Topic 10 Dividend Policy (Chapter 16, Brealey)

Contents
Topic 10 Dividend Policy (Chapter 16, Brealey) ...................................................................................... 1
10.1 How Firms Pay Dividends and Repurchase Stock ........................................................................... 1
10.2 How Do Companies Decide on Payouts .......................................................................................... 3
10.3 The Payout Controversy .................................................................................................................. 3
10.4 Stock Dividend & Stock Split ........................................................................................................... 7
10.5 Other issue .................................................................................................................................. 7

10.1 How Firms Pay Dividends and Repurchase Stock

This section describes how cash is paid to the shareholders. There are two ways of doing this: (1)
paying cash dividends and (2) repurchasing stock. Generally, a regular cash dividend is paid. In
some cases extra or special dividend may also be paid in addition to regular dividends. Some firms
may choose to pay stock dividends. A firm’s board of directors declares dividends and the payment
will be made to all the stockholders who are registered as of the record date. Stocks are traded with
dividends until a couple of days before the record date, and then they trade ex-dividend. This section
distinguishes regular, extra, special and liquidating dividends.

Firms can use cash to repurchase stock. There are, mainly, four ways—open market purchase, tender
offer, Dutch auction, and through private negotiation with a major shareholder to repurchase stock.
Many firms offer shareholders automatic dividend reinvestment plans (DRIPs).

• Information Content of Stock Repurchases:- Stock repurchases send a positive signal

that management believes that the current price is low

Dividend payment

• Declaration Date – Board declares the dividend and it becomes a liability of the firm
• Ex-dividend Date
• Occurs two business days before date of record
• If you buy stock on or after this date, you will not receive the dividend
• Stock price generally drops by about the amount of the dividend
• Date of Record – Holders of record are determined and they will receive the dividend
payment
• Date of Payment – checks are mailed

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E.g. Date of record is 22nd June, Friday, therefore the last day that the holder will be
recognize eligible for dividend payment will be on 19 June, Tuesday. Beyond 19 will be
considered as ex dividend.

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10.2 How Do Companies Decide on Payouts

A survey of financial executives provides the following statements regarding dividend policy:
 Managers are reluctant to make dividend changes that may have to be reversed.
 In order to avoid the risk of a reduction in payout, financial executives “smooth” dividends.
 Managers focus more on dividend changes than on absolute levels.
 The cost of external capital is lower than the cost of a dividend cut.
 Rather than reducing dividends managers would raise new funds to undertake a profitable
project.
 Generally, firms buy back stock when they have accumulated excess cash or wish to change
their capital structure by replacing equity with debt.
Recently, many countries have eased restrictions on stock repurchases. Consequently, many multi-
nationals have repurchased huge amounts of stock.

10.3 The Payout Controversy

This section starts by explaining Modigliani-Miller (MM) irrelevance proposition. Three schools of
thought on this issue are then discussed:
 The middle-of-the-road party believes dividend policy is irrelevant. This is the original MM
position.
 The leftists stress tax effects, which favor low dividends.
 The rightists stick to the traditional position that investors like high dividend payout.

The rightists

This section discusses the arguments favoring generous payout policies. The early theoretical
objections to MM’s theory turned out to be unfounded. The text dissects the “bird in the hand”
fallacy, for example. There are natural clientele for dividend-paying stocks, however. Also, market
imperfections may upset the MM argument. If information costs are substantial, then dividends could
be a way of showing investors that the firm really is earning money.

Taxes and the radical left

Firms can transmute dividends into capital gains by cutting dividends and repurchasing shares instead.
If the tax system rewards this, then one would expect to find investors paying a premium for low-
payout stocks. Stock prices would change until expected after-tax rates of return were equalized at
each level of risk. The authors discuss the empirical evidence on dividends and taxes before the 1986
Tax Reform Act, and note that this evidence has more historical than current relevance: the 1986 tax
law changes may have considerably weakened the leftist case and correspondingly strengthened the
case for dividend irrelevance.

The middle-of-the-roaders

The traditional and leftist arguments implicitly hold the supply of dividends is fixed. If the investors
did favor high-payout companies, then presumably firms would pay out more and more until the high-

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payout clientele was satisfied. At that point, dividend policy would be irrelevant again. This does not
explain why so many investors wanted high dividends when they also brought high taxes. Since
1986, the tax disadvantage of dividends is greatly reduced in the United States, so it is easier to
suppose there is now a large clientele of investors who are happy with high payouts. In the United
States, shareholders’ returns are taxed twice. They are taxed at the corporate level and at the
shareholder level. In Germany, investors are taxed at a higher rate on dividends than on capital gains.
Corporations are taxed at a higher rate on retained earnings than on distributed dividends. This is
called a split-level system. In Australia, shareholders are taxed on dividends, but they get a tax credit
on their share of corporate tax that the firm has paid. This is called an imputation tax system.

Dividends matter:-

- the value of the stock is based on the present value of expected future dividends
- Dividend growth model, the process of valuing share price will be determined by how
much dividend the company pays.

Clientele Effect

- Some investors prefer low dividend payouts and will buy stock in those companies that
offer low dividend payouts
- Some investors prefer high dividend payouts and will buy stock in those companies that
offer high dividend payouts

Low Payout Please

• Why might a low payout be desirable?

