Dividend Policy and Share-value

ABC's current position

Cash = $2,500 D = Debt = $0

Net Fixed Assets = $8,500 S = Equity = $11,000

Total = $11,000 Total = $11,000

N = Number of Shares outstanding = 1,000

P = Price Per Share = $11,000 / 1,000 = $11.00
V = S + D = $11,000 + $0 = $11,000

It has an investment proposal with: I = $2,500 PV = $4,000 NPV = $1,500

When ABC announces that it has come up with a +ve NPV investment, its share-price goes up to $12.50

Cash = $2,500 D = Debt = $0

Net Fixed Assets = $8,500 S = Equity = $12,500
NPV of New Project = $1,500

Total = $12,500 Total = $12,500

How can it use its $2,500 cash?

1) Invest the $2,500 cash in the new project

2) Pay out the $2,500 in cash dividends
3) Retain the $2,500 in firm and pay stock dividends
4) Use the $2,500 to repurchase shares

Option 1

$2,500 cash would be used up.

Cash = $0 D = Debt = $0
Net Fixed Assets = $11,000 S = Equity = $12,500
NPV of New Project = $1,500

Total = $12,500 Total = $12,500

P remains at $12.50.
Wealth of stockholders remains unchanged at $12.50. W0= D0 + P0= $0 + $12.50 = $12.50
Option 2

Each existing stockholder would receive $2,500 / 1,000 = $2.50 as there are 1,000 shares. So, D0 = $2.50.

The Balance Sheet looks as follows thereafter.

Cash = $0 D = Debt = $0
Net Fixed Assets = $8,500 S = Equity = $10,000
NPV of New Project = $1,500

Total = $10,000 Total = $10,000

P0 = $10,000 / 1,000 = $10.00 =>

W0 = D0 + P0 = $2.50 + $10.00 = $12.50 => Shareholders' wealth is unchanged.

ABC would need to raise $2,500 for investing in the project. It would issue Niss new shares at Piss, so that

Niss x Piss = $2,500.

New shareholders know that, after the issue, there will be N + Niss shares outstanding and the Balance Sheet
would look as follows.

Cash = $2,500 (new capital raised) D = Debt = $0

Net Fixed Assets = $8,500 S = Equity = $12,500
NPV of New Project = $1,500

Total = $12,500 Total = $12,500

So, for each share,

VAI (Value After Issue) = $12,500 / [N + Niss] = $12,500 / [1000 + Niss]

Moreover, fair-pricing would ensure that the issue-price is equal to the value of each share after the issue:

Piss = VAI

If Piss is greater, the new shareholders would have been fooled, while, if it is less, the new shareholders would
have gained at the expense of the existing shareholders ("wealth transfer" from existing shareholders to new
shareholders).

It is easy to check that, in this scenario, the issue-price should be the prevailing market-price.

Piss = $12,500 / [1000 + Niss] => Piss x [1000 + Niss] = 12,500

=> 1000 Piss + (Niss x Piss) = 12,500
=> 1000 Piss + 2,500 = 12,500 => Piss = 10
And, therefore, Niss = 2,500 / 10 = 250.

So, there would be 1,250 shares outstanding after the issue, with each share valued at $10. The wealth of the
existing shareholders would, therefore, not be affected.
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Option 3

If the $2,500 is retained in the firm, the wealth of the stockholders remains unchanged at $12.50.

Cash = $2,500 D = Debt = $0

Net Fixed Assets = $8,500 S = Equity = $12,500
NPV of New Project = $1,500

Total = $12,500 Total = $12,500

Now, if the firm pays a stock dividend by issuing Niss shares to the existing shareholders, their wealth still remains
unchanged. To see this let us assume = 250, that is, the firm issues 25% stock-dividend, 1 free new share for
each 4 shares held. Then, there would be 1250 shares outstanding after the dividend-payment, but, since no
new capital has been generated, we get that

P = 12,500 / 1,250 = $10

But, since each old shareholder has now 1.25 shares, her shares are worth 1.25 x $10 = $12.50, thus keeping
her wealth unchanged.

