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Advanced Finance 2006-2007 Dividend policy: a puzzle

Advanced Finance 2006-2007 Dividend policy: a puzzle. Professor André Farber Solvay Business School Université Libre de Bruxelles. Dividend yields are low Gross dividend yield Jan. 2002 FTSE All-World Index (2261)1.7% USA (488) 1.4% Europe (648) 2.4% Japan (332) 0.9%

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Advanced Finance 2006-2007 Dividend policy: a puzzle

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  1. Advanced Finance2006-2007Dividend policy: a puzzle Professor André Farber Solvay Business School Université Libre de Bruxelles

  2. Dividend yields are low Gross dividend yield Jan. 2002 FTSE All-World Index (2261)1.7% USA (488) 1.4% Europe (648) 2.4% Japan (332) 0.9% Belgium (22) 3.1% France (49) 2.4% Germany (37) 2.2% UK (140) 2.7% Not all companies pay dividend 1000 largest companies - May 2000 US Non US Number 484 516 Div. Yield>5% 17 6 Div. Yield = 0 183 20 Source: based on Business Week Global 1000 – Business Week, July 10, 2000 Some facts Advanced Finance 2007 Dividend policy

  3. Types of dividends • Cash dividend - Regular/Special • Ex-Dividend Date - ex coupon • Stock dividend • Stock repurchase • Buy shares on the market • Tender Offer to Shareholders • Private negotiation (green mail) Advanced Finance 2007 Dividend policy

  4. Who pays dividends? (1) The percentage of non-financial firms paying a dividend in the US has decreased 1978: 66.5% 1998: 20.7% (2) 3 factors explain the propensity of companies to pay dividends 1. Profitability (+) 2. Investment opportunities (-) 3. Size of company Source: Fama French « Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay » WP 509 University of Chicago, December 1999 Advanced Finance 2007 Dividend policy

  5. Stock Market Response • Type of announcement Average 2-Day Sample Announcement Size Period Return • Dividend Increases • Dividend initiation 160 3.7% • Dividend increase 280 0.9% • Dividend decrease 48 -3.6% • Source: Smith C.W., “Raising Capital: Theory and Evidence” in Chew (ed.) The New Corporate Finance McGraw-Hill 1993 Advanced Finance 2007 Dividend policy

  6. The Dividend Decision • Lintner (1956): stylized facts • 1. Firms have long term target dividend payout ratios • 2. Managers focus more on dividend changes than on absolute levels • 3. Dividend changes follow shifts in long-run, sustainable levels of earnings rather than short-run changes in earnings • 4. Managers are reluctant to make dividend changes that might be reversed. Advanced Finance 2007 Dividend policy

  7. Modelling the dividend decision • Dividend target = Target ratio × EPS1 • Target change = Dividend target - DIV0 • • Dividend change = Adjustement rate × Target change DIV1* = Payout × EPS1 DIV1 - DIV0 = a ( DIV1* - DIV0) • Dividend is a weighted average of dividend target and past dividend: DIV1 = a DIV1* + (1-a) DIV0 Advanced Finance 2007 Dividend policy

  8. Modigliani Miller (1961): irrelevance of dividend policy • Assumptions • Perfect capital markets • Symetric information • No taxes • Investment policy of company fixed • Mkt value of company = PV(Free cash flow) • Statement of cash flows: FCF = DIVIDEND - STOCK ISSUE (all equity firm, cash constant) Advanced Finance 2007 Dividend policy

  9. Dividend irrelevance: example • Number of share outstanding : 100 • Cost of equity: 10% • Expected annual earning: 1,000 • Investment project • Initial investment: 1,000 Additional annual earning: 150 • NPV = - 1,000 + 150 / 0.10 = +500 > 0 • Cash available: 1,000 • Should the company use cash available for the project? • Should it pay a dividend and issue new share? Advanced Finance 2007 Dividend policy

  10. Dividend irrelevance: example (2) • Market value of company (after announcement of project): • V = 1,000 + 1,000 / 0.10 + 500 = 11,500 • Price per share: 11,500 / 100 = 115 • Self financing policy (no dividend) • V = 1,150 / 0.10 = 11,500 • Price per share: 11,500 / 100 = 115 • SEO - Pay dividend (10 / share) + right issue (10 new shares at 100) • Price per share ex-dividend = 115 - 10 = 105 • Number of shares after SEO = 110 • V = 1,150 / 0.10 = 11,500 • Price per share: 11,500 / 110 = 104.55 • Value of right = 0.45 Advanced Finance 2007 Dividend policy

