Topic 4 Dividend Policy

Topic 4.
Dividend Policy
1
References
 Chapter 16; Brealey, R.A., Myers, S.A. and Allen, F.
(2017) Principles of Corporate Finance. McGraw-Hill
International Edition.
 Chapter 18; Hillier, D. Ross, S.A., Westerfield, R.W. and
Jaffe, J. (2010) Corporate Finance. McGraw-Hill
European Edition.
2
Topic Overview
Introduction
4.1. Dividends and share repurchase
4.2. Lintner’s dividend model
4.3. The information in dividends and share repurchase
4.4. The controversy about dividend policy
4.4.1 Dividend policy in perfect capital markets
4.4.2 Stock repurchase and valuation
4.4.3 Dividends and the Modigliani-Miller model
4.4.4 Dividends and taxes
3
Introduction
Introduction
 Financial manager's goal:
 Maximizing firm’s market value.
 Payout policy
 Dividend policy
 relates earnings and dividends
 It is a financing decision. Dividend payments have to be
financed.
 Cash Flow
 Finance new projects
 Dividends / Stock buybacks
4
Introduction
Important questions related to payout policy:
How much cash should the corporation pay out to its shareholders?
Should the cash be distributed by paying out dividends or by repurchasing

shares?
How does payout policy affect the value of the firm?
What does the price of a stock depend on?
• Dividends?
• Growth opportunities?
“What is the effect of a change in payout policy, given the firm’s capital
budgeting and borrowing decisions?”
5
Introduction
If a firm’s investment and borrowing

decisions are given:
• Higher cash dividends: issue of stock.
• Lower cash dividends: repurchase stock.
6
7
Dividends
How do corporations
pay out cash to
shareholders?
Share repurchase or
stock buyback
8
Different types of dividends

Regular Cash Dividends
• Money paid to stockholders.
• Often paid on a regular basis.
• Interim dividend: anticipated dividend, before the end of the financial year.
• Final dividend: after the release of the financial statements of the firm.
Extra or special dividend: “one-time” dividend
Stock Dividend (Scrip Dividend)

• No cash leaves the firm.
• The shareholder does not pay taxes.
• It does not change the value of the firm.
• Increases the number of outstanding shares.
• Stock price will decrease.
• If an investor wants to receive a cash dividend, she/he can sell the scrip issue on the market
(taxes on capital gains), but the proportionate holding is reduced.
Liquidating dividends
Real world examples
9
Different ways of expressing the amount of the

dividend
 Dividend per share (DPS): euros per share.
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃⁄𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
 Dividend Payout Ratio: as a percentage of earnings per share

(EPS).
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 = 𝐷𝐷𝑃𝑃𝑃𝑃⁄𝐸𝐸𝐸𝐸𝐸𝐸
 Dividend yield: as a percentage of the market share price.
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌 = 𝐷𝐷𝐷𝐷𝐷𝐷⁄𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
10
Standard method of cash dividend payment

 Procedure of dividend payment (Hillier et al. p. 489)
Thursday Wednesday Friday January Monday
January 15 January 28 30 February 16
Days
Declaration date Ex-dividend date Record date Payment date
Declaration date: The board of directors declares the payment of dividends.
Ex-dividend date: a share of equity becomes ex dividend on the date the seller is entitled to keep
the dividend; under stock exchange rules, shares are traded ex dividend on and after the second
business day before the record date.
Record date: the declared dividends are distributable to shareholders of record on a specific date.
Payment date: the dividend checks are mailed to shareholders of record.

11
Share price before and after dividend payment
 If dividends were not taxed, share price would fall by

the amount of the dividend on the ex-dividend date:
 Before dividend payment: Price = Pex-dividend + DPS
 After dividend payment (ex-dividend): Price = Pex-dividend
TELEFÓNICA
Open Close
08/11/2011 14.16 14.15
07/11/2011 14.25 14.14 Ex-dividend date (Dividend = €0.77 per share)
04/11/2011 15.34 15
03/11/2011 14.7 15.18
02/11/2011 15.02 14.94
Suorce: http://es.finance.yahoo.com
12
How do firms repurchase stock?

