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chapter 18 dividend policy why does it matter

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					Chapter 18 Dividend Policy: Why Does It Matter? Chapter Outline
18.1 18.2 18.3 Different Types of Dividends Standard Method of Cash Dividend Payment The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy

18.4 Repurchase of Stock 18.5 18.6 18.7 18.8 18.9 Personal Taxes, Issuance Costs, and Dividends Real World Factors Favoring a High Dividend Policy The Clientele Effect: A Resolution of Real-World Factors? What We Know and Do Not Know About Dividend Policy Summary and Conclusions

Appendix A: Stock Dividends and Stock Splits

Different Types of Dividends
Students always get a laugh from the dividend in kind. Barter humor.

Standard Method of Cash Dividend Payment
Getting out the calendar clears up the cum and ex date questions.

The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy
The assumptions of the Modigliani-Miller Dividend Model are similar to those we saw in their capital structure model. An additional assumption is that investment policy of the firm is set ahead of time, and not affected by changes in dividend policy. We use the following example to demonstrate that in the MM world, dividend policy is irrelevant, i.e., changes in dividend policy do not affect the value of the firm. Dividend Irrelevance in the MM World To focus on issues concerning dividend policy, our illustration assumes an all-equity firm. Basic accounting principles tell us that sources of cash must equal uses of cash. Sources of cash include cash flows from operations and new external equity. Uses of cash include net increase in assets (e.g. capital spending and increase in NWC) and dividends. If cash flows from operation and planned increase in assets do not change, any increase in cash dividends must be financed by new external equity. Pumpkin Pie Inc. currently has $1,000 shares outstanding with a total market value of $42,000. It expects cash flows from operations to be $10,000 next year. It wants to expand its product lines to include cookies and determines that it is a positive NPV project. The new product line requires a new oven that costs $8,000. 1. Dividend Policy #1 The dividend policy of Pumpkin Pie Inc. is to pay out any cash that is leftover after investing in all positive NPV projects. This policy is often referred to as the residual dividend policy. For next year, Pumpkin Pie Inc. will pay out $2,000 ($10,000 – $8,000) as cash dividend.

Pumpkin Pie stock is selling at $42 per share ($42,000 / 1,000 shares) before the cash dividend is paid. If there are no personal taxes and the firm pays a $2000 dividend ($2 per share), the total market value of the firm will fall from $42,000 to $40,000. Ex-dividend share price will be $40,000/1,000 shares = $40 per share. 2. Dividend Policy #2 Pumpkin Pie is considering a $3,000 cash dividend ($3 per share). Ex-dividend, total assets of the firm will be $39,000 ($42,000 – $3,000) and each share will sell for $39. After paying $3,000 in cash dividend, the firm only has $7,000 for capital expenditure. To maintain the investment policy, the firm must issue $1,000 new equity to purchase the oven. Since these new shares are sold after the dividends are paid, they should sell at $39 per share. To raise the $1,000 for the new oven, the firm must issue 25.64 new shares ($1,000 / $39). The value of the firm will be $40,000 after the new equity issue ($39,000 + $1,000). Both old and new shares are worth $39 per share ($40,000/1,025.64 shares). Since the value of the firm is not affected by dividends, dividend policy is irrelevant to financial managers. Should stockholders care about a firm’s dividend policy? 3. Homemade Dividends Assume that Pumpkin Pie Inc. decides to follow the residual dividend policy (#1) and pays a cash dividend of $2 per share. Investor A owns 80 shares of stock and prefers to have $3 dividend per share. Will he be better off if Pumpkin Pie switch to dividend policy #2? Net worth of investor A before dividend payment = $42 × 80 shares = $3,360 Pumpkin Pie pays a $2 dividend per share and the stock falls to $40 per share. Investor A receives $160 in dividends and his shares are now worth $3,200. His total net worth is still $3,360. If Pumpkin Pie pays a $3 dividend per share, investor A would receive $240 in cash ($3 dividend per share × 80 shares). To obtain $240 in cash when Pumpkin Pie only pays $2 dividend, investor A can sell 2 shares of stock ex-dividend ($160 in dividend + $40 × 2 shares). He now owns 78 shares valued at $3,120. His total net worth is again $3,360 ($240 + $3,120). If Pumpkin Pie pays a $3 dividend per share, stock price would fall to $39 per share. Investor A receives $240 in dividends and his shares are now worth $3,120 ($39 × 80 shares). His total net worth is, of course, $3,360. Investor A can have $240 in cash and $3,120 in stocks regardless of the firm’s dividend policy.

