Dividend Policy (Ch. 16)
HOW WE VIEW DIVIDEND POLICY
·
The key question: “What dividend policy should the firm
follow?” Answer depends on how
dividend policy affects s/h wealth (just dividend policy by itself).
·
Want to change just the dividend, holding everything else
constant, and see what effect it has on s/h wealth
o
Investment
decision does not change
o
Debt
financing does not change
·
Think of the sources and uses of funds:
o
Sources:
operating cashflows and new equity issues (since we don’t change debt)
o
Uses:
investment and dividends
=> OCF + New Equity = Investment
+ Dividends
o
Holding
the investment decision constant means both OCF and Investment are fixed
(don’t change as you change the dividend)
o
If
you increase dividends by $1, you will have to issue $1 worth of new shares to
finance the dividend
·
So, to identify the impact of just dividend policy by itself
on s/h wealth, we have to ask what happens to s/h wealth when you increase
dividends and finance the increase by issuing new shares.
·
One thing to bear in mind:
o
if
OCF > investment, the firm needs to pay out the difference to s/h
o
but
dividends are not the only way to disburse cash to s/h
o
the
firm can also repurchase shares
WHAT FIRMS ACTUALLY DO IN PRACTICE
·
They are reluctant to reduce dividends
o
Tend
to increase dividends only when they feel the higher dividend can be maintained
o
This
means dividends are increased when managers are confident future earnings will
be higher
o
Typically,
dividend increases follow earnings increases; and after dividend increases
earnings stay constant or increase further
o
Earnings
are volatile; dividends follow a step function (“dividend smoothing”)
·
Firms use target payout ratios, but only as a long range
target
o
If
you used a fixed payout ratio, dividends would increase every time earnings went
up and decrease every time earnings went down.
o
With
dividend smoothing, actual payout ratio fluctuates around target payout ratio
o
As
earnings increase, actual ratio becomes consistently lower than target ratio for
a while
o
If
firm feels the earnings increase is permanent rather than temporary, they will
step up dividends, and bring actual ratio close to target ratio again
INFORMATION CONTENT OF DIVIDENDS
·
Suppose two firms have the same increase in earnings today.
But firm P’s managers know the increase is permanent, while firm T’s
manager’s know the increase is temporary.
·
Firm P will increase its dividend, firm T will not.
o
P
and T announce the same increase in earnings
o
T
announces an unchanged dividend; P announces a dividend increase
·
The market understands what these dividend announcements
imply about future earnings. Both
firms will have a positive reaction to their announcements, but P’s will be
more positive. The dividend
increase announced by P conveys good news about future earnings.
·
Bottom line: looking just at earnings increases the market
cannot tell which increases are permanent and which are temporary.
Dividend announcements allow the market to distinguish them apart.
So the market reacts to dividend announcements based on what information
the dividends convey about future earnings.
·
Dividend increases are treated as good news; stock price goes
up. Dividend decreases are bad
news; stock price falls.
THE DIRECT EFFECT OF DIVIDENDS
·
The
information content of dividends is clearly relevant, and represents part of the
effect that dividend policy has on s/h wealth.
·
But it’s
an indirect effect. And ultimately
all it achieves is that information that would have been reflected in the price
later (as it became known through other channels) gets reflected in the price
today. Even if there’s no
dividend increase today, s/h will get the same increase in their wealth later,
as the market learns about the permanent increase in earnings.
·
We are more
concerned about the direct effect of dividends.
Leaving information content to one side, when a firm pays out an extra
dollar of dividends (financing it by issuing a dollar’s worth of new equity)
is that good for s/h or bad?
·
Unfortunately,
there is absolutely no consensus what the correct answer to that question is.
All we can do is understand what the issues are, and why the question
remains unresolved.
PERFECT
CAPITAL MARKETS
·
The best
starting point is to consider what effect dividend policy would have in
“Perfect Capital Markets (PCM)”
·
PCM is an
artificial world, defined as follows:
o
No taxes
o
No transaction costs (in primary markets as well as
secondary markets). So no issue costs, and no brokerage commissions or bid-ask
spreads either.
o
Equal information; managers don’t know anything
the market doesn’t
·
It’s a far
cry from the real world but it sheds very useful light on how things should work
in the real world
·
It’s the
starting point for understanding both dividend policy and capital structure.
·
Turns out
that dividend policy will be irrelevant in PCM: has no impact on s/h wealth
·
Why is that
useful to know? Tells us that there
are only three reasons why dividend policy might be relevant in the real world:
taxes, transaction costs or inside information
·
We’ve
already discussed information effects. That
leaves us with two factors to consider: taxes and transaction costs.
Anything else is irrelevant.
·
Effect of
dividend policy in PCM:
o
An all-equity firm has the following assets, and an
investment opportunity today which requires an investment of $1,000 and has an
NPV of $600:
§
Cash
1,000
§
Real assets
9,000
o
Suppose the firm pays no dividends.
Wealth of s/h = value of their equity = value of the firm = value of
existing assets + PVGO = 10,000 + 600 = 10,600
o
Suppose the firm pays a $500 dividend.
It will now have to issue $500 worth of new equity to finance the
investment.
§
Value of the
firm once the new equity is issued and dividend is paid = value of existing
assets + PVGO = 10,000 + 600 = 10,600
§
New s/h’s
share of this value = $500 (they’ve
been issued shares worth $500)
§
Old s/h’s
share of this value = 10,600 – 500 = 10,100
§
Wealth of
old s/h = dividend received + value of their shares = 500 + 10,100 = 10,600
=>
no change in s/h wealth
o
Suppose initially there were 1,000 shares.
§
Each share
would originally be worth $10.60. The
dividend per share would be 50 cents.
§
From above,
the ex-dividend value of these original 1,000 shares = 10,100
§
Ex-dividend
value per share = $10.10
§
The new
shares will be issued at this price. To
raise $500, the firm will have to issue 500/10.10 = 49.50 shares
§
Without the
dividend, each old s/h has a share worth $10.60.
§
With the
dividend, each old s/h gets 50c in cash and has a share worth $10.10.
§
Assume a s/h
has bought his shares last year for $8 each, and sells today.
Without the dividend, his return consists of a capital gain of $2.60.
With the dividend, he gets a dividend of 50c and a capital gain of 2.10.
In PCM, s/h have no reason to care how their total return is divided up
between capital gains and dividends. So
they are indifferent to whether there is a dividend or not.
o
The equal access argument:
§
Some
stockholders may want cash from their portfolio today; others may not.
§
Neither type
of s/h cares whether the firm pays a dividend or not.
§
If the firm
doesn’t pay a dividend, a s/h who wants cash from her portfolio can generate
cash by selling some of her shares.
§
If the firm
pays a dividend, a s/h who don’t want cash can simply reinvest the dividend by
buying some of the shares the firm is issuing.
§
What the
firm is doing by making a dividend payment, s/h can do or undo on their own.
So it doesn’t matter to them whether the firm pays a dividend or not.
o
Stock repurchase has the same effect as a dividend:
no change in s/h wealth
§
Initially
there are 1,000 shares outstanding, for a total value of $10,600
§
The company
will use $500 to buy back 505/10.60 = 47.17 shares
§
There will
now be 952.83 shares outstanding at $10.60 each, for the same total value as
before, $10,100
§
S/h who sell
their shares will now have $10.60 in cash; s/h who keep their shares will have
$10.60 worth of shares