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Dividend policy

Dividend policy. Concepts and exemplification. Objective. Understand the role of dividend policy in the context of the firm’s overall financial policy. . Outline. Types of dividends The dividend time line Stock price reaction Dividend policy irrelevance Theories explaining dividend policy.

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Dividend policy

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  1. Dividend policy Concepts and exemplification

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

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

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

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

  6. Ex-dividend day: Stock price reaction • The stock price will drop by the amount forgone by the average investor • Clarification: • Pcum = D0 + D1/(1+ r)2 + D2/(1+r)3 + …… • Pex = D1/(1+ r)2 + D2/(1+r)3 + ……

  7. 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)

  8. 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?

  9. 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.

  10. 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

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

  12. Tax effect • 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)

  13. 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

  14. 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.

  15. 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.

  16. 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.

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