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5. Dividend Policy
[GT: Ch. 15] 1. Is corporate value affected by dividend policy? 2. What is the optimal dividend policy? Dividend policy = Given an investment budget with fixed debt financing and free cash flow to equity (FCFE), what is the optimal dividend to pay. Policy 1: Pay out all FCFE as dividends => No excess liquidity. Policy 2: Pay nothing => excess liquidity. Policy 3: Pay more than FCFE as dividends => stock issue required to finance investment. Dividend policy ≈ determining the best dividend payout ratio/amount. Also dividend policy refers to payout ratio over time, for example low payout ratios now, high later or vice versa. If investments are fixed in advance, then current high dividends mean low future dividends (except if new dividends are financed by stock issues)!
5.1. Historical dividend payout patterns in U.S.
Payout ratio 1971-1992 (U.S.)
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Aggregate share repurchases and dividends 1973-1991 (U.S.)
Selected dividend yields and payout ratios (U.S.)
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Real U.S. dividend yields 1871-2000: Robert Shiller: "Irrational Exuberance"
Real dividend yield
16,00 % 14,00 % 12,00 % 10,00 % 8,00 % 6,00 % 4,00 % 2,00 % 0,00 %
81 17 86 17 81 18 87 18 82 19 88 19 93 10 98 10 94 11 99 11 95 12 90 13 96 13 91 14 96 14 92 15 97 15 93 16 98 16 93 17 99 17 94 18 90 19 95 19 01 20
2000.12
See: http://www.econ.yale.edu/~shiller/data/
Observations: 1. Share repurchases have increased in relation to dividend payouts. 2. Although dividend payout ratios (Div(EPS) seem stable (or slightly increasing), dividends in relation to prices are virtually at ATL end of year 2000 (no marked difference even after price corrections in year 2001...) - This is probably (according to R.Shiller) due to significant overpricing of equity rather than abnormally low dividends (similar picture emerges
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5.2. MM: Dividends irrelevant
MM assume: 1. No taxes or transactions cost with security issues and trading exist. 2. All individuals have the same beliefs concerning future investment, profits, and dividends (i.e. homogenous expectations) 3. The investment policy is set ahead of time and is not altered by dividend policy.
Example. Consider a 100% equity finance company which will be closed down after 1 year. There is however a certain net cash flow of 10 million to be received from operations now and another certain 10 mill. in 1 year. No positive NPV projects exist besides these cash flows (no additional investments).
A company's sources and uses of funds states: After-tax cash flow = Investment - Change in Debt + Interest payment Change in Equity + Dividends With investmwnt and debt policy fixed, we can only replace dividend payouts with changes in equity, i.e. repurchase of shares!!! Important Caveat: Managers frequently consider another problem when discussing "dividend policy"! Dividend policy 1: Pay CF=10 mill. as dividend For the investors the company value equals the present value of received dividends:
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V0 = DIV0 + DIV1/(1+rS) If we assume that rS=10%, then V0 = 19.09 mill. = 10 + 10/(1.10). If there are 1 mill. shares outstanding the stock price will be $19.09. Dividend policy 2: Initial dividend is greater than cash flow CF. 11 $ per share is paid as dividend (11 mill. total) now and 1 mill. $ is raised through an equity issue. New shareholders require a 10% return on their investment, so 1.1. mill. $ will have to paid to them in 1 year leaving 10–1.1=8.9 for the existing shareholders. (At what price is new equity sold? New shareholders lose the present dividend so they are willing to pay 8.9/1.10 ) 8.09 $ for the stocks. In total 1000000/8.09 = 123609 new shares will be issued). Date 0 11 mill. 11 $ Date 1 8.9 mill. 8.9 $
∑Div. for existing share holders Div. per share
PV(dividends): V0 = DIV0 + DIV1/(1+rS)= 11 + 8.9/(1.10)= 19.09 mill. Unchanged! New shareholders are making a NPV=0 transaction. (Modigliani-Miller (MM) dividend proposition)
Alternative proof of MM div.prop. ”Home-Made Dividends” Assume in the above example that shareholders prefer a constant dividend stream of 10 mill. rather than the company proposal of 11 and 8.9? No problem (Home-Made dividends)!: Buy stock for 1mill. => get 1*1.10 = 1.1 mill. in 1 year. Stockholders receive 10 mill. now and 8.9+1.1 =10 mill. in 1 year!
