1

Dividend Policy
Finance 1 Text- and Workbook:
Chapter 18

Berk & DeMarzo:
Chapter 17

2
Payout Policy
when a firms investments generate
free cash flow, how to use the cash?
1. NPV > 0 opportunities
then reinvest the cash: V
investment projects
e.g. young, rapidly growing firms
acquisitions / takeovers

2. no attractive investment opportunities
e.g. mature, profitable firms
retain cash, i.e. hold the funds
as part of cash reserves
pay the cash out to shareholders
- pay a dividend
- repurchase shares

3
Dividend payout
announcement date
commonly being the declaration date,
when the board of directors
authorizes the dividend
e.g. 5 months before the payable date
the stock is said to trade cum-dividend
until the ex-dividend date: P
cum

ex-dividend date
on or after this date, anyone who
purchases the stock will not receive
the dividend: P
ex

usually two days before the record date
the stock is said to trade ex-dividend
record date
the date on which the shareholders
have to be registered in order to receive
a usually regular dividend per share
(special dividend = a one-time dividend
payment a firm makes, usually larger)
payable / distribution date
the date on which the dividend checks
are mailed to the registered shareholders
usually a month after the record date
4
Example 1: pay dividend with excess cash
in a perfect market, a firm
is all-equity financed, r
u
= 12%
has 10 million shares outstanding
has 20 million in excess cash, so
it can pay out a dividend of 2 per share
immediately
expects to generate 48 million free CFs
per year in subsequent years, therefore
it anticipates paying a dividend of
48/10 = 4,80 per year each year thereafter

P
cum
= Current Dividend + PV(Future Dividends)
= 2 + 4,80 / 0,12 = 2 + 40 = 42
P
ex
= PV(Future Dividends)= 4,80 / 0,12 = 40

5
On the ex-dividend date the share
price falls exactly by the amount
of the dividend = 2 leaving the shareholders
with stock worth 40 and 2 in cash
from the dividend, for a total of 42,
that is, they do not incur a loss overall.

No opportunity for arbitrage exists. So
in a perfect capital market, the dividend
covers the capital loss on the stock exactly
i.e., an investor cannot earn a profit by
buying the stock just before it goes ex-dividend
and selling it just thereafter, or vice versa

6
Excess Cash = 20
Enterprise Value = PV(FCFs) = 48 / 0,12 = 400
Total Market Value = 20 + 400 = 420

Cum-Dividend date
Assets Liabilities
Cash 20 E 420


Other assets 400
420 N = 10 million
P = 42


Dividend Payout = 20 V
Total Market Value = 400

Ex-Dividend date
Assets Liabilities
Cash 0 E 400
Other assets 400
400 N = 10 million
P = 40




7
If an investor doesnt want the cash,
he can undo the dividend payout
by using the proceeds of the dividend
to purchase additional shares at the
ex-dividend price (reinvesting dividends
is a NPV = 0 transaction)
e.g. an investor j
before the dividend payout
P
cum
= 42
N
j
= 1680
V
j
= 42 1680 = 70.560
after the dividend payout
Div
j
= 1680 2 = 3.360
P
ex
= 40
N
j
= 1680
V
j
= 40 1680 + 3.360 = 67.200 + 3.360
Div
j
= 3.360 is used to buy
84 additional shares (84 40 = 3.360)
P
ex
= 40
N
j
= 1680 + 84 = 1764
V
j
= 40 1764 = 70.560
NPV = 0 transaction


8
If there is no dividend payout,
by selling equity (NPV = 0 transaction)
the investor can raise the cash himself
= homemade dividend

e.g. an investor
initial position
P = 42
N
j
= 1680
V
j
= 42 1680 = 70.560
by selling 80 shares
homemade dividend = 80 42 = 3.360
P = 42
N
j
= 1680 80 = 1600
V
j
= 42 1600 + 3.360 = 67.200 + 3.360
NPV = 0 transaction

