1. Advanced Finance 2006-2007 Dividend policy: a puzzle Professor André Farber Solvay Business School Université Libre de Bruxelles

2. July 13, 2015 Advanced Finance 2007 Dividend policy |2 Some facts Dividend yields are low Gross dividend yield Jan. 2002 FTSE All-World Index (2261)1.7% USA (488) 1.4% Europe (648) 2.4% Japan (332) 0.9% Belgium (22) 3.1% France (49) 2.4% Germany (37) 2.2% UK (140) 2.7% Not all companies pay dividend 1000 largest companies - May 2000 US Non US Number 484 516 Div. Yield>5% 17 6 Div. Yield = 0 183 20 Source: based on Business Week Global 1000 – Business Week, July 10, 2000

3. July 13, 2015 Advanced Finance 2007 Dividend policy |3 Types of dividends Cash dividend - Regular/Special –Ex-Dividend Date - ex coupon Stock dividend Stock repurchase –Buy shares on the market –Tender Offer to Shareholders –Private negotiation (green mail)

4. July 13, 2015 Advanced Finance 2007 Dividend policy |4 Who pays dividends? (1) The percentage of non-financial firms paying a dividend in the US has decreased 1978: 66.5% 1998: 20.7% (2) 3 factors explain the propensity of companies to pay dividends 1. Profitability (+) 2. Investment opportunities (-) 3. Size of company Source: Fama French « Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay » WP 509 University of Chicago, December 1999

5. July 13, 2015 Advanced Finance 2007 Dividend policy |5 Stock Market Response Type of announcement Average 2-Day Sample Announcement Size Period Return Dividend Increases –Dividend initiation 160 3.7% –Dividend increase 280 0.9% Dividend decrease 48 -3.6% Source: Smith C.W., “Raising Capital: Theory and Evidence” in Chew (ed.) The New Corporate Finance McGraw-Hill 1993

6. July 13, 2015 Advanced Finance 2007 Dividend policy |6 The Dividend Decision Lintner (1956): stylized facts –1. Firms have long term target dividend payout ratios –2. Managers focus more on dividend changes than on absolute levels –3. Dividend changes follow shifts in long-run, sustainable levels of earnings rather than short-run changes in earnings –4. Managers are reluctant to make dividend changes that might be reversed.

7. July 13, 2015 Advanced Finance 2007 Dividend policy |7 Modelling the dividend decision Dividend target = Target ratio × EPS 1 Target change = Dividend target - DIV 0 Dividend change = Adjustement rate × Target change DIV 1 * = Payout × EPS 1 DIV 1 - DIV 0 = a ( DIV 1 * - DIV 0 ) Dividend is a weighted average of dividend target and past dividend: DIV1 = a DIV 1 * + (1-a) DIV0

8. July 13, 2015 Advanced Finance 2007 Dividend policy |8 Modigliani Miller (1961): irrelevance of dividend policy Assumptions –Perfect capital markets –Symetric information –No taxes –Investment policy of company fixed Mkt value of company = PV(Free cash flow) Statement of cash flows: FCF = DIVIDEND - STOCK ISSUE (all equity firm, cash constant)

9. July 13, 2015 Advanced Finance 2007 Dividend policy |9 Dividend irrelevance: example Number of share outstanding : 100 Cost of equity: 10% Expected annual earning: 1,000 Investment project –Initial investment: 1,000 Additional annual earning: 150 –NPV = - 1,000 + 150 / 0.10 = +500 > 0 Cash available: 1,000 Should the company use cash available for the project? Should it pay a dividend and issue new share?