• The firm can use the cash to purchase shares
of its own stock, often on the open market.
• The share buyback reduces the number of
outstanding shares.
• The repurchased stock may be kept in the
company’s treasury.
14
4.2. Lintner’s dividend model (1956)
15
Two important remarks concerning dividend

policy:
Real world companies typically set long-run ratios of dividends to

earnings.
• A firm is likely to set low ratios if it has many positive NPV projects relative to
available cash flow and,
• High ratio if it has few positive NPV projects.
Managers know that only part of any change in earnings is likely to be

permanent.
• Managers need time to assess the permanence of any earnings rise.
16
The model
Two parameters describe the dividend policy:

• The target payout ratio, t:
• t = Dividends per share (DPS) / Earnings per share
(EPS)
• The speed of adjustment of current dividends to the
target, s.
Dynamics of dividends:
• DPSt+1 – DPSt = s*(t*EPSt+1 – DPSt)
17
Limiting cases: s = 1 and s = 0.
s = 1: actual change in dividends = target change in dividends.

• DPSt+1 – DPSt = t*EPSt+1 – DPSt
• DPSt+1 = t*EPSt+1
• The full adjustment occurs immediately.
s = 0: There is no change in dividends at all.
• DPSt+1 – DPSt = 0
Real world companies will set s between 0 and 1.
Implication: firms smooth dividends.

• Good times t falls.
• Bad times t rises.
18
Dynamics of Dividends (Lintner's Model)

16.00
14.00
12.00
10.00
8.00
6.00
4.00
2.00
-
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49
19
EPS DPS (stationary) DPS
4.3. The information in dividends and
share repurchases
20
4.3. The information in dividends and share repurchase: Dividends
Dividends
 Investors pay more attention to the change of a

company’s dividend than to the level of the company’s
dividend.
 They view changes in dividends as an indicator of the
sustainability of earnings.
 In any case, the effect of dividend policy will depend on
the quality of the information that investors receive from
the firm.
21
4.3. The information in dividends and share repurchase: Share repurchases
Share repurchases
 Share repurchases are a way to hand cash back
to shareholders.
 Share repurchases are frequently a one-off
event.
 They may give different information from that
given in a dividend payment.
22
4.3. The information in dividends and share repurchase: Share repurchases
When do firms repurchase shares?
 When they have accumulated cash but they cannot find

positive NPV investment opportunities.
 When they want to increase their debt ratios.
 When the managers believe that the firm’s stock is
substantially undervalued.
Warren Buffett: “Anytime you can buy stock for less
than it's worth, it's advantageous to the continuing
shareholders ... but it should be by a demonstrable
margin”.*
* See Rosenbaum, E. (2018, September 1). Warren Buffett explains the enduring power of stock buybacks
for long-term investors. Quarterly Investment Guide – CNBC.
23
4.4. The controversy about dividend
policy
Does dividend policy matter?
24
4.4.1 Dividend policy in perfect capital
markets
25
4.4.1. Dividend policy in perfect capital markets
Miller and Modigliani (1961)
Dividend policy is value irrelevant in perfect capital markets

Assumptions
1. Perfect capital markets:
 There are neither taxes nor brokerage fees.
 No single participant can affect the market price of the
security through his or her trades.
 Borrowing rates = Lending rates.
2. Rational behavior
3. Perfect certainty
4. Firm assets, investments and borrowing policy are fixed.
26
EXAMPLE 1*
AC is an all-equity financed firm. The firm will dissolve in one year (date 1). At
date, 0 the managers are able to forecast cash flows with perfect certainty. The
managers know that the firm will receive a cash flow of $5,000 immediately
and another $5,000 next year. They believe that AC has no additional positive
NPV projects it can use to its advantage. AC has 500 shares outstanding.
$5,000 $5,000
0 1
V0: Value of the firm at time 0
Div 1
V0 = Div 0 +
1 + rs
*This example is based on Ross, S.A., Westerfield, R.W. and Jaffe, J. (2002). Corporate Finance. McGraw-Hill
International Edition. p. 498. 27
Steps we take to solve the problem
 Step 1: Describe the current dividend

policy.
 Step 2: Describe the alternative dividend
policy.
 Step 3: compare the results.
28
Step 1: we describe the current dividend policy

Current dividend policy: dividends set equal to cash flow
Assuming rS = 5%
Div 1 $5,000
V = Div 0 + = $5,000 + = $9,761.9
1 + rs 1.05
If 500 shares are outstanding, the value of each share before Div0 is:
$10
PCum −dividend = $10 + = $19.52
1.05
Right after the imminent dividend (Div0) is paid, the value of each share is:
DPS1 $10
PEx −dividend = = = $9.52
1 + rs 1.05
29
Step 2: we describe the alternative dividend policy

Alternative policy: initial dividend is greater than cash flow
 The company pays a dividend of $10 + $2 = $12 per share immediately.

