AFM 371 Winter 2008

Chapter 19 - Dividends And Other Payouts

1 / 29
Outline

Background

Dividend Policy In Perfect Capital Markets

Share Repurchases

Dividend Policy In Imperfect Markets

2 / 29
 Introduction
Why do corporations pay dividends? Why do investors pay attention
to dividends? Perhaps the answers to these questions are obvious.
Perhaps dividends represent the return to the investor who put his money
at risk in the corporation. Perhaps corporations pay dividends to reward
existing shareholders and to encourage others to buy new issues of
common stock at high prices. Perhaps investors pay attention to
dividends because only through dividends or the prospect of dividends do
they receive a return on their investment or the chance to sell their shares
at a higher price in the future.
Or perhaps the answers are not so obvious. Perhaps a corporation
that pays no dividends is demonstrating confidence that it has attractive
investment opportunities that might be missed if it paid dividends. If it
makes these investments, it may increase the value of its shares by more
than the amount of the lost dividends. If that happens, its shareholders
may be doubly better off. They end up with capital appreciation greater
than the dividends they missed out on, and they find they are taxed at
lower effective rates on capital appreciation than on dividends.
In fact, I claim that the answers to these questions are not obvious at
all. The harder we look at the dividend picture, the more it seems like a
puzzle, with pieces that just don’t fit together.

– F. Black, “The Dividend Puzzle”, Journal of Portfolio Management, Winter

1976, pp. 5-8.

Background 3 / 29
 Different Types of Payouts
the two main ways that firms distribute cash to equity
investors are dividends and share repurchases
different types of dividends:
cash dividends are a distribution of cash
normally paid on a quarterly basis
stock dividends are a distribution of stock
no cash leaves the firm
there is an increase in the number of shares outstanding
e.g. with a 10% stock dividend, investors receive one
additional share for each ten shares that they own
stock splits are large stock dividends (a stock dividend of
greater than 25%)
usually expressed as a ratio, e.g. 2:1 means that investors get
one new share for each share that they own (so the total
number of shares outstanding doubles)
a share repurchase (a.k.a. buyback) is a transaction where the
firm buys its own stock back from investors
can be either an open market repurchase (the firm buys on an
exchange like any other investor) or a tender offer (the firm
announces to all of its shareholders that it is willing to buy a
fixed number of shares at a specified price)
Background 4 / 29
 Standard Method of Cash Dividend Payment
on the declaration date, the board of directors declares a
payment of dividends to shareholders of record on the record
date
dividend cheques are mailed out to shareholders on the
payment date
as stock trades can take up to three business days to settle,
you must have purchased the stock at least three business
days before the record date in order to be assured of receiving
the dividend
the date two days before the record date (i.e. the first trading
date on which you are no longer entitled to the dividend) is
called the ex-dividend date
example: on Feb. 29, 2008 RBC declared a dividend of $0.50
per share payable on May 23, 2008 to common shareholders
of record on April 24, 2008
Background 5 / 29
 Ex-Dividend Date Stock Price Behaviour
in a world without taxes or transaction costs, the stock price
will fall by the amount of the dividend on the ex-dividend date
(ignoring some slight time value of money considerations)
taxes complicate matters: empirically, the price drop is less
than the dividend and occurs within the first few minutes of
trading on the ex-dividend date
notation:
original purchase price: P0
price just before stock goes ex-dividend: Pb
price just after stock goes ex-dividend: Pa
dollar amount of dividend per share: D
tax rate paid on dividend income: TD
tax rate paid on capital gains: TG
cash flows from selling just before stock goes ex-dividend:

Pb − (Pb − P0 ) × TG

cash flows from selling just after stock goes ex-dividend:

Pa − (Pa − P0 ) × TG + D × (1 − TD )

Background 6 / 29
 Ex-Dividend Date Stock Price Behaviour

the average investor should be indifferent between selling just

before and selling just after, so

Pb − (Pb − P0 ) × TG = Pa − (Pa − P0 ) × TG + D × (1 − TD )

rearranging the above expression yields

Pb − Pa 1 − TD
=
D 1 − TG
cases:
if TD = TG , then Pb − Pa = ∆P = D
if TD > TG , then Pb − Pa = ∆P < D
if TD < TG , then Pb − Pa = ∆P > D
in Canada we have TD > TG , and the ex-dividend date price
drop is smaller than the amount of the dividend

