U

S.

R.
í*lÉli$ril*ÉlÉiEii \
G
s EF-T l-'
\ .E;:
6S=
o :-* 3..S \JI
rJ *r''*Sl
a +j s 1.E-
gÉgllglIiÉlíaíÉlig 1-- FF- ;s
R. i'. E s
ñ
ft\ EF iü
\>\ e.X ¡J
:o6¡
-e F9
; ¡s
ii o
<6
s\ <5aS si¡
- ?
G Eg
-wóx=
:.E

glÉilIgÉíggíÉErggg o
\ xg S*
6 *E
s < *i
e ;.F
tr , P N : i] o S s@ - H ó < o
- I = =^
6s
tFf+€5i*írí3*igFF#

¡l ¡ ?- + #H f f g 1s 3F
-t ó n';+alo -j
Tt t + + + iíggd= ¿'E¿*, Fl á
- 3=?8.-¡;: 6= -H
ol
FI aÍf se3.>
g 3 *eE E F lll ;
ál l l l l 55*FáE íi S.++H+ -El5o.djÉ I= ñ
ot.¡ , x 5 o :j @ @ @ .i o
='.3 EFe*i== 7A
*ij F
g.l EÉ' Eá F's. Po E*qEd;K I
3l o o o I g s lE {rn
gl fá;:?i =S.gábgñ. ;2
ol ro ¡o Ix dr ?aFe*¡ ¿ 3r
O3$tÜ =*ñ- a?ir= ¿i<
il ; ZáF teá€;ñg á,t ñ
ñl gE6 tr) V) iñ P: F? *-
Éñá=É_cr= ¡r/'\
vi; O
;r
pl E
@ o @Q + .! ¡r Y( '.+< -.5-.X ¿''
2l É D ?
iHg;Ée $Éii É =1
=. lt
t*iiE;1 gS3: e 3Se 9ea:E+3 Ée :
;l llH B illt d51F@É"c
il ]: É
il @ o t - U) ,i-¡ z) ñ 38"; fs'E é: z
qi r g * ñ 9{ Ég:5:*'g s= ü
+ "=(
gl E3cs *i
*rrsiFí íEÉ ; üe - "o ó' iÉ 3
EHHi$;' +l.s á v x1d3f
rl m 5 " e + g d 9.c 5.Tq,9 o ó i<
ól 6 c r \ú ¡3gÉsa +li tFgáaiE 8 :
*l ^+o á i ililil ¡
5 + €
xa¡; 7
=i
él o = -*.8'E ñsqÉri : "**
Nl E',fr¡Eü0 d? F i'E'Éa-*E *5 {
iEg¡¡ jjj (D<:
? O .5:c
=s @
I
E FX
- r6 oq
*l I r:E á. !3iÉ.=.q
Ei
él
á 'o
O
=
d \ "sB'[E? 8 j j
^
9?6e;p. ; "-' S '88 q ! 6I +;
g -'-9I s=
*o ¡ c F 1 ó
Q-éoq'=- {
+l É- o
Ffd aC6<Í=
?r*HÉ E áf :;(joieo
^oTI-3
,=p=x*
¡
NI G
<t eriñ? ;. € + o Y o N'
xw
YI .t aai o I == da:
dl X =. á# F 5
--"'¡xY-
as á9 '5 .i
-l *iÉñ* : e
q o x j6r X
1^:I-i.i"=' - 847;Sr i
:lxt ='
sl
EI
E3¡l'á 8- it 996oHo
rl -99'fió ==^xx<
ooñXoi- (,r
ot o<;írr! o r @¡X
FD 5 s A
---=ooUtt
546 DTvTDEND PoLIcY: THEoRY THE IRRELEVANCE OF DIVIDEND POLICY IN A WORLD WITHOUT TAXES 541

If the numerator and denominator of (15.1) are multiplied by the current number of wherc V,1t + l): n.(¡ + l)Fr(r * 1). Therefore the valuation equation (15.2) may be
by rearranging terms, we have rewritten
shares outstanding, ndr), then
Div,(¿+1)+nl¿)Pf¿+1) (rs.2) (15.8)
vt(t):
l+p(¿+1)
where 3. V¡luation and the Irrelevancy of Dividend Payout
Div,(t + 1) = total dollar dividend payment : nl|divl¿ + 1)' It is no accident that dividends do not appear in the valuation equation (15.g).
l4(¡) : the market value of the firm : n¡(t)Pt(t). Given that there are no taxes, the firm can choose any dividend policy whatsoever
without affecting the stream of cash flows ¡eceived by shareholders. It could,
Hence the value of the firm is seen to be equal to the discounted sum of two cash e.g., elect
to pay dividends in excess of cash flows from operations and still be able to unáertake
flows: any dividends paid out, Div,(l * 1), and the end-of-period value of the firm'
any planned investment. The extra funds needed are supplied by issuing new equity.
To show that the present value of the firm is independent of dividend payout, we
in order to rewrite on the other hand, it could decide to pay dividends less than the amount of cash
shall examine the sources and uses of funds for the two firms
left over from operations after making investments. The excess cash would be used
(15.2) in a way that is independent of dividends.
to repurchase shares. It is the availability of external financing in a world without
information asymmetry or transactions costs that makes the value of the firm inde-
2. Sources and Uses of Funds pendent of dividend policy.
we can use Eq. (15.8) to prove that two firms that are identical in every respect
There are two majoJ sources of funds for an all-equity firm. First, it receives
except for their current dividend payout must have the same value. The equation has
cash from operations, ÑdÍ¡r + 1). Second, it may choose to issue new shares,
four terms. First, the market+equired rate of return, p, must be the same because both
m,(t + \F,( + l¡, *h"tt mt(t + l) is the number of new shares' There are also two
firms have identical risk, ÑdÍr14 : ÑdÍrp¡, for all ¿. Second, currenr cash flows from
.uior utti of funds: dividends paid out, bivt(r + 1), and planned cash outlays for operations and current investment outlays for the two firms have been assumed to be
inv;stment, I-r(¡ + l).2 By definition, sources and uses must be equal' Therefore we
identical:
have the foilowing identity:
ño*r,1r¡ : ñdr,1r¡, i¡r¡: i,1t¡.
Nolr(r+ r)+m,(t+ l),Pr(t+ 1)= i,1¿+ 1)+6ií¡(ú+ 1)' (1s.3)
Finally, the end-of-period values of the two firms depend only on future investments,
we can use this fact to rewrite the numerator of the valuation_equation (15.2).
dividends, and cash flows from operations, which also have been assumed to be
Calling the numerator of (15.2) the dollar return to shareholders, Rr(' + 1)' we have
identical. Therefore the end-of-period values of the two firms must be the same:
ñ,(¿ + t) : 6ií,1r + 1) + r4r(¿).Fr(ú + l). (15.4)
t,,o¡: 7,tt¡
we know that if new shares are issued, the total numbef of shares outstanding at consequently, the present values of the two firms must be identical regardless of their
the end of the period, n(t + 1), will be the sum of current shares' n(t), and new shares, current dividend.payout. Dividend policy is irrelevant because it has no effect on
m(¿ + 1): shareholde¡s' wealth in a world without taxes, information asymmetry, or transac-
n'(t + l): ni1) + mt(t + l). (1 5.5) tions costs.
Note that the proof of the irrelevancy of dividend policy was made using a multi_
Using (15.5), we can rewrite (15.4) as period model whose returns were unce¡tain. Therefore it is an extremely genéral argu-
ñ,p+ t¡:6iílt+ 1) +nr(¿+ l)Fr(t 1-t)-m,(t + l)Fi(ú+ 1)' (ls'6) ment. In addition to providing insight into what does not affect the value of the fiim,
it provides conside¡able insight into whaf does affect value. The value of the firm
Finally, taking Eq. (15.3), which establishes the identity of the sources and uses of
depends only on the distribution of future cash flows provided by investment deci-
funds,'to subsiitute for n,(t + l)Fi(t + 1) in the above equation, we obtain
sions. The key to the Miller-Modigliani argument is that investment decisions a¡e
ñ,(r + t): Ñ,(¿ + t)+ir|+t)_ iít+ l)+ÑdÍ,(¿ + 1)-6iv,(¿+ 1) completely independent of dividend policy. The fi¡m can pay any level ofdividends it
: ÑdÍ,(¿ + 1)- ¿(t + 1) + 4(t + 1), (1s.7) wishes without affecting investment decisions. If dividends plus desired investment
outlays use more cash flow than is provided from operations, the firm should seek
*n,i, nrf¡Ánt extefnal financing (e.g., equitv). The desire rn nreintoi- q la',-l ^r a:-.:)-'- )-
assuntes, for thc sake of convenience, tl¡at sources and uses of funds from balance sheet
548 DIVIDEND POLICY: TI{EORY VALUATION, GROWTH, AND DIVIDEND POLICY 549

