MOD004491 Corporate FinanceDividend Policy

MOD004491 Corporate Finance

Dividend Policy

Anglia Ruskin University

Dr Handy Tan
handy.tan@anglia.ac.uk

13 March 2017

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MOD004491 Corporate FinanceDividend Policy

Highlights

1 Understand method for cash dividend

2 Understand the procedures for dividends
3 Understand dividend policy
4 Understand share repurchase
5 Comprehend capital gain vs. dividend
6 Practice dividend discount model with constant growth
Reading: HRWJJ chapter 18

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MOD004491 Corporate FinanceDividend Policy

Dividend payment in practice

Typically, start-up companies reinvest 100% of their cash flows instead of distributing
dividends.
However, mature, profitable firms often generate excess cash flows that are free even
after taking into account all the positive NPV projects.
When this happens, the firm can use the excess cash flows to either pay dividends or
repurchase shares from current owners.
These choices are often referred to as the payout policy in which the dividend policy
is a part of.

Fig. 1. Excess cash flows 100% equity financed 3 / 27

MOD004491 Corporate FinanceDividend Policy

Standard method for cash dividend

Cash dividend: is a payment of cash by the firm to its shareholders.

The ex-dividend date is the date that determines whether a stockholder is entitled to
a dividend payment; anyone holding stock immediately before this date is entitled to
a dividend. Anyone who purchases the stock on or after the ex-dividend date will not
receive the dividend.
The record date is the date on which company determines existing shareholders.

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MOD004491 Corporate FinanceDividend Policy

Procedure for cash dividend

Fig. 2. Dividend timeline

Declaration date: This is when the board declares a payment of dividends.

Cum-Dividend date: The date for when the buyer still receives the dividend (cum
means with).
Ex-Dividend date: This is the date for when the seller retains the dividend (e.g. about
2 days before record date).
Record date: This is when the company prepares a list of all individuals on record
believed to be stockholders as of 5 November.
Payment date: This is the distribution date (usually about a month after the record
date) where the shareholders receive dividend cheques. 5 / 27
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Price behaviour

In a perfect world, the stock price will fall by the amount of the dividend on the
ex-dividend date.

Fig. 3. Dividend timeline of price behaviour

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Different types of dividends

Many companies pay a regular cash dividend.

(i) Public companies often pay quarterly;
(ii) Sometimes firms will pay an extra cash dividend;
(iii) The extreme case would be a liquidating dividend.
Companies will often declare stock dividends.
(i) No cash leaves the firm;
(ii) The firm increases the number of shares outstanding.
Some companies declare dividend in kind.
(i) Wrigleys Gum sends a box of chewing gum.
(ii) ARU Crematoria offers shareholders discounted cremations.

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MOD004491 Corporate FinanceDividend Policy

Stock dividends

Pay additional shares of stock instead of cash.

Increases the number of outstanding shares.
If you own 100 shares and the company declared a 10% stock dividend, you would
receive additional 10 shares.

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MOD004491 Corporate FinanceDividend Policy

Stock splits

A stock split occurs when a company issues additional shares rather than cash to its
shareholders.
Stock splits are expressed as a ratio.
For example, a 2 for 1 split is the same as a 100% stock dividend, whereas a 3 for 2
split is equivalent to a 50% stock dividend.
Stock price is reduced when the stock splits so that the dividends paid out are the
same before and after the split.
Common explanation for a split is to return price to a more desirable trading range.
Usually, the stock split strategy is used to make the stock more attractive to small
investors.

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MOD004491 Corporate FinanceDividend Policy

Share repurchase
Instead of declaring cash dividends, firms can rid themselves of excess cash through
buying shares of their own stock. This is referred to as share repurchase or buyback.
Share repurchase can occur as an open market purchase, that is, the company an-
nounces its intention to buyback its own shares in the open market.
A tender offer occurs when the company offers to buy shares at a prespecified price
during a short time period (about 20 days) at a premium of 10%-20% above the market
price.
There is the Dutch auction share repurchase where the company lists different prices
at which it is willing to buyback its shares.
The company can also initiate a targeted repurchase where it is willing to buy from
a major shareholder who cannot find a buyer in the market without severely affecting
the companys stock price.
If, however, the major shareholder is threatening to remove management from this
company, it can initiate a greenmail in which the company buys out this shareholder
at a very high premium.
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Share repurchase (cont...)

Consider a firm that wishes to distribute $100,000 to its shareholders.

The balance sheet cum-dividend date is as follows:

Tab. 1. Share repurchase

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Share repurchase (cont...)

If they distribute the $100,000 as a cash dividend, the balance sheet will look like this:

Tab. 2. Cash dividend

NB: In a perfect capital market, when a dividend is paid, the share price drops by the
amount of the dividend when the stock begins to trade ex-dividend.

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MOD004491 Corporate FinanceDividend Policy

Share repurchase (cont...)

If they distribute the $100,000 through a stock repurchase, the balance sheet will look
like this

Tab. 3. Share repurchase

NB: In perfect capital markets, as open market share repurchase has no effect on the
stock price, and the stock price is the same as the cum-dividend price if a dividend
share were paid instead.

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Share repurchase (cont...)

Keeps the stock price higher.

Good for insiders who hold stock options.
As an investment of the firm (undervaluation).
Tax benefits.

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The irrelevance of dividend policy

A compelling case can be made that dividend policy is irrelevant.

