The dividend controversy
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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

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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?


The dividend controversy

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)

C1

C0


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.


The dividend controversy

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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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