KEBIJAKAN DIVIDEN Budi Purwanto

Dilema: Untuk apa sebaiknya perusahaan menggunakan laba? Membiayai investasi baru yang menguntungkan? Membiayai investasi baru yang menguntungkan? atau atau Membayar dividen untuk pemegang saham? Membayar dividen untuk pemegang saham?

Pembayaran Dividen Announcement dateEx-dividend day Record day Payment day 2-3 weeks 2-3 days 2-3 weeks

Penurunan harga pada Ex-date Ex date Price =$10 Price =$9 -t... –2 – t The share price will fall by the amount of the dividend on the ex date (Time 0). If the dividend is $1 per share, the price will be equal to $10 – 1 = $9 on the ex date. Before ex date (Time –1) Dividend = $0 Price = $10 On ex date (Time 0) Dividend = $1 Price = $9

Bila perusahaan menahan semua laba untuk investasi yang mendatangkan laba, dividend yield akan 0, namun harga saham akan meningkat, menghasilkan capital gain yang lebih tinggi. Bila perusahaan menahan semua laba untuk investasi yang mendatangkan laba, dividend yield akan 0, namun harga saham akan meningkat, menghasilkan capital gain yang lebih tinggi. P 1 - Po D 1 P 1 - Po D 1 Po Po Po Po + Return =

Bila perusahaan membayarkan laba sebagai dividen, pemegang saham akan menerima kas atas investasi yang ditanamkan, namun capital gain akan menurun, karena kas yang sama tidak diinvestasikan ke dalam perusahaan. Bila perusahaan membayarkan laba sebagai dividen, pemegang saham akan menerima kas atas investasi yang ditanamkan, namun capital gain akan menurun, karena kas yang sama tidak diinvestasikan ke dalam perusahaan. P 1 - Po D 1 P 1 - Po D 1 Po Po Po Po + Return =

Apakah investor lebih menyukai tingkat pembayaran dividen tinggi atau rendah? Dividends are irrelevant: Dividends are irrelevant: Investors don’t care about payout. Investors don’t care about payout. Bird-in-the-hand: Bird-in-the-hand: Investors prefer a high payout. Investors prefer a high payout. Tax preference: Tax preference: Investors prefer a low payout, hence growth. Investors prefer a low payout, hence growth.

Dividend Payout Ratios for Value Line’s Selected Industries IndustryPayout ratio Banking38.29 Computer Software Services13.70 Drug38.06 Electric Utilities (Eastern U. S.)67.09 Internet n/a Semiconductors24.91 Steel51.96 Tobacco55.00 Water utilities67.35 *None of the internet companies included in the Value Line Investment Survey paid a dividend.

Early evidence on dividend policy: Lintner’s (1956) stylized facts Lintner (1956) in a series of interviews with corporate managers observed the following facts Lintner (1956) in a series of interviews with corporate managers observed the following facts Firms have long-run target dividend payout ratios; mature companies pay out a high proportion of their earnings, while young companies have low payouts Firms have long-run target dividend payout ratios; mature companies pay out a high proportion of their earnings, while young companies have low payouts Managers focus more on dividend changes than on absolute levels Managers focus more on dividend changes than on absolute levels Dividend changes follow shifts in long-run, sustainable earnings; managers “smooth” dividends Dividend changes follow shifts in long-run, sustainable earnings; managers “smooth” dividends Managers are reluctant to make dividend changes that might have to be reversed Managers are reluctant to make dividend changes that might have to be reversed

The dividend debate: Does dividend policy matter? The issue: Should a firm be preoccupied with its dividend policy? Does the choice of dividend policy affect firm value? The issue: Should a firm be preoccupied with its dividend policy? Does the choice of dividend policy affect firm value? Dividends are irrelevant: M & M (1961) showed that, under certain assumptions, dividends do not really matter because they do not affect firm value Dividends are irrelevant: M & M (1961) showed that, under certain assumptions, dividends do not really matter because they do not affect firm value Dividends are bad: Dividends create a tax disadvantage for shareholders and destroy value Dividends are bad: Dividends create a tax disadvantage for shareholders and destroy value Dividends are good: Dividends are good because shareholders (or some of them) prefer to receive them rather than not Dividends are good: Dividends are good because shareholders (or some of them) prefer to receive them rather than not

Dividend Irrelevance Theory Investors are indifferent between dividends and retention-generated capital gains. If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock. Investors are indifferent between dividends and retention-generated capital gains. If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock. Modigliani-Miller (1961) support irrelevance. Modigliani-Miller (1961) support irrelevance. Theory is based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true. Need empirical test. Theory is based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true. Need empirical test.

