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The Dividend Controversy
Should firms pay high dividends?
Trap question one:
 An
investor buys a share.
 It never pays a dividend.
 Is it valueless?
 The
investor resells it before any
dividends are paid.
 The buyer gets dividends.
Trap question two:
 A firm
never pays dividends to any
investor and is never expected to do so.
 Is it valueless?
No. Think of any small start-up.
 The
typical start-up firm is bought by
 Its investors get cash or shares in the
acquiring firm.
Dividend policy alternatives:
 Either
high dividends now, low later, or
 Low now, high later.
Dividend policy is irrelevant!
 The
firm has done all projects with NPV
> 0.
 It has some cash.
 What are the alternatives?
Separation theorem interpreted for
dividends (Figure 18.4)
L o w -d iv id e n d firm
F u tu re
r e tu rn
s lo p e = - ( 1 + r )
H ig h - d iv id e n d
d iv id e n d n o w
Homemade dividends
 Investors
who want higher dividends
sell some shares to get cash.
 Those who want lower dividends use
high dividends to buy more shares.
Example of partial tax sheltering by
capital gains
 Alternative
one: dividend of $10,000.
 Pay taxes on all of it.
 Compare to capital gains of the same
Tax shield continued, homemade
 Alternative
two: capital gains of
 Sell stock worth $10,000.
 The stock was bought when the price
was half the current price.
 Realized capital gains = $5,000
 Pay taxes on $5,000.
Some tax-class clienteles prefer dividend
 because
they have tax exemptions,
 non-profit institutions, pension funds,
corporations etc.
Some tax-class clienteles prefer capital
 because
they can't shelter dividends
from taxes,
 but they can shelter capital gains.
 High income investors, for instance.
Implications of clienteles
 Some
cash flows in the high-dividend
 Some in the low-dividend channel.
 Like the Miller channels model.
Dividend equilibrium
H iD iv
per $1
LoD iv
per $1
V *=1/Rh
V *=1/RL
E quilibriu m
H iD iv
E q u ili b riu m
L o D iv
$ of operating
cash flow s
Value is invariant to dividend policy.
 In
 i.e., almost all the time
Out of equilibrium
 i.e.,
after tax law changes,
 firms can increase value by
appropriately changing their dividend
Example of disequilibrium
 Suppose
that the capital gains tax rate
is lowered.
 LoDiv cash flows are more valuable.
 Demand for LoDiv cash flows
Cut in capital gains tax rates
Increased value
of old equity
More LoDiv
$ of operating
cash flows in
the economy
Real-world evidence
 for
not changing dividend policy
 and for existence of tax-class clienteles.
 Actual
dividends are highly smoothed
 Earnings fluctuate much more.
 Smooth means constant or increasing
at a constant rate.
 Smooth means pleasing to the tax-class
clientele that holds the shares.
A problem for the low-dividend firm
 The
firm has a quantity of spare cash
 after all NPV>0 projects are done.
 Pay
dividends: Shareholders pay extra
 Invest in financial markets: Firm
becomes a mutual fund.
Solution: use the cash to buy stock
 Investors
who sell are those who want
 Stock price is unaffected ...
 because the value of the firm falls
 by the value of the repurchased shares.
The IRS understands this game.
 Stock
buyback for tax avoidance is
 Therefore...
Excuses, excuses
 always
another reason for a stock
 usually ... our shares are a good
 or...we disburse cash to prevent
 Dividend
policy is like capital structure.
 It probably doesn’t matter.
 If it does, it matters because of taxes,
and even that is temporary.
 In equilibrium, firms cannot increase
value by changing capital structure or
dividend policy