9
Example 2: high dividend (equity issue)
the firm raises 28 million by issuing
equity, so it can start paying 48 million
in dividends now
number of shares sold = 28 / 42 = 0,67 million
number of shares outstanding = 10,67 million
dividend per share = 48 / 10,67 = 4,50
P
cum
= 4,50 + 4,50 / 0,12 = 42
the initial share price is unchanged
by this policy and increasing the dividend
has no benefit to shareholders
Alternative P = 42 constant
1: dividend=2 at t=0 2 + 4,80 / 0,12 = P
cum
2: dividend=4,50 at t=0 4,50 + 4,50 / 0,12 = P
cum

Question: P
ex
? Answer:
P
ex
= 4,50 / 0,12 = 37,50
P
ex
= 42 4,50 = 37,50


10
Because by buying or selling shares
which are zero-NPV transactions (so,
there is no benefit to shareholders),
investors can replicate or undo any
choice of dividend policy by a firm, which
therefore must also be a zero-NPV transaction

MM Dividend Irrelevance Proposition
In perfect capital markets, holding fixed
the investment policy of a firm, the firms
choice of dividend policy is irrelevant and
does not affect the initial share price


11
Share repurchase
= a buyback of shares by a firm
of its own outstanding stock
open market repurchase
in about 95% of all repurchase transactions
often, the intention to do so, is announced
tender offer
usually, the price is set at a substantial
premium to the current market price
(10% - 20% is typical)
Dutch auction
different prices are listed for different
numbers of shares; the firm then pays
the lowest price at which it can buy
back its desired number of shares
targeted repurchase
buyback directly from a major shareholder
where the purchase price is negotiated
directly with the seller
- major shareholder wants to sell
maybe at a discount
- to reduce the threat of a takeover
often at a large premium (greenmail)

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Example 3: share repurchase (no dividend)
the firms does not pay a dividend
this year, but instead uses the 20 million
to repurchase its shares on the open market

Before Repurchase
Assets Liabilities
Cash 20 E 420


Other assets 400
420 N = 10 million
P = 42

firm repurchases 20 / 42 = 0,476 million shares
leaving 9,524 million shares outstanding

After Repurchase
Assets Liabilities
Cash 0 E 400
Other assets 400
400 N = 9,524 million
P = 42



13
Firm expects to generate 48 million
free CFs per year in subsequent years,
and anticipates paying a dividend of
48 / 9,524 = 5,04 per share each year thereafter
P
rep
= 5,04 / 0,12 = 42
Thus, by not paying a dividend today and
repurchasing shares instead, the firm is able
to raise its dividends per share in the future

Alternative P = 42 constant
1: dividend=2 at t=0 2 + 4,80 / 0,12 = P
cum
2: dividend=4,50 at t=0 4,50 + 4,50 / 0,12 = P
cum

3: share repurchase 5,04 / 0,12 = P
rep



The increase in future dividends compensates
shareholders for the dividend they give up today.
Therefore, the share repurchase has no effect on
the stock price, and P
rep
= P
cum
= Div + P
ex

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Perfect capital markets

Regardless of the amount of cash the firm
has on hand, it can pay a smaller dividend
(and use the remaining cash to repurchase
shares or pay out a larger dividend by selling
equity to raise the necessary cash).


Shareholders can create a homemade
dividend of any size by buying or selling
shares themselves and, in such a way,
replicate either payout method on their own.


