explanatory power for the firms next quarter
    earnings.
  • Unexpected dividend changes positively related to
    changes in stock price.
  • Not clear why the stock price reaction if there
    is no information conveyed. Unless it is not
    signaling that causes the reaction.

21
Agency Models
  • Stockholder Bondholder conflicts.
  • Bondholder wealth expropriation.
  • Excessive dividends can expropriate wealth from
    bondholders and transfer it to stockholders.
  • Stockholder Manager conflicts.
  • Payouts as a disciplinary device.
  • Control of free cash flow problems.
  • More frequent scrutiny from the capital market.

22
Agency Models Evidence
  • Bondholder wealth expropriation
  • Bond prices do not drop when dividends are
    increased.
  • While there are covenants restricting dividends.
  • Covenants define a reserve out of which dividends
    may be paid. However, firms tend to keep excess
    reserves.
  • Payouts as a disciplinary device
  • Evidence is inconsistent with the free cash flow
    story.
  • Overall there is little convincing evidence that
    dividend payouts help control any of the commonly
    considered agency problems.

23
Other Stories
  • Prudent Man rules.
  • A stable dividend policy requirement for the
    firms that a money manager invests in may be a
    rule of thumb that helps constrain the money
    manager.
  • Transactions cost arguments.
  • If investors are looking for current income
    dividends may be a low cost way of achieving that
    end.

24
Other cont
  • Behavioral theories.
  • People like to get dividends more than they like
    to participate in repurchase programs.
  • Thaler and Shefrin (1981), Shefrin and Statman
    (1984)
  • Irrational market stories.
  • If managers have superior information and so can
    time equity issues and if the market doesnt
    fully adjust for this, dividends are a good
    policy.

25
A Prudent Prescription
  • Once again we have to admit that we dont have a
    good answer to the question of what is the best
    dividend policy. We can offer some meaningful
    advice
  • Firms should avoid having to cut back on positive
    NPV projects to pay a dividend.
  • When personal taxes are a consideration, firms
    should avoid issuing stock to pay a dividend.
  • Stock repurchases should be considered as an
    alternative way to get surplus cash out of the
    firm when there are few positive NPV projects and
    the firm has a surplus of unneeded cash.
Write a Comment
User Comments (0)
About PowerShow.com