FINANCE - DIVIDEND POLICY

Dividend Policy (I).

Introduction:

The dividends are decided by the firm’s board of directors and paid to the shareholders who are registered on the “record date”. 

Types of dividends:

1.     Cash Dividends: These Dividends are paid in cash, usually quarterly.

2.     Companies can declare both regular and “extra” dividends.  Regular dividends usually remain unchanged in the future, but “extraordinary” or “special” dividends are unlikely to be repeated.

3.     Stock dividend: Shareholders receive new stock in the corporation as a form of a dividend.  Like a “stock split”, the number of shares increases, but no cash changes hands.

Both cash and stock dividends reduce the value per share.

4.     An alternative way to distribute cash is with share repurchases.  The firm buys back its own shares. This can be done:

v On the Open Market

v Tender offer

v Buying stock from major shareholders.

Regularities observed in dividend policy:

(Results found by Lintner (1965) and Fama (2001))

1.     Firms have long-run target dividend payout ratios.

2.     Mature companies with stable earnings usually have a higher dividend pay-out ratio than growth companies.

3.     Managers focus more on dividend changes than in absolute amounts.

4.     Transitory changes in earnings usually do not affect dividend pay-outs.

5.     Only long-term shifts in earnings can be followed by changes in dividends.

6.     Managers are reluctant to change divided pay-out ratios.

Why do companies pay dividends?

If investors have to pay higher taxes on dividends than in capital gains, then firms that pay dividends should have a higher cost of equity than firms that do not pay dividends. 

Thus, why do firms pay dividends?

One argument to justify the payment of dividends is that dividends are cash in hand, while capital gains are cash in the bush.  Capital gains to be received in the future should be riskier than the dividends received today.  

Think about investor YES who invested in a firm that pays dividends and investor NO who holds shares of a firm that does not pay dividends.  Is investor YES better off than investor NO?  Investor YES receives the cash now, but what is she going to do with this cash?  She might want to spend it, but investor NO could also sell her shares and spend the proceeds.  If investor YES wants to invest the money she will face the appropriate level of risk. 

It is important to remember that the value of the firm is equal to future cash flows discounted at the appropriate discount rate.  There is no reason to think that the future cash flows will change with the dividend policy, and under the M&M assumptions, there is no reason to believe that the payment of dividends will change the discount rate.

1.     M&M (1961)

In perfect capital markets (under similar assumptions to what we studied in the M&M (1958), dividend policy is irrelevant.

          Intuition of this theory:  Let us imagine a firm that pays dividend without changing investment and financing policies.  The money that the company will pay as dividends has to come from somewhere else.  If the company maintains the amount of debt (does not borrow to pay the dividend), the company needs to issue new shares to finance the dividend.  The new shareholders (the investors who buy the shares) will pay only what the shares are worth, and the old shareholders will receive the money (as a dividend) paid by the new shareholders.  After the dividend is paid, the value per-share should be equal to the old price minus the dividend paid by the new shareholders.  The value of the firm remains the same, but money changed hands from new to old shareholders.  Dividend policies are irrelevant.

However, firms do pay dividends. 

Following a parallel argument with the lecture on cost of capital, let us modify the M&M assumptions to transform the “ideal” world that is assumed into a more “realistic” world.

The presence of Taxes

M&M (61) assume that there are no personal taxes.

Taxes on dividends (ordinary income) are higher than taxes on capital gains.  Thus, under the presence of personal taxes, companies should not pay dividends because investors require a higher return to companies that pay dividends.  If payments are to be made to shareholders, the company should opt for other alternatives, such as share repurchases.  This is truth if taxes on dividend income are higher than taxes on capital gains.

However, different investors have different tax rates.  High tax rate individuals will prefer that the firm invest more, whereas low tax individuals may prefer that the firm do not invest and pay dividends.  Investors will self-select in clienteles.  However, The presence of clienteles do not explain why firms decide start to pay dividends.

Asymmetries of Information

M&M (61) irrelevance policy argues that in perfect markets dividend policy is irrelevant.  One of the assumptions of the model is that all individuals have the same information. 

Managers and insiders have access to private information.  Managers of firms that expect a high stream of cash flows (good type of firms) would want to convey this information to the market.  Remember that good and bad firms have the incentive to signal that they are good firms, so we need a binding signal that allow us to separate the good from the bad firms. 

We already indicate that the use of debt conveys this positive signal to the market.   This signal is credible because good firms can issue debt but bad firms cannot because they will have financial problems in the future.  The market understands the signal, (Firms that issue debt are good firms) and will reward those firms that issue debt with an increases in value. 

Dividends can be used in a similar way to convey good (or bad) information.  A firm that increases dividends signals that it expects future cash flows because the dividend policy tends to remain steady over the years.  Bad firms can also increase dividends, but they are bad firms and in the future they will need to cut dividends, and the market will penalize them.

This signaling perspective could explain why firms pay dividends: to convey good private information to the marketplace. 

Agency Costs.

Dividend payments can be an instrument to monitor managers.  When firms pay dividends they often need to subsequently go to the capital markets to fund the projects.  When firms go to the financial markets they will be scrutinized by different market participants.  For instance, investors will require an analysis of the creditworthiness of the firm.

Supporting this view, companies tend to near-simultaneously announce dividend payments and raise new capital

Empirical Evidence on Dividends:

1.     Firms tend to maintain a steady dividend policy.  Firm do not like to reduce dividends, and they will only increase dividend payouts if they are sure that will be able to maintain them in the future.

2.     Companies that announce an increase of dividends or that they are initiating the payment of dividends are viewed positively by the market with an increase in the price of the stock.

3.     To the contrary, firms that announce dividend reductions experience a drop in value around the announcement date.

4.     The evidence on the presence of clienteles is ambiguous.

Share repurchases

Share repurchases are an alternative way to pay cash to current shareholders.  What do you think will happen to the value of the firm when it announces a share repurchase plan?

On average the price of the sock increases when the firm announces a stock repurchase. 

You need to think about the different theories that we saw to justify this increase in value.

1.     Increase in value of the firm because managers are signaling that the shares are undervalued (otherwise they might not want to buy them)

2.     Increase in value if they use debt to repurchase shares because of the tax benefits of debt

3.     Increase in value because investors pay taxes on capital gains, and higher taxes on ordinary income if they receive dividends.

4.     Increase in value of stocks because there is a transfer of wealth from bondholders to stockholders