Dividend Policy: Theory P.V. Viswanath Based on Damodaran’s Corporate Finance

Theories of Dividend Payout Dividend Irrelevance Dividend Clienteles Signaling Catering to Psychological Investor Preferences Disciplinary Effects on Managers P.V. Viswanath

Dividend Irrelevance Investors can create their own dividends. Consequently, firm value will not be affected by dividend payments. P.V. Viswanath

Example of Dividend Irrelevance Stellar, Inc. has decided to invest $10 m. in a new project with a NPV of $20 m., but it has not made an announcement. The company has $10 m. in cash to finance the new project. Stellar has 10 m. shares of stock outstanding, selling for $24 each, and no debt. Hence, its aggregate value is $240 m. prior to the announcement ($24 per share). P.V. Viswanath

Example of Dividend Irrelevance Two alternatives: One, pay no dividend and finance the project with cash. The value of each share rises to $26 following the announcement. Each shareholder can sell 0.0385 (= 1/26) shares to obtain a $1 dividend, leaving him with .9615 shares value at $25 (26 x 0.9615). Hence the shareholder has one share worth $26, or one share worth $25 plus $1 in cash. P.V. Viswanath

Example of Dividend Irrelevance Two, pay a dividend of $1 per share, sell $10m. worth of new shares to finance the project. After the company announces the new project and pays the $1 dividend, each share will be worth $25. To raise the $10 m. needed for the project, the company must sell 400,000 (=10,000,000/25) shares. Immediately following the share issue, Stellar will have 10,400,000 shares trading for $25 each, giving the company an aggregate value of 25 x 10,400,000 = $260 m. If a shareholder does not want the $1 dividend, he can buy 0.04 shares (1/25). Hence, the shareholder has one share worth $25 and $1 in dividends, or 1.04 shares worth $26 in total. P.V. Viswanath

Assumptions for Dividend Irrelevance The issue of new stock (to replace excess dividends) is costless and can, therefore, cover the shortfall caused by paying excess dividends. Firms that face a cash shortfall do not respond by cutting back on projects and thereby affect future operating cash flows. Stockholders are indifferent between receiving dividends and price appreciation. Any cash remaining in the firm is invested in projects that have zero net present value. (such as financial investments) rather than used to take on poor projects (i.e. there are no agency costs of outside equity). P.V. Viswanath

Implications of Dividend Irrelevance A firm cannot resurrect its image with stockholders by offering higher dividends when its true prospects are bad. The price of a company's stock will not be affected by its dividend policy, all other things being the same. (Of course, the price will fall on the ex-dividend date.) P.V. Viswanath

Dividend Clienteles: Tax Effects For individual investors, dividends are more heavily taxed than capital gains because of the tax-timing option--the ability for individual investors to postpone the tax liability on capital gains income. Hence individuals may prefer capital gains. Corporate shareholders pay income tax at a 34% peak marginal rate, but are permitted to claim a 70% dividends-received deduction. Hence the top marginal tax rate on dividend income for a corporation is only (1-.7) x 34 = 10.2%. They have a greater preference for dividends. Tax-exempt institutions, such as pension funds, do not have a bias in favor of capital gains or dividends. P.V. Viswanath

Dividend Capture Declaration date: The board of directors declares a payment Record date: The declared dividends are distributable to shareholders of record on this date. Payment date: The dividend checks are mailed to shareholders of record. Ex-dividend date: A share of stock becomes ex-dividend on the date the seller is entitled to keep the dividend.   At this point, the stock is said to be trading ex-dividend.  P.V. Viswanath

Dividend Clienteles: Transactions Costs A shareholder who desires a high income stream would prefer real cash dividend payments over homemade dividends if the firm can sell new shares more cheaply than the shareholder can sell his/her own shares. Hence such shareholders might prefer firms with a high payout ratio, while other shareholders may prefer firms with a low payout policy. Consequently, some investors prefer equity income in the form of dividends, while others prefer capital gains. P.V. Viswanath

Dividend Signalling If investors cannot observe information to distinguish a good firm from a bad firm, both firms will be valued the same. Firms that pay higher dividends than they would otherwise have, drain cash and thus increase the probability of bankruptcy. This will decrease the value of the firm. This decrease in firm value will be lower for good firms, because they are less likely to go bankrupt. Hence if a good firm increases its dividends, bad firms will be less likely to mimic the good firm. This will allow investors to separate good firms from bad firms and they will price their stock higher. This benefits stockholders who have to sell in the interim. P.V. Viswanath

Psychological Investor Preferences Dividends and Capital Gains may not be perfect substitutes due to psychological reasons. A lack of self-control may lead an investor to prefer regular cash dividends. If the investor has to sell stock to get income, he might have a tendency to sell too much stock too soon. Hence an investor might choose to invest in a firm that follows a particular type of dividend policy to minimize the total agency costs of shareholding, including the investor's human frailties. P.V. Viswanath

Disciplinary Effects on Managers Contracts between the firm and its managers cannot always be designed to take into account all possible contingencies. Hence, managers may sometimes take actions that reduce firm value. For example, it may be in the interest of managers to increase firm size or to unduly reduce the riskiness of the firm in order to reduce the probability of bankruptcy, and increase the present value of their firm specific skills. This may lead them to accept negative NPV projects or to engage in undesirable mergers. P.V. Viswanath

Disciplinary Effects on Managers This may lead some managers to reduce dividends to a suboptimal level. In contrast, managers, who want to assure the market of their desire to maximize firm value by reducing the amount of disposable resources (free cash flow beyond current investment needs) available to them, may choose to increase dividends. By doing so, they force themselves to submit to the discipline of the markets any time that they wish to raise funds to invest in a project. Such credible proof of a manager's unwillingness to take NPV < 0 projects will be rewarded by the market with an increase in the stock price. P.V. Viswanath