Dividend Policy Decision in the Real World
We demonstrated that in the MM World dividend policy is irrelevant. This section focuses on factors in the real world that violate the MM assumptions. We discuss reasons for favoring a high dividend policy and reasons for favoring a low dividend policy. • Reasons for Low Dividend • Personal Taxes • High Issuing Costs Reasons for High Dividend • Information Asymmetry Dividends as a signal about firm’s future performance • Lower Agency Costs
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capital market as a monitoring device reduce free cash flow, and hence wasteful spending • Bird-in-the-hand: Theory or Fallacy? • Uncertainty resolution • Desire for Current Income • Clientele Effect Reasons for Low Dividend If a firm wishes to increase its cash dividend without changing its investment policy, any shortfall must be financed externally. Two implications arise: 1. Taxes Dividends are taxed as ordinary income as they are received whereas capital gains are taxed only when they are realized. The firm can avoid (or delay) this drain to the IRS by omitting dividend and reinvesting the funds in positive or zero NPV investments. 2. Transactions Costs Individuals who do not want dividends will reinvest them in the firm and incur an unnecessary brokerage fee. This problem can be reduced through a dividend reinvestment plan (DRIP). If the firm needs to sell new shares to finance dividend payment it must pay new issue costs. In Chapter 19 we will see that costs of issuing new equity to the public are very high. These market imperfections suggest a low dividend payout policy should be preferred. Reasons for High Dividend 1. Information Asymmetry and The Information Content of Dividends Empirical studies find that increases in stock price are associated with announcements of dividend increases. How can we reconcile this with the dividend irrelevance argument? When managers know more than outsiders about the future prospects of the firm they can signal this knowledge to investors through changes in dividend policy. Changes in dividends consequently have information content and dividend policy is important in a semi-strong form efficient market. Increase in dividends is a credible signal about future performance because the higher dividends cannot be sustained at the firm’s current performance. If managers lie today by raising dividends, they will have to cut dividends in the future, a move that very few managers are willing to make. 2. Lower Agency Cost We discussed the potential conflicts between stockholders and managers when ownership and control of a corporation is separated. When a firm pays out dividends, it will need to raise external funds more often. The primary market acts as a control against managers deviating from stockholders’ best interests. The costs of issuing new equity shares are offset by lower agency costs. Even if a firm does not need to raise external funds, paying out dividends reduces the amount of free cash flows available to managers and will also reduce agency costs. 3. Bird-in-the-hand: Theory or Fallacy? Are near-term dividends less uncertain than dividends in the far future? The riskiness (uncertainty) of dividends depends on the firm’s systematic business and financial risk. The bird-in-the-hand argument implies that the risk of the firm increases over time. There is no reason to believe that risk increases overtime for all companies.
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4. Desire for Current Income a. Many trusts and endowments can only spend the dividend portion of returns. b. Some individuals will desire high dividend stocks for current income reasons (the proverbial widows and orphans). The transaction costs to sell small amounts of stocks at regular intervals for current income can be very expensive. The Clientele Effect Some investors prefer high dividend payout stocks because of taxes and the desire for current income. Others prefer low dividend payout stocks. If the aggregate demand is equal to the aggregate supply for each type of dividend policy stock, then no firm can increase its price by changing its dividend policy. Dividend policy can only increase shareholder wealth if there exists an unsatisfied clientele. In fact, when the market is in equilibrium, the clientele effect implies that changes to a firm’s dividend policy will reduce shareholder wealth.

Share Repurchase
In general, shareholders are better off if the firm buys back its own shares instead of paying dividends. This allows investors to avoid dividend taxes and choose when to realize capital gains. Unfortunately, the IRS may challenge regular stock repurchases. Managers may also use share repurchase to signal that the current market is too low. Security transactions are zero-NPV investments in efficient capital markets. If markets are semi-strong form efficient and managers have more information that outside investors, then insiders may be able to identify when their company is undervalued. Companies can repurchase shares through a tender offer, the open market, or targeting specific shareholders. In a tender offer repurchase, setting the offer price can be difficult. If the offer price is set too low, then stockholders who tender their shares will lose. If the offer price is set too high, then stockholders who do not tender will lose.

Supplemental Problems
Problem 18.1 Suppose firms A and B are all-equity firms with a 10% cost of equity capital. Initially, both firms have $1000 in assets and can earn a 10% return on assets with certainty. Firm A pays out all of its earnings in dividends while Firm B has a 60% dividend payout. Assume that there are no taxes and that the first dividend is paid at the end of the first year. Find the market value of equity for both firms. Solution 18.1 The earnings reinvestment and dividend payout over time for firms A and B are: Firm A 1 2 $1000 $1000 $100 $100 $100 $100 Year $1000.0 $1040.0 Assets $100.00 $104.00 Firm B NI $60.00 $62.40 Div Assets NI Div

3 $1000 . . . . and so on forever.

$100 . .

$100 . .

$1081.6 . .

$108.16 . .

$64.896 . .

The growth rate for Firm A is 0% and the growth rate for Firm B is 4% (g = ROE × Plowback Ratio). The market value of Firm A is $100/.10 = $1000. The market value of Firm B is $60/(.1 – .04) = $1000. The
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fact that both companies have the same value is consistent with the Modigliani-Miller dividend irrelevance proposition. Problem 18.2 Firms C and D have time zero EBIT of $1000. The required return on equity for both of these unlevered firms is 10%. The marginal corporate tax rate is 34%. Firm C has a dividend payout ratio of 20% and a dividend growth rate of 8%. Firm D has a dividend payout ratio of 80% and a dividend growth rate of 4%. a. What is each firm's expected dividend at the end of the next year? b. Which firm has the higher market value? c. Given a fixed dividend payout ratio, EBIT must grow at the same rate as dividends. Calculate the after-tax rate of return on each firm's reinvestment of earnings (EBIT(l –Tc)/RE). Solution 18.2 a. DIV = NI (DIV/NI) (1 + g) = (EBT(1 –Tc))(DIVIDEND PAYOUT)(1 + g) DIVC = $1000 (1 – .34) (0.2) (1.08) = $142.56 DIVD = $1000 (1 – .34) (0.8) (1.04) = $549.12 b. MVC = $142.56 / (0.1 – 0.08) = $7128 MVD = $549.12 / (0.1 – 0.04) = $9152 c. Time 0 NIC = $1000 (1 – .34) = $660 Time 0 DIVC = $660 (0.2) = $132 Time 0 REC = NIC – DIVC = $660 – $132 = $528 Time 1 dollar growth in EBIT = EBITC = $1000 (0.08) = $80 After-tax return REC = EBITC (l – T)/REC = $80(1 –.34)/$528 = 10% Similarly, EBITD (1 –T) / RED = $40 (1 – .34) / $132 = 20% Although firm D has a lower dividend growth rate, it has a higher market value because it has a higher return on reinvested earning

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