Corporate Finance

Term III, Sections E & F

Class Notes 12

Indian Institute of Management Calcutta

Prof Purusottam Sen

December 2017-March 2018
 Different Types of Dividends

• Many companies pay a regular cash dividend.

– Public companies often pay quarterly.
– Sometimes firms will pay an extra cash dividend.
– The extreme case would be a liquidating dividend.

• Companies will often declare stock dividends.

– No cash leaves the firm.
– The firm increases the number of shares outstanding but
still perceived as ‘valuable’

• Some companies declare a dividend in kind.

– Wrigley’s Gum sends a box of chewing gum.
– Bata / Vimal Discount coupons
 Standard Method of Cash Dividend

Cash Dividend - Payment of cash by the firm to its shareholders.

Ex-Dividend Date - Date that determines whether a stockholder

is entitled to a dividend payment; anyone holding stock
immediately before this date is entitled to a dividend.

Record Date – Date on which company determines existing

shareholders.
 Procedure for Cash Dividend

25 Oct. 1 Nov. 2 Nov. 4 Nov. 7 Dec.

…

Declaration Cum- Ex- Record Payment

Date dividend dividend Date Date
Date Date

Declaration Date: The Board of Directors declares a payment of dividends.

Cum-Dividend Date: Buyer of stock still receives the dividend.

Ex-Dividend Date: Seller of the stock retains the dividend.

Record Date: The corporation prepares a list of all individuals believed to

be stockholders as of 5 November.
 Price Behavior
In a perfect world, the stock price will fall by the amount of the dividend on
the ex-dividend date.

-t … -2 -1 0 +1 +2 …

Rs.P

Rs.P - div
The price drops by Ex-
the amount of the dividend
cash dividend. Date
Taxes complicate things a bit. Empirically, the price drop
is less than the dividend and occurs within the first few
minutes of the ex-date.
 M-M’s Dividend Irrelevance Theory
 Value of the firm is determined by
 Earning power of its assets and its Investment policy
 i.e. P = f(E)
 Dividend payout ratio is irrelevant
 Critical assumptions
 Perfect capital markets
 Investors are rational
 No information costs
 No transaction costs
 Infinitely divisible securities
 No taxes
 Given investment policy, not subject to change
 Certainty of future investments and profits of the firm
 M-M’s Theory –1

Effect of dividend payment on shareholder wealth is offset exactly

by other means of financing

MARKET PRICE IS ADJUSTED SO THAT “RETURN” IS THE SAME.

Return = (Dividend + Capital Gains) / Investment

pj(t) = Market Price at the beginning of time ‘t’
dj(t) = Dividend paid during ‘t’
pj(t+1) = Closing Price

d j (t)  p j (t  1)  p j (t)
ρ (t) 
p j (t)
p j (t) * (1  ρ (t) )  d j (t)  p j (t  1)
d j (t)  p j (t  1)
p j (t) 
1  ρ (t)
 M-M’s Theory-2
n(t) = no. of shares at the beginning of time ‘t’
m(t+1) = no. of shares issued during ‘t’
n(t+1) = no. of shares at the end of time ‘t’
m(t+1) + n(t) = n(t+1)
D(t) = Total dividend paid during ‘t’ on n(t) shares
V(t) = n(t) * p(t) = value of shares
1
p(t)  (d(t)  p(t  1))
(1  ρ (t) )
1
n(t) * p(t)  [n(t)d(t)  n(t)p(t  1)
(1  ρ (t) )
n(t)  n(t  1)  m(t  1)
1
V(t)  [D(t)  n(t  1) * p(t  1)  m(t  1) * p(t  1)]
(1  ρ (t) )
1
 [D(t)  V(t  1)  m(t  1) * p(t  1)] Apparent dividend relevance ?
(1  ρ (t) )
 M-M’s Theory - 3
Assuming certainty of future investment outlays the following
derivation can be made
X(t) : Income in time “t”
I(t) : Investment in time ‘t”

m(t  1)p(t  1)  I(t)  [X(t)  D(t)]

1
V(t)  [D(t)  V(t  1)  I(t)  X(t)  D(t)]
1  ρ (t)
1
 [V(t  1)  I(t)  X(t)]
1  ρ (t)
THUS, V(t) IS INDEPENDENT OF D(t)
V(t+1) IS INDEPENDENT OF D(t+1)
V(t+2) IS INDEPENDENT OF D(t+2)
VALUE IS INDEPENDENT OF DIVIDEND
M-M’s Dividend Irrelevance Theory under Uncertainity

 Concept of Symmetric Market Rationality used – essentially

same reasoning as irrelevancy of capital structure /
diversification
 Investors can devise ‘homemade’ dividends

 Replication of any dividend stream possible

 Dividends less  portion of stock sold
 Dividends more  additional stock bought

 Conservation of Value
 Homemade Dividends

 ABC’s stock price is Rs.42 stock is about to pay a Rs.2 cash dividend.
 Investor owns 80 shares and prefers a Rs.3 dividend.
 Investor’s homemade dividend strategy:
– Sell 2 shares ex-dividend
Rs. 2 Rs. 3
Dividend Dividend
Dividend 2 3
Current stock holdings
No. 80 80
Stock Price 42 42
Ex Div price 40 39

Cash from dividend 160 240

Cash from selling stock 80 0
Total Cash 240 240
Value of holdings 3,120 3,120
(40 x 78) (39 x 80)
 Impact of Homemade Dividends
Rs. 2 Rs. 3
Dividend Dividend
Dividend 2 3
Current stock holdings
No. 80 80
Stock Price 42 42
Ex Div price 40 39

Cash from dividend 160 240

Cash from selling stock 80 0
Total Cash 240 240
Value of holdings 3,120 3,120
(40 x 78) (39 x 80)

In our example, Investor began with a total wealth of Rs.3,360: (80 * 42)
After a Rs.3 dividend, his total wealth is still Rs.3,360: (80 * 39 (value of
holdings) + 240 (dividend)
After a Rs.2 dividend and sale of 2 ex-dividend shares, his total wealth is still
Rs.3,360: (78 * 40 (value of holdings) +160 (dividend) + 80 (sale of shares)
 Irrelevance of Dividend Policy

• A compelling case can thus be made that dividend policy is

irrelevant.