NOlz- 12 = X-l Table 15.1

NOIl-/1 NOll +r¡Iy-12 ... + !_o IN
.\ 4 -
Vs
.NOtr Time Cuh
Pqiod Crch Inflow Outfo,
tl
1 NOIr -Ir
Figure l5.l
Time pattern ofcash flows for a growing firm.
2 NOI, = NgJt .r rt¡t -12
3 NOI.:¡6¡, +rJr+rzl2 -13 (15.1 1)
: . N-
B. VALUATION, GROWTH, AND 1

DIYIDEND POLICY
N NOI':¡¡91r + | r,l,
.= I
-;,
The Mille¡-Modigliani argument that the value of the firm is independent of dividend
policy also extends into a world with corporate taxes but without personal taxes. In
this section the valuation model [Eq. (15.8)] is extended to include corporate taxes Equation (15.10) is the same formula used in Chapter 2 on capital budgeting. The
and a growing stream ofcash flows. The result is a valuation model that has realistic present value of the firm is the sum of the discounted cash flows from operations less
features and hence may be usefully applied to real-world valuation problems. Chapter the new investment outlays necessary to undertake them.
16 will expand on the usefulness ofthe valuation model by means ofan example. Referring to Fig. 15.1, we can see that the average return on investment, r,, is
assumed to continue foreve¡ at a constant rate. This is a perfectly reasonable assump-
1. The Valuation of an All-Equity Firm with Growth tion because if the capital budgeting decision is made correctly, each project will re-
turn enough cash to cover payments to suppliers ofcapital and to recover the initial
Figure 15.1 uses the time line as a graphic representation of the pattern of cash investment. Thus the cash flows are sufficient to provide any needed replacement
flows earned by a growing firm. Note that there is a current level of cash flow, NOI', investment to sustain the project at a constant level forever. The stream of cash flows
that is assumed to be received at the end of each year forever. If the firm made no for the growing firm in Fig. 15.1 is given in Table l5.l falso Eq. (15.11)].
new investments and only maintai4ed its cu¡rent level of capital stock, it would re- Substituting (15.11) into (15.10), we can express the present value ofthe growing
ceive cash flows each yearequal to Ñdlr, but it t"ould not be growing. Growth comes firm as
from new investment, not replacement investment- The value of new investment de-
pends on the amount of investment, 1,, and its rate of return, r,. ,, NOI1
-Ir -, NOIr lrrlr- 12 NOI1 +rrIr + r2l2-13
We can extend the valuation equation (15.8) by assuming that the discount rate, 'o- t+p {r*op-- 1t*rp-
p, does not change from time period to time period. This is reasonable if all new lv-1
projects have the same risk as those that the firm currently holds. Equation (15.8) is3 NOI'+ lryI,-ln
r...rE (rs.t2)
l/
'u
NOLt - r. v.
(15.8)
(1 + p)N
l+p l+p
This extended equation can be simplified greatly. First, rewrite it by rearranging
Given a constant discount rate, p, the valuation model can be extended to N periods terms as follows:
as follows:

n:*:'i;".T?#* *ffrl +- -!L ¡5e)

,,
vo :
NOI1 NOIr
*
I + p tti¡+..
NOI,
+6.r p¡N

rrf t, ,..., ' (1 ', - t plI

' ''L(t + p\' ,' {t+', o¡''
A reasonable assumption is that in any time period the value of the firm, 4, is finite.4
Therefore, given a model with an infinite horizon, we have +p)n t+
g
h:JT,!, NoI.
0+py
- I, (1s.10) .r,[u+tF + t+fr+ +(r+;F-#t].
3
This result can be generalized as
The tild€s (-) are dropped for notational convenienc. Also noto thal

4
After all, no one has obse¡ved a fim
NOIr=N9¡,*"t¡t.
with infinite value as yet, n :,i #h.,i .[(,á, d;) - #r] (15.13)
550 DTVIDEND PoLIcY: THEoRY VALUATION, GROWTH, AND DIVIDEND POLICY 55

We can simplify Eq. (15.13) by recognizing that the-first

term is an infinite annuitY Table 15.2

with constant payments of NOI, per period' Therefore /of $A t/

.. A NOIr NOI1 (1s.14) Firm 1 10,000 20 2,000
;'*,=¿, (1Trl p '
Firm 2 30,000 10 3,000
9,090
o
Firm 3 100,000 5 5.000
-45,454
Next, the second term in (15.13) can be simplified as follows:
grrln-trl
.!*'tt * pr: I +e ,4,1+ ü' (15.1s)
Another feature of Eq. (15.16) is that it is derived directly from Eq. (15.g), and
in both we have the result that dividend policy is irrelevant in a world without taxes,
1'-r,lrt information asymmetry, o¡ transactions costs. All that counts is cash flows from
(1+pl,l*6;7: $ +dn investment.

a simplified expression
Substituting (15.14) and (15.15) back into (15'13), we obtain
lor the present value of the firm:
3. The Value of an All-Equity Firm that Grows
at a Constant Rate Forever

