DIVIDEND POLICY
* Some facts about dividend policy
- Dividends are sticky
- Dividends follow earnings
* Payment Procedures
* Why do firms pay dividends?
- Dividends don't matter: The Miller Modigliani Theorem
- Dividends are taxed heavier than capital gains : Arguments against dividend
payments
* Evidence from ex-dividend day price changes
- Dividends are more certain than capital gains: The bird in the hand fallacy
* The Citizen's Utility case
- Dividend policy is tailored to meet clientele needs
* What are clienteles?
* Evidence on clienteles
- Dividends are a good use for excess cash
* Alternatives to dividends
* Arguments for the alternatives
- Dividends as signals
* Need for signalling
* Evidence on dividends as signals
- Dividends as a wealth transfer mechanism
* Rationale
* Evidence
- Management view of dividends
* Framework for analyzing dividend policy
SOME FACTS ABOUT DIVIDEND POLICY
* Dividends are sticky; Firms are much more reluctant to cut dividends
than increase them
Measures of Dividend Policy
* Dividend Payout : measures the percentage of earnings that the company
pays in dividends
= Dividends / Earnings
* Dividend Yield : measures the return that an investor can make from dividends
alone
= Dividends / Stock Price
Three Schools Of Thought On Dividends
1. If
(a) there are no tax disadvantages associated with dividends
(b) companies can issue stock, at no cost, to raise equity, whenever needed
Dividends do not matter, and dividend policy does not affect value.
2. If dividends have a tax disadvantage,
Dividends are bad, and increasing dividends will reduce value
3. If stockholders like dividends, or dividends operate as a signal of future
prospects,
Dividends are good, and increasing dividends will increase value
The balanced viewpoint
If a company has excess cash, and few good projects (NPV>0), returning
money to stockholders (dividends or stock repurchases) is GOOD.
If a company does not have excess cash, and/or has several good projects
(NPV>0), returning money to stockholders (dividends or stock repurchases)
is BAD.
PAYMENT PROCEDURES
* Significant Dates
Declaration date: The dividend is declared at a board of directors
meeting. On this date the directors issue a statement similar to the following:
" On November 15, 1984, the directors of the XYZ corporation met and
declared a regular quarterly dividend of 50 cents per share, plus an extra
dividend of 25 cents per share, payable to the holders of record on December
15, payment to be made on January 2, 1985."
Holder-of-record date: At the close of the business on the holder-of-record
date, December 15, the company closes its stock transfer books and makes
up a list of the shareholders on that date. These shareholders will receive
the dividends
Ex-dividend date: Suppose you buy 100 shares on December 13, 1984.
Will the company be notified in time? To avoid conflict, the brokerage industry
has set up the convention of declaring that the right to the dividend remains
with the stock until 4 days prior to the holder-of-record date; on the fourth
day before the record date the right to the dividend no longer goes with
the stock. This date is called the ex-dividend date. The ex-dividend date
in this example in December 11, 1984.
Payment date: The company mails the checks to the recorded holders
on January 2, 1985.
WHY DO FIRMS PAY DIVIDENDS?
The Miller-Modigliani Hypothesis: Dividends do not affect value
Basis: If a firm's investment policy (and hence cash flows) don't
change, the value of the firm cannot change with dividend policy. If we
ignore personal taxes, investors have to be indifferent to receiving either
dividends or capital gains.
* Underlying Assumptions:
(a) There are no tax differences between dividends and capital gains.
(b) If companies pay too much in cash, they can issue new stock, with no
flotation costs or signalling consequences, to replance this cash.
(c) If companies pay too little in dividends, they do not use the excess
cash for bad projects or acquisitions.
* The Tax Response: Dividends are taxed more than capital gains
Basis: Dividends are taxed more heavily than capital gains. A stockholder
will therefore prefer to receive capital gains over dividends.
Evidence: Examining ex-dividend dates should provide us with some
evidence on whether dividends are perfect substitutes for capital gains.
Let Pb= Price before the stock goes ex-dividend
Pa=Price after the stock goes ex-dividend
D = Dividends declared on stock
to, tcg = Taxes paid on ordinary income and capital gains respectively
Assume you are all investors in a stock that you bought a long time ago
for $P and you have the choice between-
(a) selling before the ex-dividend day, and forsaking the dividend.
(b) selling after the ex-dividend day, and receiving the dividend.