Background 7 / 29
 Dividend Policy In Perfect Capital Markets

for the time being, consider a world with perfect capital

markets (i.e. no taxes, transactions costs, information
asymmetry, etc.)
also assume that future investments and cash flows are known
with perfect certainty
further assume that the investment policy of the firm is fixed,
and, for simplicity, consider an all-equity firm
consider an all-equity firm in which
as of now (t = 0), managers know that the firm will be
liquidated after 2 years (t = 2)
at t = 0 the manager knows that the firm will generate cash
flows of $110,000 at t = 1 and $121,000 at t = 2
the firm has no additional positive NPV projects available
return on equity is 10%
there are currently 10,000 shares outstanding

Dividend Policy In Perfect Capital Markets 8 / 29

 Dividend Policy In Perfect Capital Markets (Cont’d)
for simplicity assume that the ex-dividend date is the same as
the payment date
dividend policy #1: set dividends equal to cash flow
in this case, the total dividend paid out is $110,000 at t = 1
and $121,000 at t = 2, so the value of the firm is
$110,000 $121,000
V0 = + = $200,000
1.1 1.12
since there are 10,000 shares outstanding, the price per share
is $20 and the dividends per share are $11 at t = 1 and $12.10
at t = 2
dividend policy #2: pay higher dividend at t = 1, e.g. $14 per
share
total cash required at t = 1 is $14 × 10,000 = $140,000, but
the firm only has $110,000 available ⇒ the firm must issue
new equity to raise $30,000 at t = 1

Dividend Policy In Perfect Capital Markets 9 / 29

 Dividend Policy In Perfect Capital Markets (Cont’d)
are the old shareholders better off with policy #2?

the time pattern of dividends should not matter as long as the

investor is fairly compensated through the return on equity
shareholders will not pay more for a firm if the shareholder
can either replicate or undo the dividend decision—called
homemade dividends
if this argument reminds you of homemade leverage in the
context of capital structure, that is not a coincidence: the
proposition that in perfect capital markets the value of a firm
value is independent of its dividend policy was first shown by
Modigliani and Miller (MM)
Dividend Policy In Perfect Capital Markets 10 / 29
 Homemade Dividends
since investors do not need dividends to convert shares to
cash, they will not pay higher prices for firms with higher
dividend payouts
in other words, dividend policy has no impact on the value of
a firm because investors can create whatever income stream
they prefer by using homemade dividends
continuing with our example, suppose the firm sticks with
policy #1 but an investor who owns 50 shares prefers policy
#2:

Dividend Policy In Perfect Capital Markets 11 / 29

 Homemade Dividends (Cont’d)
alternatively, suppose the firm switches to policy #2 and an
investor who holds 30 shares prefers the old policy:

Dividend Policy In Perfect Capital Markets 12 / 29

 Homemade Dividends (Cont’d)
problem: The MM Company earns a perpetual operating
income of $2.5 million per year which it pays as dividends on
its 200,000 outstanding shares. MM is all-equity financed with
a required rate of return of 10%. The VP of Finance feels
that shareholders would benefit if dividends were increased by
$7.50 next year, but only next year. Assume that issuing stock
is the only financing alternative.
(a) What is the stock price under the current dividend policy?
(b) How many new shares must MM issue in order to finance the
new policy?
(c) Mr. Jones owns 1,000 shares and prefers the current dividend
policy? How can he achieve it if the firm switches to the new
policy?