M & M: Dividends are irrelevant Assume that Assume that There are no transaction costs from converting price appreciation into cash There are no transaction costs from converting price appreciation into cash Firms that pay too much in dividends can issue stock that is fairly priced and do not face transaction costs Firms that pay too much in dividends can issue stock that is fairly priced and do not face transaction costs The firm’s investment decision is not affected by its dividend decision and operating cash flows are the same in each period The firm’s investment decision is not affected by its dividend decision and operating cash flows are the same in each period Managers of firms that pay too little in dividends do not waste excess cash Managers of firms that pay too little in dividends do not waste excess cash

Two alternative views: Dividends matter Dividends are good Dividends are good The clientele argument The clientele argument Dividends as signals Dividends as signals Dividends may discipline managers Dividends may discipline managers Dividends are bad Dividends are bad Taxes: whenever dividends are taxed more heavily than capital gains, firms should pay the lowest cash dividend they can get away with and earnings should be retained or used to repurchase shares Taxes: whenever dividends are taxed more heavily than capital gains, firms should pay the lowest cash dividend they can get away with and earnings should be retained or used to repurchase shares

Bird-in-the-Hand Theory Investors think dividends are less risky than potential future capital gains, hence they like dividends. Investors think dividends are less risky than potential future capital gains, hence they like dividends. If so, investors would value high payout firms more highly, i.e., a high payout would result in a high P 0. If so, investors would value high payout firms more highly, i.e., a high payout would result in a high P 0.

Dividends are “good” The Clientele argument There are stockholders who like dividends, either because they value the regular cash payments or because they do not face the tax disadvantage There are stockholders who like dividends, either because they value the regular cash payments or because they do not face the tax disadvantage Given the fact that there is a vast diversity among investors in terms of preferences, it is no surprise that investors may form clienteles based upon their tax brackets Given the fact that there is a vast diversity among investors in terms of preferences, it is no surprise that investors may form clienteles based upon their tax brackets Thus, investors will cluster around firms whose dividend policies match their preference (called the clientele effect) Thus, investors will cluster around firms whose dividend policies match their preference (called the clientele effect)

Dividends as signals By changing their dividend policy, firms send signals about their future cash flows to market participants By changing their dividend policy, firms send signals about their future cash flows to market participants When firms increase dividends, they somehow commit to those higher dividends, and, thus, send a signal that they expect to have higher future cash flows (share price increases) When firms increase dividends, they somehow commit to those higher dividends, and, thus, send a signal that they expect to have higher future cash flows (share price increases) Given that firms do not like to cut dividends, firms that are forced to do so send a signal that their financial future is troubling (share price decreases) Given that firms do not like to cut dividends, firms that are forced to do so send a signal that their financial future is troubling (share price decreases)

Dividends discipline managers In firms with principal-agent problems between stockholders and managers and the potential of free cash flows being wasted, making a commitment to pay dividends imposes discipline on managers In firms with principal-agent problems between stockholders and managers and the potential of free cash flows being wasted, making a commitment to pay dividends imposes discipline on managers

Dividends are “bad” If dividends are taxed differently than capital gains (dividends taxed as ordinary income) and the marginal tax rate of dividends is higher than that of capital gains, there exists a tax disadvantage for those stockholders who receive dividends If dividends are taxed differently than capital gains (dividends taxed as ordinary income) and the marginal tax rate of dividends is higher than that of capital gains, there exists a tax disadvantage for those stockholders who receive dividends Even if ordinary income and capital gains are taxed the same, dividends have a tax disadvantage because investors do not have the choice of when to report the dividend as it is the case with capital gains Even if ordinary income and capital gains are taxed the same, dividends have a tax disadvantage because investors do not have the choice of when to report the dividend as it is the case with capital gains

Tax Preference Theory Retained earnings lead to capital gains, which are taxed at lower rates than dividends: 28% maximum vs. up to 38.6%. Capital gains taxes are also deferred. Retained earnings lead to capital gains, which are taxed at lower rates than dividends: 28% maximum vs. up to 38.6%. Capital gains taxes are also deferred. This could cause investors to prefer firms with low payouts, i.e., a high payout results in a low P 0. This could cause investors to prefer firms with low payouts, i.e., a high payout results in a low P 0.

