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The Dividend Controversy. Should firms pay high dividends?. Review item. An asset A is being added to the market portfolio M. What variable indicates whether A will raise or lower the risk of the portfolio? Explain briefly. Answer: beta of A is the variable.

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the dividend controversy
The Dividend Controversy

Should firms pay high dividends?

review item
Review item
  • An asset A is being added to the market portfolio M.
  • What variable indicates whether A will raise or lower the risk of the portfolio?
  • Explain briefly.
answer beta of a is the variable
Answer: beta of A is the variable
  • Beta of A is covariance of A with M divided by variance of M.
  • Beta of A > 1 implies A varies more with M than M itself does (possible diagram).
  • Beta of A > 1 implies A raises the risk of M.
  • Beta of A < 1 implies A lowers risk of M.
normal dividends pages 461 462
Normal dividends (pages 461-462)
  • declaration date
  • ex-dividend date
  • record date
  • payment date
why is the ex dividend date early
Why is the ex-dividend date early?
  • To avoid disputes, exchanges control the right to the dividend.
  • Early date reduces costs of administering the rule.
  • Now 2 days lead time. Formerly 5 days.
dependence of value on dividends
Dependence of value on dividends
  • Notation:
  • Pt, Pt+1, Pt+2, ... are
  • prices of shares at time t, t+1, t+2
  • Dt, Dt+1, Dt+2, ... are dividends
derivation
Derivation
  • Pt = Dt+1/(1+r) + Pt+1/(1+r)
  • Pt+1= Dt+2/(1+r) + Pt+2/(1+r)
  • Pt = Dt+1/(1+r) + Dt+2/(1+r)2 + Pt+2/(1+r)2
by induction
By induction
  • Pt = Dt+1/(1+r) + Dt+2/(1+r)2 + Dt+3/(1+r)3 + …
  • Expected dividends determine value,
  • even when the share changes hands.
trap question one
Trap question one:
  • An investor buys a share.
  • It never pays a dividend.
  • Is it valueless?
slide10
No.
  • The investor resells it before any dividends are paid.
  • The buyer gets dividends.
trap question two
Trap question two:
  • A firm never pays dividends to any investor and is never expected to do so.
  • Is it valueless?
no think of webservice com
No. Think of Webservice.com
  • The typical start-up firm is bought by another.
  • Its investors get cash or shares in the acquiring firm.
dividend policy alternatives
Dividend policy alternatives:
  • Either high dividends now, low later, or
  • Low now, high later.
dividend policy is irrelevant
Dividend policy is irrelevant!
  • The firm has done all projects with NPV > 0.
  • It has some cash.
  • What are the alternatives?
alternatives
Alternatives:
  • Distribute cash as a dividend now.
  • Invest the cash in financial markets and
  • pay out as a dividend later.
separation theorem interpreted for dividends figure 18 4

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Separation theorem interpreted for dividends (Figure 18.4)

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separation theorem
Separation theorem
  • NPV is relevant.
  • Investors time preferences are not.
homemade dividends
Homemade dividends
  • Investors who want higher dividends sell some shares to get cash.
  • Those who want lower dividends use high dividends to buy more shares.
upshot
Upshot
  • Investors do not reward firms for doing what investors can do for themselves.
taxes and dividends
Taxes and dividends
  • The alternatives are
  • (1) dividends or
  • (2) capital gains.
tax class clienteles
Tax-class clienteles
  • Investors with similar tax exposure.
  • Some prefer dividends.
  • Some prefer capital gains.
some prefer dividend income
Some prefer dividend income
  • because they have tax exemptions, e.g.,
  • non-profit institutions, pension funds, corporations etc.
some investors prefer capital gains
Some investors prefer capital gains
  • because they can\'t shelter dividends from taxes,
  • but they can shelter capital gains.
  • High income investors, for instance.
example of partial tax sheltering by capital gains
Example of partial tax sheltering by capital gains
  • Alternative one: dividend of $10,000.
  • Pay taxes on all of it.
  • Compare to capital gains of the same amount.
tax shield continued homemade dividend
Tax shield continued, homemade dividend
  • Alternative two: capital gains of $10,000.
  • Sell stock worth $10,000.
  • The stock was bought when the price was half the current price.
  • Realized capital gains = $5,000
  • Pay taxes on $5,000.
implications of clienteles
Implications of clienteles
  • Some cash flows in the high-dividend channel.
  • Some in the low-dividend channel.
  • Like the Miller channels model.
slide27