%:'l'*t $ ,f/ ', \- t +t ,l]

.. [NoI,,*,=¿,"l\pd+py)- Equation (15.16) is elegant but somewhat cumbersome to use.s It has two useful
o il )J variations. The first, which is developed below, assumes that the firm experiences a
. NOI,t)- S l,(r,- Pl .
constant rate of growth forever. we shall call it the infinite constant growth moilel.
p ',?1 p$+Pl" The second, developed later on, assumes that the firm can maintain a supernormal
rate of growth (where r, > p) for a finite period of time, T, and realizes a no¡mal
: Value of assets in place + value offuture growth' (15'16)
rate of growth thereafter. It is called the finite supernormal growth mod.el.
The constant growth model can be derived from Eq. (15.16) if we assume that a
constant fraction, K, of earnings is retained for investment and the average rate of
2. Why Darnings per Share Growth Maximization return, r,, on all projects is the same. The fraction of earnings to be retained for
Is an InaPProPriate Goal investment is usually called the retention ratio; however, there is no reason to restrict
This form of valuation equation provides important insights
into the- m^uch it to be less than 100% of cash flows from operations. Rather than calling K the
present value of a firm
uuur.J ir.* growth stock.The first terÁ in Eq' (15'16) is the retention rate, we shall call ittlte inuestment rate. As was mentioned in the first sec-
an infinite stream of con-
that makes n-o new investments. It is the presént value of tion of this chapter, the firm can invest more than cash flow from operations if it
stant cash flows. In other words it is the value of a firm that is not growing' It is provides for the funds by issuing new equity. If investment is a constant proportion
itt" nulu" of assets in place. But what about the fi¡m that makes new (15'16)' It
investments? of cash flows, we have
iL prc*r, value of new investment is shown in the second term of Eq' 1,: K(NOIJ.
rrew investment depends (15.17)
i, if,, pr"t"nt value of expected future growth' The tal.ue-of
(2) the difference between the
on two things: (1) the amount of investáent made and And if the rate of return on investment, r,, is the same for every project, then
rate of return'
u*.ug. ,ut""of'ráturn on the investment, r', and the market-required they NOI':NOI'-'+rI'-t
grow, but they do not add anything to value-unless
p. TltJ uss"t, of a firm may
earn a rate of return greatei than what tÍre market requires
for assets of equivalent : NOI¡_r * TKNOI,_,
of return (i'e''
;irk. F"; example, srftposing that the market requires a l0% rate : NOI,-r(1 + rK).
p : l}%),.onrid". the ihree situations given in Table 15'2'
Firm 3 has the greatest "growth" ii earnings (ANOI 5'000)'
: But which firm By successive substitution, we have
the greatest incráse in val-ue? Obviously, firm 1 does' The reason is that it is the
has
rate.of NOI,: ¡9J,11 + rK)'-l
lnlynrti that has new investments that eam more than the required market
(15.18)
maximize
..ii.r 10%. Therefo¡e the objective of a firm should ¡¡¿u¿r be to simplythe 5
However, do not unde¡estimate the usefulness of Eq. (15.16). It is the basis for most commonly u;
gr"*ii "fit *-ings or cash flows' The objective should be to maximize market valuation models. ep AIaaD 'l;^L ¡- ^ ----- I
552 DTVTDEND PoLrcY: THEoRY VALUATION, GROWTH, AND DIVIDEND POLICY 553

Note that rK is the same as the rate of growth, g, for cash flows. In other words, NOI Given these facts and the necessary condition that g < p, the infinite growth model,
in the tth time period is the future value of NOI in the first time period, assuming Eq. (15.21), can be rewritten as
that cash flows grow at a constant rate, g:
,, Div,
(ls.21a)
NOI':N6¡t11 *'Y-t' p-g
By substituting (15.17) into (15.16) and maintaining the assumption that r, = ¡, 1rys which is the Gordon growth model.
have
4, Independence between Investment Plans and
/o:NOIt *;' KNot'(r -P). (15.1e) Dividend Payout
Q ,?t p(l + p)'
Then by using (15.18) in (15.19) we obtain This form of the valuation model can be usod to illustrate the relátionship be-
tween the result that the value ofthe firm is independent ofdividend policy and the
n":y*,.,*o,,(ry,
),i(f,# assumption that investment decisions should never be affected by dividend payout.
A commonly made error is to impücitly assume that there is some relationship
between the amount of cash flow retained and the amount of investment the firm
-Y['.+#,i("iÍ)'] (1s.20) unde¡takes. Suppose we take the partial derivative of Eq. (15.21) with respect to
changes in the investment rate, K:
lf rK < p, then the last term in (15.20) will have a finite limit:6 )Vo NOI,(r - p)

iff p>rK ax: -¡o

- ,*y ' u'
;'*,ü(*+)':=t* (15.20a)
This suggests that if the rate of return on investments, r, is greater than the market-
Substituting (15.20a) into (15.20) and simplifying, we have an equation for the value required rate of return, p, the value of the firm will increase as more cash flow is
of the firm, assuming infinite growth at a rate less than the market rate of return, p: retained, and presumably the increased amount of retained cash flow implies lower
dividend payout. This line of reasoning is incorrect for two reasons. First, the amount
y_NoIrfr_K(r-p) l+Krl of cash flow retained has nothing to do with dividend payout. As was shown in the
p l'' t+Kr p-rKf sources and uses offunds, identity (15.3), the firm can arbitrarily set dividend payout
at any level whatsoever, and if the sum of funds used for dividends and investment
_ Norl(l - K). is greater than cash flows from operations, the firm will issue new equity. Second,
( 5.21)
p-Kr 1

Equation (15.21), rewritten in a somewhat different form, is frequently referred
to as the Gordon growth model. Nofe that since K is the investment rate (although
K need not be less than one), the numerator of(15.21) is the same as dividends paid
at the end of the first time period:
the investment decision that maximizes sha¡eholder wealth depends only on the
market-required rate of return. The amount of cash flow retained could exceed the
amorjnt ofinvestment, which would imply that shares would be repurchased. There-
fore there is no reiatiooship between the value of the firm and either dividend payout
or cash flow retention.

