2. Dividend policy Concepts and exemplification

3. Objective Understand the role of dividend policy in the context of the firm’s overall financial policy.

4. Outline Types of dividends The dividend time line Stock price reaction Dividend policy irrelevance Theories explaining dividend policy

5. Dividends come in many forms:  Regular cash dividend  Extra dividends  Liquidating dividends  Shares repurchases Stock dividends

6. Dividend time Line Declaration date Cum-dividend date Ex-dividend date Record date Payment date

7. Ex-dividend day: Stock price reaction The stock price will drop by the amount forgone by the average investor Clarification: P cum = D 0 + D 1 /(1+ r) 2 + D 2 /(1+r) 3 + …… P ex = D 1 /(1+ r) 2 + D 2 /(1+r) 3 + ……

8. Stock price reaction (con't) With taxes, the price drop ~ D(1-Td)/(1-Tcg) Td = tax on dividend (average investor) Tcg = tax on capital gain (average investor)

9. Dividend Policy: Does it matter? Is there an optimal dividend policy? If no, focus on the investment decision If yes, what is the optimal policy?

10. View # 1: Dividend policy is irrelevant Shareholders are able to undo firm's dividend policy. M&M: firm value is independent of the dividend decision.

11. View # 1: Dividend policy is relevant Bird-in-hand story A $1 in dividend now is worth more than $2 in dividend later on. Signaling Dividend increase = Good times ahead The free cash-flow hypothesis $1 in dividend is $1 less to spend on M&A

12. View # 1: Dividend policy is relevant (cont’d) Clientele effect Some want dividends while others want capital gains Tax effect

13. REC Company has $1,000 in extra cash. It can invest this cash in a 5- year T-bill at 8%, or it can pay the cash to the shareholders as a dividend. Shareholders can also invest in T-bills. Assume a 44% corporate tax, a 40% individual tax on interest, and 30% individual tax on dividend income. If dividend is paid now, shareholders get 1000(1-0.3)[1+ (0.08)(1-0.4)] 5 =$884.9 If dividend is invested, shareholders get 1000[1+ (0.08)(1-0.44)] 5 (1-0.3) =$871.5 Shareholders would be indifferent between receiving the dividend now as opposed to receiving it later if and only if: (1-TE)[1+r(1-TP)] = [1+r(1-TC)](1-TE)

14. Tax effect (cont’d) Investors would like a dividend according to their tax preferences: Tax-exempt investors, investors in low tax brackets, etc. prefer high current dividend Investors in high tax brackets prefer capital gains

15. Agency costs explanation of dividends Paying dividends can result in a need for external financing. Raising equity and/or debt more often intensifies market’s scrutiny of the company.

16. Reality check Earnings increase one year before dividend initiation. Earnings decrease one year before dividend omission. Following dividend initiation, earnings increases appear to be permanent. Following dividend omission, earnings decreases appear to be temporary. Weak reaction to earnings changes following dividend changes.

17. Overview of financial policy: Why is it important? Capital structure policy, long-term financing policy, dividend policy, etc.…do have some impact on market valuation. Remember, however: Capital budgeting is the bread and butter of wealth maximization. Financial policy is only fine-tuning.