The Dividend Controversy
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Transcript The Dividend Controversy
The Dividend Controversy
Should firms pay high dividends?
Trap question one:
An
investor buys a share.
It never pays a dividend.
Is it valueless?
No.
The
investor resells it before any
dividends are paid.
The buyer gets dividends.
Trap question two:
A firm
never pays dividends to any
investor and is never expected to do so.
Is it valueless?
No. Think of any small start-up.
The
typical start-up firm is bought by
another.
Its investors get cash or shares in the
acquiring firm.
Dividend policy alternatives:
Either
high dividends now, low later, or
Low now, high later.
Dividend policy is irrelevant!
The
firm has done all projects with NPV
> 0.
It has some cash.
What are the alternatives?
Separation theorem interpreted for
dividends (Figure 18.4)
C1
L o w -d iv id e n d firm
F u tu re
r e tu rn
or
s lo p e = - ( 1 + r )
H ig h - d iv id e n d
firm
d iv id e n d n o w
C0
Homemade dividends
Investors
who want higher dividends
sell some shares to get cash.
Those who want lower dividends use
high dividends to buy more shares.
Example of partial tax sheltering by
capital gains
Alternative
one: dividend of $10,000.
Pay taxes on all of it.
Compare to capital gains of the same
amount.
Tax shield continued, homemade
dividend
Alternative
two: capital gains of
$10,000.
Sell stock worth $10,000.
The stock was bought when the price
was half the current price.
Realized capital gains = $5,000
Pay taxes on $5,000.
Some tax-class clienteles prefer dividend
income
because
they have tax exemptions,
e.g.,
non-profit institutions, pension funds,
corporations etc.
Some tax-class clienteles prefer capital
gains
because
they can't shelter dividends
from taxes,
but they can shelter capital gains.
High income investors, for instance.
Implications of clienteles
Some
cash flows in the high-dividend
channel.
Some in the low-dividend channel.
Like the Miller channels model.
Dividend equilibrium
H iD iv
value
per $1
LoD iv
value
per $1
V *=1/Rh
V *=1/RL
E quilibriu m
H iD iv
E q u ili b riu m
L o D iv
$ of operating
cash flow s
...
Value is invariant to dividend policy.
In
equilibrium
i.e., almost all the time
Out of equilibrium
i.e.,
after tax law changes,
firms can increase value by
appropriately changing their dividend
policy.
Example of disequilibrium
Suppose
that the capital gains tax rate
is lowered.
LoDiv cash flows are more valuable.
Demand for LoDiv cash flows
increases.
Cut in capital gains tax rates
HiDiv
value
LoDiv
value
Increased value
of old equity
More LoDiv
firms
$ of operating
cash flows in
the economy
Real-world evidence
for
not changing dividend policy
and for existence of tax-class clienteles.
Evidence
Actual
dividends are highly smoothed
Earnings fluctuate much more.
Smooth means constant or increasing
at a constant rate.
Smooth means pleasing to the tax-class
clientele that holds the shares.
A problem for the low-dividend firm
The
firm has a quantity of spare cash
after all NPV>0 projects are done.
Dilemma
Pay
dividends: Shareholders pay extra
taxes.
Invest in financial markets: Firm
becomes a mutual fund.
Solution: use the cash to buy stock
Investors
who sell are those who want
cash.
Stock price is unaffected ...
because the value of the firm falls
by the value of the repurchased shares.
The IRS understands this game.
Stock
buyback for tax avoidance is
illegal.
Therefore...
Excuses, excuses
always
another reason for a stock
buyback,
usually ... our shares are a good
investment
or...we disburse cash to prevent
takeover.
Summary
Dividend
policy is like capital structure.
It probably doesn’t matter.
If it does, it matters because of taxes,
and even that is temporary.
In equilibrium, firms cannot increase
value by changing capital structure or
dividend policy