Download Topic Note-11

Thomas J. Chemmanur
MF807
Topic Note-11
"Morality is all right, but what about dividends?"---Kaiser Wilhelm II
1. Dividend Policy
Dividend policy is concerned with the following issues: Out of the earnings of the company, how
much should be paid out to shareholders as dividends, and how much retained (hence the name "retained
earnings") for future investment? Further, of the amount that the company wants to distribute to share
holders, how should they make this distribution: By sending a dividend cheque to share holders (called a
cash dividend) or by repurchasing stock? We will find that the answers to these questions are not easy. In
fact, based on the current theoretical work on dividend policy, I cannot give you a formula, which will give
you precisely what fraction of earnings each firm should pay as dividends. What I can do, however, is to use
the theory to dispel several fallacious notions that many have about dividend policy, and thus arrive at some
basic principles which should guide the setting of the dividend policy of any company.
My discussion of dividend policy here will be in two parts. I will first discuss what a firm's dividend
policy ought to be in an economy with no market imperfections. By market imperfections, I mean frictions
like taxes, asymmetries in information between firm insiders and outsiders, transactions costs of various
kinds (e.g., investment banking and other fees associated with issuing new equity), agency problems
between stockholders and managers etc. Thus, in the first part of my analysis, I am going to assume that
such imperfections are absent, and that managers take various corporate decisions keeping in mind the
shareholders' best interests at heart (i.e., they want to maximize stock value). The reason I am going to make
the rather unrealistic assumption of perfect capital markets initially is because this assumption makes the
problem very transparent, and serves as a good bench mark for the second part of my analysis, where I am
going to discuss the more realistic case where the economy is characterized by market imperfections of
various kinds.
2. Some institutional details
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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).
3. Dividend policy in an economy 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:
Assets
Cash
Fixed
Assets
1000
Liabilities
Debt
0
9000
Equity
12,000
New Project
NPV
2000
---------------------------------------------------------------------------------------------------------12,000
12,000
----------------------------------------------------------------------------------------------------------Assume that the firm has currently 120 shares outstanding. Implementing the new project requires an
investment outlay of $1,000. 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.
From the above problem, we learned the following lessons:
(i) In an economy without market imperfections, dividend policy is irrelevant, as long as the firm's
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investment policy is fixed (i.e., the firm undertakes all positive NPV projects that it has available). This
result is the well known Modigliani-Miller irrelevance proposition on dividends.
(ii) Under no market imperfections, if the firm does pay out dividends (keeping its investment policy
unchanged), the price per share will fall by exactly the same amount as the dividend paid.
(iii) Under no market imperfections, it never makes sense for any firm to pass up positive NPV projects in
order to pay dividends. If, on the other hand, the firm has no positive NPV projects available to it, it should
pay out any cash it has to its equity holders (since, by saying that the firm has no positive NPV projects, we
mean that the firm has no projects which can earn the required rate of return of its equity holders, and
therefore, they can invest the money on better terms than the firm).
(iv) Under no market imperfections, if the firm does want to distribute value to its shareholders, cash
dividends and stock repurchases are equivalent (this is, of course, only an elaboration of result (i)).
The above result may look slightly puzzling in the context of the constant dividend growth model
for valuing stocks, which you learned at the beginning of this course. There we learned that stock price is
the present value of expected future dividends, and devoted some effort to try to incorporate the "right"
growth rate in dividends into our computations. Is the Modigliani-Miller Proposition on dividends
consistent with the constant growth model? We will see that it is, by doing the following problem.
Problem 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%.
(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.
The above discussion proves an important point. Value is created by undertaking real investment
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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.
4. 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.
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 simple 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). 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
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taken into account).
5. 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. 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;1
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, in equilibrium, we have:2
(1)
P B - ( P B - P0 ) t G = P A - ( P A - P0 ) t G + d(1 - t D ) _
( P B - P A ) (1 - t D )
=
.
d
(1 - t G )
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. 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
1
Of course, if the investor wants to hold on to the share for a longer period for other reasons, he can buy
back the share after it has gone ex dividend.
2
I am ignoring trading costs here. However, this relationship holds approximately, since these are small.
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documented average fall in share price.3
6. 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. 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" of investors. 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. 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
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However, it should be emphasized that this is only an average. It is quite difficult to accurately predict ex
ante this proportion for any specific stock, since there will be various categories of investors with different
values of tD and tG trading in any given stock around its ex dividend date (for instance, there may be quite a
few arbitragers whose tax rates are the same for both dividends and capital gains). The final price on the
stock after it goes ex dividend will be determined by the proportions of the demand for the stock arising from
these various categories of investors.
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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.
7. A summary of the discussion 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.