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Chapter 8Dividend Decisions

8.1 Introduction

Dividends refer to that portion of a firm's net earnings which are paid out to the

shareholders. Our focus here is on dividends paid to the ordinary shareholders

because holders of preference shares are entitled to a stipulated rate of dividend.

Moreover, the discussion is relevant to widely held public limited companies as the

dividend issue does not pose a major problem for closely private limited companies.

Since dividends are distributed out of the profits, the alternative to payment of

dividends is the retention of earnings/profits. The retained earnings constitute an

easily accessible important source of financing the investment requirements of

firm’s. There is, thus, a type of inverse relationship between retained earnings and

cash dividends: larger retentions, dividends; smaller retentions, larger dividends.Thus, the alternative uses of the net earnings-dividend and retained earnings-are

competitive and conflicting.

A major decision of financial management is the dividend decision in the sense that

the firm has choose between distributing the profits to the shareholders and

ploughing them back into the business. The choice would obviously hinge on the

effect of the decision on the maximization of shareholders wealth. Given the

objective of financial management of maximizing present values, the firm should be

guided by the consideration as to which alternative use is consistent with the goal of

wealth maximization. That is, the firm would be well advised to use the net profitsfor paying dividends to the shareholders if the payment will lead to the

maximization of wealth of the owners. If not, the firm should rather retain them to

finance investment programmes. The relationship between dividends and value of

the firm should, therefore, be the decision criterion.

There are, however, conflicting opinions regarding the impact of dividends on the

valuation of a firm. According to one school of thought, dividends are irrelevant so

that the amount of dividends paid has no effect on the valuation of a firm. On the

other hand, certain theories consider the dividend decision as relevant to the value

of the firm measured in terms of the market price of the shares.

The purpose of the present Chapter is, therefore, to present a critical analysis of some important theories representing these two schools of thought with a view toillustrating the relationship between dividend policy and the valuation of a firm.



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8.2 Irrelevance of dividend

General

The crux of the argument supporting the irrelevance of dividends to valuation is

that the dividend policy of a firm is a part of its financing decision. As a part of thefinancing decision, the dividend policy of the firm is a residual decision and dividends

are a passive residual.

If dividend policy is strictly a financing decision, whether dividends are paid out of

profits, or earnings are retained, will depend upon the available investment

opportunities. It implies that when a firm has sufficient investment opportunities, it

will retain the earnings to finance them.

Conversely, if acceptable investment opportunities are inadequate, the implication is

that the, earnings would be distributed to the shareholders. The test of adequate

acceptable investment opportunities is the relationship between the return on the

investments (r) and the cost of capital (k). As long as r exceeds k, a firm has

acceptable investment opportunities. In other words, if a firm can earn a return (r)

higher than its cost of capital (k), it will retain the earnings to finance, investment

projects. If the retained earnings fall short of the total funds required it will raise

external funds-both equity and debt-to make up the shortfall. If, however, the

retained earning exceeds the requirements of funds to finance acceptable investment

opportunities, the excess earnings would be distributed to the shareholders in the

form of cash dividends. The amoun t of dividend will fluctuate from year to year

depending upon the availability of acceptable investment opportunities. Withabundant opportunities, the dividend payout ratio (D/P ratio, that is, the ratio of

dividends to net' earnings) would be zero. When there are no profitable

opportunities, the D/P ratio will be 100. For situations between these extremes, the

D/P ratio will range between zero and 100.

Those dividends are irrelevant, or are a passive residual, are based on the

assumption that the investors are indifferent between dividends and capital gains.

So long as the firm is able to earn more than the equity-capitalization rate (ke), the

investors would be content with the firm retaining the earnings. In contrast, if the

return is less than the ke investors would prefer to receive the earnings (i.e.dividends).



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8.3 Modigliani and Miller (MM) Hypothesis

The most comprehensive argument in support of the irrelevance of dividends is

provided by the MM hypothesis. Modigliani and Miller maintain that dividend

policy has no effect on the share price of the firm and is, therefore, of no

consequence. What matters, according to them, is the investment policy throughwhich the firm can increase its earnings and thereby the value of the firm. Given the

investment decision of the firm, the dividend decision-splitting the earnings into

packages of retentions and dividends-is a matter of detail and does not matter.

'Under conditions of perfect capital markets, rational investors, absence of tax

discrimination between dividend income and capital appreciation, given the firm's

investment policy, its dividend policy may have no influence on the market price of

shares.

Assumptions The MM hypothesis of irrelevance of dividends is based on the

following critical assumptions:

1. Perfect capital markets in which all investors are rational. Information is

available to all free of cost, there are no transactions costs; securities are infinitely

divisible; no investor is large enough to influence the market price of securities;

there are no flotation costs.

2. There are no taxes. Alternatively, there are no differences in tax rates applicable

to capital gains and dividends.

3. A firm has a given investment policy which does not change. The operational

implication of this assumption is that financing of new investments out of retained

earnings will not change the business- risk complexion of the firm and, therefore,

there would be no change in the required rate of return.

4. There is a perfect certainty by every investor as to future investments and profits

of the firm.

In other words, investors are able to forecast future prices and dividends with

certainty. This assumption is dropped by MM later.

Crux of the Argument The crux of the MM position on the irrelevance of dividend isthe arbitrage argument. The arbitrage process involves a switching and balancing

operation. In other words, arbitrage refers to entering simultaneously into two

transactions which exactly balance or completely offset each other. The two

transactions here are the acts of paying but dividends and raising external funds-

either through the sale of new shares or raising additional loans-to finance



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investment programmes. Assume that a fino has some investment opportunity.

Given its investment decision, the firm has two alternatives:

i. it can retain its earnings to finance the investment programmeii. Or distribute the earnings to the shareholders as dividend and raise

an equal amount externally through the sale of new shares/bonds forthe purpose.If the firm selects the second alternative, arbitrage process is involved, in that

payment of dividends is associated with raising funds through other means of

financing. The effect of dividend payment on shareholders' wealth will be exactly

offset by the effect of raising additional share capital.

