Dividend Policy

Dividend Policy
dividend = distribution (usually of cash) from the firm to the owner(s) of the firm
earnings retained or paid out to shareholders as dividends how much to pay out is one of most important decisions of a corporation same decision faced by all firms, even small sole proprietorships does owner reinvest in the firm to make it grow, or take the profits out?

Types of Dividends
Three different types of dividend:

1. Cash Dividend most common portion of earnings paid out to shareholders typically on an ongoing basis 2. Stock Dividend give shareholders new shares of stock in lieu of cash as a dividend increases the number of shares outstanding same effect as a stock split 3. Special Dividend or Stock Repurchase special dividend = a large, one time dividend stock repurchase = distribute cash to shareholders by firm buying stock

Cash Dividend
most common type of dividend

level of dividends often measured by dividend yield:

dividend yield =
annual dividend D stock price P

measures % return earned by investor from dividends alone

firms dividend policy can also be measured by payout ratio:

annual dividend D payout ratio = earnings per share EPS

plowback ratio = 1-payout

Cash Dividend
dividends paid out of earnings (actually paid out of free cash flow)
typically, dividends are paid on an ongoing basis, year after year some firms have target payout ratios however, despite being paid out of earnings, dividends are typically much less volatile than EPS Why?

Cash Dividend
Changes in dividends act as a signal to the market about the health and prospects of the firm
Firm do not like to reduce dividends unless absolutely necessary

A dividend reduction sends a bad signal to the market (empirically, approx. 4% drop on average in stock price)
To avoid sending bad signal, firms only raise dividend if they are very confident that the new level can be maintained in the future Therefore, dividends are sticky

Stock Dividend
Firm distributes new shares of stock to shareholders as a dividend instead of cash Only real effect is to increase number of shares and dilute the value of each share Sometimes used to try and fool investors into thinking they are getting a dividend when the firm cannot afford it A stock split is essentially just a large stock dividend

Stock Splits and Stock Dividends

Example: Firm has 100,000 shares, each worth $100 Does a 2-for-1 stock split Doubles number of shares, but does not change anything about firm There should now be 200,000 shares, each worth $50 No difference to shareholders
However, empirically it turns out that the shares are worth a little more than the $50 expected On average, stock prices go up about 2%-3% when stock splits announced Why?

Stock Splits and Stock Dividends

Usual explanation for benefits of stock split = optimal trading range Keeping share price within an optimal range is beneficial
Keeping price low allows small investors to buy shares, increase demand and liquidity of stock Do not want price too low however, as transaction costs become too high (bid-ask spread as proportion of price gets large)

Special Dividends
Firms with large amounts of excess cash sometimes pay out large dividends Firms are normally very explicit about the large dividend being a special dividend No implication that dividends of that size will continue Avoids signaling problem
Another way to distribute cash to shareholders, often used when firm has large amount of excess cash on hand: repurchase of stock

Stock Repurchase
Use firms excess cash to buy stock back Repurchases are an alternative to dividends for distributing cash to shareholders, with some advantages over paying cash
Advantages of Stock Repurchases: 1. Cash is distributed to shareholders who want it Only shareholders who decide to sell get cash 2. As repurchases are usually done over time, firm has flexibility to scale back or reverse decision

3. Tax advantage to shareholders since cash distributed comes to shareholders as a capital gain rather than classified as dividend dividends are taxed at higher rate 4. Purchasing stock provides signal to market that firm believes share undervalued typically results in increase in share price 5. In some firms, control by certain shareholders is important and a reduction in number of shares increases their percentage ownership

Dividend Policy
Many ways to distribute cash to shareholders We will concentrate on on-going cash dividends as exemplifying a firms dividend policy
Dividend policy extremely important to value of the firm Consider typical model for share value assuming constant future growth:

D1 P rg

 Obviously, as D1 is part of equation, the level of dividends affects price of share. But, that is not the only effect of dividend policy Dividends affect growth rate (g)

The greater the proportion of earnings paid out as dividends, the less that is re-invested in the firm If less is being re-invested in the firm (lower retained earnings), than future growth will be lower.