Option 4

What if $2,500 is used to repurchase shares? It is easy to see that, if ABC repurchases Nrep shares, then the
Repurchase-Price (RP) must be so set that

RP x Nrep = $2,500 => RP = 2,500 / Nrep

When the repurchase offer is announced, some shareholders would tender their shares against the offer, while
others would not tender (and stick to their shares). To ensure that those tendering are not better off or worse
off than those not tendering, we need that the RP equal the Price After Repurchase (PAR)

RP = PAR

But, we know that the Balance Sheet after the repurchase would as follows

Cash = $0 D = Debt = $0
Net Fixed Assets = $8,500 S = Equity = $10,000
NPV of New Project = $1,500

Total = $10,000 Total = $10,000

So, PAR = 10,000 / [N - Nrep] = 10,000 / [1,000 - Nrep]

Therefore, RP = PAR condition implies that

2,500 / Nrep= 10,000 / [1,000 - Nrep] => Nrep = 200 and, therefore, RP = PAR = 2,500 / 200 = 12.50

Thus 1,000 - 200 = 800 shares would be outstanding after the repurchase, each with a share-price of $12.50.
So, independent of whether she tenders or not, the wealth of an old shareholder would remain unchanged at
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$12.50. To raise $2,500 required for investment, 200 shares may be issued at the market-price of $12.50, thus
pushing up the number of shares to 1,000, each valued at $12.50. Back to square one.

Debt Financed Repurchase

What happens when ABC goes for a debt-financed repurchase. That is, suppose ABC invests the $2,500 in the
project and then go for a debt-financed repurchase of shares. As we saw under Option-1, after investing the
$2,500 in the project, the shareholder's wealth remains at $12.50. At this point, suppose that ABC plans to go
for share-repurchase, financed by debt-issuance.

Let us take the corporate tax-rate as 40%. As we know, since interest-payments are tax-deductible, for each
$1 debt, ABC's share-value would go up by the PVITS (PV of Interest Tax Shield) of $0.40 (= $1 x 40%). Thus,
for each $10,000 loan, ABC's share-price would rise by $4000 / 1,000 = $4.00, as soon as the announcement
regarding the proposed debt-issue is made, and the shares can be bought back only at this post-announcement
price. For example, if the firm announces plan to go for a share-repurchase financed by new debt of $2,500,
the share price would zoom to $13.50, as $2,500 debt would engender PVITS of $1,000 or $1 per share. In
that case, the new debt of $2,500 would be able to buy-back 185 shares, leaving 815 shares outstanding
afterwards, with a per-share-price of $13.50 and a total market-value of $11,000.

Window-Dressing Dividend Change Does NOT Affect Stock Price: An Example

t=0 t=1 t=2

Re = 12%
N = 260

D1 = 2.00 D2 = 2.16
g = 8%
P = 2.00 / (12% - 8%) = 50.00 => (Ex) P1 = 50.00 (1 + 8%) = 54.00
Cum P1 = W1 = 2.00 + 54.00 = 56.00

DIV1 = 520 DIV2=520 (1+8%)

E0 = N x P0 = 13,000 (Ex) E1 = 13,000 (1+8%) = 14,040

Which also equals 260 x (Ex) P1

Cum E1 = 260 x Cum P1 = 14,560

Changed to
D1 = 4.00

P = 4.00 / (12% - 4%) = 50.00 Revised DIV1 = 4.00 x 260 = 1,040

 Need 260 x (4.00-2.00) more
 Need Rs.520 more
 Niss x Piss = 520

But, Piss = E1 / (260 + Niss)

(Ex) E1 = Cum E1 + 520 – DIV1 = 14,040

Which also equals 260 x (Ex) P1
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 So, Piss = 14,040 / (260 + Niss)

 Piss = 52 & Niss = 10

 Naft = 270 => D2 = 2.08

 P1 = 2.08 / (12% - 8%) = 52.00

 W1 = 4.00 + 52.00 = 56.00