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					     The Dividend Decision

             P.V. Viswanath

Based on Damodaran’s Corporate Finance
           Theories of Dividend Payout

   Dividend Irrelevance
   Dividend Clienteles
   Signaling
   Catering to Psychological Investor Preferences
   Disciplinary Effects on Managers

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               Dividend Irrelevance

 Investors can create their own dividends.
  Consequently, firm value will not be affected by
  dividend payments.

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      Example of Dividend Irrelevance

 Stellar, Inc. has decided to invest $10 m. in a
  new project with a NPV of $20 m., but it has
  not made an announcement.
 The company has $10 m. in cash to finance the
  new project.
 Stellar has 10 m. shares of stock outstanding,
  selling for $24 each, and no debt.
 Hence, its aggregate value is $240 m. prior to
  the announcement ($24 per share).

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      Example of Dividend Irrelevance

Two alternatives:

One, pay no dividend and finance the project with
   The value of each share rises to $26 following
   the announcement. Each shareholder can sell
   0.0385 (= 1/26) shares to obtain a $1
   dividend, leaving him with .9615 shares value
   at $25 (26 x 0.9615). Hence the shareholder
   has one share worth $26, or one share worth
   $25 plus $1 in cash.

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        Example of Dividend Irrelevance

Two, pay a dividend of $1 per share, sell $10m. worth of
   new shares to finance the project.
 After the company announces the new project and
   pays the $1 dividend, each share will be worth $25.
 To raise the $10 m. needed for the project, the
   company must sell 400,000 (=10,000,000/25) shares.
   Immediately following the share issue, Stellar will
   have 10,400,000 shares trading for $25 each, giving
   the company an aggregate value of 25 x 10,400,000
   = $260 m.
 If a shareholder does not want the $1 dividend, he
   can buy 0.04 shares (1/25).
 Hence, the shareholder has one share worth $25 and
   $1 in dividends, or 1.04 shares worth $26 in total.
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    Assumptions for Dividend Irrelevance

1. The issue of new stock (to replace excess
   dividends) is costless and can, therefore, cover
   the shortfall caused by paying excess dividends.
2. Firms that face a cash shortfall do not respond by
   cutting back on projects and thereby affect future
   operating cash flows.
3. Stockholders are indifferent between receiving
   dividends and price appreciation.
4. Any cash remaining in the firm is invested in
   projects that have zero net present value. (such
   as financial investments) rather than used to take
   on poor projects (i.e. there are no agency costs of
   outside equity).
                     P.V. Viswanath                7
    Implications of Dividend Irrelevance

 A firm cannot resurrect its image with
  stockholders by offering higher dividends
  when its true prospects are bad.
 The price of a company's stock will not
  be affected by its dividend policy, all
  other things being the same. (Of course,
  the price will fall on the ex-dividend

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         Dividend Clienteles: Tax Effects

 For individual investors, dividends are more heavily
  taxed than capital gains because of the tax-timing
  option--the ability for individual investors to postpone
  the tax liability on capital gains income. Hence
  individuals may prefer capital gains.
 Corporate shareholders pay income tax at a 34% peak
  marginal rate, but are permitted to claim a 70%
  dividends-received deduction. Hence the top marginal
  tax rate on dividend income for a corporation is only
  (1-.7) x 34 = 10.2%. They have a greater preference
  for dividends.
 Tax-exempt institutions, such as pension funds, do not
  have a bias in favor of capital gains or dividends.

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        Stockholder Marginal Tax Rate
 Suppose to represents the tax rate on ordinary
  dividends and tcg represents the tax rate on
  capital gains. Let PB denote the cum-dividend
  stock price, and PA the ex-dividend stock price,
  and P the price at which the stock was
 For the marginal investor,

  PB-(PB-P)tcg = PA-(PA-P)tcg + D(1-to)

  where the LHS is the after-tax gain from selling
  the stock cum-dividend and the RHS is the
  after-tax gain from selling the stock ex-
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       Stockholder Marginal Tax Rate
 From this, we get the relationship:

 By examining the empirical price drop,
  one may then infer the marginal tax
  bracket for holders of the firm's stock.
 However, this opens up the possibility of
  dividend capture.