When dividends are paid to the shareholders, the market price of the shares will

decrease. What is gained by the investors as a result of increased dividends will be

neutralized completely by the reduction in the terminal value of the shares. The

market price before and after the payment of dividend would be identical. The

investors, according to Modigliani and Miller, would, therefore, be different

between dividend and retention of earnings. Since the shareholders are indifferent,

the wealth would not be affected by current and future dividend decisions of the

firm. It would depend entirely upon the expected future earnings of the firm.

Therefore would be no difference to the validity of the MM premise, if external

funds are raised in the form of debt instead of equity capital. This is because of their

indifference between debt and equity with respect to leverage. The cost of capital is

independent of leverage and the real cost of debt is same as the real cost of equity.

The investors are indifferent between dividend and retained earnings imply that thedividend decision is irrelevant. The arbitrage process also implies that the total

market value plus current dividend ends of two firms which are alike in all respects

except D/P ratio will be identical. The individual shareholder can retain and invest

his own earnings as well as the firm would.

With dividends being irrelevant, a firm's cost of capital would be independent of its

DIP ratio. Finally, the arbitrage process will ensure that under conditions of

uncenainty also the dividend policy would be irrelevant. When two firms are similar

in respect of business risk, prospective future earnings and investment policies, the

market price of their shares must be the same. This, argue, is because of the rationalbehaviors of investors who are assumed to prefer more wealth to less wealth.

Differences in current and future dividend policies cannot affect the market value of

the two firms as the present value of prospective dividends plus terminal value is the

same.



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Proof: - MM provide the proof in support of their argument in the following

manner.

Step 1 The market price of a share in the beginning of the period is equal to the

present value of dividend paid at the end of the period plus the market price of

share at the end of the period.

Symbolically,

( )( )110

1

1P D

k P

e

++

=

Where Po= Prevailing market price of a share

Ke =Cost of equity capital

D1 =Dividend to be received at the end of period 1

P1 =Market price of a share at the end of period 1

Step 2 Assuming no external financing, the total capitalized value of the firm would

be simply number of shares (n) times the price of each share (P0). Thus,

( )( )110

1

1nPnD

k nP

e

++

=

Step 3 If the firm's internal sources of financing its investment opportunities fall

short of the funds required, and ∆ n is the number of new shares issued at the end of year 1 at price of P1, above equation can be written as:

( )( )( )[ ]1110

1

1nPPnnnD

k nP

e

∆−∆+++

=

• Where = Number of shares outstanding at the beginning of the period

• ∆ n= Change in the number of shares outstanding during the period / Additional shares issued

The above equation implies that the total value of the firm is the capitalized value of the dividends to be received during the period plus the value of the number of

shares outstanding at the end of the period , considering new shares, less the value

of the new shares. Thus, in effect, above equation step 3 is equivalent to step 2

equations.



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Step 4 If, the firm were to finance all investment proposals, the total amount raised

through new shares issued would be given in the following equation.

( )

11

11

nD E I nP

nD E I nP

+−=∆

−−=∆or

Where ∆ nP1 = Amount obtained .from the sale of new shares of finance capital

budge

I = Total amount/requirement of capital budget

E = Earnings of the firm during the period

nD1 = Total dividends paid

(E – nD1) = Retained earnings

According to step 4 equations, whatever investment needs (I) are not financed by

retained earnings, must be financed through the sale of additional equity shares.

Step 5 .If we substitute step 4 equation into step 3 we derive step 5 equations

( )( ) ( )[ ]1110

1

1nD E I PnnnD

k nP

e

+−−∆+++

=

Solving the above equation we have

( )( )

ek

nD E I PnnnDnP

+

−+−∆++=

1

1110

There is a positive nD1 and negative nD1. Therefore, nD1 cancels. We then have

( )( )

ek

E I PnnnP

+

+−∆+=

1

10

Step 6 Conclusion Since dividends (D) are not found in the step 5 equation,

Modigliani and miller conclude that dividends do not count and that dividend policyhas no effect on the share price. MM’s approach to irrelevance of dividend to

valuation is illustrated in following example

A company belongs to a risk class for which the approximate capitalization rate is

10 per cent. It current has outstanding 25,000 shares selling at Rs 100 each. The

firm is contemplating the declaration of a dividend of Rs 5 per share at the end of



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the current financial year. It expects to have a net income of Rs 2, 50, 000 and has a

proposal for making new investments of Rs 5, 00,000. Show that under the MM

assumptions, the payment of dividend does not affect the value of the firm.

Solution

(a) Value of the Firm, When Dividends Are Paid:

I. Price per share at end of year 1,

( )( )110

1

1P D

k P

e

++

=

( )

105

5110

510.1

1100

1

1

1

=

+=

+=

P

P Rs

P Rs Rs

II. Amount required to be raised from the issue of new shares,

11 nD E I nP +−=∆

= Rs 5, 00,000-(Rs 2, 00,000-Rs 1, 25,000) = Rs 3, 75,000

III. Number of additional shares to be issued,

shares Rs

Rs

n 21 / 000,75105

000,75,3

==∆

IV. Value of the firm,

( )( )

( )

000,00,2510.1

000,50,27000,50,2000,00,5

10521

000,75

1

000,25

1

10

Rs Rs

Rs Rs

Rsk

E I PnnnP

e

==+−

⎥⎦

⎤⎢⎣

⎡−=

+

+−∆+=

b Value of the Firm when dividend Are not Paid:

I. Price per share at end of year 1, Rs 100 = P1/1.10, or 110 =P1

II. Amount required to be raised from the issue of new shares,

∆nP1 = (Rs 5, 00,000 – Rs 2, 00,000) = Rs 2, 50,000

III. Number of additional shares to be issued,



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= Rs 2, 50, 000/Rs 110 = 25, 000/11 shares

IV. Value of the firm( )

000,00,251.1 / 000,50,27

000,50,2000,00,511011

000,25

1

000,25

Rs Rs

Rsw Rs Rs

==

+−⎥⎦

⎤⎢⎣

⎡+

Thus, whether dividends are paid or not, value of the firm remains the same.