The cash flows from selling before then are-
Pb - (Pb - P)
tcg
The cash flows from selling after the ex-dividend day are-
Pa - (Pa - P)
tcg + D(1-to)
Since the average investor should be indifferent between selling before
the ex-dividend day and selling after the ex-dividend day -
Pb - (Pb - P)
tcg = Pa - (Pa
- P) tcg + D(1-to)
Moving the variables around, we arrive at the following:
Holding other things equal, the price drop on the ex-dividend day will
be equal to the dollar dividend if and only if the marginal investor in
the stock faces the same tax rate on dividends and capital gains; it will
be less than the dividend if the tax rate on dividends exceeds the tax rate
on capital gains; it will be greater than the dividend if the tax rate on
dividends is less than the tax rate on capital gains.
If Pb - Pa = D then to
= tcg
Pb - Pa < D then to
> tcg
Pb - Pa > D then to
< tcg
1. Assume that the company that you are analysing has only wealthy individual
investors, and that they face a marginal tax rate of 41% on ordinary income,
and 28% on capital gains. If the company pays a dividend of $1.00, how much
would you expect the price to drop on the ex-dividend day?
What will happen if the capital gains tax rate is lowered to 19.6%, as is
being proposed in Congress right now?
The Evidence on Ex-Dividend Day Behavior
The difference between the tax rates on ordinary income and capital gains
has changed has changed substantially over time in the United States.
2. Assume that you are a tax exempt investor, and that you know that
the price drop on the ex-dividend day is only 90% of the dividend. How would
you exploit this differential?
( ) Invest in the stock for the long term
( ) Sell short the day before the ex-dividend day, buy on the ex-dividend
day
( ) Buy just before the ex-dividend day, and sell after.
( ) ______________________________________________
Example of dividend capture strategy with tax factors: XYZ company
is selling for $50 at close of trading May 3. On May 4, XYZ goes ex-dividend;
the dividend amount is $1. The price drop (from past examination of the
data) is only 90% of the dividend amount. The transactions needed by a tax-exempt
U.S. pension fund for the arbitrage are as follows:
1. Buy 1 million shares of XYZ stock cum-dividend at $50/share.
2. Wait till stock goes ex-dividend; Sell stock for $49.10/share (50 - 1*
0.90)
3. Collect dividend on stock.
Net profit = - 50 million + 49.10 million + 1 million = $0.10 million
Clearly these profits have to exceed transactions costs for this to be worth
it. (Transactions costs have to be less than 10 cents per share)
Example of dividend capture strategy even without tax factors
On May 4, 1988 American Electric Power began trading ex-dividend; the dividend
amount was $0.565. On May 3, 1988 the following transactions were reported.
10:09:30 am 5,500,000 shares traded at $27.25.
10:09:34 am 2,640,000 shares traded at $26.75
10:09:37 am 2,860,000 shares traded at $26.625
The first transaction represented a buy of 5.5 million shares at $27.25
by a Japanese insurance company (which were then obligated to pay yields
of 7-8% to their policy holders from dividend income) from a U.S. pension
fund. The second and third transactions represent a sell-back by the same
company to the same pension fund of 5.5 million shares at a weighted average
price of $26.685 (These were special trades where the pension fund agreed
to allow the Japanese firm to collect the dividends of $0.565 on the stock).
Japanese company: was able to collect dividend income of $0.565*5.5 million
shares= $3.1 mil
U.S. pension fund: was able to receive the $3.1 million almost 5 weeks early.
* The wrong reasons for paying dividends
A. The bird in the hand fallacy
Argument: Dividends now are more certain than capital gains later.
Hence dividends are more valuable than capital gains.
Counter: The appropriate comparison should be between dividends today
and price appreciation today. (The stock price drops on the ex-dividend
day.)
B. The excess cash hypothesis
Argument: The firm has excess cash on its hands this year, no investment
projects this year and wants to give the money back to stockholders.
Counter: So why does not it just repurchase stock? If this is a one-time
phenomenon, the firm has to consider future financing needs. Consider the
cost of issuing new stock:
| Size of Issue |
Cost of Issue |
| |
Bonds |
Preferred Stock |
Common Stock |
| Under $ 1 million |
14.0% |
- |
22.0% |
| $ 1 - $ 1.9 million |
11.0% |
- |
16.9% |
| $ 2- $ 4.9 million |
4.0% |
- |
12.4% |
| $ 5 -$9.9 million |
2.4% |
2.6% |
8.1% |
| $10 - $ 19.9 million |
1.2% |
1.8% |
6.0% |
| $ 20 - $ 49.9 million |
1.0% |
1.7% |
4.6% |
| > $ 50 million |
0.9% |
1.6% |
3.5% |
* Are firms perverse? Some evidence that they are not
Some investors clearly prefer to receive dividends. Companies with such
investors have to pay dividends to keep them happy.
Citizens Utility is a company which has two classes of stock. Class A gets
a stock dividend and can be converted freely into Class B stock. Class B
gets a cash dividend and cannot be converted to Class A stock. The stock
dividend is generally 7% to 13% greater than the cash dividend.
