Dividend Policy,Corporate Finance,2,The Questions,What is dividend policy? How do companies pay dividends? How to evaluate a firms dividend policy? Does it matter at all?,Corporate Finance,3,What is Dividend Policy?,The choice of paying dividends now or in the future, or to pay dividends or repurchase shares, for a given investment policy Dividend policy tends to be stable: Regular cash dividend: the usual dividend Special dividend,Corporate Finance,4,How do companies pay them?,Declaration date: date when the board announces the dividend payment Holder-of-Record date: list of current shareholders is finalized and closed Shares are traded cum dividend till (normally) four days before the record date The first date the stock trades without dividend is the ex dividend date Payment date,Corporate Finance,5,Measures of Dividend Policy,Dividend per share Dividend payout: net profit/shares Dividend yield: dividend per share/dividend price (price per share),Corporate Finance,6,The Relevance of DP,Assumptions: No taxes No financial distress costs Symmetric information on the firms investment opportunities CS (capital structure) and investment opportunities are independent Proposition: Under the assumptions above two firms with different dividend policies have the same market value (MM),Corporate Finance,7,Example,All equity firm, 100 shares Liquidation in two years time The firm generates 10,000 a year in the next two years Discount rate = 10% Current policy: pay out all cash flow:,Corporate Finance,8,Example,Alternative Policy: Initial dividend = 110 (instead of 100) This requires additional financing 110 100 = 10 per share Assume new shares are issued New shareholders require still 10%, so they demand: 1,000 x 1.1 = 1,100 of date 2 cash flow This leaves 10,000 1,100 = 8,900 to the old ones,Corporate Finance,9,Example,For the old shareholders:,Corporate Finance,10,Conclusion,Dividend policy makes no difference because an early increase in dividends is offset by a future decrease in them. Considering the financing cost, the net effect is zero Check: you could also finance the dividend in the second scenario using debt (instead of new equity),Corporate Finance,11,Formally,n(t) = shares outstanding at time t p(t) = price per share at time t Div (t) = total dividend pay at t -ie div per share x n(t) m(t+1) = shares issued between t and t+1,Remember this follows from the definition of return first lecture,Corporate Finance,12,Formally,Plugging this in Vt above:,Notice that m(t+1) + n(t) = n(t+1),Corporate Finance,13,Formally,And applying the reasoning recursively:,Note that Dividends do not appear in this equation hence they are irrelevant,Beware of the assumptions needed to make this result valid box in slide 11,Notice that the formula above is the DCF formula to value companies!,Corporate Finance,14,Taxes,Dividends cannot be used to reduce taxes Dividend income is taxed at the individual level: Taxes on dividends are thus paid at the corporate and at the individual levels (“double taxation”) Corporate investors are to some extent tax-exempt Taxation of dividends and capital gains differs across countries,Corporate Finance,15,Taxes,US: Dividends and capital gains are taxed at the income tax rate Capital gains taxed only when realised The tax system encourages low dividend payout policy,In general, the optimal choice between paying dividends or not depends on the relation between: Tax rate on dividends Tax rate on capital gains,Corporate Finance,16,Signalling (656-660),Dividends are adversely taxed (not everywhere) and a cash payment This makes them costly and therefore a credible signal to convey information We can think of div policy as a trade off between: Conveying positive info about the firms financial health, future cash flows etc, and Having shareholders incur high tax payments,Corporate Finance,17,Signalling (656-660),Information content of dividends: A low dividend payout may signal that the firm will not generate high cash flow in the future The market then revises downwards the stock price after a dividend cut Example: in 1974 Consolidated Edson lost 1/3 of its equity value when it announced that it would omit its regular dividend ($.43 per share: about 2% of the share price, that went from 18 to 12),Corporate Finance,18,Dividends News,The empirical evidence supports the signalling theories:,Source: Smith (1986),Corporate Finance,19,Agency costs,Theory of dividends without tax effect Remember: dividends are irrelevant because no-dividends and external financing are substitutes However: Paying dividends need for external financing more external monitoring reduced cost of agency (e.g. less underpricing when issuing equity) One implication of the theory is that companies with higher volatility of cash flows will pay less dividends (as it will need the capital markets more often anyways) Empirical research indeed finds that growth and dividends are negatively correlated (table page 661),Corporate Finance,