The above example clearly demonstrates that the shareholders are indifferent

between the retention of profits and the payment of dividend,

Critique Modigliani and Miller argue that the dividend decision of the firm is

irrelevant in the sense that the value' of the firm is independent of it, The crux of

their argument is that the investors are indifferent between dividend and retention

of earnings, This is mainly because of the balancing nature of internal financing

(retained earnings) and external financing (raising of funds externally) consequentupon distribution of earnings to finance investment programmes. Whether the MM

hypothesis provides a satisfactory, framework for the theoretical relationship

between dividend decision and valuation will depend, in the ultimate analysis, on

whether external and internal financing really balance each other. This, in turn,

depends upon the critical assumptions stipulated by them. Their conclusions, it may

be noted, under the restrictive assumptions, are logically consistent and intuitively

appealing. But these assumptions are unrealistic and untenable in practice. As a

result, the conclusion that dividend payments and other methods of financing

exactly offset each other and, hence, the irrelevance of dividends, is not a practical

proposition; it is merely of theoretical relevance. The validity of the MM Approachis open to question on two counts :(i) Imperfection of capital market, and (ii)

Resolution of uncertainty.

Market Imperfection Modigliani and Miller assume that capital markets are

perfect. This implies that there are no taxes; flotation costs do not exist and there is

absence of transaction costs. These assumptions are untenable in actual situations.

Tax Effect An assumption of the MM hypothesis is that there are no taxes. It implies

that retention of earnings (internal financing) and payment of dividends (external

financing) are, from the view point of tax treatment, on an equal footing. Theinvestors would find both forms of financing equally desirable. The tax liability of

the investors, broadly speaking, is of two types:

(i) tax on dividend income, and(ii) Capital gains.



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While the first type of tax is payable by the investors when the firm pays dividends,

the capital gains tax is related to retention of earnings. From an operational

viewpoint, capital gains tax is

(i) Lower than the tax on dividend income and

(ii) It becomes payable only when shares are actually sold, that is, it is adeferred tax till the actual sale of the shares.

The types of taxes, corresponding to the two forms of financing, are different,

although the MM position would imply otherwise. The different tax treatment of

dividend and capital gains means that with the retention of earnings the

shareholders' tax liability would be lower or there would be tax saving for the

shareholders. For example, a firm pays dividends to the shareholders out of the

retained earnings. To finance its investment programmes, it issues rights shares.

The shareholders would have to pay tax on the dividend income at rates appropriate

to their income bracket. Subsequently, .they would purchase the shares of the firm.

Clearly, the tax could have been avoided if, instead of paying dividend, the earningswere retained. If, however, the investors required funds, they could sell a part of

their investments, in which case they will pay tax (capital gains) at a lower rate.

There is a definite advantage to the investors owing to the tax differential in

dividend and capital gains tax and, therefore, they can be expected to prefer

retention of earnings. This line of reasoning is also supported by empirical evidence.

Elton and Gruber have shown that investors in high income brackets have a

preference for capital gains over dividends while those in low tax brackets favour

dividends. In a more comprehensive study Brittain found an inverse relationship

between dividend payout ratios and the differential between tax rates on dividend

income and capital gains. That is, rising tax rates tend to depress dividends. In brie

the investors are not, from the viewpoint of taxes, indifferent between dividends and

retained earnings. The MM assumption is, therefore, untenable.

With effect from financial year 2002-3, dividend income from Indian corporate

firms and mutual funds is exempt from tax upto Rs 12,000.

Floting Costs Another assumption of a perfect capital market underlying the MM

hypothesis is dividend irrelevance is the absence of flotation costs. The term

'flotation cost' refers to the cost involved in raising capital from the market, for

instance, underwriting commission, brokerage and other expenses. The presence of flotation costs affects the balancing nature of internal (retained earnings) and

external (dividend payments) financing. The MM position, it may be recalled,

argues that given the investment decision of the firm, external funds would have to

be raised, equal to the amount of dividend, through the sale of new shares to finance

the investment programme. The two methods of financing are not perfect

substitutes because of flotation costs. The introduction of such costs implies that the



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net proceeds from the sale of new shares would be less than the face value of the

shares, depending upon their size. It means that to be able to make use of external

funds, equivalent to the dividend payments, the firm would have to sell shares for an

amount in excess of retained earnings. In other words, external financing through

sale of shares would be costlier than internal financing via retained earnings. The

smaller the size of the issue, the greater is the percentage flotation cost. To illustrate,

suppose the cost of flotation is 10 per cent and the retained earnings are Rs 900. In

case dividends are paid, the firm will have to sell shares worth Rs 1,000 to raise

funds equivalent to the retained earnings. That external financing is curlier is

another way of saying that firms would prefer to retain earnings rather than pay

dividend and then raise funds externally.

Transaction and Inconvenience Costs Yet another assumption which is open to

question that there are no transaction costs in the capital market. Transaction costs

refer to costs associated with the sale of securities by the shareholder-investors. The

no-transaction costs postulate implies that if dividends are not paid (or earnings are

retained),the investors desirous of current income to meet consumption needs can

sell a part of their holdings without incurring any cost, like brokerage and so on.

This is obviously an unrealistic assumption. Since the sale of securities involves cost,

to get current income equivalent to the dividend, if paid, the investors would have to

sell securities in excess of the income that they will receive. Apart from the

transaction cost, the sale of securities, as an alternative to current income, is

inconvenient to the investors. Moreover, uncertainty is associated with the sale of

securities. For all these reasons, an investor cannot be expected, as MM assume, to

be indifferent between dividend and retained earnings. The investors interested incurrent income would certainly prefer dividend payment to ploughing back of

profits by the firm.