Under MM Dividend Irrelevance (Modigliani and Miller, 1961): In perfect capital mar-
kets, holding fixed the investment policy of a firm, the firms choice of dividend policy
is irrelevant and does not affect the initial share price.
If dividends are not paid, the capital gain is higher.
The necessary assumptions are:
(i) No transaction costs;
(ii) No taxes;
(iii) Perfect information and;
(iv) Project independence of dividend policy.

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Homemade dividends

Bianchi Inc. is a $42 stock and the company is about to pay a $2 cash dividend.
An investor Bob owns 80 shares and prefers a $3 dividend.
Bobs homemade dividend strategy: Sell 2 shares ex-dividend.

Tab. 4. Homemade dividends

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MOD004491 Corporate FinanceDividend Policy

Dividend policy is irrelevant

In the above example, Bob investor began with the total wealth of
$42
$3, 360 = 80 shares .
share
After a $3 dividend, his total wealth is still $3,360:
$39
$3, 360 = 80 shares + $240.
share
After a $2 dividend and the sale of 2 ex-dividend shares, his total wealth is still $3,360:
$40
$3, 360 = 78 shares + $160 + $80.
share

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MOD004491 Corporate FinanceDividend Policy

Dividends and investment policy

Firms should never forgo positive NPV projects to increase a dividend (or to pay a
dividend for the first time).
One of the assumptions underlying the dividend-irrelevance argument is: The invest-
ment policy of the firm is set ahead of time and is not altered by changes in dividend
policy.

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Capital gain vs. dividend

When a firm pays dividend, shareholders are taxed according to the dividend tax rate.
If the firm repurchases shares instead, and shareholders sell shares to create a home-
made dividend, the homemade dividend will be taxed according to the capital gains
tax rate.
Naturally, if dividends are taxed at a higher rate than capital gains, shareholders will
prefer share repurchases to dividends.
When the tax rate on dividends exceeds the tax rate on capital gains, shareholders will
pay lower taxes if a firm uses share repurchases for all payouts rather than dividends.
This tax savings will increase the value of a firm that uses share repurchases rather
than dividends.

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MOD004491 Corporate FinanceDividend Policy

The effective dividend tax rate

To compare investor preferences, we must quantify the combined effects of dividend

and capital gains taxes to determine an effective dividend tax rate for an investor.
If an investor buys a stock prior to ex-dividend (thus qualifying him to earn a dividend)
and sells it right after (subject to the tax rate d ), then the after-tax cash flow from
the dividend is D(1 d ), where D is the dividend.
Given that the price prior to ex-dividend, Pcum > Pex , then the investors after-tax loss
is given by (Pcum Pex )(1 g ), where g is the capital gains tax.
One then can set-up an arbitrage opportunity where (Pcum Pex )(1g ) = D(1d ),
i.e. if the after-tax capital loss exceeds the after-tax dividend, the investor benefits by
selling the stock just before it goes ex-dividend and buying afterwards, thereby avoiding
the dividend (and conversely vice versa).

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The effective dividend tax rate (cont...)

We can rewrite slightly the arbitrage in the following way:

(Pcum Pex )(1 g ) = D(1 d )

!
1 d
Pcum Pex =D
1 g
!
1 d +g g
Pcum Pex =D
1 g
!
d g
Pcum Pex =D 1
1 g
!
d g
where is the effective dividend tax rate.
1 g

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MOD004491 Corporate FinanceDividend Policy

UK capital gain and dividends tax

Tab. 5. UK Example

If you pay tax at the higher rate.

You pay a total of 32.5% tax on dividend income that falls above the basic income tax
limit (33,500 for the 2017-18 tax year). But because the first 10% of the tax due
on your dividend income is already covered by the tax credit, in practice you owe only
22.5%.

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MOD004491 Corporate FinanceDividend Policy

USA capital gain and dividends tax

Tab. 6. USA Example

Long term vs. short term. Generally, appreciated capital assets that are sold by an
individual after being held more than one year (long-term capital gain) will be taxed
at a maximum rate of 15%. For the sale of collectibles and small business stock, the
rate of taxation for individuals is a maximum of 28%.
Appreciated capital assets that are sold by individuals after being held less than one
year (short-term capital gain) will be taxed as ordinary income, which rises as high as
39.6% in the US progressive tax system. Capital gains by entities taxed as corporations
do not receive preferential treatment and are taxed at a maximum rate of 35%.
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MOD004491 Corporate FinanceDividend Policy

Principal-agent problem

CEO can be selfish:

(i) invest in too risky projects;
(ii) overspend on business trips;
(iii) expand the firm beyond the optimal size.
Dividend controls CEO expenditures.
Dividend payment and signalling.
(i) dividends are easier to observe than profit;
(ii) growing firm would reinvest the profit;
(iii) reduction of dividend payment is considered as a bad signal.

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Dividend policy as signalling

It is difficult to evaluate the future cash flow.

However, the dividends are observable.
Firm make dividend promises in order to signal about its profitability.

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Valuing stocks Dividend discount models (DDM)

Recall that the price of a stock in a company is given by:

X Dt
P0 = (1)
(1 + k)t
t=1

where Dt is the dividend payment at time t and k is the market rate to discount the
dividend payment stream.
If we assume that we can know (approximately) the growth rate of future dividends
(g ) such that Dt = D0 (1 + g )t , then:

X D0 (1 + g )t1
P0 = (2)
(1 + k)t
t=1
D0 (1 + g )
= (3)
k g
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Summary

Understand method for cash dividend

Understand the procedures for dividends
Understand dividend policy
Understand share repurchase
Comprehend capital gain vs. dividend
Practice dividend discount model with constant growth

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