14 1 B40 2302 Class 8 BM6 chapters 16 5 16 8 18 1 18 3 18 5 19 16 5 16 8 Dividend relevance under taxes etc 18 1 18 3 18 5 Capital structure relevance under taxes and financial distress 19 Valuation under financing effects Based on slides created by Matthew Will Modified 10 31 2001 by Jeffrey Wurgler Irwin McGraw Hill The McGraw Hill Companies Inc 200 Principles of Corporate Finance Brealey and Myers Sixth Edition The Dividend Controversy Slides by Matthew Will Jeffrey Wurgler Irwin McGraw Hill Chapter 16 5 16 8 The McGraw Hill Companies Inc 200 14 3 Topics Covered Views on dividend relevance The Rightists dividends increase value The Radical Left dividends decrease value The Middle of the Roaders little or no effect Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 4 Dividends Increase Value A rightist high payout view the considered and continuous verdict of the stock market is overwhelmingly in favor of liberal dividends as against niggardly ones Benjamin Graham and David Dodd Security Analysis 1951 1st ed 1934 Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 5 Dividends Increase Value Rightist argument M M ignore risk Dividends are cash in hand but capital gains are not Bird in hand versus bird in bush So isn t the dividend to be preferred Questionable argument Declaring high dividend makes residual capital gain component more risky overall risk to shareholders does not change Can get dividend like bird in hand whenever you like just by selling some of your stock M M assume efficient capital market 1 in dividend would otherwise be capitalized at 1 in share price So long as this is true the bird in hand argument is invalid If this is not true as Graham and Dodd imply argument is valid Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 6 Dividends Increase Value Rightist argument There are clienteles that prefer dividends Some financial institutions cannot hold stocks that do not have established dividend records Trusts and endowments may be discouraged from spending capital gains which may be viewed as principal but allowed to spend dividends may be viewed as income Retirees Small investors may prefer to spend from their AT T dividend checks rather than sell a few shares every month Reduces transaction costs inconvenience Corporations pay corporate income tax on only 30 of dividends they receive but 100 of capital gains The demand of these dividend clienteles may increase the price of a dividendpaying stock But Unclear whether any particular firm can benefit by increasing dividends There may already be enough high dividend stocks to choose from Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 7 Dividends Increase Value Rightist argument Dividends can t be wasted Investors may not trust managers to invest retained earnings wisely Firms that refuse to pay out cash may sell at a discount Comments In this case dividend decision is tied to investment decision May have particular merit in countries with poor corporate governance systems Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 8 Dividends Decrease Value Leftist low payout argument Taxes If dividends are taxed more heavily than capital gains investors dislike dividends Firms should pay low dividend retain cash or repurchase shares Investors should require higher pre tax return on dividend paying stocks i e dividend paying stocks sell at a discount price Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 9 Dividends decrease value Effect of investor taxes 50 dividend 20 capital gain on share prices and returns Next year s price Dividend Firm A no dividend 112 50 0 Firm B high dividend 102 50 10 Total pretax payoff 112 50 112 50 Today s stock price Capital gain 100 12 50 96 67 5 83 Pretax rate of return Tax on div 50 Tax on Cap Gain 20 Total After Tax income div cap gain taxes After tax rate of return Irwin McGraw Hill 12 5 100 100 12 5 0 20 12 50 2 50 0 12 50 2 50 10 10 100 100 10 0 15 83 96 67 100 16 4 50 10 5 00 20 5 83 1 17 10 5 83 5 1 17 9 66 9 66 96 67 100 10 0 The McGraw Hill Companies Inc 200 14 10 Dividends decrease value 1998 Marginal Income Tax Brackets Income Bracket Marginal Tax Rate 15 28 31 36 39 6 Single 0 25 350 25 351 61 400 61 401 128 100 128 101 278 450 over 278 450 Married joint return 0 42 350 42 351 102 300 102 301 155 950 155 951 278 450 over 278 450 Dividends are taxed at the personal income rate Capital gains are for most investors taxed at 28 High tax bracket investors therefore still prefer capital gains Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 11 Dividends decrease value Empirical evidence on dividends prices returns Mixed Generally a positive relationship between dividend yield and pre tax returns as predicted by leftists But statistically unreliable Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 12 Middle of the road Maybe M M conclusion of irrelevance is right even when some of the assumptions are relaxed High or low payout clienteles may exist but they are already satisfied so no firm can increase its value by changing dividends This middle of the road view argues that dividends have little or no effect on value Irwin McGraw Hill The McGraw Hill Companies Inc 200 Principles of Corporate Finance Brealey and Myers Sixth Edition How Much Should a Firm Borrow Slides by Matthew Will Jeffrey Wurgler Irwin McGraw Hill Chapter 18 118 3 18 5 The McGraw Hill Companies Inc 200 14 14 Topics Covered Corporate Taxes Corporate and Personal Taxes Costs of Financial Distress Financial distress games The trade off theory of capital structure Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 15 Corporate Taxes Main advantage of debt in U S Corporations can deduct interest Whereas retained earnings and dividends are taxed at the corporate level Thus more cash left for investors if firm uses debt finance Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 16 Corporate Taxes Example Firm U is unlevered firm L is levered Firms have same investment policy so same operating cash flows U L 1 000 1 000 0 80 1 000 920 350 322 Net Income to shhs 650 598 EBIT Interest Pmt Pretax Income Tax Tc 35 Net to bhhs Total to investors 80 650 678 Interest tax shield 35 interest 28 The McGraw Hill Companies Inc 200 Irwin McGraw Hill 14 17 Corporate Taxes What is present value of tax shield If the same savings occur every year value as a perpetuity If the savings are as risky as the debt discount at cost of debt Under these assumptions PV of Tax Shield D x rD x Tc D x Tc rD