Institutional Restrictions The dividend alternative is also supported by legal

restrictions as to the type of ordinary shares in which certain investors can invest.

For instance, the life insurance companies are permitted in terms of section 27-A (1)

of the Insurance Act, 1938, to invest in only such equity shares on which a dividend

of not less than 4 per cent including bonus has been paid for 7 years or for atleast 7

out of 8 or 9 years immediately preceding. To be eligible for institution investment,

the companies should pay dividends. These legal impedients, therefore, favourdividends to retention of earnings. A variation of the legal requirement to pay

dividends is to be found in the case of mutual funds. They are required in terms of

the stipulations governing their operations, to distribute at least 90 per cent of its

net income to investors. The point is that the eligible securities for investment by the

mutual funds are assumed to be those that are on the dividend-paying list.



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To conclude the discussion of market imperfections, there are four factors which

dilute the indifference of investors between dividends and retained earnings. Of

these, flotation costs seem to favour retention of earnings. On the other hand, the

desire for current income and, the related transaction and inconvenience costs, legal

restrictions as applicable to the eligible securities for institutional investment and

tax exemption of dividend income imply a preference for payment of dividends. In

sum, therefore, market imperfections imply that investors would like the company

to retain earnings to finance investment programmes. The dividend policy is not

irrelevant.

Resolution of Uncertainty Apart from the market imperfection, the validity of the

MM hypothesis, insofar as it argues that dividends are irrelevant, is questionable

under conditions of uncertainty. MM hold, it would be recalled, that dividend policy

is as irrelevant under conditions of uncertainty as it is when perfect certainty is

assumed. The MM hypothesis is, however, not tenable as investors cannot be

indifferent between dividend and retained earnings under conditions of uncertainty.

This can be illustrated with reference to four aspects:

(i) Near Vs distant dividend;(ii) Informational content of dividends;(iii) Preference for current income; and(iv) Sale of stock at uncertain price/under pricing.

Near Vs Distant Dividend One aspect of the uncertainty situation is the payment of

dividend now or at a later date. If the earnings are used to pay dividends to theinvestors, they get 'immediate' or ‘near' dividend. If, however, the net earnings are

retained, the shareholders would be entitled to receive a return after some time in

the form of an increase in the price of shares (capital gains) or bonus shares and so

on. The dividends may, then, be referred to as 'distant' or 'future' dividends. The

crux of the problem is: are the investors indifferent between immediate and future

dividends? Or would they prefer one over the other? According to Gordon,

investors are not indifferent; rather, they would prefer near dividend to distant

dividend. The payment of dividend is uncertain; how much dividend and when it

would be paid by the firm to the investors cannot be precisely forecast. The longer

the distance in future dividend payment, the higher is the uncertainty to the

shareholders. The uncertainty increases the risk of the investors. The payment of

dividend is not associated with any such uncertainty. In other words, payment of

immediate dividend resolves uncertainty. The argument that near dividend implies

resolution of uncertainty is referred to as the 'bird-in-hand' argument. This

argument is developed in some detail in the later part of this chapter. In brief, since



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current dividends are less risky than future/distant dividends, shareholders would

favour dividends to retained earnings.

Informational Content of Dividends Another aspect of uncertainty, very closely

related to the first (i.e. resolution of uncertainty or the 'bird-in-hand' argument) is

the 'informational content of dividend argument. According to the latter argument,as the name suggests, the dividend contains some information vital to the investors.

The payment of dividend conveys to the shareholders information relating to the

profitability of the firm. If, for instance, a firm has been following a stable dividend

policy in the sense of, say, Rs 4 per share dividend, an increase in the amount to,

say, Rs 5 per share will signify that the firm expects its profitability to improve in

future or vice versa. The dividend policy is likely to cause a change in the market

price of the shares. The significance of this aspect of current dividend payments is

expressed by Ezra Solomon in these words.

In an uncertain world in which verbal statements can be ignored or misinterpreted, dividend action does provide a clear-cut means of 'making a

statement' that speaks louder than a thousand words.

Modigllani and Miller also concede the possibility of tl1e effect of the informational

content. But they still maintain that dividend policy is irrelevant as dividends do not

determine the market price of shares. They contend that value is determined by the

investment decision of the firm. All that the informational content of dividends

implies is that dividends reflect the profitability of the firm. They cannot by

themselves determine the market price of shares. The basic factor, therefore, is not

dividend, but, expectation of future profitability.

The informational content argument finds support in some empirical evidence. It is

contended that changes in dividends convey more significant information than what

earnings announcements do. Further, the market reacts to dividend changes-prices

rise in response to a significant increase in dividends and fall when there is a

significant decrease or omission.

Preference for Current Income The third aspect of the uncertainty question relating

to dividends is based on the desire of investors for current income to meet

consumption requirements. The MM hypothesis of irrelevance of dividends impliesthat in case dividends are not paid, investors who prefer current income can sell a

part of their holdings in the firm for the purpose. But, under uncertainty conditions,

the two alternatives are not on the same footing because

(i) The prices of shares fluctuate so that the selling price is uncertain, and(ii) Selling a small fraction of holdings periodically is inconvenient.



213

That selling shares to obtain income, as an alternative to dividend, involves

uncertain price and inconvenience, implies that investors are likely to prefer current

dividend. The MM proposition would, therefore, not be valid because investors are

not indifferent.

Under pricing Finally, the MM hypothesis would also not be valid when conditionsare assumed to be uncertain because of the prices at which the firms can sell shares

to raise funds to finance investment programmes consequent upon the distribution

of earnings to the shareholders. The irrelevance argument would be valid provided

the firm is able to sell shares to replace dividends at the current price. Since the

shares would have to be offered to new investors, the firm can sell the shares only at

a price below the prevailing price. It is rightly contended by Lintner that the

equilibrium price of shares will decline as the firm sells additional stock to replace

dividends. The under pricing or sale of shares at prices lower than the current

market price implies that the firm will have to sell more shares to replace the

dividend. The firm would be better off by retaining the profits as opposed to paying

dividends.