NOIl(l-K) :Divr. 5. The Bird-in-Hand Fallacy

Also, as was shown earlier, the product of the investment rate and the average rate
A more sophisticated argument for a relationship between the value of the firm
of return on investment is the same as the growth :c:te, g, in cash flows; therefore
and dividend payout is that although the dividend decision cannot change the
Kr: Q. present value of cash payments to shareholders, it can affect the temporal pattern
of payouts. Suppose that investors view distant dividend payments as riskier than
current payments, might they not prefer a bird in the hand to two in the bush? We
s:u+u2+...+Yn. can represent this argument mathematically by assuming that higher investment
rates mean lower current dividend payout, more risk, and therefore an increase in
Multiplying this by U and subtracting ihe resuit from the above, we have
the market rate of return, p, as a function of the investment rate, K. A simple example
s=ul0-q-uN+Ll0-u). would be to specify the relationship as
The second tem approaches zero in the limit as N approaches infinity. By substituting brck the deflnition
of U, we get (15.20h). p:d+8K2, p>0.
 IF
554 DTVTDEND PoLIcY: THEoRY VALUATIoN, GRowTH, AND DIVIDEND PoLIcY 555
I
I

Then we would have I

Substituting (15.21b) into (15.20) yields
avo _Nott(pKz-?pK+!-o.), _rK>0. : N;I'
AK @*fK¿-rK)'
This function will have a maximum where
d.+ BKz

É
',, {,
.
#1, _
(+f)J} (ts.22)

NOI'ffK2 -2PK+ r-a):Q. ii As long as Kr is approximately equal to p, and T is small, we can approximate the
last term as?
To see the error in this line of reasoning, we need only to return to our understanding
of vah¡ation under uncertainty. The risk of the firm is determined by the riskiness
of the bash flows from its projects. An increase in dividend payout today will result
(+f,)'-1-r(--!!) (1s.23)

in an equivalent drop in the ex-dividend price of the stock. It will not increase the
value of the firm by reducing the riskiness of future cash flows. By substituting the approximation (15.23) into the varuation
equation (r5.22), we have
an approximate valuation fo¡mula for finite supernormal g.o*th,t

6. Finite Supernormal Growth Model for an

/o: NOI' K(" Not'
AlFEquity Firm p * p_Kr'\t+p)
=l)r14-lr'\ p
Perhaps the most useful variation of the valuation equation is one that assumes NoIr
that the rate of return on investment is greater than the market-required rate of
return for a finite number of years, T, and from then on is equal to the market-
- p * *t¡6¡'¡7[-r:-P
' Lp1+dl1' (ls.24)

required rate of return. In other words the firm experiences supernormal growth
for a short period of time, then settles down and grows at a rate that is equal to ?_The
¡inomial expansion en be used- to a"tu" th
the rate of growth in the economy. Obviously a firm cannot grow faster than the (1 + p; : 1 + A. Then, recalling that Kr = c, we haye
economy forever or it would soon be larger than the economy.

ffi':,' *ar:i ([)or-.a"

To derive the finite growth model we start with Eq. (15.20). Note that the sum-
mation is no longer infinite:

n,:Y['.H,\ (l.Tf)] (15.20)

Solving for A, we have
:r+? *i,(f)o"'t*ro
I
Instead, growth lasts for only years. After year ?, we assume that r:
p, which
A:l+Kt- l=K'-P.
means that the second term adds nothing to the present value of the firm. Whenever t *o 1 * p
a firm is earning a rate of return just equal to its cost of capital, the net present Therebrethecor¡e"tapproximation,r
value of investment is zero. The summation term in Eq. (15.20) can be evaluated
as follows. Let 1+rA= r-r(o-:":\.
\t+P)
u: [(1 + rK)10 + df. ::l::lT_r11,-1P-"jl]igitl
rerum on rnyestmcnt' r' is 1l:he
app¡oximarion, asume that the investmcnl rate, K, is 50%, rhe rate
of
202. and.the_market-required rare of ¡etu¡n is tsz. Éigir" rs.Á'i, piái
We can then expand the sum: l(l + Ktll{.l + p)1. We can see visually that t¡" rinüi up-pñ,i"iüilr.*"onu¡r". " "i
S:U+U2+"'+Ur.
Multiplying thiq by U and subtracting the result, we have (ff¡'' o
('#)' ,
S - US: U - (Jr*1. 0.9
.9565 I
Solving for S and substituting back for U, we obtain .9t49 2
.8',152 3
. IJ -TJT+I [(1 + KrXl + p)] - [(1 + Kr)/(l + p)]rrl .83'71
.8007
4
5
1-U
 7. Finite Supernormal Growth Model for a Firm is provided by Farrar and Selwyn [1967] and extended into a market equilibrium
with Debt ¡nd Taxes framework bY Brennan [1970]'ro
Farrar and Selwyn use partial equilibrium analysis and assume that individuals
Up to this point, we have maintained the assumption that we are dealing with
attempt to maximize their after-tax income. Sha¡eholders have two choices. They can
an all-equity firm in a world without taxes. To extend the above valuation equation
into a world where firms have debt as well as equity and where there are corporate own shares in an all-equity firm and borrow in order to provide personal leverage,
taxes, we can rely on the results obtained in Chapter 13. The value of a levered firm
or they can buy shares in a levered firm. Therefore the first choice is the amount of
personal versus corporate leverage that is desired. The second choice is the form of
with finite supernormal growth can be written as follows:
paym"nt to be made by the firm. It can pay out earnings as dividends, or it can retain
'.7 -¡.) + r"B + K[NoI,(l - a)]rlwAcc(l
-. NOl,(l [ r-WACC I .-
+ wAcc)_1, tts.zsl
éarnings and allow shareholders to take their income in the form of capital gains.
Shareholders must choose whether they want dividends or capital gains.
where
If the firm pays out all its cash flows as dividends, the ith shareholder will receive
the following after-tax income, if:
:
NOI
:
end-of-year net operating profits,
: pll - +
ií : ttÑo"r - rD)(r - t") - rD,¡l(r - t ), (15.26)
WACC weighted average cost of capital c"B/(B S)],
B : market value of debt, where

K: investment rate, i! : the uncertain income to the ith individual if corporate income is received
as dividends,
T: the number of years that r > WACC,
r: the average rate ofreturn on investment, ÑO*I : ttre uncertain cash flows from operations provided by the firm,

p: the cost ofequity capital for an all-equity firm.

r: the borrowing rate, which is assumed to be equal for individuals and firms,
D" : corporate debt,
The first two terms in (15.25) are the value of a levered firm with no growth, i.e., the
'?alue De¡: personal debt held by the lth individual,
of assets in place. They are the same as Eq. (13.3), the Modigliani-Miller result
that assumes that firms pay corporate taxes but are not growing. The third term in r" = the corporate tax rate,
Eq. (15.25) is the value ofgrowth for the levered firm. It depends on the amount of rri : lbe personal income tax rate of the ith individual.
investment, /, : K(NOIJ, the difference between the expected average rate of return
The first term within the brackets is the after-tax cash flow of the firm, which is
on investment and the weighted average cost of capital, r - WACC, and the length of
time, T, that the new investment is expected to earn more than the weighted average fidÍ - rD)(l - z"). All of this is assumed to be paid out as dividends. The before-tax
income to the shareholder is the dividends received minus the interest on debt used
cost of capital.
Equation (15.25) is used in Chapter 16 as the basis fo¡ the valuation ofBethlehem
to buy shares. After subtracting income taxes on this income, we are left with Eq.
(ts.26).
Steel. Note, however, that even in this model (which is the most realistic of those
Alternatively, the firm can decide to pay no dividends, in which cas€ we assume
developed so far in this chapter) dividend payout is not relevant for determining the
that all gains are realized immediately by investors and taxed at the capital gains
value of the ñrm.
rate.rr In this event the after-tax income of a shareholder is