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                Dividend Mechanics

 Declaration date: The board of directors declares a
  Record date: The declared dividends are
  distributable to shareholders of record on this date.
  Payment date: The dividend checks are mailed to
  shareholders of record.
 Ex-dividend date: A share of stock becomes ex-
  dividend on the date the seller is entitled to keep
  the dividend. At this point, the stock is said to be
  trading ex-dividend.

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                Dividend Capture

 On Aug 2, 2005, XYZ declares a dividend payable
  on October 3, 2005. XYZ announces that
  shareholders of record on or before Sept 30, 2005
  are entitled to the dividend. The stock goes ex-
  dividend Sept 28, 2005, two days before the
  record date.
 Anyone who bought the stock before September
  28, 2005 or after would get the dividend.
 The stock price will fall after the dividend
  payment, but usually less than the div amount. If
  the trader is tax-neutral, selling right after the
  stock goes ex-dividend, i.e. on Sept 28, can net
  the trader a profit.

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   Dividend Clienteles: Transactions Costs

 A shareholder who desires a high income
  stream would prefer real cash dividend
  payments over homemade dividends if the firm
  can sell new shares more cheaply than the
  shareholder can sell his/her own shares. Hence
  such shareholders might prefer firms with a
  high payout ratio, while other shareholders may
  prefer firms with a low payout policy.
 Consequently, some investors prefer equity
  income in the form of dividends, while others
  prefer capital gains.

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                  Dividend Signalling

 If investors cannot observe information to distinguish a good
  firm from a bad firm, both firms will be valued the same.
 Firms that pay higher dividends than they would otherwise
  have, drain cash and thus increase the probability of
  bankruptcy. This will decrease the value of the firm.
 This decrease in firm value will be lower for good firms,
  because they are less likely to go bankrupt.
 Hence if a good firm increases its dividends, bad firms will
  be less likely to mimic the good firm.
 This will allow investors to separate good firms from bad
  firms and they will price their stock higher.
 This benefits stockholders who have to sell in the interim.

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    Psychological Investor Preferences
 Dividends and Capital Gains may not be perfect
  substitutes due to psychological reasons.
 A lack of self-control may lead an investor to
  prefer regular cash dividends. If the investor
  has to sell stock to get income, he might have a
  tendency to sell too much stock too soon.
 Hence an investor might choose to invest in a
  firm that follows a particular type of dividend
  policy to minimize the total agency costs of
  shareholding, including the investor's human

                    P.V. Viswanath              16
       Disciplinary Effects on Managers

 Contracts between the firm and its managers
  cannot always be designed to take into account
  all possible contingencies.
 Hence, managers may sometimes take actions
  that reduce firm value. For example, it may be
  in the interest of managers to increase firm size
  or to unduly reduce the riskiness of the firm in
  order to reduce the probability of bankruptcy,
  and increase the present value of their firm
  specific skills.
 This may lead them to accept negative NPV
  projects or to engage in undesirable mergers.

                     P.V. Viswanath              17
      Disciplinary Effects on Managers

 This may lead some managers to reduce
  dividends to a suboptimal level.
 In contrast, managers, who want to assure the
  market of their desire to maximize firm value
  by reducing the amount of disposable resources
  (free cash flow beyond current investment
  needs) available to them, may choose to
  increase dividends.
 By doing so, they force themselves to submit to
  the discipline of the markets any time that they
  wish to raise funds to invest in a project. Such
  credible proof of a manager's unwillingness to
  take NPV < 0 projects will be rewarded by the
  market with an increase in the stock price.
                    P.V. Viswanath               18
          Dividends and Firm Life-Cycle

                  Stage 1
                  Limited by size and other infrastructure
Funding Needs
Cash flows
                  Negative as investments are made
                  No dividends
Dividend Policy
                  New Stock Issues

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         Dividends and Firm Life-Cycle

                                       Stage 2
                                   Rapid expansion

Funding Needs        High relative to firm value
                     Cash flow low relative to firm
Cash flows generated
Dividend Policy      No or very low dividends

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        Dividends and Firm Life-Cycle

                                          Stage 3
                                       Mature growth

Funding Needs     Moderate relative to firm value
Cash flows        Cash flow increases as percentage of firm
generated         value
Dividend Policy   Increase dividends