Under conditions of uncertainty, therefore, the MM doctrine of irrelevance does not

hold good.

To recapitulate the preceding discussion, in the context of market imperfections and

uncertainty situations, shareholders are not indifferent between retained earnings

and current dividends. The considerations that support the proposition that

investors have a systematic preference for current dividend relative to retained

earnings are

(i) Desire for current income,(ii) Resolution of uncertainty and the allied aspect of informational content of

dividends,(iii) Transaction and inconvenience costs, and(iv) Under pricing of new shares.

The more favorable tax treatment of dividend income relative to capital gains

favours distribution of earnings. The empirical evidence regarding the effect of

dividends on the market price of shares is only suggestive. Yet, it is indicative of thefact that companies behave as if dividends are relevant. The MM hypothesis,

therefore, is untenable.



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8.4 Relevance of Dividends

In sharp contrast to the MM position, there are some theories that consider

dividend decisions to be an active variable in determining the value of a firm. The

dividend decision is, therefore, relevant. We critically examine below two theories

representing this notion:

(i) Walter’s Model and(ii) Gordon's Model.

8.4.1 Walter's Model

Proposition Walter's model supports the doctrine that dividends are relevant. The

investment policy of a firm cannot be separated from its dividends policy and both

are, according to Walter, interlinked. The choice of an appropriate dividend policy

affects the value of an enterprise. The key argument in support of the relevance

proposition of Walter's model is the relationship between the return on a firm’sinvestment or its internal rate of return (r) and its cost of capital or the required

rate of return (k). The firm would have an optimum dividend policy which will be

determined by the relationship of rand k. In other words, if the return on

investments exceeds the cost of capital, the firm should retain the earnings, whereas

it should distribute the earnings to the shareholders in case the required rate of

return exceeds the expected return on the firm's investments. The rationale is that if

r > k, the firm is able to earn more than what the shareholders could by reinvesting,

if the earnings are paid to them. The implication of r < k is that shareholders can

earn a higher return by investing elsewhere.

Walter's model, thus, relates the distribution of dividends (retention of earnings) to

available investment opportunities. If a firm has adequate profitable investment

opportunities, it will be able to earn more than what the investors expect so that r >

k. Such firm may be called growth firms. For growth firms, the optimum dividend

policy would be given by a DIP ratio of zero. That is to say, the firm should plough

back the entire earnings within the firm. The market value of the shares will be

maximized as a result.

In contrast, if a firm does not have profitable investment opportunities (when r < k),

the shareholders will be better off if earnings are paid out to them so as to enablethem to earn a higher return by using the funds elsewhere. In such a' case, the

market price of shares will be maximized by the distribution of the entire earnings

as dividends. A DIP ratio of 100 would give optimum dividends policy.



215

Finally, when r = k (normal firms), it is a matter of indifference whether earnings are

retained or distributed. This is so because for all D/P ratios (ranging between zero

and 100) the market price of shares will remain constant. For such firms, there is no

optimum dividend policy (D/P ratio).

Assumptions The critical assumptions of Walter's Model are as follow:

• All financing is done through retained earnings: external sources of fundslike debt or new equity capital are not used.

• With additional investments undertaken, the firm's business risk does notchange. It implies that r and k are constant.

• There is no change in the key variables, namely, beginning earnings pershare, E, and dividends per share, D. The values of D and E may be changedin the model to determine results, but, any given value of E and D areassumed to remain constant in determining a given value.

• The firm has perpetual (or very long) life.

Formula Walter has evolved a mathematical formula to arrive at the appropriatedividend decision. His formula is based on a share valuation model which states:

gK

DP

e −=

Where P = Price of equity shares

D=Initial dividend

ke=Cost of equity capital

g=Expected growth rate of earnings

To reflect earnings retentions, 'we have

rbK

DP

e −=

Where r = Expected rate of return on firm's investments

b = Retention rate (E - D)/ E

Thus, rb measures growth rate in dividends, which is the product of the rate of

profitability of retained earnings (r) and the earnings retention percentage (b).

From the above first Eq, we derive an equation for determining ke



216

( ) D E k

r Pceand

P

P

P

D

k

haveweP

Pgce

gP

Dk

e

e

e

−=∆

∆

+=

∆=

+=

sin

,sin

Substituting the value of ∆ p, we have

( )

( )

e

e

ee

k

D E k

r D

P

P

D E k

r D

k

−+

=

−+

=

or

Where P= the prevailing market price of a share

D = Dividend per share

E = Earnings per share

r = The rate of return on the firms investment

The above Equation shows that the value of a share is the present value of aU

dividends plus the present value of all capital gains. Walter's model with reference

to the effect of dividend/retention policy on the market value of shares under

different assumptions of r (return on investments) is illustrated in the following

example.

The following information is available in respect of a firm:

Capitalization rate (ke) = 0.10

Earnings per share (E) = Rs 10

Assumed rate of return on investments (r):

(i) 15, (ii) 8, and (iii) 10.Show the effect of dividend policy on the market price of shares, using Walter's

model.



217

Solution

(i) When r is 0.15, that is, r> ke. The effect of different D/P ratios depicted inTable 1.

(ii) When r = 0.08 and 0.10, that is, r < ke and r = ke respectively The effect of

different DIP ratios on the value of .shares is shown in Table 2.