Since equity is fairly priced, these buys and
sells are zero-NPV transactions and therefore
do not add or destroy value. If this holds for
the shareholders achieving the same result
as the firm obtains, its payout choices must
leave the current share price unchanged.
15
Notice that, if possible, an alternative policy is
to invest the excess cash in an equal risk project
which produces the same present value per share
as in the case of a share repurchase: P = P
rep

Example 4: purchase financial assets
That is, 20 million immediately is equivalent to
an investment in financial assets producing 2,4
million each year thereafter, discounted at 12%:
20 = 2,4 / 0,12 or, likewise, 2 per share is
equivalent to an investment in financial assets
producing 0,24 per share each year thereafter,
discounted at 12%: 2 = 0,24 / 0,12
Alternative P = 42 constant
1: dividend=2 at t=0 2 + 4,80 / 0,12 = P
cum
2: dividend=4,50 at t=0 4,50 + 4,50 / 0,12 = P
cum

3: share repurchase 5,04 / 0,12 = P
rep

4: purchase securities 0,24 / 0,12 + 4,80 / 0,12


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As a rule, a firm only goes to the capital market
for financing purposes or risk management
and does not make it its object to trade in
securities.

If a firm retains cash, it holds the cash in the
bank or purchases Treasury bills, which are
zero-NPV financial investments.
The firm can then pay the money (+ interest) to
shareholders at a future time or invest it when
positive-NPV investment opportunities become
available.
17

Example 5: retaining cash

That is, 20 million immediately is equivalent to
an investment in Treasury bills producing 0,80
million interest each year thereafter, discounted
at 4%: 20 = 0,80 / 0,04 or, likewise, 2 per share
is equivalent to an investment in Treasury bills
paying 0,08 interest per share each year
thereafter, discounted at 4%: 2 = 0,08 / 0,04

Alternative P = 42 constant
1: dividend=2 at t=0 2 + 4,80 / 0,12 = P
cum

2: dividend=4,50 at t=0 4,50 + 4,50 / 0,12 = P
cum

3: share repurchase 5,04 / 0,12 = P
rep

4: purchase securities 0,24 / 0,12 + 4,80 / 0,12
5: retaining cash 0,08 / 0,04 + 4,80 / 0,12


MM Payout Irrelevance Proposition

In perfect markets, if a firm invests excess cash
in financial securities, the firms choice of payout
versus retention is irrelevant and does not affect
the initial value of the firm [holding fixed the
investment policy of the firm]



18
Summarizing :

1. dividend payout financed by cash reserves
V , Div + P
ex
= P
cum
, N = constant

2. dividend payout fully financed
by an equity issue at the same time
(to hold a fixed investment policy)
V =, P
ex
< P
cum
, N

3. share repurchase financed by cash reserves
V , P
rep
= P
cum
, N

4. purchase securities financed by excess cash
V = and P =

5. retain cash
V = and P =

There is no difference to shareholders
if the firm pays the cash immediately
if the firm retains the cash (and invests it in
financial securities) and pays it out at a future date

In perfect capital markets, holding fixed the investment
policy of a firm, the firms announcement of a (change
in) payout policy does not affect the initial share price



19
Dividend policy

with perfect capital markets
while dividends do determine share
prices, a firms choice of dividend
policy does not

with corporate tax
no dividend irrelevance
cash is equivalent to negative leverage;
so, the tax advantage of leverage implies
a tax disadvantage of holding cash;
to retain excess cash and invest it in
financial assets is costly (NPV<0), since
the interest a firm earns is taxed


20
with personal taxes
= capital gains tax rate
= dividend tax rate
if , e.g. , then
personal taxes discriminate between
capital gains and dividend payouts
(which make up the investors income)
P
cum

P
now

P
ex


under the assumption that arbitrage
opportunities are absent, the expected
rates of return r* relating to just before
the stock goes ex-dividend and to just
thereafter must be the same





g
t
d
t
d g
t t =
d g
t t <
now g now cum
*
)/P )(1 P (P r =
now d g now ex
*
)]/P Div(1 ) )(1 P [(P r + =
g
d
ex cum
1
1
Div P P

=
time
21
Similarly, the change from just before
to just thereafter yields no return

(P
ex
P
cum
)(1
g
) + Div(1
d
) = 0

Thus

So, the price drop is determined by the
dividend policy of the firm and by the tax
rates
g
&
d
the market faces, or
more precisely, by
of the firms investor clientele