 The company only has a cash flow of $5,000 and needs 500 x $2 = $1,000 extra
cash.
 The company raises $1,000 issuing new stock and new stockholders require 5%
return, or: $1,000 x (1 + 0.05) = $1,050 in one period of time.
Date 0 Date 1
Cash flow $5,000 $5,000
Aggregate dividend (Div) $6,000 $5,000 – $1,050 = $3,950

to old stockholders
Dividends per share (DPS) $12.00 ($3,950 / 500) = $7.90
to old stockholders
Present value of the dividends per share

DPS1 $7.90
PCum −dividend = DPS0 + = $12 + = $19.52
1 + rs 1.05
30
Result: The indifference proposition

Share price is the same under both dividend policies
1. Current dividend policy: dividends set equal to cash

flow
$10
$19.52 = $10 +
1.05
2. Alternative dividend policy: initial dividend is

greater than cash flow
$7.90
$19.52 = $12 +
1.05
Either alternative are indifferent

31
Alternative policy (old shareholders)
Dividends $
6,000
Current dividend policy 3,950
Dividends $
0 1
Alternative policy (new shareholders)

5,000
Cash flows $
1,050
0 1
0 1
-1,000
0 32
Homemade dividends
 Investor X prefers dividends per share of $10 at both

dates 0 and 1.
DPS0 = $10; DPS1 = $10
 The firm’s management is adopting the alternative

dividend policy:
DPS0 = $12; DPS1 = $7.90
 Would she be disappointed?
33
 She can reinvest the $2 excess dividend received

in t = 1 at a 5% rate of return.
(Recall we are always considering 5% rate of return)
 Then:
 CF0= DPS0 - Investment = $12 - $2 = $10
 Investment return = $2*(1+0.05) = $2.10
 CF1 = DPS1 + Investment return = $7.90 + $2.10 = $10
 In other words, we always consider the present
value of our wealth.
n
Dt
PV = ∑
t =0 (1 + r )
t
34
Example 2: Stock issue*
AC’s Balance Sheet (Market Values)

Before making the investment
Cash (5,000 held for 5,000 Debt 0
investment)
Fixed assets 15,000 Equity 20,000 + NPV
Investment opportunity NPV

(5,000 investment
required)
Total asset value 20,000 + NPV Firm Value (V) 20,000 + NPV
This example is based on Brealey, R.A., Myers, S.A. and Allen, F. (2009). Principles of Corporate Finance.
McGraw-Hill International Edition, p. 452. 35
Example 2: Stock issue (cont.)
 Now AC uses $5,000 to pay dividend to its

stockholders from its cash account.
 The company continues with its investment
project.
 The company needs $5,000 and finances it with a
$5,000 stock issue.
 Very important assumption: the new shares are
issued at a fair price.
36
Example 2: Stock issue (cont.) Dividend = $5,000

Immediately after making the investment and paying out dividends
Cash 0 Debt 0
Fixed assets 15,000 Equity 20,000 + NPV
Investment opportunity 5,000 + NPV

(5,000 investment
required)
Total asset value 20,000 + NPV Firm value (V) 20,000 + NPV
 Value of original stockholders’ shares = Value of company – Value of new

shares = (20,000 + NPV) – 5,000 = 15,000 + NPV
 Original shareholder’s wealth = Value of original shareholders’ shares +
Dividend paid = 15,000 + NPV + 5,000 = 20,000 + NPV.
37
Example 2: Stock issue (cont.) Dividend = $5,000
Calculating share price before dividend payment

