Session on Dividend Policy

Dividend Policy
Measures of Dividend Policy

 Dividend yield (dividend expressed as a % of market price)

 Dividend payout (dividend expressed as a % of earnings per share)

 Dividend per share (dividend expressed as amount per share)

 Steps to a Dividend decision

*Reference book : Applied Corporate Finance by A.Damodaran

 Real world Characteristics of Dividend
Policy
 Dividends are “sticky” – Corporations smooth dividends

 Dividends tend to follow earnings

 Dividends are substantial

 Fewer companies pay dividends

 Dividend policy depends on the lifecycle of the company

 Dividends are “sticky”

Reference: Applied Corporate Finance by Aswath Damodaran

Y-axis is% of cos., X axis is year

Companies are reluctant to change the way they pay dividends
 Dividends tend to follow earnings

Reference: Applied Corporate Finance by Aswath Damodaran

Companies wait to make sure that earnings have gone up long term before
they increase dividends
 Dividends are substantial in some
economies

Reference: http://aswathdamodaran.blogspot.in/2014/09/stock-buybacks-they-are-big-they-
are.html
 Dividends are substantial in some
economies

Reference: http://aswathdamodaran.blogspot.in/2014/09/stock-buybacks-they-are-big-they-
are.html
Dividends are substantial in some
economies

Reference: Applied Corporate Finance by Aswath Damodaran

 Fewer Companies pay Dividends

25 top dividend paying firms accounted for more than 50% of aggregate
dividends in U.S. in the year 2000
Lifecycle and Dividends
Payment procedure for Cash Dividend

 Declaration date : Dividend is declared at the board of directors’

meeting

 Ex – dividend date : Date that determines whether a stockholder is

entitled to a dividend payment; anyone holding stock immediately
before this date is entitled to a dividend.

 Payment date : Company mails the dividend checks to the recorded

holders

 Record date : Date on which company determines existing

shareholders.
Procedure for Cash Dividend (Example)

25 Oct. 1 Nov. 2 Nov. 5 Nov. 7 Dec.

…

Declaration Till 1Nov. Ex- Record Payment

Date Buyer of stock dividend Date Date
receives Date
dividend
Declaration Date: The Board of Directors declares a payment of dividends.

Ex-Dividend Date: Date that determines whether a stockholder is entitled

to a dividend payment; anyone holding stock immediately before this date
is entitled to a dividend.

Record Date: The corporation prepares a list of all individuals believed to

be stockholders as of 5 November.
Price Behavior
 In a perfect world, the stock price will fall by the amount of the dividend on
the ex-dividend date.

-t … -2 -1 0 +1 +2 …

$P

$P - dividend
The price drops Ex-
by the amount of dividend
the cash Date
dividend.
Taxes complicate things a bit. Empirically, the price drop is less than the dividend
and occurs within the first few minutes of the ex-date.
If personal tax rate is t, and capital gains tax of 0.
New price (on or after ex-dividend date) = Old Price – Dividend* (1-t)
Price behaviour on Ex-dividend date
Cash flows from selling stock
Dividend versus Share Repurchase/Buy
back
X Co. has excess cash of 300,000 INR and No. of shares outstanding is
100,000. is considering following ALTERNATE plans:-

Plan A: A payment of this amount as dividend to shareholders.

Firm forecasts that after the dividend is paid, earnings will be 450,000 INR per
year. P/E ratio of comparable firms is 6.