• Individuals in upper income tax brackets might prefer lower
dividend payouts, given the immediate tax liability, in favor of
higher capital gains with the deferred tax liability
• Flotation costs – low payouts can decrease the amount of capital
that needs to be raised, thereby lowering flotation costs
• Dividend restrictions – debt contracts might limit the percentage
of income that can be paid out as dividends

High Payout Please

• Why might a high payout be desirable?

• Desire for current income
• Individuals that need current income, i.e. retirees
• Groups that are prohibited from spending principal
(trusts and endowments)
• Uncertainty resolution – no guarantee that the higher future
dividends will materialize
• Taxes
• Dividend exclusion for corporations

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 • Tax-exempt investors don’t have to worry about
differential treatment between dividends and
capital gains

Implications of the Clientele Effect

• What do you think will happen if a firm changes its policy from a high payout to
a low payout?
• What do you think will happen if a firm changes its policy from a low payout to
a high payout?
• If this is the case, does dividend POLICY matter?

If a firm changes its policy, it will just have different investors. Consequently, dividend policy
won’t affect the value of the stock.

Dividend does not matter:-

Dividend Irrelevance Theory':- company’s point of view

The dividend irrelevance theory essentially indicates that an issuance of dividends should have
little to no impact on stock price.

Read more: http://www.investopedia.com/terms/d/dividendirrelevance.asp#ixzz1y6ihynWp

- Dividend policy is the decision to pay dividends versus retaining funds to reinvest in the
firm

- In theory, if the firm reinvests capital now, it will grow and can pay higher dividends in
the future

- Illustration of Irrelevance

• Consider a firm that can either pay out dividends of $10,000 per year for each
of the next two years or can pay $9000 this year, reinvest the other $1000 into
the firm and then pay $11,120 next year. Investors require a 12% return.

• Market Value with constant dividend = $16,900.51

𝐷1 𝐷2
Po = (1+𝑅)1 + (1+𝑅)2

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 10000 10000
Po = (1.12)1 + (1.12)2 = 8928.57 + 7971.93 = $16,900.51,

• Market Value with reinvestment = $16,900.51,

𝐷1 𝐷2
• Po = (1+𝑅)1 + (1+𝑅)2

9000 11120
• Po = (1.12)1 + (1.12)2 = 8035.71 + 8864.80 = $16,900.51

• If the company will earn the required return, then it doesn’t matter when it
pays the dividends

Dividend irrelevance theory: - investors point of view

- A theory that investors are not concerned with a company’s dividend policy since they
can sell a portion of their portfolio of equities if they want cash.

Read more: http://www.investopedia.com/terms/d/dividendirrelevance.asp#ixzz1xerr8PlH

- Best can be illustrate under homemade dividends (see your text book under sub topic
homemade dividends)

Case 1:-
Company announce Yr1 = $110 Yr2= $89
Mr X prefers dividends constant $100 for both year, required rate of return =10%

So how to exercise homemade?

Yr 1
Sell the excess $110 - $100 = $10, and use $10 to purchase/invest in investment which
could provide 10% return.

Yr2
Receive dividend $89 and reinvestment return from Yr1 $10 x 1.10 = $11
Therefore total $89 + $11 = $100

In a nutshell, Mr X still receive $100 in Yr1 and $100 in Yr2

Case 2:-
Company announce Yr. 1 = $100 Yr. 2= $100
Mr Z prefers dividends Yr1= $110 Yr2= $89

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 Required rate of return =10%

So how to exercise homemade?

Yr1
Sell some shares to meet the cash shortage $110 - $100 = $10,

Yr2
Since we have sell $10 worth of shares in Yr1 so we will let go $10 x 1.10 = $11
So in total Mr X will receive $100 - $11 = $89 worth of dividend.

In a nutshell, Mr X still meets his target i.e. $110 in Yr1 and $89 in Yr2

10.4 Stock Dividend & Stock Split

Stock dividend

- Pay additional shares of stock instead of cash

- Increases the number of outstanding shares
- Small stock dividend
- Less than 20 to 25%
- If you own 100 shares and the company declared a 10% stock dividend, you would
receive an additional 10 shares
- Large stock dividend – more than 20 to 25%

Stock Split

- Stock splits – essentially the same as a stock dividend except expressed as a ratio
a. For example, a 2 for 1 stock split is the same as a 100% stock dividend
- Stock price is reduced when the stock splits
- Common explanation for split is to return price to a “more desirable trading range”

10.5 Other issue

Dividends and Signals: - Asymmetric information and Signalling Theory

• Asymmetric information – managers have more information about the health of

the company than investors. Therefore in signaling theory, it is assume that
dividend announcement could transmit inside information of the financial
condition of a company, hence it could influence the behavior of the investors
by positively (price increase due to buy condition) or negatively (price decrease
due to sell condition).

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• Changes in dividends convey information
– Dividend increases
• Management believes it can be sustained
• Expectation of higher future dividends, increasing
present value
• Signal of a healthy, growing firm
– Dividend decreases
• Management believes it can no longer sustain the
current level of dividends
• Expectation of lower dividends indefinitely;
decreasing present value
• Signal of a firm that is having financial difficulties