The tax disadvantage of dividends leads to the following conclusions The tax disadvantage of dividends leads to the following conclusions Firms whose stockholders are primarily individuals should pay a lower dividend compared to firms that are mainly owned by institutional investors (they are under a tax-exempt status) Firms whose stockholders are primarily individuals should pay a lower dividend compared to firms that are mainly owned by institutional investors (they are under a tax-exempt status) The higher the income level of the firm’s investors, the lower the dividend paid by the firm should be The higher the income level of the firm’s investors, the lower the dividend paid by the firm should be As the tax disadvantage of dividends increases, the aggregate amount of dividends paid should decrease As the tax disadvantage of dividends increases, the aggregate amount of dividends paid should decrease

Some “not so good” reasons for paying dividends The Bird-in-the-hand fallacy Risk-averse investors may prefer the certainty of dividend payments over the uncertainty of capital gains Risk-averse investors may prefer the certainty of dividend payments over the uncertainty of capital gains The proper comparison is between dividends today and an almost equivalent amount of price appreciation today The proper comparison is between dividends today and an almost equivalent amount of price appreciation today The evidence shows that share prices drop on the ex- dividend day (firms that pay dividends experience a decline in their share price on that day) The evidence shows that share prices drop on the ex- dividend day (firms that pay dividends experience a decline in their share price on that day)

The excess cash hypothesis A firm has excess cash in a year and decides to return it to its stockholders through a dividend (assuming no investment projects in that year) A firm has excess cash in a year and decides to return it to its stockholders through a dividend (assuming no investment projects in that year) If the lack of investment projects is temporary, then firm should consider future financing needs and the cost of raising capital If the lack of investment projects is temporary, then firm should consider future financing needs and the cost of raising capital Why not return the excess cash through a share repurchase, given the evidence on firms’ reluctance to change dividends? Why not return the excess cash through a share repurchase, given the evidence on firms’ reluctance to change dividends?

Double taxation of dividends The issue: Corporate income was taxed twice, at the corporate level and at the stockholder level The issue: Corporate income was taxed twice, at the corporate level and at the stockholder level Corporate earnings were taxed at 35% and shareholders receiving dividends were also faced with marginal tax rates as high as 38.6% (combined tax rate could be as high as 60%) Corporate earnings were taxed at 35% and shareholders receiving dividends were also faced with marginal tax rates as high as 38.6% (combined tax rate could be as high as 60%) In the US, The Bush administration passed legislation that would limit the tax rates for dividends to a maximum of 15% during the period In the US, The Bush administration passed legislation that would limit the tax rates for dividends to a maximum of 15% during the period The capital gains tax was also reduced from 20% to 15% The capital gains tax was also reduced from 20% to 15%

“Signaling,” hypothesis? Managers hate to cut dividends, so won’t raise dividends unless they think raise is sustainable. So, investors view dividend increases as signals of management’s view of the future. Managers hate to cut dividends, so won’t raise dividends unless they think raise is sustainable. So, investors view dividend increases as signals of management’s view of the future. Therefore, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends. Therefore, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends.

The “clientele effect” Different groups of investors, or clienteles, prefer different dividend policies. Different groups of investors, or clienteles, prefer different dividend policies. Firm’s past dividend policy determines its current clientele of investors. Firm’s past dividend policy determines its current clientele of investors. Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies. Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies.

The “residual dividend model” Find the retained earnings needed for the capital budget. Find the retained earnings needed for the capital budget. Pay out any leftover earnings (the residual) as dividends. Pay out any leftover earnings (the residual) as dividends. This policy minimizes flotation and equity signaling costs, hence minimizes the WACC. This policy minimizes flotation and equity signaling costs, hence minimizes the WACC.

Using the Residual Model to Calculate Dividends Paid Dividends = –. Net income Target equity ratio Total capital budget [] ) )((

Data for SSC Capital budget: $800,000. Given. Capital budget: $800,000. Given. Target capital structure: 40% debt, 60% equity. Want to maintain. Target capital structure: 40% debt, 60% equity. Want to maintain. Forecasted net income: $600,000. Forecasted net income: $600,000. How much of the $600,000 should we pay out as dividends? How much of the $600,000 should we pay out as dividends?

Of the $800,000 capital budget, 0.6($800,000) = $480,000 must be equity to keep at target capital structure. [0.4($800,000) = $320,000 will be debt.] With $600,000 of net income, the residual is $600,000 - $480,000 = $120,000 = dividends paid. Payout ratio = $120,000/$600,000 = 0.20 = 20%.

How would a drop in NI to $400,000 affect the dividend? A rise to $800,000? NI = $400,000: Need $480,000 of equity, so should retain the whole $400,000. Dividends = 0. NI = $400,000: Need $480,000 of equity, so should retain the whole $400,000. Dividends = 0. NI = $800,000: Dividends = $800,000 - $480,000 = $320,000. Payout = $320,000/$800,000 = 40%. NI = $800,000: Dividends = $800,000 - $480,000 = $320,000. Payout = $320,000/$800,000 = 40%.

How would a change in investment opportunities affect dividend under the residual policy ? Fewer good investments would lead to smaller capital budget, hence to a higher dividend payout. Fewer good investments would lead to smaller capital budget, hence to a higher dividend payout. More good investments would lead to a lower dividend payout. More good investments would lead to a lower dividend payout.

