Dividend PolicyHistorical ViewSlide 3Along Came M&MDividend Irrelevance ExampleSlide 6Slide 7Slide 8Slide 9Slide 10Empirical Observation 1Empirical Observation 2Empirical Observation 3Empirical Observation 4Empirical Observation 5TaxesSlide 17Asymmetric InformationAsymmetric Information: EvidenceAgency ModelsAgency Models: Evidence“Other” Stories“Other” cont…A Prudent PrescriptionDividend PolicyMore Properly:Payout PolicyHistorical ViewIllustrated by the arguments of Gordon (1959) - more dividends = more valueFollows from the discounted dividend approach to valuing a firm:10)1(ttttrDVHistorical ViewGordon argued that retained earnings rather than current dividends made the cash flow stream for the shareholder riskier.This would increase the cost of capital.The future dividend stream would presumably be higher due to the investment of retained earnings (+NPV).He argued the first effect would be the dominant one.Now called the “bird in the hand fallacy.”Along Came M&MBasic Point: Firm value is determined by its investment policy, net dividends are simply the residual of earnings after investment.Dividend IrrelevanceNo Taxes or Transactions CostsSymmetric InformationComplete Contracting PossibilitiesPerfect Capital MarketsDividend Irrelevance ExampleConsider the case of Ralph Inc.Currently (time 0) Ralph Inc. is expected to survive another year in business (till time 1). At which time the firm will liquidate and all value will be distributed to claimants. The firm is presently all equity financed with 50,000 shares outstanding. The cash flow of the firm is risk free and it is common knowledge that Ralph Inc. will receive $1 million immediately and another $1 million at time 1.The current dividend policy is for Ralph Inc. to payout its entire cash flow as dividends as it is received. So $20 per share now and at time 1.The risk free rate in the economy is 5%. And the firm has no positive NPV projects available.Dividend Irrelevance ExampleRalph, the CEO of Ralph Inc. is convinced that an alternative dividend policy would increase the current stock price.The current value of the firm and the price per share is: V0 = Div0 + Div1/(1.05) = $1m + $1m/(1.05) = $1,952,380.95 or P0 = $39.05 per share.The share price will drop to $19.05 after the time 0 dividend is paid.Ralph wants you to evaluate the impact on the current stock price of an increase or a decrease of the current dividend of $2 per share.Dividend Irrelevance Example$2 per share dividend increase:A $2 per share dividend requires $1,100,000 in total so the firm must raise $100,000 to accomplish this policy change.The firm can issue risk free bonds to raise $100,000 today they must promise to repay $105,000 (5% risk free rate) in one year.This will leave only $895,000 in total dividends, or $17.90 per share, for the existing shareholders at time 0.The time zero stock price will then be: P0 = $22 + $17.90/(1.05) = $39.05 (??). The price will drop to $39.05 - $22 = $17.05 when the time 0 dividend is paid.Dividend Irrelevance Example$2 per share dividend decrease:With an $18 per share dividend today this leaves an extra $100,000 in cash within the firm.Because the firm has no positive NPV projects it does the next best thing and makes a zero NPV investment, buying t-bills. With a risk free rate of 5%, the t-bills will return $105,000 at time 1. This implies a total dividend of $1,105,000 or $22.10 per share at time 1.The current stock price is: P0 = $18 + $22.10/(1.05) = $39.05Dividend Irrelevance ExampleWhat made this example work?Two things were critical:1. We fixed the cash the firm will receive and assumed they had no positive NPV projects. This is a version of the assumption that the dividend policy will not alter the investment policy of the firm.2. We assumed no taxes or transactions costs.Several were not:The one year time frame.The risk free cash flows.The fact that the firm was all equity financed.Dividend Irrelevance ExampleThe insight this example is supposed to bring to you is that under the irrelevance assumptions a change in dividend policy results in the company simply moving money across time.Using the capital markets (so the NPV is zero) ensures that no value is created or destroyed by this movement. Thus the current stock price is not changed.Moving money across time is also what the capital markets allow individual investors to do. Therefore, a change in dividend policy doesn’t do anything for the investors they couldn’t do themselves. Again no price change is the result.Empirical Observation 1Corporations typically payout a significant percentage of their after-tax profits as dividends.Examination of dividend payouts over time shows that on average firms paid out between 40% and 50% of their profits.This percentage has been rising.Recently, a smaller percentage of all firms are paying dividends. Seems in part due to a lot of new firms (who traditionally don’t pay dividends) and in part to the fact that fewer firms of all types are paying dividends. Some evidence suggests that firms are beginning to substitute repurchases for dividends.The dividend decision is an important financing decision!Empirical Observation 2Historically, dividends have been the predominant form of payout. Share repurchases were relatively unimportant until the mid 1980’s.Before 1984 repurchases amounted to between 2% and 11% of corporate earnings. Since 1984 they have accounted for between 30% and 40% and have been on the rise.It is interesting to note that in the mid 80’s the other major form of payout from the corporate sector, M&A activity, also dramatically increased.Empirical Observation 3Individuals in high tax brackets receive large amounts of dividends and pay large taxes on these dividends. That they choose to do so is referred to by Fisher Black as the “Dividend Puzzle.”Study by Peterson, Peterson, & Ang (1985) showed that individuals received $33 B in dividends in 1979 (2/3rds of total paid) and the marginal tax rate paid on the dividends was 40% (versus 20% on capital gains).Empirical Observation 4Corporations smooth dividends.Lintner in a survey of companies noted that:Firms are primarily concerned with the stability of their dividends.Changes in earnings are the most important determinant of