C. DIVIDEND POLICY IN A WORLD WITH

ii : tÑdl - rD"){l - ?"X1 - tr¡) - rDo¡(r - cn¡), (15.21)

PERSONAL AND CORPORATE TAXES where

i1 -_ tneuncertain income to the ith individual if corporate income is received as

Up to this point the models of firms that have been introduced assume a world with capital gains,
only corporate taxes. What happens when personal taxes are considered? In partic-
ular, how is dividend policy affected by the important fact that in the United States
?ri: the capital gains rate for the ith individual.
the capital gains tax is less than the personal income tax?e An answer to this question r0
More recently Miller and Scholes [1978] have also considered a world with dividends and taxes. The
implications of this paper are discussed later on in this chapter.
e The 1986 tax code nominally makes the capital gains rafe equal to the ordinary income rate. However, rr Obviously there is the third possibility that earnings ¿re translated into capital gains and the capital
capital gains taxos are still lcs than ordinary taxes in effect, because capital gains can be deferred in- gains taxes are defer¡ed to a lat€r date. This possibility is considered in Farrar and Selwyn [1967]; it does
definitely, whereas taxes on ordinary income cannot. not change their conclusions.
 r'
Now the individual pays a capital gains tax rate on the income from the firm and further. He shows that if the borrowing rate on debt is "grossed up" so that the
leducts after-tax interest expenses on personal debt. The corporation can implement after-tax rate on debt equals the after-tax rate on other.sources ofcapital, the marginal
.he policy of translating cash flows into capital gains by simply repurchasing its I investor will be indifferent between personal and corporate debt.12
¡hares in the open market. Empirical evidence about the existence of debt clienteles is discussed in Chapter
We can rewrite Eq. (15.27) as follows: 1ó. Some clientele efects are obvious. For example, high tax bracket individuals hold
E tax-free municipal bonds, whereas low tax bracket investors like pension funds (which
Íg = ¡1ñr -rD)(I -t")-rDr,f(t _ rg¡)*rDo¡(zo¡-toi). (15.28) ,
pay no taxes) prefer to invest in taxable corporate bonds. A much more subtle ques-
irom Eqs. (15.26) and (15.28) the advantage to investors of receiving returns in the
* tion, however, is whether investors discriminate among various corporate debt issues,
É
brm of capital gains rather than dividends should be obvious. So long as the tax F i.e., do high tax bracket investors choose lowleverage firms?
'ate on capital gáins is less than the personal tax rate (rn¡ < toi), individuals will pre- *{i Brennan [1970] extends the wo¡k ofFarrar and Selwyn into a general equilibrium
br capital gains to dividends for any positive operating cash flows, rate of interest, framework where investors are assumed to maximize their expected utility of wealth.
md level of debt (personal or corporate). The ratio of the two income streams, rf Although this framework is more robust, Brennan's conclusions are not much differ-
ent from those of Farrar and Selwyn. With regard to dividend payout Brennan con-
if _ [(Ño*I - rD"Xl -r.)- rDo,](l - ¡0,) + rDr,(¡r, - ¡r,) _ , /r{ro.l
$g.
cludes that "for a given level of risk, investors require a higher total return on a
-r, \tr.z>J security the higher its prospective dividend yield is, because of the higher rate of tax
?= .F,
levied on dividends than on capital gains." As we shall see in the next chapter, this
s greater than one if tr¡ 1 xpi. In general the best form of payment is the one that statement has empirical implications for the CAPM. It suggests that dividend payout
rl
s subject to least taxation. The implication, of course, is that corporations should should be included as a second factor to explain the equilibrium rate of return on
rever pay dividends. Ifpayments are to be made to shareholders, they should always #
1l securities. If true, the empirical CAPM would become
re made via share repurchase. This allows shareholders to avoid paying income tax tr
'ates on dividends. Instead, they receive their payments in the form of capital gains
tf
L R¡, - R7, : 6o + ó rpt, + 6rl(div t,lP." - R/J] + dj,, (rs.32\
hat are taxed at a lower rate. fll where
What about debt policy? Again the same principle holds. The debt should be
teld by the party who can obtain the greatest tax shield from the deductible interest f óo: a constant,
)ayments. This is the party with the greatest marginal tax rate. If the firm pays out :
ór influence of systematic risk on R;¡,
¡ll its cash flow in the form of dividends, the favorable tax treatment of capital gains
s irrelevant. In this case we have the familiar Modigliani-Miller [1963] ¡esult that óz : influence ofdividend payout on R¡,
he value of the firm is maximized by taking on the maximum amount of debt (see f¡, : lhe systematic risk of the jth security,
Jhapter 13). Proof is obtained by taking the partial derivative of Eq. (15.26) with div¡,fP¡, : the dividend yield of the jth security,
'espect to personal and corporate debt and comparing the results.
drr : a random erro¡ term,
Debt policy becomes more complex when the corporation repurchases shares in-
rtead of paying dividends. Taking'the partial derivatives of the capital gains income R¡, : the risk-free rate.
:quation, (15.27), we obtain
If the dividend yield factor turns out to be statistically significant, then we might con-
clude that dividend policy is not irrelevant. Direct empirical tests of the relationship
Corporate debt:
#:
-,nt - t")(I - t), (15.30) between dividend yield and share value are discussed in Chapter 16.
A paper by Miller and Scholes [1978] shows that even if the tax on ordinary
o*: personal income is gre¿ter than the capital gains tax, many individuals need not pay
Personal debt:
dD pi
-,r(t - ri. (1s.3 1)
more than the capital gains rate on dividends. The implication is that individuals
will be indifferent between payments in the form of dividends or capital gains (if the
.ftheeffective tax rate on capital gains is zero (as Miller [1977] suggests), then per-
firm.decides to repurchase shares). Thus the firm's value may be unrelated to its divi-
;onal debt will be preferred to corporate debt by those individuals who are in marlinal
dend policy even in a world with personal and corporate taxes.
ax b¡ackets higher than the marginal tax bracket of the ñrm. This result allows the
rcssibility of clientele effects where low-income investors prefer corporate debt and
righ-income investors prefer personal debt. Miller [1977] takes this argument even 12
The reader is referred to Chapter 13 for a complete discussion of this point.
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 UI V I'TI TUIIU I: I HbUKY
rather than to make up the shottfall of funds through external financing. (5) Share-
holder disagreement over internally financed investment policy will be more likely
the greater the amount ofinternally generated funds relative to the firm's investment
opportunities. In these cases, firms are more likely to experience takeover attempts,
proxy fights, and efforts to "go private." Given these tax-induced shareholder con-
flicts, diffuse ownership is more likely for externally financed firms than for internally
finanoed firms.
2. Theories Based on the Informativeness of
Dividend Payout
Ross [1977] suggests that implicit in the Miller-Modigliani dividend irrelevancy
proposition is the assumption that the market knows the (random) return stream of
the firm and values this stream to set the value of the firm. What is valued in the
marketplace, however,is the perceiu¿d stream of returns for the firm. Putting the issue
this way raises the possibility that changes in the capital structure (or dividend pay-
out) may alter the market's perception. In the terminology of Modigliani and Miller,
a change in the financial structure (or dividend payout) of the firm alters its perceived
risk class even though the actual risk class remains unchanged.
Managers, as insiders who have monopolistic access to information about the
firm's expected cash flows, will choose to establish unambiguous signals about the
firm's future if they have the proper incentive to do so. We saw, in Chapter 14, that
changes in the capital structure of the firm may be used as signals. In particular, Ross
[1977] proved that an increase in the use of debt will represent an unambiguous
signal to the marketplace that the firm's prospects have improved. Empirical evidence
se€ms to confirm the theory.
The signaling concept is easily applied to dividend policy as well as to financial
structure. We shall see that a possible benefit of dividends is that they provide valu-
able signals. This benefit can be balanced against the costs of paying dividends to
establish a theory of optimal dividend policy.
A firm that increases dividend payout is signaling that it has expected future cash
flows that are sufficiently large to meet debt payments and dividend payments with-
out increasing the probability of bankruptcy. Therefore we may expect to find em-
pirical evidence that shows that the value of the firm inc¡eases because dividends are
taken as signals that the firm is expected to have permanently higher future cash
flows. Chapter 1ó reviews the empirical evidence on dividends as signals.
Bhattacharya [1979] develops a model closely related to that of Ross that can be
used to explain why firms may pay dividends despite the tax disadvantage of doing
so. If investors believe that firms that pay greater dividends per share have higher
values, then an unexpected dividend increase will be taken as a favorable signal. Pre-
sumably dividends convey information about the value of the firm that cannot be
fully communicated by other means such as annual reports, earnings forecasts, or
presentations before security analysts. It is expensive for less successful firms to mimic
the signal because they must incur extra costs associated with raising external funds
TOWARD A THEORY OF OPTIMAL DIVIDEND POLICY 565
in order to pay the cash dividend.l6 Hence the signaling value ofdividends is posi-
tive and can be traded ofl against the tax loss associated with dividend income (as
opposed to capital gains). Even firms that are closely held would prefer to pay divi-
dends because the value induced by the signal is received by current owners only
when the dividend message is communicated to outsiders. One of the important im-
plications of this signaling argument is that it suggests the possibility of optimal divi-
dend policy. The signaling benefits from paying dividends may be traded off against
the tax disadvantages in order to achieve an optimal payout.
Hakansson [1982] has expanded the understanding ofinformative signaling to
show that in addition to being informative at least one of three sufficient conditions
must be met. Either investors must have different probability assessments of dividend
payouts, or they must have differing attitudes about how they wish to allocate con-
sumption expenditures over time, or the financial markets must be incomplete. All
three of these effects may operate in a complementary fashion, and all three are
reasonable.
Miller and Rock [1985] develop a financial signaling model founded on the con-
cept of "net dividends." It is the first theory that explicitly combines dividends and
external financíng to show that they are merely two sides of the same coin. The
announcement that "heads is up" also tells us that "tails is down." As was pointed
out in the original Miller-Modigliani [1961] article, every firm is subject to a sources
and uses of funds constraint:
NOI +,nP * AB :1 + Div. (15.36)
Recall that sources of funds are NOI, the firm's net operating income; nP, the pro-
ceeds from an issue of external equity (the number of new shares, m, times the price
per share, PI and AB, the proceeds from new debt. Uses of funds are investment, I,
and dividends, Div. The sources and uses constraint can be rearranged to have net
cash flows from operations on the left-hand side and the firm's "net dividend" on the
right-hand side:
NOI-I:Div- A,B-mP. (15.37)
Now imagine a model where time 1 is the present, time 0 is the past, and time 2 is
the future. The present value of the firm, cum dividend, is the value of the current
dividend, Divr, plus the discounted value ofcash flows (discounted at the appropdate
risk-adjusted rate, k):
4=Divr.ffi ( 15.38)
16
This suggests that dividend payout and debt level increases are interrelated signals. A firm that simul-
taneously pays dividends and borrows nay be giving a diferent signal than if it had made the same
dividend payment without borrowing.
 566 DTVTDEND pol-rcy: THEoRy TOWARD A THEORY OF OPTIMAL DIVIDEND POLICY 567

