Dividend Policy: Alex Tajirian

DIVIDEND POLICY
Chapter 17
Alex Tajirian
Dividend Policy 17-2
1. OUTLINE
# What to do with excess cash?

# Types of dividends
# Theories of optimal dividend policy: dividend puzzle
# Some practical considerations
© morevalue.com, 1997
Alex Tajirian
Graphics: WHAT TO DO WITH EXCESS CASH
Alex Tajirian
2. OBJECTIVE & DEFINITION

Definition: Dividend is the distribution of value to shareholders.
Dividend Policy: What happens to the value of the firm as dividend

is increased, holding everything else (capital
budgets, borrowing) constant. Thus, it is a trade-off
between retained earnings on one hand, and
distributing cash or securities on the other.
Alex Tajirian
3. TYPES
3.1 CASH DIVIDEND1
Example: $.5 for every share you hold
Regular, regular + "extra" , special
Dates:
|_____________|______________|___________|____
1/15 1/26 1/30 2/15
Declaration Ex-dividend Record Payment
Date Date Date Date
Only investors who hold the security prior to the ex-dividend

date receive the dividend.
Alex Tajirian
3.2 STOCK DIVIDEND

Example: 1 new stock for each 10 you hold
3.3 STOCK REPURCHASE2

3.1 Method
in the open market
tender offer
direct negotiation with major shareholders
3.2 Reasons
! Alternative to "extra" or special dividend.
Example. A company just sold a division and cannot use the
proceeds for favorable investments.
! If management believes the stock is under-valued.
! As an obstacle to takeovers.
Q If management re-purchases stocks, then the price increases,
thus prevents raiders from acquiring company at an attractive
price.
Q Greenmail
! EPS increases, thus value of firm increases !?
3.3 Advantages(
! Shareholders have a choice: sell shares or keep.
! Firm has no obligation to make future repurchases.
Alex Tajirian
2.3.4 Disadvantages;
! May signal to investors that the firm's investment opportunities
are limited.
! The firm may pay too high a price for the repurchase.
Example: Greenmail
2.4 STOCK SPLIT

Example. (2-1 split), i.e., for every share you own, now you own
two.
! Argument for splits: To make stock "more attractive" to investors?!
! Value of firm is not expected to change.
Alex Tajirian
4. DIVIDEND CONTROVERSY
THEORIES
Irrelevant, rightists (high dividend), leftists (low payoff), Middle of
the Road
k = capital gains + dividend yield
4.1 IRRELEVANT
M & M in the case of perfect markets.
Reasoning: There is nothing the firm can do that investors

cannot duplicate. Firm and investors have identical
opportunities.
Alex Tajirian
4.2 RIGHTISTS
! Bird in the hand fallacy. "Paying out some cash today reduces
risk of future payoff uncertainty"
Alternatives CF1 CF2 CF CFT
1 0 0 ... 100 ...
2 20 20 ... 60 ...
What about return?
! Grand Ma's argument: "I need the regular cash dividend to live
on!"
4.3 LEFTISTS
Tax argument:
Tax on dividends = tax on income $ tax on capital gains.
But tax on dividends must be paid now, while on capital gains
would be in the future.
Alex Tajirian
Illustration. Invest $100, ks = 10% , T = 40%

Case 1. Stock held for 20 years.
FV20 = $100(1+.1)20 = 672.75
after tax FV20 = final value - tax paid
= 672.75 - (T)(capital gains)
= 672.75 - (.4)(672.75 - 100)
= 443.65
Case 2. Assume that all earnings are paid as dividends.

Investor takes money and buys back stock
FV20 = $100 (1 + After tax rate of return )20

= 100 [1 + ks (1 - T)]20
= 100 [ 1 + .1(1 - .4)]20 = 320.7
ˆ Case 1 is better. Thus, Optimal dividend policy is zero/very

low.
Alex Tajirian
hg; dividend and tax
Alex Tajirian
4.4 MIDDLE OF THE ROAD

Signaling. Regular dividend can be used by managers to
provide information/signal about future prospects.
In practice, it is too expensive to signal with dividends.
5. PRACTICAL ISSUES
! Legal Requirements:
Companies cannot keep "excess" cash as retained earnings if
no investment opportunities exist. They have to distribute them
as dividends.
! Institutional Restrictions:
Many trust portfolios are required to protect the investment
principle and can only spend investment income. Thus, they
tend to invest in companies with high dividends.
! Market Reaction to Dividend `:

Price usually `. Investors interpret it as a negative signal, in that
the firm's future opportunities are not good.
Alex Tajirian
6. DIVIDEND POLICY IN PRACTICE

