1 / 18

Advanced Finance 2006-2007 Dividend policy: a puzzle

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

wilsonn
Download Presentation

Advanced Finance 2006-2007 Dividend policy: a puzzle

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Advanced Finance2006-2007Dividend policy: a puzzle Professor André Farber Solvay Business School Université Libre de Bruxelles

  2. 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 Some facts 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) 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 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 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. Advanced Finance 2007 Dividend policy

  7. Modelling the dividend decision • Dividend target = Target ratio × EPS1 • Target change = Dividend target - DIV0 • • Dividend change = Adjustement rate × Target change DIV1* = Payout × EPS1 DIV1 - DIV0 = a ( DIV1* - DIV0) • Dividend is a weighted average of dividend target and past dividend: DIV1 = a DIV1* + (1-a) DIV0 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) 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? 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 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 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 Advanced Finance 2007 Dividend policy

  13. Classical sytem: shareholders are taxed twice Operating income 100 Corporate Tax (Tc = .40) 40 After Tax Income 60 Dividend 60 Income Tax (TP = .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 (TP = .40) 36 Tax credit 30 Tax to pay 6 Net Dividend 54 Dividend Taxation: examples 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) 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) 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=[102.50+ 0.50x10 - 0.20 (102.50 - P0)] P0=[112.50 - 0.20 (112.50 - P0)] 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% 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. Advanced Finance 2007 Dividend policy

More Related