original shareholders'wealth is the value ofthe firm minus the market value ofdebt Subtracting (15.41) from (15.42) gives the announcement efect
and new equity issued:

: :
s,-E(sl)=r,[t.#]
St Vt -AB, ¡¡u, . ffi - LB, - mPr. (15.39)

Using the sources and uses constraint, Eq. (15.37), we have

: [Norl - EoNor,)][l . #] (15.43)

sr:Norr-r,*ul\oi,,.
Without any information asymmetry, this is just the original Miller-Modigliani prop-
osition that dividends are irrelevant. All tlrat counts is the investment decision.
If there is information asymmetry, Eq. (15.40) must be rewritten to show how
market expectations are formed. If future earnings depend on current investment,
then we can write that net operating income is a function of the amount of investment
plus a random error term,
NOI, :/(10) + e,,
NOI, =/(11) + er,
where e , and e, are random error terms with zero mean, i.e., E(er) : E(eJ : 0. We
also adopt the special assumption that the expectation of e, given e, is not necessarily
zefo'.
E(erlet) : yer.
If 7 is interpreted as a persistence coefficient, 0 < I < l, the market is assumed to
only partially adjust to new information (the first-period error). If we use the notation
Eo to remind us that the current value of the firm is based on preannoutrcement
information, then the current expected value of shareholders' wealth is
Equation (15.43) says that the announcement effect on shareholders'wealth will de-
(1s.40) pend on the "earnings surprise." Thus we would expect that unexpected changes in
earnings will be correlated with share price changes on the announcement date.
Miller and Rock go on to show that the earnings, dividend, and financing an-
nouncements are closely related. Assuming that the expected and actual investment
decisions are at an optimum level, and are therefore equal, then the difference between
the actual and net dividends is
Div, -AB, -ttttPt- Eo(Div, - LB1-mrPr) =NOI' -11 - [¿(NOI') -ir]
: NOIr - E(NOII}
Thus the earnings surprise and the net dividend surprise can convey the same in-
formation. The financing announcement efect is merely the dividend announcement
effect, but with the sign reversed. An unexpected increase in dividends will increase
shareholders' wealth, and an unexpected issue of new equity or debt will be inter-
preted as bad news about the future prospects of the firm'
The Miller-Rock signaling approach shows that announcement effects (including
earnings surprises, unexpected dividend changes, and unexpected external financing)
emerge naturally as implications of the basic valuation model rather than as ad hoc
appendages.
One problem that the above theories have in common is that although they
explain how an optimal dividend policy may arise, none of them can successfully
.*plain c.orr-rectional differences in dividend payouts across firms.l7

