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Dividend policy. Concepts and exemplification. Objective. Understand the role of dividend policy in the context of the firm’s overall financial policy. . Outline. Types of dividends The dividend time line Stock price reaction Dividend policy irrelevance Theories explaining dividend policy.

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dividend policy

Dividend policy

Concepts and exemplification

objective
Objective
  • Understand the role of dividend policy in the context of the firm’s overall financial policy.
outline
Outline
  • Types of dividends
  • The dividend time line
  • Stock price reaction
  • Dividend policy irrelevance
  • Theories explaining dividend policy
dividends come in many forms
Dividends come in many forms:
  • Regular cash dividend
  • Extra dividends
  • Liquidating dividends
  • Shares repurchases
  • Stock dividends
dividend time line
Dividend time Line
  • Declaration date
  • Cum-dividend date
  • Ex-dividend date
  • Record date
  • Payment date
ex dividend day stock price reaction
Ex-dividend day: Stock price reaction
  • The stock price will drop by the amount forgone by the average investor
  • Clarification:
  • Pcum = D0 + D1/(1+ r)2 + D2/(1+r)3 + ……
  • Pex = D1/(1+ r)2 + D2/(1+r)3 + ……
stock price reaction con t
Stock price reaction (con't)
  • With taxes, the price drop ~ D(1-Td)/(1-Tcg)
  • Td = tax on dividend (average investor)
  • Tcg = tax on capital gain (average investor)
dividend policy does it matter is there an optimal dividend policy
Dividend Policy: Does it matter? Is there an optimal dividend policy?
  • If no, focus on the investment decision
  • If yes, what is the optimal policy?
view 1 dividend policy is irrelevant
View # 1: Dividend policy is irrelevant
  • Shareholders are able to undo firm's dividend policy.
  • M&M: firm value is independent of the dividend decision.
view 1 dividend policy is relevant
View # 1: Dividend policy is relevant
  • Bird-in-hand story
  • A $1 in dividend now is worth more than $2 in dividend later on.
  • Signaling
  • Dividend increase = Good times ahead
  • The free cash-flow hypothesis
  • $1 in dividend is $1 less to spend on M&A
view 1 dividend policy is relevant cont d
View # 1: Dividend policy is relevant (cont’d)
  • Clientele effect
  • Some want dividends while others want capital gains
  • Tax effect
tax effect
Tax effect
  • REC Company has $1,000 in extra cash. It can invest this cash in a 5-year T-bill at 8%, or it can pay the cash to the shareholders as a dividend. Shareholders can also invest in T-bills. Assume a 44% corporate tax, a 40% individual tax on interest, and 30% individual tax on dividend income.
  • If dividend is paid now, shareholders get
  • 1000(1-0.3)[1+ (0.08)(1-0.4)]5=$884.9
  • If dividend is invested, shareholders get
  • 1000[1+ (0.08)(1-0.44)]5(1-0.3) =$871.5
  • Shareholders would be indifferent between receiving the dividend now as opposed to receiving it later if and only if:
  • (1-TE)[1+r(1-TP)] = [1+r(1-TC)](1-TE)
tax effect cont d
Tax effect (cont’d)
  • Investors would like a dividend according to their tax preferences:
  • Tax-exempt investors, investors in low tax brackets, etc. prefer high current dividend
  • Investors in high tax brackets prefer capital gains
agency costs explanation of dividends
Agency costs explanation of dividends
  • Paying dividends can result in a need for external financing.
  • Raising equity and/or debt more often intensifies market’s scrutiny of the company.
reality check
Reality check
  • Earnings increase one year before dividend initiation.
  • Earnings decrease one year before dividend omission.
  • Following dividend initiation, earnings increases appear to be permanent.
  • Following dividend omission, earnings decreases appear to be temporary.
  • Weak reaction to earnings changes following dividend changes.
overview of financial policy why is it important
Overview of financial policy: Why is it important?
  • Capital structure policy, long-term financing policy, dividend policy, etc.…do have some impact on market valuation.
  • Remember, however:
  • Capital budgeting is the bread and butter of wealth maximization.
  • Financial policy is only fine-tuning.