10. July 13, 2015 Advanced Finance 2007 Dividend policy |10 Dividend irrelevance: example (2) Market value of company (after announcement of project): V = 1,000 + 1,000 / 0.10 + 500 = 11,500 Price per share: 11,500 / 100 = 115 Self financing policy (no dividend) V = 1,150 / 0.10 = 11,500 Price per share: 11,500 / 100 = 115 SEO - Pay dividend (10 / share) + right issue (10 new shares at 100) Price per share ex-dividend = 115 - 10 = 105 Number of shares after SEO = 110 V = 1,150 / 0.10 = 11,500 Price per share: 11,500 / 110 = 104.55 Value of right = 0.45

11. July 13, 2015 Advanced Finance 2007 Dividend policy |11 Dividend irrelevance: example (3) Comparing financing policies Dividend per share t = 0 t = 1 to ∞ Self-financing 0 11.50 Stock issue 10.00 10.45 Difference - 10.00 + 1.045 NPV(Difference) = -10.00 + 1.045 / 0.10 =0.45 - Right 0.45 0.00

12. July 13, 2015 Advanced Finance 2007 Dividend policy |12 Dividend and Taxes A complex problem because: –level of taxation: company/investor –tax basis: dividend income / capital gain capital gains are taxed at a lower rate than dividend income –dealing with double taxation “classical system” : US, Belgium (witholding tax = 25%) “imputation system”: Germany, France, UK, Australia

13. July 13, 2015 Advanced Finance 2007 Dividend policy |13 Dividend Taxation: examples Classical sytem: shareholders are taxed twice Operating income 100 Corporate Tax (T c =.40) 40 After Tax Income 60 Dividend 60 Income Tax (T P =.40) 24 Net Dividend 36 Imputation sytem based on tax credit (“avoir fiscal” in France) Suppose tax credit = 50% div Operating income 100 Corporate Tax (Tc =.40) 40 After Tax Income 60 Dividend div 60 Taxable income div(1+a) 90 Income Tax (T P =.40) 36 Tax credit 30 Tax to pay 6 Net Dividend 54

14. July 13, 2015 Advanced Finance 2007 Dividend policy |14 Additional complications Corporate tax rate might be different for retained earnings Capital gains might be taxable for shareholders when realized Example: Germany –Corporate Tax: Undistributed 54% Distributed 41% –Personal Tax: Capital gain 0% Dividend: 53% –Imputation rate: 42% If operating income = 1 Net revenue (a) Dividend : (1 - 0.41)(1.42)(1-0.53) = 0.39 (b) Capital gain: (1-0.54) (1 - 0.00) = 0.46 Dividend tax preference: (a)/(b) = 0.86 Source: La Porta, Lopez-De-Silanes and Vishny, “Agency Problems and Dividend Policies around the World” Journal of Finance 55, 1, (Feb. 2000)

15. July 13, 2015 Advanced Finance 2007 Dividend policy |15 Dividend Tax Disadvantage around the World Belgium 0.74 France 0.63 Germany 0.86 Italy 0.77 Netherlands 0.40 United Kingdom 0.83 United States 0.58 Source: La Porta, Lopez-De-Silanes and Vishny, “Agency Problems and Dividend Policies around the World” Journal of Finance 55, 1, (Feb. 2000)

16. July 13, 2015 Advanced Finance 2007 Dividend policy |16 Dividend, taxes and cost of capital If taxation of dividend higher than capital gain, cost of capital of dividend paying firms should be higher Example: consider two companies of same risk Tax rate: Dividend = 50% Capital gain = 20% Next year’s price 112.50 102.50 Dividend 0 10 After tax return 10% 10% Current stock price 100.00 96.67 Pretax return 12.50% 16.40% (See Brealey Myers Table 16.1 for details) P0=[112.50 - 0.20 (112.50 - P0)] P0=[102.50+ 0.50x10 - 0.20 (102.50 - P0)]

17. July 13, 2015 Advanced Finance 2007 Dividend policy |17 Dividend, taxes and cost of capital: empirical evidence Some evidence in favor of a higher cost of capital for high yield firms. Many methodological issues still pending. See BM Table 16.2 for summary of studies on the effect of yield on return. Implied tax rates difficult to measure with precision. Estimated value vary from 0% (Miller Scholes) to 57%

18. July 13, 2015 Advanced Finance 2007 Dividend policy |18 Why pay dividend? Clientele Effect –There are natural clients for high-apyout stocks (insurance companies, pension funds) Signal. –Insiders know more about the firm. –Dividend increase send good news about cash flows and earnings. Dividend cuts send bad news. –High payout ratio costly to firms that do not have the cash flow to support it. Corporate Governance (Easterbrook 1984) –Conflicts of interest between insiders and outsiders.