! Constant $ pay-off
! Constant payoff: fixed % of earnings
! Residual Theory: Pay out $ that cannot be re-invested in the
firm at the required rate of return ks.
Alex Tajirian
7. ENDNOTES
1. On recent trends, see LAT 1/27/93 p. E158. On Dividend
Reinvestment Plans (DRIPs) see LAT 2/16/93 p. E56.
2. See LAT 6/12/92 p. E164.
Alex Tajirian
8. QUESTIONS
True\False-Explain
1. If a company has excess cash, then it should acquire another.
2. Given U.S. tax laws, the optimal dividend policy should be zero dividends.
3. Stock repurchase is a form of dividend.
4. Stock splits should have no effect on the value of a company.
5. If XYZ Inc. announces an increase in its dividends and the price of the stock increases on
the same day, then you can conclude that investors prefer dividend income over capital gains.
6. The 1993 tax changes (tax on dividend $ tax on capital gains) make high dividend paying
stocks more attractive to the average investor.
7. SPDRs can have no disadvantages over an S&P500 mutual fund.
8. If splitting a stock increases its liquidity, then the firm necessarily benefits.
9. A 3-to-1 stock split means that for every 3 shares you currently own you end up with one.
Moreover, the new price, after the split, would be 3 times the original price.
Alex Tajirian
9.0 ANSWERS TO QUESTIONS
True\False-Explain
1. False. If the company does not have any positive NPV projects to invest in, then it
should pay shareholders dividend (either extra dividends or repurchase stock). Note,
acquiring another company in the same line of business is also considered a project.
2. True. See notes for explanation
3. True. Since dividends are defined as a distribution of wealth. Stocks have to be re-
purchased at a price higher than then market price. Thus, additional value has to be
distributed to shareholders.
4. True.
Value of Firm ' Price× (# of Shares)

Price
Value After Split: × (# of shares × 2)
2
Y Value unchanged
5. False. A possible explanation for the price increase might be than investors interpret the
increase as a strength in the company's future earnings prospects. Thus, they buy the
stock, this increases the demand for the stock, and thus its price goes up. An alternative
explanation, which has nothing to do with dividends, might be that the general stock
Alex Tajirian
market went up, and so did XYZ Inc!
6. False. Actually the opposite is true. The new lax laws make high paying dividend stocks
even less attractive to the average investor.
7. False. One disadvantage of SPDRs is that dividends, from the underlying stocks, are
distributed to shareholders. An index fund, on the other hand, can devise a dividend re-
investment plan to reduce the dividend tax effect.
8. False. Liquidity in the secondary market benefits the investors not the company.
Remember the secondary market is for the exchange of ownership. It is the primary
market that is more of a concern to the firm.
9. False. With a 3-to-1 split you end up with 3 shares for each that you held. Moreover, the
new price ought to be a third of the original price.
Alex Tajirian

Dividend Policy: Alex Tajirian

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DIVIDEND POLICY

# What to do with excess cash?

Graphics: WHAT TO DO WITH EXCESS CASH

2. OBJECTIVE & DEFINITION

Dividend Policy: What happens to the value of the firm as dividend

Example: $.5 for every share you hold

Regular, regular + "extra" , special

Only investors who hold the security prior to the ex-dividend

3.2 STOCK DIVIDEND

3.3 STOCK REPURCHASE2

! If management believes the stock is under-valued.

! EPS increases, thus value of firm increases !?

2.4 STOCK SPLIT

! Argument for splits: To make stock "more attractive" to investors?!

! Value of firm is not expected to change.

k = capital gains + dividend yield

Reasoning: There is nothing the firm can do that investors

What about return?

Illustration. Invest $100, ks = 10% , T = 40%

Case 2. Assume that all earnings are paid as dividends.

FV20 = $100 (1 + After tax rate of return )20

ˆ Case 1 is better. Thus, Optimal dividend policy is zero/very

hg; dividend and tax

4.4 MIDDLE OF THE ROAD

In practice, it is too expensive to signal with dividends.

! Market Reaction to Dividend `:

6. DIVIDEND POLICY IN PRACTICE

2. See LAT 6/12/92 p. E164.

3. Stock repurchase is a form of dividend.

4. Stock splits should have no effect on the value of a company.

7. SPDRs can have no disadvantages over an S&P500 mutual fund.

9.0 ANSWERS TO QUESTIONS

2. True. See notes for explanation

Value of Firm ' Price× (# of Shares)

market went up, and so did XYZ Inc!

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