The Dividend Controversy Should firms pay high dividends?

Review item  An asset A is being added to the market portfolio M.  What variable indicates whether A will raise or lower the risk of the portfolio?  Explain briefly.

Answer: beta of A is the variable  Beta of A is covariance of A with M divided by variance of M.  Beta of A > 1 implies A varies more with M than M itself does (possible diagram).  Beta of A > 1 implies A raises the risk of M.  Beta of A < 1 implies A lowers risk of M.

Normal dividends (pages )  declaration date  ex-dividend date  record date  payment date

Why is the ex-dividend date early?  To avoid disputes, exchanges control the right to the dividend.  Early date reduces costs of administering the rule.  Now 2 days lead time. Formerly 5 days.

Dependence of value on dividends  Notation:  P t, P t+1, P t+2,... are  prices of shares at time t, t+1, t+2  D t, D t+1, D t+2,... are dividends

Derivation  P t = D t+1 /(1+r) + P t+1 /(1+r)  P t+1 = D t+2 /(1+r) + P t+2 /(1+r)  P t = D t+1 /(1+r) + D t+2 /(1+r) 2 + P t+2 /(1+r) 2

By induction  P t = D t+1 /(1+r) + D t+2 /(1+r) 2 + D t+3 /(1+r) 3 + …  Expected dividends determine value,  even when the share changes hands.

Trap question one:  An investor buys a share.  It never pays a dividend.  Is it valueless?

No.  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 Webservice.com  The typical start-up firm is bought by another.  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?

Alternatives:  Distribute cash as a dividend now.  Invest the cash in financial markets and  pay out as a dividend later.

Separation theorem interpreted for dividends (Figure 18.4) C1C1 C0C0 slope=-(1+r) Low-dividendfirm High-dividend firm w Future return or dividendno

Separation theorem  NPV is relevant.  Investors time preferences are not.

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.

Upshot  Investors do not reward firms for doing what investors can do for themselves.

Taxes and dividends  The alternatives are  (1) dividends or  (2) capital gains.

Tax-class clienteles  Investors with similar tax exposure.  Some prefer dividends.  Some prefer capital gains.

Some prefer dividend income  because they have tax exemptions, e.g.,  non-profit institutions, pension funds, corporations etc.

Some investors prefer capital gains  because they can't shelter dividends from taxes,  but they can shelter capital gains.  High income investors, for instance.

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 amount.

Tax shield continued, homemade dividend  Alternative two: capital gains of $10,000.  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.

Implications of clienteles  Some cash flows in the high-dividend channel.  Some in the low-dividend channel.  Like the Miller channels model.

Dividend equilibrium $ofoperating cashflows HiDiv value per$1 LoDiv value per$1 mqiliriu oiv E L mEquilibriu HiDiv ub D V*=1/RhRh V*=1/RLRL...

Value is invariant to dividend policy.  In equilibrium  i.e., almost all the time

Out of equilibrium  i.e., after tax law changes,  firms can increase value by appropriately changing their dividend policy.

Example of disequilibrium  Suppose that the capital gains tax rate is lowered.  LoDiv cash flows are more valuable.  Demand for LoDiv cash flows increases.

Cut in capital gains tax rates $ of operating cash flows in the economy HiDiv value LoDiv value Increased value of old equity More LoDiv firms

Result of capital gains tax cut  Value of old equity rises (instantly)  Firms increase value by switching to lower dividends  until equilibrium is restored.

Real-world evidence  for not changing dividend policy  and for existence of tax-class clienteles.

Evidence  Actual dividends are highly smoothed  Earnings fluctuate much more.  Smooth means constant or increasing at a constant rate.

A problem for the low-dividend firm  The firm has a quantity of spare cash  after all NPV>0 projects are done.

Dilemma  Pay dividends: Shareholders pay extra taxes.  Invest in financial markets: Firm becomes a mutual fund.

Solution: use the cash to buy stock  Investors who sell are those who want cash.  Stock price is unaffected...  because the value of the firm falls  in proportion to the shares repurchased.

Example: Firm is worth $10M. $1M is spare cash.  There are 1M shares, at $10 per share.  Buy back.1M shares at $10 apiece.  Cost is $1M.

After the buyback,  Remaining value of the firm is $9M  because there are no financial illusions.  There are.9M shares remaining  still at $10 apiece.

Stock buybacks  are associated with rising share value in the financial press.  Can this be correct?

Outsider's model before the buyback  Pr{underpriced} =.5  Pr{overpriced} =.5

If insiders think the stock is overpriced  a buyback would reduce the value of the firm.  Therefore, no buyback occurs.

Since the buyback occurs  Outsiders know that insiders think  the stock is underpriced (or fairly priced).

Therefore, the buyback  signals the knowledge of insiders  that the stock is underpriced  and outsiders raise their estimates of its value.  Thus, share price rises on the buyback.

The IRS understands this game.  Stock buyback for tax avoidance is illegal.  Therefore...

Excuses, excuses  always another reason for a stock buyback,  usually... our shares are a good investment  or...we disburse cash to prevent takeover.

Summary  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.

Review item  A share paid a dividend of $5 last year.  The dividend is expected to grow at 3% forever.  The discount rate is 13%.  What is the value of the share?

Answer:  Next year’s dividend is $5.15 ( = 1.03 x 5)  Value is $5.15/( ) = $  Not $50.