Number of shares before dividend payment: 5,000
Project NPV = $5,000
Value of Stock = 20,000 + NPV = $25,000 (Equity)
Share price = 25,000 / 5,000 = $5 per share
After the dividend old stock is worth:
15,000 + NPV = $20,000 20,000 / 5,000 = $4 per share
Old shareholder’s wealth per share after the dividend payment:

P + DPS = 4 + (5,000 / 5,000) = 4 + 1 = $5
Number of new shares (new shares are issued at a fair

Price, $4) = 5,000 / 4 = 1,250
38
Some important conclusions
 In perfect capital markets investors do not need

dividends to get their hands on cash (they can sell the
shares).
 In perfect capital markets (borrowing rates = lending
rates), as long as the present value of shareholders’
cash flow is constant, dividend policy is irrelevant
(investors can create whatever income stream they
prefer by using homemade dividends).
 Dividends are relevant.
 MM is a starting point.
39
4.4.2. Stock repurchase and valuation
40
Stock repurchase, an example
The firm X has 100 stocks outstanding. Required return on equity, r = 0.10
Annual earnings = €1,000, all of which are paid out as dividends.
1000 1000 1000 1000 1000 1000 1000 1000

…
Div €1,000
Firm Value = = = €10,000
r 0.10
Expected dividend per share= E(DPS) = €1,000 / 100 = €10; required return = 10%
10 10 10 10 10 10 10 10
…
Today’s share price = DPS / r = €10 / 0.10 = €100

41
 Or: €1,000 Stock repurchase in t = 1

Repurchased stock’s present value (in t = 0) = €1,000 / (1+0.10) =€909.09
0 1,000 0 0
…
t=0 t=1 t=2 t=3
Remaining stock’s present value (in t = 0; from t = 2 hence) = 1,000 € / ((0.10)*(1+0.10)) =

€9,090.09
0 0 1,000 1,000 1,000 1,000 1,000 1,000
…
t=0 t=1 t=2 t=3 t=4
Firm’s present value =

= PV (Repurchased stock) + PV(Remaining stock) = 909.09 + 9,090.09 = €10,000
FIRM VALUE IS UNAFFECTED!
42
How many shares will be repurchased?

Firm Value t=1 (just before stock repurchase)
Vt=1 = Div + (Div / r) = $1,000 + $1,000 / 0.1 = $11,000
Share price (just before share repurchase):
Pt=1 = Vt=1 / (n of shares) = $11,000 / 100 = $110 (100 shares outstanding)
Number of repurchased shares = $1,000 / $110 = 9.09
Remaining shares today’s price:

Number of remaining shares after share repurchase
= 100 – 9.09 = 90.9
Dividend per share = $1,000 / 90.9 = $11
1 𝐷𝐷𝐷𝐷𝐷𝐷 1 $11
Share price (t = 0) = = = $100
1+𝑟𝑟 𝑟𝑟 1+0.1 0.10
43
Example* Stock repurchase (No positive AC’s Balance Sheet (Market Values)
NPV investment opportunities) Just after the dividend payment
nº of shares: 1,000
Cash 0 0 Debt
Fixed assets 15,000 15,000 Equity
Just before dividend payment or stock repurchase
New project NPV = 0
Cash 5,000 0 Debt
Total asset $15,000 $15,000 Firm
Fixed assets 15,000 20,000 Equity value Value
New project NPV = 0

Total asset $20,000 $20,000 Firm Just after the stock repurchase
value Value Number of shares: 1,000 – 250 = 750
1. Fair share price before div. payment = Cash 0 0 Debt

$20,000 / 1,000 = $20
Fixed assets 15,000 15,000 Equity
2. Share price after div. payment = $20 – $5 =
$15 New project NPV = 0
3. Shareholder wealth after div. Payment = $15 Total asset $15,000 $15,000 Firm
+ $5 = $20 value Value
4. Nº of repurchased stocks = $5,000 / $20 =

250 This example is based on Brealey, R.A., Myers,
S.A. and Allen, F. (2009) Principles of Corporate
5. Share price after the stock repurchase = Finance. McGraw-Hill International Edition, p.
$15,000 / 750 = $20 452. 44
4.4.3. Dividends and the Miller and
Modigliani (MM) model
 No transaction costs.
 No taxes.
 No uncertainty.
Then dividend policy is IRRELEVANT
45
4.4.4. Dividends and taxes
 Perfect capital markets.