E(s,¡: ¿o¡¡6¡r) - -
Eo(I,)
YP 3. Agency Costs, External Financing, and
Optimal Dividend Payout
:f(to)_rr*H. (1s.41) Rozeff [1982] suggests that optimal dividend policy may exist even though we
ignore tax considerations. He suggests that c¡oss-sectional regularities in corporate
The corresponding postannouncement value of the firm is dividend payout ratiosrs may be explained by a trade-off betw€en the flotation costs
of raising external capital and the benefit of reduced agency costs when the firm in-
Sr:NOIr -1, +ffi creases its dividend payout. It is not hard to understand that owners prefer to avoid
paying the transactions costs associated with external financing.
As discussed earlier (Chapter 14, section B.4), there are agency costs that arise
= f(to) + e, - * N##
11 when owner-managers sell portions of their stockholdings to so-called outside equity

- 1, * t!##
r? A posible exaption is the work of Miller and Rock
[1985], which suggsts that the oext theory shows
: f(I¡ + e, (ts.42) better promis in this regard.
r8 The payout ratio is the tatio of dividends to net income.
 568 DTvTDEND por,rcy: THEoRy
OTHER DIVIDEND POLICY rssuFs 569
owners. The outsiders *t|l,*lrr" e,x
ante, for the potential problem that
managers may increase their personar owner_ Table 15.4 Cross-Sectional Diviilend Payout Regressions
weartñ at the ex'pense ofoutsiders
more perquisites or shirking. To decrease by means of
ne oni[ CONSTANT ¡N,S GROWL GROW2 BETA STOCK Rz D.W. F-statistic
find it in their own interest to agree to incu¡ ", "narg", "*"..-n,"i",Tjil,i
monito¡ing or bonding costs if such
costs a¡€ less than the ex ante charge
that ou,rl¿.rr^*áulA b. f"r;i;;;;;;;:
(1) 47.81 - 0.090
-0.32r -0.526 -26.543 2.584 0.48 1.88 185.47
Th-us a wealth-maximizing firm
wifl (12.83) (-4.10) (-6.38) (-6.43) (-17.05) (7.73\
m¡nrmrzes agency cosrs. "¿.pi "" "piirn"i.", tttonngAol-iile nglicr rhat (2) 24.73 -0.068 -0.474 -0.758 2.517 0.33 1.79 t23.23
Dividend payments may well se¡ve as (6.27',) (-2.7s) (-8.44) (-8.28) ,u:,
a means of moniroringro, uo¡áingii'":a 0.4r
agement performance. Although greater
dividenJ puyou, i_pti". costly external
(3) 70.63 -0.402 -0.603 -25.409 1.88 231.46