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If management pays 10 mill. + 10 mill. but shareholders prefer 11 och 8.9: Sell stock for + 1mmk, total cash then 10+1 = 11 mill. as desired. Future dividends drop by 1.10 $ per sold share, thus yielding 10 – 1.1 = 8.9 in year 1 - as desired!
Individuals can undo company dividend decisions => they will not pay extra for dividend policy.
The importants assumption is that investments are held constant. Firms should never pay dividends if it involves sacrificing positive NPV investment projects!
5.3. Taxes and Issue Costs
• Because a stock issue is not free, firms can not replace dividend cash flow (internal funds) costlessly => Do not issue stock to pay a dividend. Taxes on dividend income is comparable to issue costs, since the tax is an extra cost for the stock holder (However: Finland 0% tax on dividends, company pays 29%). => MM does not hold. Increases in dividends are not well received on the market (again holding investments fixed), since they involve more taxes and issue costs. => Do not pay dividends at all? A: Firms with inadequate cash to pay a dividend. => lower dividends. But: stockholders may prefer stable dividends => tradeoff. B: Firms with ample cash for dividends
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What do managers do? 1. Select more investment projects (even with NPV<0) Problem: These destroy firm value. 2. Buy another firm. Problem: Cost for buyer tends to be higher than benefit, especially for mergers outside main line of business. 3. Purchase financial assets. Problem: Typically does not increase wealth for stock holders, except for when corporate tax rates are below, personal dividend tax rates. => Alternative use of funds is important! • Existence of TC on trading: More expensive to take out cash by buying and selling stock => high dividend stocks are preferred to low dividend stocks. Especially true when stock holders value high near term income. If costs borne by the firm when paying dividends is lower than costs of trading involved in ”home made dividends”, raise dividend.
Dividend taxes and taxes on capital gains • As long as personal taxation of dividends and capital gains is symmetric => dividend policy is irrelevant. High payout ratio is better if capital gains are taxed more heavily than dividends (Finland) (assuming no issue costs or debt financing).
But: In practice capital gains and dividends are not perfect substitutes even with same tax rate (say 29%) since capital gains can be deferred into future. 5.4. Agency Costs and Dividends
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• Excessive Perk consumption problem: => higher dividends constrains the use of free cash flow. => if high dispersion in ownership, pay higher dividends. • Personal taxes and issue costs favor low dividend payout policy (i.e. stock price is negatively related to dividend payout) • Agency costs (and trading costs) favor high dividend payout policy (negative relation) => Which effect dominates? Unresolved… Empirically: • Stock prices rise when dividends are increased.
5.5. Informational Content of Dividends
[also see GT: Ch. 18 about dividend signalling] If asymmetric information between management and market, then Dividend increase informs the market about higher cash flow prospects, i.e. provides free cash flow news. So cash flow out of which dividends are paid IS important but dividend policy may not be. The clientele effect: What happens in a portfolio context? • When tax rules change dividend policies are likely to be adjusted. Then investors’ portfolios are rebalanced to take advantage of the new tax code. • After this initial effect there should be no dividend policy related effect on stock price => demand is satisfied quickly.
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• Buying only tax favored stocks (for example high dividend yield stocks) makes for a badly diversified portfolio => additional cost!
5.6. Summary - What we know
1. Corporations smooth dividends Lintner model: DIV1– DIV0 = *(p*EPS1–DIV0) or DIV1 = *p*EPS1+(1–)*DIV0 where = speed of adjustment p = target payout ratio,i.e. DIV/EPS Conservative company, is low => strong dividend smoothing p is high (low) for companies having few (many) NPV>0 projects relative to available cash. 2. Dividends provide information to the market 3. Dividend policy suggestions There is no formula for computing the optimal DIV/EPS ratio. but… 1. Avoid cutting back on good investments by insisting on dividends 2. Avoid issuing stock to pay dividend when personal taxes on dividends are high (Finland: Are issue costs lower than personal tax gain on dividends?) 3. Avoid cutting dividends unnecessarily (i.e low dividend policy with smoothing is typically favored)