Dividend Policy and Value of Shares (Walter’s Model)- Table 1

a) D/P Ratio = 0 (Dividend per Share = Zero)

( )150

10.0

01010.0

15.00

RsP =

−⎥⎦

⎤⎢⎣

⎡+

=

b) D/P Ratio = 25 (Dividend per Share = Rs 2.5)

( )50.137

10.0

5.21010.015.05.2

RsP =

−⎥⎦⎤⎢⎣

⎡+=

c) D/P Ratio = 50 (Dividend per Share = Rs 5)

( )125

10.0

51010.0

15.05

RsP =

−⎥⎦

⎤⎢⎣

⎡+

=

d) D/P Ratio = 75 (Dividend per Share = Rs 7.5)

( )5.112

10.0

5.71010.0

15.0

5.7 RsP =

−⎥⎦

⎤

⎢⎣

⎡+

=

e) D/P Ratio = 100 (Dividend per Share = Rs 10)

( )100

10.0

101010.0

15.010

RsP =

−⎥⎦

⎤⎢⎣

⎡+

=

Dividend Policy and Value of Shares (Walter Model) – Table 2

(A ) r=0.8 (r<k) (B) r = 0.10 (r=k)

a D/P Ratio = Zero

( )80

10.0

01010.0

08.00

RsP =

−⎥⎦

⎤⎢⎣

⎡+

=

( )100

10.0

01010.0

10.00

RsP =

−⎥⎦

⎤⎢⎣

⎡+

=



218

b D/P Ratio = 25

( )85

10.0

5.21010.0

08.05.2

RsP =

−⎥⎦

⎤⎢⎣

⎡+

=

c D/P Ration = 50

( )90

10.0

51010.0

08.05

RsP =

−⎥⎦

⎤⎢⎣

⎡+

=

d D/P Ration = 75

( )

9510.0

5.71010.0

08.05.7

RsP =

−⎥⎦

⎤⎢⎣

⎡+

=

e D/P Ration = 75

( )100

10.0

101010.0

08.010

RsP =

−⎥⎦

⎤⎢⎣

⎡+

=

( )100

10.0

5.21010.0

10.05.2

RsP =

−⎥⎦

⎤⎢⎣

⎡+

=

( )100

10.0

51010.0

10.05

RsP =

−⎥⎦

⎤⎢⎣

⎡+

=

( )100

10.0

5.71010.010.05.7

RsP =

−⎥⎦⎤⎢⎣

⎡+

=

( )100

10.0

101010.0

10.010

RsP =

−⎥⎦

⎤⎢⎣

⎡+

=

Interpretation The calculations of the value of shares according to Walter's formula

in Tables 1and 24.2 yield the following conclusions:

1. When the firm is able to earn a return on investments exceeding the

required rate of return that is, r> Ke the value of shares is inversely related to the D/P

ratio: as the payout ratio increases, the market value of shares declines. (Table 1). Its

value is the highest when the DIP ratio is zero. If, therefore, the firm retains its

entire earnings, it will maximize the market value of shares (Rs 150). When all

earnings are distributed, its value is the lowest. In other words, the optimum payout

ration (dividend policy) is zero.

2. It is clear from Table 24.2 that when r < ke that is, when the firm does not

have ample profitable investment opportunities, the DIP ratio and the value of shares

are positively correlated: as the payout ratio increases, the market price of the shares

also increases. The dividend policy is optimum when the DIP ratio = 100 per cent. In



219

other words, when r < ke, the firm would be well advised to distribute the entire

earnings to the shareholders.

3. For a situation in which r = ke the market value of shares is constant

irrespective of the D/P ratio (Table 2); there is no optimum dividend policy (DIP)

ratio. In other words, the market price of shares in not affected by the D/P ratio.Whether the firm retains the profits or distributes dividends is a matter of

indifference. Ibis is a hypothetical situation. In actual practice, the two values (r and

k) are different and Walter concludes that dividend policy does matter as a variable

in maximizing share prices.

Limitations

The Walter's. Model, one of the earliest theoretical models, explains the relationship

between dividend policy and value of the firm under certain simplified assumptions.

Some of the assumptions do not stand critical evaluation. In the first place, theWalter's model assumes that the firm’s investments are financed exclusively by

retained earnings; no external financing is used. The model would be only

applicable to all-equity firms. Secondly, the model assumes that r is constant. This is

not a realistic assumption because when increased investments are made by the

firm, r also changes. Finally, as regards the assumption of constant, ke the risk

complexion of the firm has a direct bearing on it. By assuming a constant ke'

Walter's model ignores the effect of risk on the value of the firm.

8.5 Gordon's Model

Another theory which contends that dividends are relevant is Gordon's model This

model, which opines that dividend policy of a firm affects its value, is based on the

following assumptions:

1. The firm is an ail-equity firm. No external financing is used and investment

programmes are financed exclusively by retained earnings.

2. r and ke are constant.

3. The firm has perpetual life.

4. The retention ratio, once decided upon, is constant. Thus, the growth rate, (g = br)

is also constant.

5. ke > br.



220

Arguments It can be seed from the assumptions of Gordon's model that they are

similar to those of Walter's model. As a result, Gordon's model, like Walter's,

contends that dividend policy of the firm is relevant and that investors put a positive

premium on current incomes/dividends. The crux of Gordon's arguments is a two-

fold assumption

(i) Investors are risk averse, and(ii) They put a premium on a certain return and discount/penalize uncertain

returns.As investors are rational, they want to avoid risk. The term risk refers to the

possibility of not getting a return on investment. The payment of current dividends

ipso facto completely removes any chance of risk. If, however, the firm retains the

earnings (i.e. current dividends are withheld), the investors can expect to get a

dividend in future. The future dividend is uncertain, both with respect to the

amount as well as the timing. The rational investors can reasonably be expected to

prefer current dividend. In other words, they would discount future dividends, thatis, they would place less importance on it as compared to current dividend. The

retained earnings are evaluated by the investors as a risky promise. In case the

earnings are retained, therefore, the market price of the shares would be adversely

affected.

The above argument underlying Gordon's model of dividend relevance is also

described as a bird-in-the-hand argument. That a bird in hand is better than two in

the bush is based on the logic that what is available at present is preferable to what

may be available in the future. Basing the model on this argument, Gordon argues

that the future is uncertain and the more distant the future is, the more uncertain itis likely to be. If, therefore, current dividends are withhled to retain profits, whether

the investors would at all receive them later is uncertain. Investors would naturally

like to avoid uncertainty. In fact, they would be inclined to pay a higher price for

shares on which current dividends are paid. Conversely, they would discount the

value of shares of a firm which postpones dividends. The discount rate would vary,

as shown in the following fig, with the retention rate or level of retained earnings.

