Dividend Policy (Part 1) MF 807: Corporate Finance Professor Thomas Chemmanur

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Dividend Policy(Part 1)

MF 807: Corporate FinanceProfessor Thomas Chemmanur

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Dividend Policy

Dividend policy is concerned with the following: How much of company earnings should be paid out to

shareholders as dividends, and how much retained (hence “retained earnings”) for future investment?

How should dividends be distributed (e.g. cash dividend, share repurchase)

There are no formulas for determining the precise fraction of earnings that each firm should pay out as dividends

Theory does help us to dispel myths and misconceptions about dividend policy

Our analysis starts with the assumption of no imperfections (i.e. taxes, information asymmetries, transaction costs, agency issues). This serves as our benchmark. We then extend the analysis to a realistic economy which has these imperfections.

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Institutional Details

A firm’s dividend is set by its board of directors. All investors who have purchased shares in the company before

a particular date, called the ex dividend date, are entitled to receive the dividend.

On the other hand, if you buy it after the ex-dividend date, you are not entitled to receive the dividend (regardless of whether the actual dividend cheque has been sent out when you buy shares or not).

Most companies which pay a regular dividend do so on a quarterly basis (however, some make semi-annual or annual payments, and a handful make monthly payments).

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Dividend Policy With No Market Imperfections

In order to analyze what dividend policy of any company ought to be in the case of no market imperfections, let us do the following problem.

Problem 1: Consider a company with the following market value balance sheet:

Assume 120 shares outstanding, and the project outlay is $1000.

Assets LiabilitiesCash 1000 Debt 0Fixed Assets 9000 Equity 12,000New Project NPV

2000

12,000 12,000

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Example

Now compute the wealth of a shareholder who owns 1 share in the firm under each of the following alternatives:(a) The firm implements the project using the $1,000 available

to it, and pays no dividends.(b) It pays the $1,000 as a dividend to its equity holders, and

finances the project by issuing new equity.(c) It implements the project using the $1,000, but pays a 10%

stock dividend (i.e., it gives free an extra share for every ten shares).

(d) It uses the $1,000 to buy back equity, but then issues new equity to raise the $1,000 required to implement the project.

(e) It does not implement the project, but pays out the $1,000 cash to equity holders.

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Example

(a) Spending cash to implement project Net change in equity value = -1000 + 1000 = 0 Price per share = 12,000/120 = $100 per share

Personal wealth from holding 1 share = $100 (b) Distributing dividend & then selling equity

New shares sold = 1000/PEx-dividend price per share = 1000/120 = $8.33New number of shares = 120 + 1000/PNew price per share = (12,000 – 1000)/120 = $91.66Personal wealth of shareholder = $91.66 + $8.33 = $100

(c) Stock dividend of 10% New shares outstanding = 120*(1.1) = 132

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Example

Price per share = 12,000 / 132 = $90.90Shareholder wealth = $90.90 * 1.1 = $100

(d) Repurchase $1000 in equity, then sell $1000 in equityResults in only a temporary reduction in the number of shares; the new issue recovers the original number. Total wealth per shareholder is unchanged at $100.

(e) Reject project but use $1000 to pay dividend Dividend per share = $8.33

Price per share = $9000/120 = $75.00Total wealth = $75 + $8.33 = $83.33Wealth has fallen from forgoing the positive NPV project.

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Dividend Policy With Perfect Markets: Summary

(i) Dividend policy is irrelevant, as long as investment policy is unchanged. This is the Modigliani-Miller irrelevance proposition on dividends.

(ii) If a firm pays out dividends, keeping investment policy unchanged, the share price falls by the same amount as the dividends paid.

(iii) It never makes sense to pass up positive NPV projects. (iv) Cash dividends are the SAME as stock repurchases. (v) Stock dividends do not create any value. But isn’t this result puzzling in light of the constant dividend

growth model for valuing stocks? We learned that a stock price is the present value of expected future dividends, so is M-M consistent with the constant growth model?

