Download Dividend Policy

Dividend Policy
05/30/07
Ch. 21
Dividend Process
 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 / electronic
payment made
Theoretically, stock price should adjust
exactly…
Actual ex-dividend day price behavior
and tax differences
 The stock price around the ex-dividend date actually drops by less than
the dividend amount to accommodate the tax preferences of investors.
 Certain investors (tax-exempt or very low tax bracket) may be able to
make excess returns by trading around this date.
 These investors would buy the stock before the ex-dividend day, sell it
after it goes ex-dividend, collect the dividend making a profit because
the dividend exceeds the price drop. This is referred to as dividend
capture or dividend arbitrage.
 Ex-dividend day equality where the marginal investor is indifferent
between selling the stock before and after the ex-dividend day:
PB  PA (1  t0 )

D
(1  tcg )
Empirical evidence on dividends
 Dividends tend to lag earnings
 Dividends are changed to reflect long-term shifts in
earnings
 Dividends are sticky
 Dividends are less volatile than earnings
 Dividend policy tends to follow the life cycle of the
firm with mature firms returning more to owners
How does dividend policy affect stock
price?
 Constant growth stock valuation model:
D1
P0 
rg
 An increase in dividends increases D1 but also
decreases g
Three schools of thought on dividends
 If
(a) there are no tax disadvantages associated with dividends
 (b) companies can issue stock, at no cost, to raise equity,
whenever needed
 Dividends do not matter, and dividend policy does not
affect value.
 If dividends have a tax disadvantage,
 Dividends are bad, and increasing dividends will reduce
value
 If stockholders like dividends, or dividends operate as a signal of
future prospects,
 Dividends are good, and increasing dividends will
increase value

Dividends are irrelevant…
 The Miller-Modigliani Hypothesis: Dividends do not affect
value
 Basis:
 If a firm's investment policy (and hence cash flows) does not
change, the value of the firm cannot change with dividend
policy. If we ignore personal taxes, investors have to be
indifferent to receiving either dividends or capital gains.
 Underlying Assumptions:
 (a) There are no tax differences between dividends and
capital gains.
 (b) If companies pay too much in cash, they can issue new
stock, with no flotation costs or signaling consequences, to
replace this cash.
 (c) If companies pay too little in dividends, they do not use
the excess cash for bad projects or acquisitions.
Dividends are bad…
 Individuals in upper income tax brackets might prefer
lower dividend payouts, with the immediate tax
consequences, in favor of higher capital gains
 Additionally,
 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
Dividends are good….not for these
reasons
 The bird in the hand fallacy: Dividends are
better than capital gains because dividends
are certain and capital gains are not.
 The Excess Cash Argument: The excess
cash that a firm has in any period should be
paid out as dividends in that period.
The bird in the hand fallacy
 Argument: Dividends now are more certain
than capital gains later. Hence dividends are
more valuable than capital gains.
 Counter: The appropriate comparison should
be between dividends today and price
appreciation today.
The excess cash hypothesis
 Argument: The firm has (temporary) excess
cash on its hands this year, no investment
projects this year and wants to give the
money back to stockholders.
 Counter: So why not just repurchase stock?
If this is a one-time phenomenon, the firm has
to consider future financing needs.


Consider the cost of issuing new stock
If it initiates dividends, it may need to raise
capital through a stock issue just to pay
dividends in the future.
Dividends are good….possibly for
these reasons
 The Clientele Effect: There are stockholders who
like dividends, either because they value the regular
cash payments or do not face a tax disadvantage. If
these are the stockholders in your firm, paying more
in dividends will increase value.
 Dividends as Signals: Dividend changes act as
signals to financial markets about the future
sustainable earnings of the firm
 Wealth Transfer: By returning more cash to
stockholders, there might be a transfer of wealth from
the bondholders to the stockholders.
A clientele based explanation
 Basis: Investors may form clienteles based upon
their tax brackets. Investors in high tax brackets may
invest in stocks which do not pay dividends and those
in low tax brackets may invest in dividend paying
stocks.
 Evidence: A study of 914 investors' portfolios was
carried out to see if their portfolio positions were
affected by their tax brackets. The study found that


(a) Older investors were more likely to hold high
dividend stocks and
(b) Poorer investors tended to hold high dividend
stocks
Dividends as signals
 Dividend increases
 Stock prices increase significantly around dividend
increase announcements.
 Management is signaling to the market that earnings
will be sustainable at a higher level thus allowing the
company to maintain a higher dividend level
 The opposite is true for dividend decreases
 Signals are most effective for smaller firms
 Can you think of a negative implication of dividend
increases?
The wealth transfer hypothesis
EXCESS RETURNS ON STRAIGHT BONDS AROUND DIVIDEND CHANGES
0.5
0
t:- -12
-0.5 15
-9
-6
-3
0
3
6
9
12
15
CAR (Div Up)
CAR
CAR (Div down)
-1
-1.5
-2
Day (0: Announcement date)
Dividend policy summary
 No definite conclusion can be reached about the
optimal dividend policy
 Investors in aggregate cannot be shown to uniformly
prefer either high or low dividends
 Individual investors, however, have strong dividend
preferences and will tend to invest in companies
whose dividend policies match their preferences
 Regardless of the payout ratio, investors prefer a
stable, predictable dividend policy