The Dividend Controversy Should firms pay high dividends?

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 any small start-up.  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?

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

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 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.

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

Some tax-class clienteles prefer capital gains  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 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

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.  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.

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  by the value of the repurchased shares.

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