 Common amongst analysts to estimate future growth as:

g= (1-payout ratio) ROE

Where ROE is the return on equity expected from future projects of the firm. In the dividend growth model, g is the rate of growth in dividends it is also the rate of growth in the stock price Therefore, a firms dividend policy affects the return investors receive from dividends, and also the return they receive in the form of capital gains

 A firms dividend policy is a trade-off between providing shareholders returns in the form of dividends, or in the form of capital gains Essentially a choice between cash versus a higher stock price The dividend growth model can be rearranged to give:

D1 P rg D1 r g P
The return to a shareholder is broken down into dividend yield and capital gains. Dividend policy determines the breakdown how investors earn their money

Example: Firm expects EPS next year to be $1.50. Payout ratio is 27.5% (this is average in US). Required return on stock (r) is 15%. ROE expected on future projects of firm is 15%. What is effect of varying the dividend policy? What happens if the payout ratio is changed? (Assume no changes in the firms investments and that any change provides no signal to the market and does not change required return.)

Dividend policy in this case does not affect value of the firm and does not affect the return earned by shareholders It simply affects where the return comes from (dividends versus capital gains) If shareholders do not care where they get their income, then it makes sense that dividend policy does not matter

The result that dividend policy is irrelevant depends on two key things: 1. Retained earnings are invested in projects which return an ROE equal to required return (r) 2. Investors really are indifferent between income from dividends and income from capital gains. Lets now look at each of these two assumptions

Effect of a Firms Expected ROE

Example: Consider a sole proprietorship. The owner takes some cash out of the firm each year. Assume owner pays no taxes. From current business set-up, owner expects to take $100,000 out of the company next year, and this is expected to grow at 5% per year thereafter. The company has $1,000,000 in extra cash on hand right now. The owner could take the $1,000,000 out of firm now in cash, or could keep the money in the firm and use it to expand business. What should the owner do? If the owner takes the cash, he could invest it elsewhere (with the same level of risk as the company) and expect to earn 10%.

Affect of a Firms Expected ROE

Key Conclusion: If a firm has NPV>0 projects which it can undertake, then it should retain earnings to fund these. These projects earn an ROE that is higher than the return an investor could earn if they took the dividends and invested themselves. If firms have good investment opportunities available that are not available to individual investors, then the firm should retain more earnings to fund the investments.

Affect of a Firms Expected ROE

The same result can be shown using the dividend growth model.

Example: EPS = $3 r = 18% Payout = 27.5% Firm has potential investments available which have ROE = 20%
D1 = $3(0.275) = $0.825 g = (1-payout)ROE = (1 - 0.275)0.2 = 14.5% Stock price = P = 0.825/(0.18 -0.145) = $23.57

 Firm has good investments available. If it reduces dividends and invests more, then shareholders are better off. Reduce payout to 20%. D1 = 0.2($3) = $0.60 g = (1 0.2)0.2 = 16% Stock Price = P = 0.60/(0.18 0.16) = $30 Stock price rises and shareholders benefit from change in dividend policy because the firm has good investment opportunities.

Affect of a Firms Expected ROE

Implication: Firms with lots of investment opportunities should generally pay lower dividends than firms in mature industries with few investment opportunities.
Empirically, this is found to be true. Analysis of whether a firms dividend policy is appropriate often centers round estimating/examining investment opportunities available to the firm.

Are investors really indifferent between dividends and capital gains?

Assume that any investments a firm makes are NPV = 0 Investments themselves would not create or destroy value.

As before, dividends then merely determine where an investor gets income from dividends versus capital gains
Is dividend policy irrelevant in this case? Do investors care how they get income?

Are investors really indifferent between dividends and capital gains?