nancing, the very fact that the firm mur, fi_ (40.35) (-7.58) (-6.94) (- 15.35)
eo ,o ih. ;;ü mu.k"t, implies that it will (4) 39.56 - 0.116 - 33.506 3.15 1 0.39 1.80 218.10
come under greater scrutiny. For exampri
u"rt, *iiirio"r. ;i;; (10.02) (-4.92) (-21.28) (8.82)
creditworrhiness of rhe fir;' r"¿ ,tr.
quire prospectus filings for new
í*"t¡,r'*;l';;h"rg, " ""r"¡;i;;;ü;;
commission w'r re- (5) 1.03 -0.102 3.429 o.t2 1.60 69_33
equity irru.r. ffrrs *irlde suppliers of capital (0.24) (-3.60) (7.97)
to monitor the owner-manag"r on tenarrof help
ou,rt¿..q"¡-,y of course, audited t-statisti6 are shown in parentheses under estimated values of the regression coemcients. R2 is adjusted
financial statements are a substitute_means
for rupplyi'g "*"ers.
the same information, but for degres of freedom. D.W. is Durbin-Watson statistic.
they may.not be a perfect substitute
for tt. "aau"rJu'.y;
--'v¡vq¡r r!¡.llationship between the firm From M. Rozeff, "Crowth, Beta, and Agency Costs as Deteminants of Dividend Payout Ratios," Jo&rru¡
and suppliers of new capital. of Financial Research,Fall 1982,249-259. Reprinted with permission
Because of the t¡ansactions costs
of external financing Rozeff arso argues
the variabilitv of a firm's cash_flows rill that
payout. consider rwo The best regression in Table 15.4 explains 48% ofthe cross-sectional variability
firms with the same averase cash flows "Á."il,r'JJiá"nd
across tlrnl Uui á-if.r"nt variability. The firm
with g¡eater voratility *iñ borrow in bad years in dividend payout across individual firms. Although the results cannot be used to
nnance externarry more often. consequentíy,
un;-;üy in good. It wi, need to distinguish among various theories of optimal dividend policy, they are consistent
payout ratio.
i, *iii,."'J," have a lower dividend with Rozeff's predictions. Furthermore, the very existence of strong cross-sectional
Rozetr [19821 selected a sample of 1000 regularities suggests that there is an optimal dividend policy.
nonregulated firms in 64 different in-
dustries and examined their averáge_diuid"nd
put;;t-;;;ios during the 1974_1980
interval' Five proxy variables were chosen
," téri'rtirii.".y. The results a¡e shown E. OTHER DTVIDEND POLICY ISSUES
in Table r5'4: The independenr variables
measure the effect of costlv external
cnowi are an artempt to
""á'óRow2
ñnancing. fi..r-tn1t grow faster can reduce
their need ro use exremal fiíancing 1. Dividends, Shares Repurchase, and Spinoffs
by payin;l&;;;d.rds. GRoWI from the Bondholders' Point of View
growth rate in ¡evenues between measures the
tglc in¿-tg¡g, rt.;;;; cRow2 is varue Line,s
fo¡ecast of the growth of sales revenue Debt contracts, particularly when long-term debt is involved, frequently restrict
over the five-year period 1979-19g4. Both
variables are negativerv related-to a firm's ability to pay cash dividends. Such restrictions usually state that (1) future
.The variables INS and STOCK
di"id.J p;;;;i';;;.. statistically significanr.
ur. pro*i.ri;;;;lgJn;; relationship. rNS dividends can be paid only out of earnings generated after the signing of the loan
percenrage of the firm held by is rhe
insiders. Dividend o^tJ i; negativery agreement (i.e., future dividends cannot be paid out of past retained earnings) and
percentage of insiders because given related to the
l"y:.¡;;;;'g;f,riutsi¿ers (2) dividends cannot be paid when net working capital (current assets minus current
to pay dividends to reduce agency costs.re
" there is less need
ó" tt..it", ¡"nd, ifthe distribution of liabilities) is below a prespecified amount.
outsider holdings is diffuse' rh.o One need not restrict the argument to only dividend payout. When any of the
ug.n.y costs will be higher; hence one wourd
srocK' the number or.."trtoii..r.'," l"
expect
p"rrí".iy"'.'Jt'u,"0 ,o dividend payout. assets ofa corporation are paid out to shareholders in any type ofcapital distribution,
Both INS and STOCK are statistically the effect is to "steal away" a portion ofthe bondholders'collateral. In effect, some
,igninJu't
-oiiÁ. uni'oiir,. pr.oi"t.a sign. Finally,
the variable BETA measures ttt" of the assets that bondholders could claim, in the event that shareholders decide to
have lower dividend payout is
,irLin.r, ñ.* Trtáor"¿iction thar riskier firms
*rin"Juy ir," .";;;:.;;;.t" default, are paid out to shareholders. This diminishes the value ofdebt and increases
the wealth of shareholders.
Of course, the most common type of capital dist¡ibution is a dividend payment.
tn
tntt r"t",tonrntO A portion of the firm's assets is paid out in the form of cash dividends to share-
prcler to rake rheir rerurn in
rhe form of g"in..i.it;; il;il;á:ñ. holders. The most extreme example of defrauding bondholders would be to simply
""pit"f
liquidate the assets of the firm and pay out a single, final dividend to shareholders,
 570 DTVTDEND por.rcy: THEoRy
thereby leaving bondholders with a claim to nothing. For this very reason, most
bond
indentures explicitly restrict the dividend policy of shareholders. usually dividenás
cannot exceed the current earnings of the firm, and they cannot be paid oui ofretaineJ
earnings.
other types of capital distributions are share repurchase and spinoffs. share re-
purchase has exactly the same effect as dividend payment except that the form
of
payment is capital gains instead ofdividend income. The conventional procedure
for
a spinoff is to take a portion of a firm's assets, often a division relativily un."lat"á
to the rest of the firm, and c¡eate an independent firm with these assets. ih. i.npo.-
tant fact is that the shares of the new entity are distríbuted solely to the sharehoíders
of the parent corporation. Therefore, like dividend payment o. ,hur" repurchase,
this
may be used as a technique for taking collateral from bondholders. Émpiricaí evi-
dence on the effects ofrepurchases and spinoffs is covered in Chapter 16.
It is an interesting empirical question whether or not any diviáend payment, no
matter how large it is, will affect the ma¡ket value of bonds. one would eipect ihat
the ma¡ket price of bonds would reflect the risk that future dividend paymenis would
lower the asset base that secures debt.2. However, as changes in the dividend pay-
ments are actually realtzed, there may be changes in the expectations of the báná-
holde¡s, which in tu¡n would be reflected in the market price of bonds. All other
things being equal, we may expect that higher dividend payments or share repurchases
will be associated with a decline in the market value of debt. However, ,u."ly do ,.
have a situation where all other things are equal. For example, if announcements
about dividend changes are interpreted as information about iuture cash flows, then
a dividend increase means that current debt will be more secure because of the antic-
ipated higher cash flows, and we would observe dividend increases to be positively
correlated with inc¡eases in the market value of debt.
2. Stock Dividends and Share Repurchase
Stock dividends are often mentioned as part of the dividend policy of the firm.
However, a stock dividend is nothing more than a small stock split. it simply in-
creases the number of shares outstanding without changing any of th. underiying
risk or ¡eturn characteristics of the firm. Therefore we mighl exiect that ¡t ¡as iittli
or no effect on shareholders'wealth except for the losses associated with the clerical
and transactions costs that accompany the stock dividend. Recall, however, that the
empirical evidence in chapter 11 indicated that stock dividend announcements are
in fact accompanied by statistically significant abnormal returns on the announce-
ment date. So far, no adequate explanation has been provided for this fact, although
Brennan and copeland [1987] suggest that stock dividends may be used to force tie
early conversion of convertible debt, convertible preferred, or warrants, because these
securities are frequently not protected against stock dividends.
2oDividendpaymentsdonotnecessarily"h"ng"th"".,"t"ffi
in order to pay dividends, the¡e is an asset efect. However, it is not ¡ecessary. oi"¡¿""¿,
a1e rgduce!.
aho be,paid by issuing new debt or equity. In this case, ass€ts remain uíaffected, a¡a tne áini¿ena
áecision
is purely frnancial in nature.
SUMMARY 57I
Another question that often arises is whether share repurchase is preferable to
dividend payment as a means of distributing cash to shareholde¡s. Share repurchase
allows shareholders to receive the cash payment as a capital gain rather than as
dividend income. Any shareholder who pays a higher tax rate on income than on
capital gains would prefer share repurchase to dividend payment. But not all classes
ofihareholders have this preference. Some, like tax-free university endowment funds,
are indifferent to income versus capital gains, whereas others, such aS corporations
with their dividend exclusions, would actually prefer dividends.
To see that share repurchase can result in the same benefit per share, consider
the following example. The Universal Sourgum Company earns $4.4 million in 1981
and decidesio pay out 50%, or $2.2 million, either as dividends or repurchase. The
company tras 1,IOO,OOO shares outstanding with a market value of $22 per share' It
can pay dividends of s2 per share or repurchase shares at $22 each. We know that
the maiket price for repurchase is $22 rather than $20 because $22 will be the price
per share afier repurchase. To demonstrate this statement, we know that the current
value of the (all-equity) firm is $24.2 million. For $2.2 million in cash it can repurchase
100,000 shares. Therefore after the repurchase the value of the firm falls to $24.2 -
2.2:$22 million, and with 1,000,000 shares outstanding the price per share is $22'
Thus, in theory, there is no price effect from repurchase.
A comparison of shareholders' wealth before taxes shows that it is the same with
either payment technique. If dividends are paid, each shareholder receives a $2 divi-
dend, áná the ex-dividend price per sha¡e is $20 ($22 million -: 1.1 million shares).
Alternately, as shown above, each share is worth $22 under repurchase, and a share-
holder who needs cash can sell off a portion of his or her shares. The preferred form
of payment (dividends versus repurchase) wili depend on shareholders' tax rates.
-
In the example shown above there is no price effect from share repurchase. How-
ever, recent emplrical studies of repurchases via tender offers have found a positive
announcement effect. These studies are discussed in detail in Chapter 16'
STII\4MARY
Several valuation models with or without growth and with or without corporate taxes
have been developed. Dividend policy is ir¡elevant in all instances. It has no effect
on shareholders'wealth. When personal taxes are introduced we have a result where
dividends matter. For shareholders who pay higher taxes on dividends than on capital
gains, the preferred dividend payout is zero; they would rather have the company
áistribute óash payments via the share fepurchasó mechanism. Yet corporations do
pay dividends. The Rozeff [1982] paper suggests that there appear to be strong cross-
iectionai regularities in dividend payout. Thus there may be optimal dividend policies
that result fiom a trade-off between the costs and benefits of paying dividends. The
list of possible costs includes (1) tax disadvantages of receiving income in the form
of diviáends rather than capital gains, (2) the cost of raising external capital if divi-
""" dends are paid out, and (3) ihe foregone use of funds for productive investment. The
possible benefits of dividend payout are (1) higher perceived corporate value because