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Dividend equilibrium

...

value is invariant to dividend policy
Value is invariant to dividend policy.
  • In equilibrium
  • i.e., almost all the time
out of equilibrium
Out of equilibrium
  • i.e., after tax law changes,
  • firms can increase value by appropriately changing their dividend policy.
example of disequilibrium
Example of disequilibrium
  • Suppose that the capital gains tax rate is lowered.
  • LoDiv cash flows are more valuable.
  • Demand for LoDiv cash flows increases.
cut in capital gains tax rates

Increased value

of old equity

More LoDiv

firms

Cut in capital gains tax rates

HiDiv

value

LoDiv

value

$ of operating

cash flows in

the economy

result of capital gains tax cut
Result of capital gains tax cut
  • Value of old equity rises (instantly)
  • Firms increase value by switching to lower dividends
  • until equilibrium is restored.
real world evidence
Real-world evidence
  • for not changing dividend policy
  • and for existence of tax-class clienteles.
evidence
Evidence
  • Actual dividends are highly smoothed
  • Earnings fluctuate much more.
  • Smooth means constant or increasing at a constant rate.
a problem for the low dividend firm
A problem for the low-dividend firm
  • The firm has a quantity of spare cash
  • after all NPV>0 projects are done.
dilemma
Dilemma
  • Pay dividends: Shareholders pay extra taxes.
  • Invest in financial markets: Firm becomes a mutual fund.
solution use the cash to buy stock
Solution: use the cash to buy stock
  • Investors who sell are those who want cash.
  • Stock price is unaffected ...
  • because the value of the firm falls
  • in proportion to the shares repurchased.
example firm is worth 10m 1m is spare cash
Example: Firm is worth $10M. $1M is spare cash.
  • There are 1M shares, at $10 per share.
  • Buy back .1M shares at $10 apiece.
  • Cost is $1M.
after the buyback
After the buyback,
  • Remaining value of the firm is $9M
  • because there are no financial illusions.
  • There are .9M shares remaining
  • still at $10 apiece.
stock buybacks
Stock buybacks
  • are associated with rising share value in the financial press.
  • Can this be correct?
outsider s model before the buyback
Outsider\'s model before the buyback
  • Pr{underpriced} = .5
  • Pr{overpriced} = .5
if insiders think the stock is overpriced
If insiders think the stock is overpriced
  • a buyback would reduce the value of the firm.
  • Therefore, no buyback occurs.
since the buyback occurs
Since the buyback occurs
  • Outsiders know that insiders think
  • the stock is underpriced (or fairly priced).
therefore the buyback
Therefore, the buyback
  • signals the knowledge of insiders
  • that the stock is underpriced
  • and outsiders raise their estimates of its value.
  • Thus, share price rises on the buyback.
the irs understands this game
The IRS understands this game.
  • Stock buyback for tax avoidance is illegal.
  • Therefore...
excuses excuses
Excuses, excuses
  • always another reason for a stock buyback,
  • usually ... our shares are a good investment
  • or...we disburse cash to prevent takeover.
summary
Summary
  • Dividend policy is like capital structure.
  • It probably doesn’t matter.
  • If it does, it matters because of taxes, and even that is temporary.
  • In equilibrium, firms cannot increase value by changing capital structure or dividend policy.
review item1
Review item
  • A share paid a dividend of $5 last year.
  • The dividend is expected to grow at 3% forever.
  • The discount rate is 13%.
  • What is the value of the share?
answer
Answer:
  • Next year’s dividend is $5.15 ( = 1.03 x 5)
  • Value is $5.15/(.13-.03) = $51.50.
  • Not $50.
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