Modigliani and Miller looked at this question:
Conclusion: Dividend policy is irrelevant if:

Dividends provide no signal about the firm. Firm projects are NPV = 0. There are no transaction costs in buying/selling shares. There are no taxes.

 M & Ms idea is that investors can replicate any dividend policy they might like by buying or selling shares. Since investors can create any dividend policy they want, what a firm chooses to do is irrelevant.
Example: A firm pays large dividends, but a certain investor would prefer not to get cash, would prefer increase in stock value. Investor simply takes dividends and uses them to buy more shares Example: A firm pays no dividends, provides returns to investor in capital gains form, but a certain investor would prefer getting current income Investor simply sells some shares as the price goes up, creating homemade dividends. Investor gets current income even though firm pays no dividends.

 M & M Dividend Irrelevance depends on certain assumptions. In real world, there are transaction costs It costs money to buy/sell shares Therefore, it is not free for an investor to replicate any dividend policy that they want Therefore, a firm's dividend policy does matter (if investors have a preference for a certain type of income) Possible (partial) solution: Dividend Reinvestment Plans (DRIPs) Second big assumption is taxes. Investors DO care about how they earn income from stock. Dividend income is not a perfect substitute for capital gains income because the two forms of income are taxed differently.

Dividend Policy and Taxes

Dividend policy determines how investors receive income.
This is an important issue because dividends are taxed more heavily than capital gains. In Canada: Only 50% of a capital gain is taxable Dividends are taxed as regular income, although dividend tax credit reduces the excess taxation Ceteris paribus, investors prefer income to be in form of capital gains.

Dividend Policy and Taxes

Because dividends are taxed more highly than capital gains, taxable investors prefer small or no dividends (all else being equal).
Firms which pay dividends have to offer higher before tax returns in order to compensate investors for the higher tax they must pay. Implication: Firms with high dividends should have lower share prices than identical firms with lower dividends. Dividend policy does matter. Implication: Tax free investors (e.g. pension funds) will prefer to invest in high dividend stocks.

Dividend Policy and Taxes

Note: even if dividends and capital gains are taxed at same rate, there is still a tax advantage in capital gains Tax timing option Taxes on capital gains are only paid when realized Investors can therefore decide when to sell shares and pay tax Valuable option Investors can sell shares and realize gain when most advantageous for tax purposes Dividends do not have this option Also means that taxes on capital gains can be delayed Present value of taxes to be paid is less if the shares are to be sold far into the future

Dividend Policy and Taxes

In the extreme, the tax disadvantage of dividends means that firms should pay no dividends As long as they have NPV > 0 or NPV = 0 projects to invest in, investors prefer not to get any dividends paid to them.
What mitigates the tax effect? Why do firms pay dividends?

Factors Favouring Paying Dividends

1. Tax Free Investors: Tax exempt investors do not worry about taxation aspects of dividends Generally, tax exempt investors will prefer high dividend paying stocks (as their pre-tax returns are higher) There may be demand from tax-exempt investors for high dividend stocks If there are enough tax-exempt investors, and not enough high dividend stocks available, the excess demand may push stock prices up Firms may choose to pay high dividends to attract this type of investor This is a form of the Clientele Effect in dividends

Factors Favouring Paying Dividends

2. Agency Problems If firm does not pay dividends then management retains control of funds If there are NPV > = 0 projects available, this is fine However, if no good investments are available, there may be incentive for management to invest in NPV < 0 projects simply to retain control of the funds That is, management may waste money This may offset the tax disadvantage to investors of getting the funds paid out as dividends

Factors Favouring Paying Dividends

3. Signaling firm s can use their dividend policy to signal to the market the firms prospects. Increasing dividends signals that the management is confident in the future.
4. Some Investors Preference for Current Income Some investors simply prefer current income People who need cashflow, or live off of income from investments Firms may attempt to serve this clientele by paying dividends

Factors Favouring Paying Dividends

In the end, there does exist a tax disadvantage to dividends
However, many firms do pay dividends

Some, or all, of these other factors must be important in the real world.