Dividend Policy In Perfect Capital Markets 13 / 29

 Irrelevance of Stock Splits and Stock Dividends

XYZ Inc. is an all-equity firm with 2 million shares

outstanding that are trading at $15 per share. The company
declares a 50% stock dividend. How many shares will be
outstanding after the stock dividend is paid? After the stock
dividend what is the new price per share and the new value of
the firm?
a 50% stock dividend will increase the number of shares by
50% to 2 × 1.5 = 3 million (in fact, this is really a 3:2 split)
the value of the firm was 2 × $15 = $30 million, which is
unchanged after the dividend
the price per share is $30,000,000 ÷ 3,000,000 = $10
note that there is no effect on any investor’s wealth: an
investor who owned 50 shares had a total value of
50 × $15 = $750 before the stock dividend and a total value of
75 × $10 = $750 after it

Dividend Policy In Perfect Capital Markets 14 / 29

 Summary: Perfect Capital Markets

given the MM assumptions of perfect capital markets, then:

dividend policy is irrelevant—given the firm’s investment
decisions, how the firm decides to pay dividends doesn’t
matter since shareholders can achieve any desired income
pattern with homemade dividends
dividends are relevant—shareholders prefer high dividends to
low dividends at any single date if this higher dividend level
can be maintained over time (however, this is possible only if
net cash flows increase due to a change in the firm’s
investment policy)
main implication: if dividend policy does matter, it is because
of market imperfections such as taxes, transactions costs,
asymmetric information, etc.
another important point: firms should never give up a positive
NPV project in order to increase a dividend

Dividend Policy In Perfect Capital Markets 15 / 29

 Share Repurchases

instead of declaring cash dividends, firms can get rid of excess

cash by buying shares of their own stock
in the U.S., the amount of cash distributed by a share
repurcahse in recent years has been roughly equivalent to the
amount paid out as dividends
there are potential tax advantages to repurchases:
if you choose to sell back your shares, you pay capital gains
taxes
if you choose to hold on to your shares, your wealth is not
affected by taxes
alternatively, with dividends you pay taxes on them (at a
higher effective rate than you would with capital gains)
when tax minimization is important, share repurchases are a
potentially useful alternative to dividends

Share Repurchases 16 / 29
 Share Repurchase vs. Dividend
consider a firm with the following market value balance sheet
that wants to distribute $100,000 to its shareholders:
Assets Liabilities & Equity
(Original Balance Sheet)
Cash $150,000 Debt $0
Other assets $850,000 Equity $1,000,000
Firm value $1,000,000 Firm value $1,000,000
Shares outstanding: 100,000
Price per share: $1,000,000/100,000 = $10
if the $100,000 is distributed as a cash dividend, the balance
sheet will look like this:
Assets Liabilities & Equity
(Balance Sheet After $1 Per Share Dividend)
Cash $50,000 Debt $0
Other assets $850,000 Equity $900,000
Firm value $900,000 Firm value $900,000
Shares outstanding: 100,000
Price per share: $900,000/100,000 = $9

Share Repurchases 17 / 29
 Share Repurchase vs. Dividend (Cont’d)
if the $100,000 is distributed through a repurchase, the
balance sheet will look like this:
Assets Liabilities & Equity
(Balance Sheet After Share Repurchase)
Cash $50,000 Debt $0
Other assets $850,000 Equity $900,000
Firm value $900,000 Firm value $900,000
Shares outstanding: 90,000
Price per share: $900,000/90,000 = $10
with the dividend, the holder of a share receives $1 and
retains a share worth $9
with a repurchase, the holder of a share either sells it for $10
or keeps it
this shows that, absent imperfections such as taxes, there is
no reason to prefer one method of distribution over the other