The study found that PB > PA by more than 10%. In other words, the cash
dividend shares sold at a premium of 10% over the capital gains shares.
An Updated Study of Canadian companies arrives at similar conclusions.
An updated study of Canadian stocks arrives at similar conclusions; cash
dividend shares sell at a premium over stock dividend shares.
| Company |
Premium on Cash Dividend Shares over
Stock Dividend Shares |
| Consolidated Bathurst |
19.30% |
| Donfasco |
13.30% |
| Dome Petroleum |
0.30% |
| Imperial Oil |
12.10% |
| Newfoundland Light & Power |
1.80% |
| Royal Trustco |
17.30% |
| Stelco |
2.70% |
| TransAlta |
1.10% |
Average |
7.54% |
3. Clearly some investors like dividends. What types of investors do
you think are most likely to fall into this category? (You can pick more
than one)
( ) Wealthy investors
( ) Institutional Investors
( ) Less well-off investors
( ) Tax-exempt investors
* A clientele based explanation
Basis: Investors may form clienteles based upon their tax brackets.
Investors in high tax brackets may invest in stocks which do not pay dividends
and those in low tax brackets may invest in dividend paying stocks.
Evidence: A study of 914 investors' portfolios was carried out to
see if their portfolio positions were affected by their tax brackets. The
study found that
(a) Older investors were more likely to hold high dividend stocks and
(b) Poorer investors tended to hold high dividend stocks
The following regression captures the determinants of dividend yield
Dividend Yieldt = a + b bt + c Aget + d Incomet
+ e Differential Tax Ratet + et
Variable |
Coefficient |
Implies |
| Constant |
4.22% |
|
| Beta Coefficient |
-2.145 |
Higher beta stocks pay lower dividends. |
| Age/100 |
3.131 |
Firms with older investors pay higher
dividends. |
| Income/1000 |
-3.726 |
Firms with wealthier investors pay lower
dividends. |
| Differential Tax Rate |
-2.849 |
If ordinary income is taxed at a higher rate
than capital gains, the firm pays less
dividends. |
4. Assume that you run a phone company, and that you have historically
paid large dividends. You are now planning to enter the telecommunications
and media markets. Which of the following paths are you most likely to follow?
( ) Courageously announce to your stockholders that you plan to cut dividends
and invest in the new markets.
( ) Continue to pay the dividends that you used to, and defer investment
in the new markets.
( ) Continue to pay the dividends that you used to, make the investments
in the new markets, and issue new stock to cover the shortfall
( ) Other
Can you find a way out of your dilemma?
* The Signalling Hypothesis
Context: In a world of asymmetric information, firms have to convince
investors about their future prospects. An increase in dividends is one
way to signal good future prospects.
On average, at least, increases in dividends seem to be viewed as positive
signals and decreases as negative signals.
* Why is the positive reaction to a dividend increase more muted than
the negative reaction to a dividend decrease?
An Alternative Story..Dividends as Negative Signals
The problem with signalling stories is that an equally compelling case can
be made for increasing dividends being a negative signal, especially for
young, high growth firms. There is evidence that earnings growth declines
after firms initiate dividends.
Extending the effects of dividend changes on stock prices - long term
While dividend increases (decreases) tend to have a positive (negative)
effect in the short term, there seems to be an interesting evening out of
returns in the month after the announcement.
* The Wealth Transfer Hypothesis
Basis: Dividends are one way stockholders can transfer wealth from
bondholders to themselves. Since bondholders anticipate this, they write
constraints into bond covenants and stockholders who do not pay dividends
will actually be transferring wealth to bondholders.
CAR: Cumulative Abnormal Return (Actual Return - Expected Return: CAPM)
* Management Beliefs about Dividend Policy
| Statement of Management Beliefs |
Agree |
No Opinion |
Disagree |
| 1. A firm's dividend payout ratio affects the price of the stock |
61% |
33% |
6% |
| 2. Dividend payments provide a signaling device of future prospects |
52% |
41% |
7% |
3. The market uses dividend announcements as information for
assessing firm value. |
43% |
51% |
6% |
| 4. Investors have different perceptions of the relative riskiness of dividends
and retained earnings. |
56% |
42% |
2% |
| 5. Investors are basically indifferent with regard to returns from dividends
and capital gains. |
6% |
30% |
64% |
| 6. A stockholder is attracted to firms that have dividend policies appropriate
to the stockholders' tax environment. |
44% |
49% |
7% |
| 7. Management should be responsive to shareholders' preferences regarding
dividends. |
41% |
49% |
10% |
DETERMINANTS OF DIVIDEND POLICY
A. Investment Opportunities
Basis: Other thing remaining equal, a firm with more investment opportunities
will pay a lower fraction of its earnings as dividends than a stable firm.