Suppose investor n is lightly
taxed on dividends:
d,n
low, then


Thus, investor n will have a preference
for this stock if it pays a high dividend


g
d
ex cum
1
1
Div P P

=
) )/(1 (1
g d

) 1 ( ) 1 ( ) 1 )( (
,n d d g ex cum
Div Div P P t t t < =
22













All investors in the same tax bracket
will have a preference for this stock,
whereas investors which are heavily taxed
on dividends will have a preference for
stocks that pay low or no dividend
The process of investors tuning their
tax-determined preferences to the dividend
policy of a firm eventually leads to an
equilibrium:

clientele effects
the dividend policy of a firm reflects
the tax preference of its investor clientele

for every investor, there exists a stock
where the firms dividend policy matches
his preferences
a change in the dividend
policy of one single firm
- does not disturb equilibrium
- does not create / add value
- is irrelevant with respect to V


23
Six empirical results:
1. Elton & Gruber (1970)
P
cum
P
ex
= 0,778 Div
this is in support of taxes
having an impact
2. But findings for the Hong Kong
Stock Exchange, among other stock
markets / countries where relevant
taxes are absent, show that
P
cum
P
ex
< Div
this invalidates a tax-effect
3. The Netherlands: relevant taxes
are absent
US: in 2003 tax rates were cut such
that the discriminative effect of
taxes on dividend payouts and
capital gains was strongly reduced,
so



1 ) )/(1 (1
g d
~
24
if so true, P
cum
P
ex
Div

recall

rewrite

where

effective dividend tax rate


If investor ns
then he should sell the stock before it goes
ex-dividend, thereby avoiding the dividend
which in his case is heavily taxed.


If investor ns
he should buy the stock & capture the dividend.

g
d
ex cum
1
1
Div P P

=
*) (1 Div P P
d ex cum
=
g
g d
d
- 1

*

=
= *
d
0 *
n d,
>
0 *
n d,
<
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4. Recent research focuses on order
imbalances around the ex-dividend
date, among other things in view
of a dynamic clientele effect:
the dividend-capture theory
= the theory that absent transaction
costs, investors can trade shares at
the time of the dividend so that
non-taxed investors receive the dividend
empirical implication:
= larges volumes of trade in a stock
around the ex-dividend day, as
high-tax investors sell and low-tax
investors buy the stock in anticipation
of the dividend, and then reverse those
trades just after the ex-dividend day
practice shows supportive evidence,
but it is also true that many high-tax
investors continue to hold stocks even
when dividends are paid




26
5. If < , then shareholders
will pay lower taxes if a firm uses
share repurchases for all payouts
rather than dividends. The fact that
firms continue to issue dividends
despite their tax disadvantage is
referred to as the dividend puzzle
- bird in the hand heuristic
- repurchasing stock on a regular
basis as a substitute for dividends
(in order to save stockholders taxes)
is not allowed by the tax authorities
- financial managers do not show much
concern with the tax effects of payout
choices (see hereafter)
6. The costs of retaining excess cash
depend on the combined effect of the
corporate and capital gains taxes,
compared to the single tax on interest.
Using 2012 tax rates, the effective
tax disadvantage of retained cash
appears to be substantial


g

27
Agency costs
Firms should choose to retain cash
for the same reasons they would use
low leverage: to preserve financial
slack for future growth opportunities
and to avoid financial distress costs
e.g. high-tech and biotechnology firms
have little debt & large cash balances
These needs must be balanced against
the tax disadvantage of holding cash
(which is equivalent to negative leverage
in view of taxes owed on the interest
receipts of a firm) and the
agency costs of retaining cash

as a means to increase managers
job security and to avoid the
discipline of the market
to fund wasteful investments
e.g. pet projects or overpaying for
acquisitions
e.g. excessive salaries


28
To avoid a conflict of interests between
the firms shareholders and managers,
a similar role by taking cash out
of the firm is performed by
leverage
share repurchases
dividends

Agency benefits of dividends (V )




Agency costs of dividends
exist when there is financial distress
and the potential conflict of interest
between the debt holders and the
shareholders intensify.