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Example 2

The CRC company has a current share price of $50. Its expected dividend D1 in the coming year is $2 per share,

which reflects the company's current dividend policy of paying out 50% of earnings (i.e., next year's expected earnings is $4 per share).

Investors currently expect earnings (and therefore dividends) to grow at a constant rate of 8% per year.

The firm has currently 1000 shares outstanding. The required rate of return, r, is 12%.

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Example 2

(a) What is the current price per share? What is the expected price one year from now?

(b) Suppose the board of directors of the company announces tomorrow that the firm is going to change its payout policy to a payout ratio of 100%. It will, however, keep its investment policy unchanged (i.e., it will take on the same projects as before), but will now raise the money required for investment by issuing new equity at the end of each year, as required. Compute the new share price of the firm today, and at the end of the year, under this new policy. What will be the new growth rate in dividends? Ignore all market imperfections in your computations.

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Example 2

(a) P0 = D1 / (r – g) = 2/(0.12 – 0.08) = 2/0.04 = $50 P1 = D2/ (r – g) = 50*(1.08) = $54 (b) Amount to be raised = 2*1000 = $2000 = n*P1’

Firm value at t = 1: 54,000 = 1000 + n)P1’

54,000 = (1000 + 2000/P1’)*P1’ P1’ = $52

52 = (1 + g) P0’ (I)

P0’ = 4/(0.12 – g) (II)Substituting (II) into (I) P0’ = $50 ; g = 4%

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What Example 2 Illustrates

The above discussion proves an important point. Value is created by undertaking real investment projects: by building cars, stereos, TVs, buildings, bridges, etc.

Financial transactions (like changes in the dividend policy, capital structure, etc.) are paper transactions which cannot create value in themselves, but can affect value only by influencing real investment decisions, or by minimizing the impact of some market imperfections.

Therefore, we will now introduce such market imperfections into the analysis, in order to analyze what the right dividend policy ought to be under those conditions.

We will first look at taxes, then later on we will explore the implications of information asymmetries and agency issues.

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Dividend Policy with Taxes

Dividend policy with a higher personal income tax rate on dividends than on capital gains

We all know that any dividends that an individual earns from his equity investments are taxable by the IRS as ordinary income.

On the other hand, before the 1986 tax reform act, capital gains on equity were taxed at a much lower rate. Even though this tax differential was removed under the 1986 act, there is, even now, some advantage to ordinary investors in getting their investment income in the form of capital gains, since they can postpone the realization of capital gains (thus minimizing the present value of taxes paid).

In other words, the effective tax rate on capital gains is still somewhat lower than that on dividends.

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In order to analyze what the right dividend policy ought to be in the case where dividends are taxed at a higher personal income tax rate than capital gains, consider the following example.

Assume that an entrepreneur owns all the shares in a firm. The firm has $100 in cash, which the entrepreneur can use to pay himself a dividend (and sell fresh equity to himself for the same amount to generate money for investment) or use the cash directly to fund the investment required.

Now, we know that if there is no taxation on personal income, whether the entrepreneur pays dividends to himself or not doesn't matter: he is going to give cash to himself (in the form of dividends) and then take the same amount from himself (by selling himself equity).

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However, consider now the case where dividends are taxed at a personal tax rate of 35%, while capital gains are untaxed. In that case, if the entrepreneur pays himself a dividend of $100, he will have to pay the IRS $35 in income tax!

In other words, the entrepreneur will be $35 poorer! Thus, in an economy where dividends are taxed (at the personal level) at a higher rate than capital gains, no firm should pay dividends, since it only serves to dissipate value (unless there is some other opposing effect we have not taken into account).

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Personal taxes, tax arbitrage, and the fall in share price on the ex dividend day.

How does the differential taxation of dividends and capital gains affect the fall in the price of shares on the ex dividend date?

Let us try to figure it out. Denote by PB the price of a share just before the stock goes ex dividend, while PA denotes the price just after the stock goes ex dividend.

Let d be the amount of the dividend, and tG and tD respectively the personal tax rates on capital gains and dividends.