Share Repurchases 18 / 29
 Real World Factors Affecting The Repurchase Decision
besides taxes, what other potential advantages do share
repurchases offer?
flexibility: an increase in a dividend is often viewed as an
ongoing commitment, whereas a repurchase is more of a
one-time deal → firms which have temporary increases in cash
flow are more likely to repurchase, while firms with permanent
increases in cash flow are more likely to pay dividends
executive compensation: firms with lots of executive stock
options are more likely to prefer repurchases (the share price
will fall when dividends are paid out, reducing the value of the
options)
offset to dilution: this is another reason why firms with lots of
executive stock options often use repurchases (i.e. to counter
the dilution that occurs when the options are exercised)
repurchase as investment: managers may believe that their
firm’s stock price is temporarily undervalued, and so buying
back shares represents a good investment (and empirical
evidence supports this—long term stock price performance of
firms after a repurchase tends to be substantially better than
the stock price performance of similar firms which do not
repurchase)
Share Repurchases 19 / 29
 Personal Taxes, Issuance Costs, and Dividends
as noted above, the effective tax rate on capital gains is lower
than the effective tax rate on dividends for individual investors
suppose a firm does not have sufficient cash to pay a
dividend:
if it issues shares worth, say $1 million, in order to pay a
dividend, then in aggregate investors contribute $1 million but
they get back less because of taxes on dividends
as a result, in general firms should not issue stock in order to
pay a dividend
flotation costs to issue the new shares add to this effect
if instead that a firm does have enough cash to pay a
dividend:
if the firm already has no further positive NPV projects to
invest in, then any additional capital expenditures will be in
negative NPV projects (which could be worse than subjecting
investors to taxes on dividends)
the firm could acquire other companies (but this is often very
costly and the general tendency is that acquiring firms is an
unprofitable strategy)
it might go with a share repurchase instead of a dividend
Dividend Policy In Imperfect Markets 20 / 29
 Personal Taxes, Issuance Costs, and Dividends (Cont’d)
another possibility for a firm with enough cash to pay a
dividend is to purchase financial assets instead
example: a firm has $10,000 of extra cash. It can retain the
cash and invest it in Treasury bills yielding 4% or it can pay
the cash out to shareholders as a dividend. Shareholders can
also invest in Treasury bills with the same yield. Assume that
Treasury bills pay interest annually. Both the firm and the
shareholders reinvest the interest income received from the
Treasury bills. The corporate tax rate is 40% and the
individual tax rate for dividend income is 30% and for interest
income is 40%. What amount of cash will shareholders have
after 5 years if (i) the firm pays out the $10,000 today as a
dividend; and (ii) the firm invests the $10,000 in Treasury bills
and distributes the cash as a dividend after 5 years?

Dividend Policy In Imperfect Markets 21 / 29

 Personal Taxes, Issuance Costs, and Dividends (Cont’d)
does anything change if we reduce the dividend tax rate to
20%?
how about changing the personal tax rate on interest income
to (i) 25%, and (ii) 45%?
other things equal, if Ti is the tax rate on investment income
for investors (either interest or capital gains), and TC is the
corporate tax rate, then the firm has an incentive to pay out
dividends now if Ti < TC and an incentive to retain the cash
if Ti > TC
in other words, higher personal tax rates (compared to
corporate tax rates) give firms an incentive to reduce payouts
other points:
also recall that firms pay no tax on dividend income received
however, some investors are tax exempt (e.g. pension funds),
giving an incentive to increase payouts

Dividend Policy In Imperfect Markets 22 / 29

 Expected Returns, Dividend Yields, and Personal Taxes
consider two firms, A and B, which are equally risky
firm A does not pay any dividends, whereas firm B does
assume effective capital gains taxes are zero (or that investors
are going to hold onto their shares)
since the firms are equally risky, they will offer the same
after-tax expected return:

E (P1A ) − P0A E (P1B ) + E (d1B )(1 − Td ) − P0B

=
P0A P0B

(where Td is the tax rate on dividend income)

therefore, on a pre-tax basis:

E (P1A ) − P0A E (P1B ) + E (d1B ) − P0B

A
<
P0 P0B

in other words, expected returns (pre-tax) will be higher for

firms paying higher dividends
this implies that tax-exempt institutional investors (e.g.
pension funds) should hold stocks which pay high dividends
Dividend Policy In Imperfect Markets 23 / 29
 Real World Factors in Favour of High Dividends
from a tax perspective, the higher effective tax rate on
dividends compared to capital gains suggests that dividends
should be reduced
other considerations, however, indicate that dividends should
be increased:
desire for current income: the homemade dividend argument in
perfect markets ignores transaction costs, so investors who
want income now may prefer to receive it directly rather than
incurring costs of selling securities
agency costs of equity:
recall the free cash flow argument from Ch. 17, i.e. that
managers will tend to waste the firm’s resources on
themselves rather than trying to benefit the shareholders
paying out dividends reduces the ability of managers to do this
but repurchases would also accomplish this
tax arbitrage: some people argue that investors may be able to
avoid taxes on dividends (e.g. if you borrow money to invest,
interest payments are tax deductible against investment
income received; moreover, if you don’t like the extra risk due
to borrowing, you can invest in safe bonds in a tax-deferred
savings plan such as an RRSP to offset the leverage)
Dividend Policy In Imperfect Markets 24 / 29
 Information Content and Signalling