The term retention ratio means the percentage of earnings retained. It is the inverse

of D/P ratio. The omission of dividends, or payment of low dividends, would lower

the value of the shares.



221

Dividend Capitalization Model According to Gordon, the market value of a share is

equal to the present value of future streams of dividends. A simplified version of

Gordon's model can be symbolically expressed as

( )( )br k

b E P

e −

−=

1

Where P = Price of a share

E = Earnings per share

b = Retention ratio or percentage of earnings retained.

1 - b =D/P ratio, i.e. percentage of earnings distributed as dividends

ke =Capitalisation rate/cost of capital

br = g =Growth rate = rate of return on investment of an all-equity firm.

The implications of dividends policy according to Gordon's model are illustrated in

following example.

The following information is available in respect of the rate of return on investment

(r), the capitalization rate (ke, and earnings per share (E) of Hypothetical Ltd.

r =12 per cent

E =Rs 20

I

RETENTION RATE



222

Determine the value of its shares, assuming the following:

S.No D/P Ratio (1-b) Retention Ratio (b) Ke (%)

A

B

C

D

E

F

G

10

20

30

40

50

60

70

90

80

70

60

50

40

30

20

19

18

17

16

15

14

Solution The value of shares of Hypothetical Ltd for different D/P and retention

ratios is depicted in following table.

Dividend Policy and Value of Shares of Hypothetical Ltd (Gordon’s Model)

A D/P Ratio 10

Retention Ratio 90

( )74.21

092.0

2

108.020.0

9.0120 Rs

Rs RsP ==

−

−=

( ) 108.012.09.0 =×=gbr

A D/P Ratio 20

Retention Ratio 80

( ) 55.42096.019.0

8.0120 Rs RsP =−

−= ( ) 096.012.08.0 =×=gbr

A D/P Ratio 30

Retention Ratio 70

( )50.62

084.018.0

7.0120 Rs

RsP =

−

−=

( ) 084.012.07.0 =×=gbr

A D/P Ratio 40

Retention Ratio 60

( )63.81

072.017.0

6.0120 Rs

RsP =

−

−=

( ) 072.012.06.0 =×=gbr

A D/P Ratio 50

Retention Ratio 50

( )100

072.017.0

5.0120 Rs

RsP =

−

−=

( ) 06.012.05.0 =×=gbr

A D/P Ratio 60

Retention Ratio 40

( )65.117

048.015.0

4.0120 Rs

RsP =

−

−=

( ) 048.012.04.0 =×=gbr



223

A D/P Ratio 70

Retention Ratio 30

( )62.134

036.014.0

3.0120 Rs

RsP =

−

−=

( ) 036.012.03.0 =×=gbr

Gordon, thus, contends that the dividend decision has a bearing on the market price

of the share. The market price of the share is favorably affected with moredividends in the above table.

The Dividend Decision, in Corporate finance, is a decision made by the directors of a company. It relates to the amount and timing of any cash payments made to thecompany's stockholders. The decision is an important one for the firm as it mayinfluence its capital structure and stock price. In addition, the decision maydetermine the amount of taxation that stockholders pay.

There are three main factors that may influence a firm's dividend decision:

• Free-cash flow• Dividend clienteles• Information signaling

The free cash flow theory of dividends

Under this theory, the dividend decision is very simple. The firm simply pays out, asdividends, any cash that is surplus after it invests in all available positive net presentvalue projects.

A key criticism of this theory is that it does not explain the observed dividend

policies of real-world companies. Most companies pay relatively consistentdividends from one year to the next and managers tend to prefer to pay a steadilyincreasing dividend rather than paying a dividend that fluctuates dramatically fromone year to the next. These criticisms have led to the development of other modelsthat seek to explain the dividend decision.

Dividend clienteles

A particular pattern of dividend payments may suit one type of stock holder morethan another. A retiree may prefer to invest in a firm that provides a consistentlyhigh dividend yield, whereas a person with a high income from employment may

prefer to avoid dividends due to their high marginal tax rate on income. If clientelesexist for particular patterns of dividend payments, a firm may be able to maximiseits stock price and minimize its cost of capital by catering to a particular clientele.This model may help to explain the relatively consistent dividend policies followedby most listed companies.

A key criticism of the idea of dividend clienteles is that investors do not need to relyupon the firm to provide the pattern of cash flows that they desire. An investor who



224

would like to receive some cash from their investment always has the option of selling a portion of their holding. This argument is even more cogent in recent times,with the advent of very low-cost discount stockbrokers. It remains possible thatthere are taxation-based clienteles for certain types of dividend policies.

Information signaling

A model developed by Merton Miller and Kevin Rock in 1985 suggests that dividendannouncements convey information to investors regarding the firm's futureprospects. Many earlier studies had shown that stock prices tend to increase whenan increase in dividends is announced and tend to decrease when a decrease oromission is announced. Miller and Rock pointed out that this is likely due to theinformation content of dividends.

When investors have incomplete information about the firm (perhaps due to opaqueaccounting practices) they will look for other information that may provide a clue as

to the firm's future prospects. Managers have more information than investorsabout the firm, and such information may inform their dividend decisions. Whenmanagers lack confidence in the firm's ability to generate cash flows in the futurethey may keep dividends constant, or possibly even reduce the amount of dividendspaid out. Conversely, managers that have access to information that indicates verygood future prospects for the firm (e.g. a full order book) are more likely to increasedividends.

Investors can use this knowledge about managers' behavior to inform their decisionto buy or sell the firm's stock, bidding the price up in the case of a positive dividendsurprise, or selling it down when dividends do not meet expectations. This, in turn,

may influence the dividend decision as managers know that stock holders closelywatch dividend announcements looking for good or bad news. As managers tend toavoid sending a negative signal to the market about the future prospects of theirfirm, this also tends to lead to a dividend policy of a steady, gradually increasingpayment.