Finally, let P0 be the price at which an investor who currently holds a share of XYZ company has purchased its shares.

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If the investor sells the share just before the stock goes ex dividend, his after-tax income will be PB - (PB - P0)tG.

If, on the other hand, he waits another instant, and sells it after the stock has just gone ex dividend, his income will be PA - (PA - P0)tG + d(1 - tD).

Investors for whom the first term above is larger will sell the stock just before it goes ex dividend; those for whom the second term is larger will hold on to the stock, thus receiving the dividend. For the marginal investor, who is indifferent to selling the stock of holding on to it, these two terms will be equal. Thus, in equilibrium, we have:

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Equation (1) gives the relationship between the fall in share price on the ex dividend date as a proportion of the dividend paid and the personal tax rates on dividends and capital gains.

Notice that the tax rate in (1) should be those of the marginal investor, who is indifferent to selling the stock just before or just after the stock goes ex dividend.

B B 0 A A 0G G D

B A D

G

- ( - ) = - ( - ) + d(1- ) t t tP P P P P P( - ) (1 - )tP P = .

d (1 - )t

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For example, if tD = 0.4 and tG = 0.25, this ratio will work out to be 0.8: i.e., the fall in share price should be 80% of the dividend amount. It turns out that this is in fact equal to the empirically documented average fall in share price.

However, different investors have different tax rates. We observe “tax arbitrage” around the EX-DIVIDEND day.

I.e. buy at PB, collect d, sell at PA.

Ex- dividend Date

P0

Announcement

PAPB

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The tax clientele hypothesis The position I have presented so far, that dividends are taxed at

a higher rate than capital gains, and therefore to be avoided, is rather extreme.

In fact, there are several categories of investors who do not face a higher tax rate on dividends, or may even face a lower tax rate on dividends.

For example, pension funds pay no taxes on either dividends or capital gains. Corporations, on the other hand, have to pay tax on only 30% of the dividends that they receive (on the shares of other companies that they hold), but are fully taxed on all capital gains that they receive, so that their effective tax rate is higher on capital gains.

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The tax clientele hypothesis Finally, ordinary investors in low tax brackets may prefer

dividends because, if the stock they hold does not pay dividends, they will have to sell an equivalent number of shares (thus incurring trading costs) if they want to generate income for current consumption.

The clientele hypothesis states that, depending on their tax rates, some investors prefer high dividend payouts, while others prefer low dividend payouts. Depending on its level of dividend payout, each company may attract the corresponding "clientele“.

For example, assume that 40% percent of all investors prefer high dividends and 60% prefer low (or no) dividends. Further assume that 70% of all firms pay high dividends, and only 30% low dividends. Then, the shares of low dividend firms will be bid up to reflect the excess demand for such shares.

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The tax clientele hypothesis However, the dividend clientele hypothesis argues that, since

the dividend policies of various companies can be easily changed, so that enough companies will shift to a low dividend payout, so that the demand for the shares of such firms will be fully satisfied in equilibrium.

After this has happened, there will be no excess supply or excess demand for either high dividend or low dividend firm's equity, so that dividend policy will again be irrelevant. In such a setting, if a firm changes its dividend policy from high to low dividend (or vice versa), the only thing it will accomplish is to switch the group of investors who hold its equity: it will not succeed in increasing its market value.

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What We’ve Learned About Dividend Policy So Far

To summarize our discussion so far, it seems to be the case that if we consider only personal income taxes, our analysis would suggest that paying dividends is either harmful to firm value, or at best, irrelevant.

If, in addition, we consider the fact that if a firm pays out its cash as dividends, it may have to raise additional funds by issuing new equity (a costly process, considering the high investment banking fees involved) the implication is that dividends are, overall, more harmful than beneficial.

One is therefore still left without any positive reason for paying dividends. However, I will discuss two such reasons when we continue this discussion on dividend policy.

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Dividend Policy (Part 1) MF 807: Corporate Finance Professor Thomas Chemmanur