• Since investors do not need dividends to convert shares to

cash; they will not pay higher prices for firms with higher
dividends.

• In other words, dividend policy will have no impact on the

value of the firm because investors can create whatever
income stream they prefer by using homemade dividends.
 Taxes and Dividends
• Dividend policy irrelevanance needed three assumptions:
– No taxes
– No transactions costs
– No uncertainty

• Tax rates on dividends and capital gains are important decision variables.
Tax on capital gains can be deferred

• Tax impact on shareholders could be higher for dividends vis-à-vis share

repurchase (not so in India, tax on Dividends is zero)

In the presence of personal taxes:

1. A firm should not issue stock to pay a dividend.
2. Managers have an incentive to seek alternative uses for funds to
reduce dividends.
3. Though personal taxes mitigate against the payment of dividends,
these taxes are not sufficient to lead firms to eliminate all dividends.
 Firms without Sufficient Cash

Investment Bankers The direct costs of

stock issuance will add
to this effect.

Cash: stock issue

Stock
Firm
Holders
Cash: dividends

Taxes
In a world of personal taxes, firms
should not issue stock to pay a
Gov. dividend.
 Repurchase of Stock

• Instead of declaring cash dividends, firms can rid themselves of excess cash
through buying shares of their own stock.

• Recently, share repurchase has become an important way of distributing

earnings to shareholders.

Initial
Liabilities Assets
Equity 1,000,000 Fixed and Other Assets 850,000
Debt Cash 150,000
1,000,000 1,000,000
Shares 100,000
Price/share 10
 Stock Repurchase versus Dividend

Dividend
Cash Dividend 100,000
Liabilities Assets
Equity 900,000 Fixed and Other Assets 850,000
Debt Cash 50,000
900,000 900,000
Shares 100,000
Price/share 9

Share Repurchase
Shares Repurchased 100,000
Liabilities Assets
Equity 900,000 Fixed and Other Assets 850,000
Debt Cash 50,000
900,000 900,000
Shares 90,000
Price/share 10
 Share Repurchase

• Flexibility for shareholders

• Keeps stock price higher

– Good for insiders who hold stock options

• As an investment of the firm (undervaluation)

• Tax benefits
 Real-World Factors Favoring High Dividends
• Desire for Current Income

• Behavioral Finance
– forces investors to be disciplined.

• Dividend Signaling
– Information content of dividends

• Agency Costs
– High dividends reduce free cash flow.
 The Clientele Effect

Clienteles for various dividend payout policies are likely to form

in the following way:

Group Stock Type

High Tax Bracket Individuals Zero-to-Low payout

Low Tax Bracket Individuals Low-to-Medium payout
Tax-Free Institutions Medium payout
Corporations High payout

Once the clienteles have been satisfied, a corporation is unlikely to create

value by changing its dividend policy.
 Bird-in-the-Hand Theory

The bird-in-the-hand theory, states that dividends are relevant. Considering that
total return (k) is equal to dividend yield plus capital gains, Myron Gordon and
John Lintner (Gordon/Litner) took this equation and assumed that k would
decrease as a company's payout increased.

Gordon and Lintner argued that investors value dividends more than capital
gains when making decisions related to stocks.

However, it is possible that as a company increases its payout ratio, investors

become concerned that the company's future capital gains will dissipate since
the retained earnings that the company reinvests into the business will be less.
 The Dividend Puzzle - What We Know

• Corporations “smooth” dividends.

• Fewer companies are paying dividends in some countries –
for example in the US. In India dividends continue to be very
important
• Dividends provide information to the market.
• Firms should follow a sensible policy:
– Do not forgo positive NPV projects just to pay a dividend.
– Avoid issuing stock to pay dividends.
– Consider share repurchase when there are few better uses for the cash.
But very few share repurchases in India due to certain issues

 Dividends relevant, but dividend policy could well be

irrelevant?
 Dividend as a Long Term Residual
Year
0 1 2 3 4 5 5 year Total
Earnings 7.00 5.00 3.00 6.50 3.50 25.0
Dividend 1.92 1.92 1.92 1.92 1.92 9.6
Retained Earnings 5.08 3.08 1.08 4.58 1.58 15.4
Total Equity 200.00 205.08 208.16 209.24 213.82 215.40
New Debt 4.60
Total Debt 60.00 60.00 60.00 64.60 64.60 64.60
D/E 0.30 0.29 0.29 0.31 0.30 0.30
Dividend Payout 0.27 0.38 0.64 0.30 0.55 0.38

Funds Available for Investment

Retained Income 5.08 3.08 1.08 4.58 1.58

New Debt 0.00 0.00 4.60 0.00 0.00
Cumm. Total 5.08 8.16 13.84 18.42 20.00

Cumm. Investment Requirement 4 8 12 16 20

 Dividend Policy?
 If dividend payout irrelevance  purely a financing decision  a passive

residual

Other Considerations :
 Assessment of valuation information
 Apart from expectations of investors and clientele issues, one
must also consider benchmark with other companies in industry
 Control
 High dividends and need to raise capital later
 Low dividends and take over bids
 Restrictions in bond indenture and loan agreement