  11. Dividend irrelevance: example (3) • Comparing financing policies • Dividend per share t = 0 t = 1 to ∞ Self-financing 0 11.50 Stock issue 10.00 10.45 Difference - 10.00 + 1.045 NPV(Difference) = -10.00 + 1.045 / 0.10 = 0.45 - Right 0.45 0.00 Advanced Finance 2007 Dividend policy

  12. Dividend and Taxes • A complex problem because: • level of taxation: company/investor • tax basis: dividend income / capital gain • capital gains are taxed at a lower rate than dividend income • dealing with double taxation • “classical system” : US, Belgium (witholding tax = 25%) • “imputation system”: Germany, France, UK, Australia Advanced Finance 2007 Dividend policy

  13. Classical sytem: shareholders are taxed twice Operating income 100 Corporate Tax (Tc = .40) 40 After Tax Income 60 Dividend 60 Income Tax (TP = .40) 24 Net Dividend 36 Imputation sytem based on tax credit (“avoir fiscal” in France) Suppose tax credit = 50% div Operating income 100 Corporate Tax (Tc = .40) 40 After Tax Income 60 Dividend div 60 Taxable income div(1+a) 90 Income Tax (TP = .40) 36 Tax credit 30 Tax to pay 6 Net Dividend 54 Dividend Taxation: examples Advanced Finance 2007 Dividend policy

  14. Additional complications • Corporate tax rate might be different for retained earnings • Capital gains might be taxable for shareholders when realized • • Example: Germany • Corporate Tax: Undistributed 54% Distributed 41% • Personal Tax: Capital gain 0% Dividend: 53% • Imputation rate: 42% • If operating income = 1 Net revenue • (a) Dividend : (1 - 0.41)(1.42)(1-0.53) = 0.39 • (b) Capital gain: (1-0.54) (1 - 0.00) = 0.46 • Dividend tax preference: (a)/(b) = 0.86 • Source: La Porta, Lopez-De-Silanes and Vishny, “Agency Problems and Dividend Policies around the World” Journal of Finance 55, 1, (Feb. 2000) Advanced Finance 2007 Dividend policy

  15. Dividend Tax Disadvantage around the World • Belgium 0.74 • France 0.63 • Germany 0.86 • Italy 0.77 • Netherlands 0.40 • United Kingdom 0.83 • United States 0.58 • Source: La Porta, Lopez-De-Silanes and Vishny, “Agency Problems and Dividend Policies around the World” Journal of Finance 55, 1, (Feb. 2000) Advanced Finance 2007 Dividend policy

  16. Dividend, taxes and cost of capital • If taxation of dividend higher than capital gain, cost of capital of dividend paying firms should be higher • Example: consider two companies of same risk • Tax rate: Dividend = 50% Capital gain = 20% • Next year’s price 112.50 102.50 • Dividend 0 10 • After tax return 10% 10% • Current stock price 100.00 96.67 • Pretax return 12.50% 16.40% • (See Brealey Myers Table 16.1 for details) P0=[102.50+ 0.50x10 - 0.20 (102.50 - P0)] P0=[112.50 - 0.20 (112.50 - P0)] Advanced Finance 2007 Dividend policy

  17. Dividend, taxes and cost of capital: empirical evidence • Some evidence in favor of a higher cost of capital for high yield firms. • Many methodological issues still pending. • See BM Table 16.2 for summary of studies on the effect of yield on • return. • Implied tax rates difficult to measure with precision. • Estimated value vary from 0% (Miller Scholes) to 57% Advanced Finance 2007 Dividend policy

  18. Why pay dividend? • Clientele Effect • There are natural clients for high-apyout stocks (insurance companies, pension funds) • Signal. • Insiders know more about the firm. • Dividend increase send good news about cash flows and earnings. Dividend cuts send bad news. • High payout ratio costly to firms that do not have the cash flow to support it. • Corporate Governance (Easterbrook 1984) • Conflicts of interest between insiders and outsiders. Advanced Finance 2007 Dividend policy

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