The Dividend Controversy

1. The Dividend Controversy Should firms pay high dividends?

2. Review item • An asset A is being added to the market portfolio M. • What variable indicates whether A will raise or lower the risk of the portfolio? • Explain briefly.

3. Answer: beta of A is the variable • Beta of A is covariance of A with M divided by variance of M. • Beta of A > 1 implies A varies more with M than M itself does (possible diagram). • Beta of A > 1 implies A raises the risk of M. • Beta of A < 1 implies A lowers risk of M.

4. Normal dividends (pages 461-462) • declaration date • ex-dividend date • record date • payment date

5. Why is the ex-dividend date early? • To avoid disputes, exchanges control the right to the dividend. • Early date reduces costs of administering the rule. • Now 2 days lead time. Formerly 5 days.

6. Dependence of value on dividends • Notation: • Pt, Pt+1, Pt+2, ... are • prices of shares at time t, t+1, t+2 • Dt, Dt+1, Dt+2, ... are dividends

7. Derivation • Pt = Dt+1/(1+r) + Pt+1/(1+r) • Pt+1= Dt+2/(1+r) + Pt+2/(1+r) • Pt = Dt+1/(1+r) + Dt+2/(1+r)2 + Pt+2/(1+r)2

8. By induction • Pt = Dt+1/(1+r) + Dt+2/(1+r)2 + Dt+3/(1+r)3 + … • Expected dividends determine value, • even when the share changes hands.

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

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

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

12. No. Think of Webservice.com • The typical start-up firm is bought by another. • Its investors get cash or shares in the acquiring firm.

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

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

15. Alternatives: • Distribute cash as a dividend now. • Invest the cash in financial markets and • pay out as a dividend later.

16. 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

17. Separation theorem • NPV is relevant. • Investors time preferences are not.

18. 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.

19. Upshot • Investors do not reward firms for doing what investors can do for themselves.

20. Taxes and dividends • The alternatives are • (1) dividends or • (2) capital gains.

21. Tax-class clienteles • Investors with similar tax exposure. • Some prefer dividends. • Some prefer capital gains.

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

23. Some investors prefer capital gains • because they can't shelter dividends from taxes, • but they can shelter capital gains. • High income investors, for instance.

24. 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.

25. 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.

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

27. 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 ...

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

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

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

31. 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

32. Result of capital gains tax cut • Value of old equity rises (instantly) • Firms increase value by switching to lower dividends • until equilibrium is restored.

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

34. Evidence • Actual dividends are highly smoothed • Earnings fluctuate much more. • Smooth means constant or increasing at a constant rate.

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

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

37. 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 • in proportion to the shares repurchased.

38. Example: Firm is worth $10M. $1M is spare cash. • There are 1M shares, at $10 per share. • Buy back .1M shares at $10 apiece. • Cost is $1M.

39. After the buyback, • Remaining value of the firm is $9M • because there are no financial illusions. • There are .9M shares remaining • still at $10 apiece.

40. Stock buybacks • are associated with rising share value in the financial press. • Can this be correct?

41. Outsider's model before the buyback • Pr{underpriced} = .5 • Pr{overpriced} = .5

42. If insiders think the stock is overpriced • a buyback would reduce the value of the firm. • Therefore, no buyback occurs.

43. Since the buyback occurs • Outsiders know that insiders think • the stock is underpriced (or fairly priced).

44. Therefore, the buyback • signals the knowledge of insiders • that the stock is underpriced • and outsiders raise their estimates of its value. • Thus, share price rises on the buyback.

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

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

47. 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.

48. Review item • A share paid a dividend of $5 last year. • The dividend is expected to grow at 3% forever. • The discount rate is 13%. • What is the value of the share?

49. Answer: • Next year’s dividend is $5.15 ( = 1.03 x 5) • Value is $5.15/(.13-.03) = $51.50. • Not $50.