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Asymmetric Information
In practice

dividend smoothing =
the practice of maintaining
relatively constant dividends

dividend increases are more
frequent than dividend cuts
So, the firms dividend choice will
contain information, especially when
managers cut the dividend
dividend signaling hypothesis
= the idea that dividend changes
reflect managers views about a
firms future earnings prospects



30
Consistent with this hypothesis
average size stock price reaction

- increases with the magnitude
of the dividend change

- is larger for a dividend cut e.g. -3,7%
(costly for managers in terms of their
reputation and the reaction of investors)
than for a dividend raise e.g. + 1,3%
- is smaller than that of leverage changes
e.g. D & E : -7% and D & E : +10%
due to a somewhat weaker information
signal by a dividend change because of
a less strong commitment


31
Survey of corporate managers
by Lintner (1956), who suggested

managements desire to maintain a
long-term target level of dividends
as a fraction of earnings
an investors preference for stable
dividends (with sustained growth)

the focus is on dividend changes
= target dividend payout ratio,
percentage of earnings (per share)
s = adjustment rate
e.g. s = 0: Div
t
= Div
t-1
sticky
s = 1: Div
t
= EPS
t
direct adjustment
0 < s < 1: partial adjustment
s close to zero: smoothing

Empirical results: = 50%, s = 30%
Suppose: Div
t+1
announced at t+1 such that
Div
t+1
>> Div
t
+ 0,30(0,50 EPS
t+1
Div
t
)
Interpretation? Favorable info!


) Div EPS s( Div Div
1 t t 1 t t
=

32
Survey of financial executives
Brav, Graham, Harvey & Michaely (2005)

Dividend policy
not decreasing Div has top priority
that is, if necessary at the cost of
NPV > 0 project inconsistent with MM
so, Div = very bad signal: P
Div = residual CF decision
in principle, consistent with MM in the
sense that firm value is determined
by operating & investments decisions
and not by financing & payout policy
Div only if permanent earnings
and if desired by shareholders
(as a monitoring and control
mechanism to discipline managers)
preference for stable dividends

Share repurchases
= residual CF decision
if earnings only temporarily
and if desired by shareholders:
agency costs and/or under-valuation
no long-term commitment, still P 3%


33
Question 30, exam 17 December 2009

Consider a perfect capital market.
On 1 January 2008 investor X buys shares of company X
for an aggregate amount of 1000 and at a price of 20,00
per share.
On 1 March 2008 company X implements a stock split,
where shareholders receive three new shares for each
existing (and subsequently withdrawn) share.
On 1 June 2008 the company pays a dividend of 1,50 per
share. During the remainder of the year, X holds the
dividend proceeds in cash and therefore receives no
interest.
On 1 September 2008 every investor receives a stock
dividend (dividend in stocks) of 6 percent.
On 31 December 2008 the closing price of the shares of S
is 6,70.

Question: Measured from 1 January until 31 December
2008 the total return of investor X on the
shares of S is closest to

a. 14%
b. 29%
c. 105%
d. 114%

34
Answer 30, exam 17 December 2009


Alternative b

January: N=50, P=20, V=1000

Stock split: N=50x3=150, P=20/3=6,67, V=1000

Cash dividend: N=150, P=6,67-1,50=5,17
V=775 & cash=150x1,50=225

Stock dividend: N=150x1,06=159, P=5,17/1,06=4,87
V=775 & cash=225

December: N=159, P=6,70
V=159x6,70=1065,30 & cash=225

Return=(end-begin)/begin=(1065,30+225-1000)/1000=29%



Another route is by backward computation of the stock
price (=6,70) to an equivalent in January
end: 6,70
6,70x1,06
6,70x1,06+1,50
begin: (6,70x1,06+1,50)x3=25,806 versus 20

Return=(25,806-20)/20=29%