OR

Plan B: Firm could use the cash to repurchase some of its own stock.
Assumption : Perfect markets (no taxes, no transaction costs)

Are stockholders indifferent between a share repurchase (Plan B) and dividend

payment (Plan A)?
 Dividend versus Share Repurchase contd.
Dividend payment For Entire Per Share Repurchase For Entire Per
firm Share firm Share
Plan A Plan B
Shares outstanding 100,000 MV of stock before 30,00,000 30
shares Repurchase
Proposed Dividend 300,000 3 Repurchase of stocks 300,000 INR 30
Forecasted Annual 450,000 4.5 No. of shares 10,000
earnings after dividend repurchased shares
Market Value of stock 2700,000 27 Shares outstanding after 90,000
after dividend (on or repurchase shares
after ex-dividend date) Forecasted Annual 450,000 INR 5
Market Value of stock 30,00,000 30 earnings after repurchase
before dividend (before Market Value of stock 2700,000 30
ex-dividend date) after repurchase

In a world of perfect markets, shareholders are indifferent between a dividend and

a repurchase.
Look at EPS after share repurchase: It increases because no. of shares outstanding
reduces
 Dividend Irrelevance proposition –
First school of thought
Few Assumptions:
Perfect markets exist i.e there are no taxes and no brokerage fees (no
transaction costs), and no single participant can affect the market price of the
security through this/her trades.
 No information asymmetry and no agency costs
 All are rational agents
The investment policy of the firm is set ahead of time, and is not altered by
changes in dividend policy. (Firms should never give up a positive NPV
project to increase a dividend (or to pay a dividend for the first time)).

MM proves that investors are indifferent to dividend policy or a share

repurchase policy
 Why do some firms choose
repurchases over dividends?
•Flexibility
• Executive compensation
• Offset to dilution
•Undervaluation
• Tax advantage
Personal Taxes, Dividends and Share
repurchase
 Under taxes, repurchase is preferred to a dividend
 Say tax rate on dividends is 15% and capital gains tax is also 15%
 Tax on dividends is 15% but the tax on repurchase is on gain from a
sale.
 Tax on repurchase is less than the tax on dividend, go for repurchase of
shares
Real world factors favoring high
dividend policy – Third school of
thought
 Desire for current income
 Self control: self control aspect of dividends (behavioral finance),
dividend does not give much leeway, stock selling does.
 Agency costs
 a. Costs between stockholders and bondholders: bondholders frequently
create loan agreements restricting dividend payments.
 b. Costs between stockholders and managers: Managers find it easier to
pursue these selfish goals when the firm has plenty of free cash flow.
Several scholars have suggested that dividends can serve as a way to reduce
agency costs.
 Information content of dividends: Dividends can be signals to the
market that you believe that you have good cash flow prospects in the
future.
 Empirical evidence: Stock prices rise about 3% following announcements of
dividend increase and fall about 7% following announcements of dividend
decrease
Information content of dividends
Two different positions on dividends:
 1). Because of tax effects, a firm’s stock price may be negatively
related to the current dividend when future earnings are held constant.
 2). Because of the desire for current income and related factors, a firm’s
stock price may be positively related to its current dividend, even when
future earnings are held constant.
 It has been empirically established that the price of a firm’s stock will
generally rise when its current dividend is increased and fall when its
current dividend has been reduced or omitted.
 Dividend is giving the signal that the firm is expected to do well
 Rise in the stock price following dividend signal is called information
content effect of the dividend (dividends cause stockholders to increase
their expectation of future earnings and cash flows)
Clientele effect
 Different investors in different tax-bracket, favor different firms with
different dividend policies.
 The clientele effect is the idea that the type of investors attracted to a
particular kind of security will affect the price of the security when
policies or circumstances change. (here policy regarding dividends)
 Clientele may choose to sell their stock if a firm changes its dividend
policy, and deviates considerably from its preferences. On the other
hand, the firm may attract a new clientele group if its new dividend
policy appeals to the group's dividend preferences.
 At last, the demand and supply of high-dividend stocks is at
equilibrium.
 A firm can boost its stock price only if an unsatisfied clientele exists.
Framework for Analyzing Dividend
Policy : First step – Estimate FCFE or
EFCF
Framework to Analyze Dividend policy

Reference: Applied Corporate Finance by Aswath Damodaran

Framework to Analyze Dividend policy –
Dividend Matrix

Reference: Applied Corporate Finance by Aswath Damodaran