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# The Dividend Controversy PowerPoint PPT Presentation

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.

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

• 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)

• declaration date

• ex-dividend date

• record date

• payment date

### 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

• 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

• 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

• 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:

• An investor buys a share.

• It never pays a dividend.

• Is it valueless?

### No.

• The investor resells it before any dividends are paid.

### 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

• The typical start-up firm is bought by another.

• Its investors get cash or shares in the acquiring firm.

### Dividend policy alternatives:

• Either high dividends now, low later, or

• Low now, high later.

### Dividend policy is irrelevant!

• The firm has done all projects with NPV > 0.

• It has some cash.

• What are the alternatives?

### Alternatives:

• Distribute cash as a dividend now.

• Invest the cash in financial markets and

• pay out as a dividend later.

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### Separation theorem

• NPV is relevant.

• Investors time preferences are not.

• Investors who want higher dividends sell some shares to get cash.

• Those who want lower dividends use high dividends to buy more shares.

### Upshot

• Investors do not reward firms for doing what investors can do for themselves.

### Taxes and dividends

• The alternatives are

• (1) dividends or

• (2) capital gains.

### Tax-class clienteles

• Investors with similar tax exposure.

• Some prefer dividends.

• Some prefer capital gains.

### Some prefer dividend income

• because they have tax exemptions, e.g.,

• non-profit institutions, pension funds, corporations etc.

### 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

• 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

• 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

• Some cash flows in the high-dividend channel.

• Some in the low-dividend channel.

• Like the Miller channels model.

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Dividend equilibrium

...

### Value is invariant to dividend policy.

• In equilibrium

• i.e., almost all the time

### Out of equilibrium

• i.e., after tax law changes,

• firms can increase value by appropriately changing their dividend policy.

### Example of disequilibrium

• Suppose that the capital gains tax rate is lowered.

• LoDiv cash flows are more valuable.

• Demand for LoDiv cash flows increases.

Increased value

of old equity

More LoDiv

firms

HiDiv

value

LoDiv

value

\$ of operating

cash flows in

the economy

### 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

• for not changing dividend policy

• and for existence of tax-class clienteles.

### 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

• The firm has a quantity of spare cash

• after all NPV>0 projects are done.

### Dilemma

• Pay dividends: Shareholders pay extra taxes.

• Invest in financial markets: Firm becomes a mutual fund.

### 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.

• There are 1M shares, at \$10 per share.

• Buy back .1M shares at \$10 apiece.

• Cost is \$1M.

• Remaining value of the firm is \$9M

• because there are no financial illusions.

• There are .9M shares remaining

• still at \$10 apiece.

• are associated with rising share value in the financial press.

• Can this be correct?

### Outsider's model before the buyback

• Pr{underpriced} = .5

• Pr{overpriced} = .5

### If insiders think the stock is overpriced

• a buyback would reduce the value of the firm.

• Outsiders know that insiders think

• the stock is underpriced (or fairly priced).

• 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.

• Stock buyback for tax avoidance is illegal.

• Therefore...

### Excuses, excuses

• always another reason for a stock buyback,

• usually ... our shares are a good investment

• or...we disburse cash to prevent takeover.

### 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 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?