                      P.V. Viswanath                     21
         Dividends and Firm Life-Cycle

                      Stage 4
Funding Needs        Low as projects dry up
                     Cash flow high relative to firm
Cash flows generated
                     Special dividends
Dividend Policy
                     Repurchase stock

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      Relevant factors in dividend policy

 Investment Opportunities: A firm with more
  investment opportunities should pay a lower
  fraction of its earnings.
 Stability of earnings: A firm with more volatile
  earnings should pay, on average, a lower
  proportion of its earnings, so that it will not have
  to cut dividends.
 Alternative sources of capital: To the extent that a
  firm can raise alternative capital at low cost, it
  can afford to pay higher dividends. Hence, large
  firms tend to pay higher dividends.

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     Relevant Factors in Dividend Policy

 Degree of financial leverage: If a firm has high
  leverage, it will probably also have covenants
  restricting the payment of dividends.
  Furthermore, to a certain extent, dividends and
  debt can be considered substitutes for the
  purpose of manager discipline.
 Signalling incentives: To the extent that a firm
  can signal using other less costly means, for
  example debt, it should pay lower dividends.
 Stockholder Characteristics: If a firm's
  stockholders want higher dividends, it should
  provide them.

                    P.V. Viswanath               24
    Computing optimal payout: first step

 Questions: How much cash is available to
  be paid out as dividends?
 Answer: The funds available to be paid out
  as dividends are essentially equal to free
  cash flow to equity (FCFE)

  Keep in mind these quantities should be
  computed prospectively.

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           Three definitions of FCFE

 FCFE = Net Income - (Capital Expenditures -
  Depreciation) - (Change in Noncash Working
  Capital) + (New Debt Issued - Debt Repayments) -
  Preferred Dividends
 FCFE = Net Income - (Capital Expenditures
  - Depreciation)*(1- Debt Ratio) - Change in
  Non-cash Working Capital (1-Debt Ratio).
 Cash Flows from Operating Activities - (Capital
  expenditures) - (preferred dividends) - (New Debt
  Issued - Debt Repayments).

                     P.V. Viswanath              26
    Computing optimal payout: second step

 How good are the projects available to the
 If Dividends greatly exceed FCFE, dividends
  should be cut.
 If the rate of return on equity is greater than
  the cost of equity, the released funds should be
  invested in new projects and if funds are
  inadequate, funding should be sought from
 If projects are unprofitable, investment should
  be reduced.

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   Computing optimal payout: second step

 If FCFE greatly exceed Dividends, the CFO must
  check to see how funds are being invested.
 If the actual rate of return (accounting rate of
  return) on equity is greater than the required
  rate of return, then the excess funds should be
  invested in new projects. If necessary, the
  dividend payout ratio should also be decreased
  to release funds for new projects.
 If the actual rate of return is low relative to the
  required rate of return, then dividends should
  be increased.

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          Solution to Problem 8, Chapter 22
Year    Net     Cap. Depr. Noncash Change in     Dividends FCFE
        Income Exp.        WC      Noncash WC
 1991       240   314  307      35            25        70 220.8
 1992       282   466  295    -110         -145         80 266.4
 1993       320   566  284     215          325         95 -44.2
 1994       375   490  278     175           -40      110 271.8
 1995       441   494  293     250            75      124 275.4
Conrail could have paid, on average, yearly dividends equal to its FCFE.
Conrail is earning an average accounting return on equity of 13.5%.
The required rate of return = 0.07 + 1.25(0.125-0.07) = 13.875.
Hence Conrail’s projects have done badly on average.
It’s average dividends have been much lower than the average FCFE.
Conrail should pay more in dividends.
                              P.V. Viswanath                         29
          Solution to Problem 9, Chap. 22

      Year     Net      (Cap Ex -            Ch WC FCFE
               Income Depr) (1-DR)           (1-DR)
        1996    $485.10      $151.96           $8.75 $324.39
        1997    $533.61      $164.11           $9.19 $360.31
        1998    $586.97      $177.24           $9.65 $400.08
        1999    $645.67      $191.42          $10.13 $444.12
        2000    $710.23      $206.73          $10.64 $492.86

This is the amount that the company can afford to pay in dividends.
The perceived uncertainty in these cash flows implies that the firm
should be more conservative in paying out the entire amount of
FCFE each year.

                            P.V. Viswanath                            30