 No taxes.
Then, according to MM, dividend policy is IRRELEVANT.
 Under these assumptions, an investor could design a
homemade dividend policy regardless of the firm’s
dividend policy and, consequently, dividend policy would
be irrelevant for the shareholder.
46
 MM’s model is our benchmark:

 PROBLEM: Real world factors such as
taxes have not been considered.
 Dividends and capital gains are taxed
differently:
 Dividends: are taxed when distributed.
 Capital gains: are taxed when the shares are
sold (can be deferred).
47
Conclusions
 In the presence of dividend taxes:

1. A firm should not issue stock to pay dividends.
2. Managers have an incentive to seek
alternative uses for funds to reduce dividends.
3. Though personal taxes mitigate against the
payment of dividends, these taxes are not
sufficient to lead firms to eliminate all
dividends.
50
Real world factors favoring a high-dividend

policy
 Desire for current income (clientele effect).

 Uncertainty resolution. A bird in the hand
is worth two in the bush.
 Agency costs.
 Dividends and signals.
51
References
 Chapter 16; Brealey, R.A., Myers, S.A. and Allen, F.
(2017) Principles of Corporate Finance. McGraw-Hill
International Edition.
 Chapter 18; Hillier, D. Ross, S.A., Westerfield, R.W. and
Jaffe, J. (2010) Corporate Finance. McGraw-Hill
European Edition.
52

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Topic 4.

Important questions related to payout policy:

Should the cash be distributed by paying out dividends or by repurchasing

How does payout policy affect the value of the firm?

What does the price of a stock depend on?

If a firm’s investment and borrowing

Different types of dividends

Stock Dividend (Scrip Dividend)

Real world examples

Different ways of expressing the amount of the

 Dividend per share (DPS): euros per share.

 Dividend Payout Ratio: as a percentage of earnings per share

𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌 = 𝐷𝐷𝐷𝐷𝐷𝐷⁄𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝

Standard method of cash dividend payment

Declaration date Ex-dividend date Record date Payment date

Declaration date: The board of directors declares the payment of dividends.

Payment date: the dividend checks are mailed to shareholders of record.

Share price before and after dividend payment

 If dividends were not taxed, share price would fall by

How do firms repurchase stock?

Two important remarks concerning dividend

Real world companies typically set long-run ratios of dividends to

Managers know that only part of any change in earnings is likely to be

• Managers need time to assess the permanence of any earnings rise.

Two parameters describe the dividend policy:

Limiting cases: s = 1 and s = 0.

s = 1: actual change in dividends = target change in dividends.

Real world companies will set s between 0 and 1.

Implication: firms smooth dividends.

Dynamics of Dividends (Lintner's Model)

 Investors pay more attention to the change of a

When do firms repurchase shares?

 When they have accumulated cash but they cannot find

Does dividend policy matter?

Miller and Modigliani (1961)

Dividend policy is value irrelevant in perfect capital markets

V0: Value of the firm at time 0

 Step 1: Describe the current dividend

Step 1: we describe the current dividend policy

Step 2: we describe the alternative dividend policy

 The company pays a dividend of $10 + $2 = $12 per share immediately.

Aggregate dividend (Div) $6,000 $5,000 – $1,050 = $3,950

Present value of the dividends per share

Result: The indifference proposition

1. Current dividend policy: dividends set equal to cash

2. Alternative dividend policy: initial dividend is

Either alternative are indifferent

Current dividend policy 3,950

Alternative policy (new shareholders)

 Investor X prefers dividends per share of $10 at both

 The firm’s management is adopting the alternative

 She can reinvest the $2 excess dividend received

Example 2: Stock issue*

AC’s Balance Sheet (Market Values)

Investment opportunity NPV

Example 2: Stock issue (cont.)

 Now AC uses $5,000 to pay dividend to its

Example 2: Stock issue (cont.) Dividend = $5,000

Fixed assets 15,000 Equity 20,000 + NPV

Investment opportunity 5,000 + NPV

 Value of original stockholders’ shares = Value of company – Value of new

Example 2: Stock issue (cont.) Dividend = $5,000

Calculating share price before dividend payment

Share price = 25,000 / 5,000 = $5 per share