empirical evidence shows that stock prices increase when firms

announce an increase in their dividends and decrease when
firms announce cuts in dividends or suspensions of dividend
payments
is this because a higher dividend is a good financial decision,
or because it conveys favourable information to the market?
some (e.g. Lintner) have argued that a firm’s earnings should
be viewed as containing both permanent and temporary
components, and that firms have long run dividend payout
ratio targets that depend on the permanent component
management will use a dividend increase to signal its
expectation of high future (permanent) earnings
changes in dividends will be smoother than changes in earnings

Dividend Policy In Imperfect Markets 25 / 29

 Information Content and Signalling (Cont’d)
let t be the target dividend payout ratio and let s denote the
speed of adjustment of dividends to target, so that
dt+1 = dt + s × [t × EPSt+1 − dt ]
special cases:
s = 1 implies that there is an immediate and full adjustment
to target
s = 0 implies that there is no change at all in dividends
there is a good deal of empirical support for this; in addition
to the stock price reactions described above:
changes in dividends lag changes in retained earnings (firms
are reluctant to cut dividends during temporarily bad times;
firms do not increase dividends as fast as retained earnings
during economic expansions)
special dividends (firms sometimes announce an extra dividend
payment but state that it is only temporary): basically a signal
that the firm has been doing very well, but that this is not
necessarily expected to continue
Dividend Policy In Imperfect Markets 26 / 29
 The Clientele Effect

investors may form clienteles based upon their tax brackets

clienteles for various dividend payout policies are likely to form
in the following way:
Group Stocks
High tax bracket individuals Zero-to-low payout stocks
Low tax bracket individuals Low-to-medium payout stocks
Tax-exempt institutions Medium-to-high payout stocks
Corporations High payout stocks
once the clienteles have been satisfied (e.g. if there are
already enough firms paying high dividends to meet demand),
a firm is unlikely to be able to create value by changing its
dividend policy

Dividend Policy In Imperfect Markets 27 / 29

 Summary and Other Considerations
in perfect capital markets, dividend policy is irrelevant
firms should not cut back on positive NPV projects to pay a
dividend and should generally avoid issuing stock in order to
pay a dividend
repurchases should be considered when there are few positive
NPV investments available and there is a surplus of cash
flotation costs: firms should keep dividends low to avoid costs
of issuing new securities (this will be more important to firms
with lots of investment opportunities)
transactions costs and indivisibility of shares: the purchase or
sale of shares to create homemade dividends incurs
transactions costs. This factor could favour either high or low
dividends, depending on investor preferences for dividends vs.
capital gains. Indivisibility implies that investors may not be
able to create exactly the dividend policy they want. DRIPS
and stripped common shares are evidence that these factors
do matter.
corporate control: issuing new shares may mean giving up
some control to new shareholders; this can be limited by
reducing dividend payments
Dividend Policy In Imperfect Markets 28 / 29
 Summary and Other Considerations (Cont’d)
agency costs: management will tend to waste excess cash on
perks and bad investments, so dividends should be kept high
legal factors, including:
institutional holdings: some institutional investors are legally
prohibited from investing in firms which have not paid
dividends
impairment of capital: some institutional investors are not
allowed to spend principal
debt covenants: these provisions may include restrictions on
the amount that can be paid out as a dividend
signalling: dividends can be used to convey information about
management’s expectations about the firm’s future prospects
clientele effects: for various reasons (e.g. taxes, desire for
current income, etc.), different groups of investors are
attracted to firms with high or low dividends. When a firm
changes its dividend policy, it just attracts a different clientele
(⇒ keep policy stable to avoid transactions costs). Unless
there is an unsatisfied clientele (e.g. not enough firms paying
low dividends relative to market demand), there is no reason
to change the firm’s dividend policy.
Dividend Policy In Imperfect Markets 29 / 29