Advantages and Disadvantages of the Residual Dividend Policy Advantages: Minimizes new stock issues and flotation costs. Advantages: Minimizes new stock issues and flotation costs. Disadvantages: Results in variable dividends, sends conflicting signals, increases risk, and doesn’t appeal to any specific clientele. Disadvantages: Results in variable dividends, sends conflicting signals, increases risk, and doesn’t appeal to any specific clientele. Conclusion: Consider residual policy when setting target payout, but don’t follow it rigidly. Conclusion: Consider residual policy when setting target payout, but don’t follow it rigidly.

Which theory is most correct? Empirical testing has not been able to determine which theory, if any, is correct. Empirical testing has not been able to determine which theory, if any, is correct. Thus, managers use judgment when setting policy. Thus, managers use judgment when setting policy. Analysis is used, but it must be applied with judgment. Analysis is used, but it must be applied with judgment.

Implications for Managers TheoryImplication IrrelevanceAny payout OK Bird-in-the-handSet high payout Tax preferenceSet low payout But which, if any, is correct???

Setting Dividend Policy Forecast capital needs over a planning horizon, often 5 years. Forecast capital needs over a planning horizon, often 5 years. Set a target capital structure. Set a target capital structure. Estimate annual equity needs. Estimate annual equity needs. Set target payout based on the residual model. Set target payout based on the residual model. Generally, some dividend growth rate emerges. Maintain target growth rate if possible, varying capital structure somewhat if necessary. Generally, some dividend growth rate emerges. Maintain target growth rate if possible, varying capital structure somewhat if necessary.

Appendix: Examples

Example 1: Dividend irrelevance Suppose that Illini Corp. has after-tax operating income of $100m growing at 5% per year and its cost of capital is 10% Suppose that Illini Corp. has after-tax operating income of $100m growing at 5% per year and its cost of capital is 10% Assume that the firm has reinvestment needs of $50m also growing at 5% per year and that it has 105m outstanding shares Assume that the firm has reinvestment needs of $50m also growing at 5% per year and that it has 105m outstanding shares The firm pays out any residual cash flows as dividends each year The firm pays out any residual cash flows as dividends each year The FCFF = EBIT(1 – t) – Reinvestment needs = $100m - $50m = $50m The FCFF = EBIT(1 – t) – Reinvestment needs = $100m - $50m = $50m

The firm’s value (using the Gordon growth model) is The firm’s value (using the Gordon growth model) is FCFF(1 + g)/(WACC – g) = $50(1.05)/(0.10 – 0.05) = $1,050m The price per share is $1,050m/105m = $10 The price per share is $1,050m/105m = $10 The dividend per share is $50m/105m = $0.476 The dividend per share is $50m/105m = $0.476 The value per share is $10 + $0.48 = $10.48 The value per share is $10 + $0.48 = $10.48

Case 1: UIUC Corp. decides to double its dividends, but its investment needs remain the same, meaning that the firm has to raise $50m Case 1: UIUC Corp. decides to double its dividends, but its investment needs remain the same, meaning that the firm has to raise $50m Suppose the firm can issue stock worth $50m at no cost Suppose the firm can issue stock worth $50m at no cost The existing shareholders receive dividends of $100m or dividends per share equal to $100m/105m = $0.953 The existing shareholders receive dividends of $100m or dividends per share equal to $100m/105m = $0.953 Given no change in the firm’s cash flows, the growth rate of cash flows or the cost of capital, the firm’s value has not changed Given no change in the firm’s cash flows, the growth rate of cash flows or the cost of capital, the firm’s value has not changed

However, existing shareholders now own $1,000m and new shareholders $50m of the firm However, existing shareholders now own $1,000m and new shareholders $50m of the firm Thus, the price per share for existing shareholders is $1,000m/105m = $9.523 Thus, the price per share for existing shareholders is $1,000m/105m = $9.523 The value per share for existing shareholders is $ $0.953 = $ The value per share for existing shareholders is $ $0.953 = $ The average shareholder is indifferent to this change in dividend policy (higher dividend per share is offset by lower price per share) The average shareholder is indifferent to this change in dividend policy (higher dividend per share is offset by lower price per share)

Case 2: UIUC Corp. decides to eliminate dividends and retain the $50m Case 2: UIUC Corp. decides to eliminate dividends and retain the $50m Total value of the firm is Total value of the firm is PV of after-tax operating cash flows + Cash balance = $1,050m + $50m = $1,100m The value per share is $1,100m/105m = $10.476, meaning that the increase in share price is offset by the loss of dividends The value per share is $1,100m/105m = $10.476, meaning that the increase in share price is offset by the loss of dividends