Proxy for investment opportunities: Growth rate in firm's assets;
Capital Investment;
Testable proposition: A firm with higher growth rates in assets or
earnings, and greater capital investment needs will pay out a lower fraction
of its earnings as dividends
B. Stability in earnings
Basis: Other things remaining equal, a firm with more stable earnings
will pay out a higher fraction of its earnings as dividends than a firm
with variable earnings
Proxy for variability in earnings: Variance in EPS
Testable proposition: A firm with higher variance in EPS will have
a lower dividend payout ratio
C. Alternative sources of capital
Basis: Other things remaining equal, a firm which can issue new stock
or bonds at low cost (such as underwriting commissions) will be more likely
to have a high dividend payout ratio.
Proxy for cost of issue: Size of the firm
Testable proposition: A smaller firm will almost invariably have
a higher issuance cost than a larger firm in issuing new stock and debt.
It will therefore be less likely to have a high payout ratio.
D. Constraints
Basis: Firms which have borrowed large amounts of debt usually have
several constraints on their dividend policy and will therefore follow more
conservative dividend policies
Proxy for leverage: Debt ratio
Testable proposition: A firm with a high debt ratio will very seldom
be able to make make major changes in its dividend policy because of constraints
on payout.
E. Signalling Incentives
Basis: Firms which are undervalued may use dividend increases as
signals to the market
Proxy for undervaluation: Price/ Value ratios
Testable proposition: As the ratio of price to value decreases dividend
increases will become more frequent.
F. Stockholder characteristics
Basis: Firms which have acquired a reputation as high dividend yield
firms also acquire stockholders who desire high dividends. Consequently
they cannot suddenly shift policy. Testable proposition: The past
history of a company's dividend policy is usually be a good indication of
what it will do in the future.
BOEING: SUMMARY OF DIVIDEND ANALYSIS
|
Average |
Standard Deviation |
Maximum |
Minimum |
| Free CF to Equity |
$350.47 |
$366.99 |
$879.19 |
($176.57) |
| Dividends+Repurchases |
$237.60 |
$87.38 |
$374.00 |
$134.00 |
|
|
|
|
|
| Dividend Payout Ratio |
29.05% |
|
|
|
| Cash Paid as % of FCFE |
67.79% |
|
|
|
|
|
|
|
|
| ROE |
12.38% |
|
|
|
| Required Return |
16.32% |
|
|
|
| ROE - Required return |
-4.92% |
11.83% |
18.84% |
-20.65% |
MERCK: SUMMARY OF DIVIDEND POLICY
|
Average |
Standard Deviation |
Maximum |
Minimum |
| Free CF to Equity |
$807.36 |
$474.51 |
$1,457.64 |
$57.78 |
| Dividends+Repurchases |
$512.40 |
$317.05 |
$1,086.00 |
$213.00 |
|
|
|
|
|
| Dividend Payout Ratio |
42.15% |
|
|
|
| Cash Paid as % of FCFE |
63.47% |
|
|
|
|
|
|
|
|
| ROE |
35.14% |
|
|
|
| Required Return |
17.30% |
|
|
|
| ROE - Required return |
17.84% |
18.42% |
49.07% |
-10.44% |
BP: SUMMARY OF DIVIDEND POLICY ANALYSIS
|
Average |
Standard Deviation |
Maximum |
Minimum |
| Free CF to Equity |
$571.10 |
$1,382.29 |
$3,764.00 |
($612.50) |
| Dividends+Repurchases |
$1,496.30 |
$448.77 |
$2,112.00 |
$831.00 |
|
|
|
|
|
| Dividend Payout Ratio |
81.95% |
|
|
|
| Cash Paid as % of FCFE |
236.83% |
|
|
|
|
|
|
|
|
| ROE |
13.22% |
|
|
|
| Required Return |
14.89% |
|
|
|
| ROE - Required return |
-1.67% |
11.49% |
20.90% |
-21.59% |
T HE LIMITED: SUMMARY OF DIVIDEND ANALYSIS
|
Average |
Standard Deviation |
Maximum |
Minimum |
| Free CF to Equity |
($34.20) |
$109.74 |
$96.89 |
($242.17) |
| Dividends |
$40.87 |
$32.79 |
$101.36 |
$5.97 |
| Dividends+Repurchases |
$40.87 |
$32.79 |
$101.36 |
$5.97 |
|
|
|
|
|
| Dividend Payout Ratio |
18.59% |
|
|
|
| Cash Paid as % of FCFE |
-119.52% |
|
|
|
|
|
|
|
|
| ROE |
21.81% |
|
|
|
| Required Return |
20.12% |
|
|
|
| ROE - Required return |
1.69% |
19.07% |
29.26% |
-19.84% |