The Dividend Controversy

1. The Dividend Controversy Should firms pay high dividends?

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

3. No. • The investor resells it before any dividends are paid. • The buyer gets dividends.

4. Trap question two: • A firm never pays dividends to any investor and is never expected to do so. • Is it valueless?

5. 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.

6. Dividend policy alternatives: • Either high dividends now, low later, or • Low now, high later.

7. Dividend policy is irrelevant! • The firm has done all projects with NPV > 0. • It has some cash. • What are the alternatives?

8. L o w - d i v i d e n d f i r m s l o p e = - ( 1 + r ) F u t u r e r e t u r n o r H i g h - d i v i d e n d f i r m d i v i d e n d n o w Separation theorem interpreted for dividends (Figure 18.4) C1 C0

9. 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.

10. 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.

11. 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.

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

13. 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.

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

15. L o D i v H i D i v v a l u e v a l u e p e r $ 1 p e r $ 1 V * = 1 / Rh V * = 1 / RL E q u i l i b r i u m E q u i l i b r i u m H i D i v L o D i v $ o f o p e r a t i n g c a s h f l o w s Dividend equilibrium ...

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

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

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

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

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

21. 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.

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

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

24. 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.

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

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

27. 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