In a fully informed, efficient market with no taxes and no transaction costs, the freecash flow model of the dividend decision would prevail and firms would simply payas a dividend any excess cash available. The observed behaviour of firms differsmarkedly from such a pattern. Most firms pay a dividend that is relatively constantover time. This pattern of behavior is likely explained by the existence of clienteles

for certain dividend policies and the information effects of announcements of changes to dividends.

The dividend decision is usually taken by considering at least the three questions of:how much excess cash is available? What do our investors prefer? And what will bethe effect on our stock price of announcing the amount of the dividend?



225

The result for most firms tends to be a payment that steadily increases over time, asopposed to varying wildly with year-to-year changes in free cash flow.

Dividend decisions are an important aspect of corporate financial policy since they

can have an effect on the availability as well as the cost of capital. The Lintner

proposition which asserts that the corporate management maintains a constanttarget payout ratio has been the most influential.

However, the concept of primary of dividend decisions as well as the reasons for it is

not unambiguously defined. There is a variety of theories which attempt to

rationalize the observed secular constancy of the dividend payout ratio. These

studies examine the factors underlying the structure of the management, the nature

of the product and financial markets, as well as the influence of the shareholders in

their attempt to explain the Lintner proposition. However, in the case of any one

firm, the following two pertinent questions need to be examined on an empirical

basis to provide substance to the notion of primary of dividend decisions. (a) Whatare dividend decisions primary for?, and (b) for whom are they primary? An

attempt has been made to develop a theoretical framework to approach these

questions and identify the appropriate concept of primary and determine

empirically the relationship of the primary notion with the objectives of the share

holders and the management.

The modeling framework postulates that (a) the dividend decisions may be primary

to the management of the firm and /or the shareholder, and (b) each of the decision

makers can have a short run and /or long run objective when they evaluate dividend

decisions. Share price increases have been postulated as the basic short runobjective of both the groups of decision makers. Similarly, both the share holders

and the management are viewed as net worth maximizes over the long run.

The fundamental hypothesis for the short run models is that the management

increases the dividend per share whenever the share price down, and that the share

holder responds, to these in such a way as to increase the share price. This result is

expected if dividend decisions are primary for both the groups.

In the long run context, it was felt that a progressive management would increase

the net worth the firm by investments in fixed assets or through building the reservebase. Dividends would be a primary decision if the internal financing of investment

is constrained by the necessity to pay dividends at a constant rate.



226

These are two extreme forms in which dividend decisions can be considered to be

primary. A variety of intermediate positions are possible in any specific case of a

firm.

The models were designed to accommodate a rich variety of such behavioral

patterns. The theoretical structure was empirically tested for 71 firms of thecorporate sector in 6 industries using the data of the Bombay Stock Exchange

Directory for the period 1967-68 to 1980-81. The results generally indicate that the

methodology of the present study would be helpful in examine the notion of the

primary of corporate dividend policy.

The following are the salient features of the empirical results.

(a) In the case of 17 firms dividend decisions were found to be primary. The factors

which accounted for primary were the following:

(1) Need to build the desired internal reserve base in the long run, and

(2) Inadequacy of funds to finance available investment opportunities while

maintaining a desired payout ratio.

(b) The Lintner hypothesis was validated under the following circumstance:

(1) The managers are oriented towards building up reserves to minimize

dependence on external funds,

(2) There is a lack of motivation or market opportunity for growth of the

firm and

(3) There is no shortage of funds to pursue the desired objectives.

(c) Primary of dividends in the long run was observed in the case of 27 firms. The

significant reasons were

(1) Shortage of funds to take care of growth opportunities as well as requisite

dividends, and

(2) Inadequacy of funds the desired reserve base.

Throughout this analysis dividend decisions were considered to be primary, if and

only if, both the groups of decision makers agree to the same objective and respond

to each other’s perception of goal satisfaction. Viewed form this vantage point

dividend decision were primary only in a few cases. The Lintner hypothesis of a

constant dividend payout ratio appears to hold only because of managerial

motivations and not as a response to share holders desire. To that extent attributing



227

primary to dividend decisions in such content appears to be misplaced. Most of the

management in the corporate sector appears to desire the security of internal

financing and build reserves as a priority after paying certain minimum dividend

per share.

Despite these conclusions from the models of the present study two inadequaciesbecame apparent during the course of work: (a) the goals pursued by the

management and the share holders can be at variance. The conflict resolution

mechanisms have not been explicitly modeled. (b) The interrelationships between

the short run and long run models are as yet tenuous. Further progress along these

lines is possible. But it wills bee an agenda for the future.

8.5 DIVIDEND POLICY

* Some facts about dividend policy

- Dividends are sticky

- Dividends follow earnings

* Payment Procedures

* Why do firms pay dividends?

- Dividends don't matter: The Miller Modigliani Theorem

- Dividends are taxed heavier than capital gains: Arguments against dividendpayments

* Evidence from ex-dividend day price changes

- Dividends are more certain than capital gains: The bird in the hand fallacy

* The Citizen's Utility case

- Dividend policy is tailored to meet clientele needs

* What are clienteles?

* Evidence on clienteles

- Dividends are a good use for excess cash

* Alternatives to dividends



228

* Arguments for the alternatives

- Dividends as signals

* Need for signaling

* Evidence on dividends as signals

- Dividends as a wealth transfer mechanism

* Rationale

* Evidence

- Management view of dividends

* Framework for analyzing dividend policy

SOME FACTS ABOUT DIVIDEND POLICY

* Dividends are sticky; Firms are much more reluctant to cut dividends thanincrease them.

Measures of Dividend Policy

• Dividend Payout: measures the percentage of earnings that the companypays in dividends = Dividends / Earnings

• Dividend Yield: measures the return that an investor can make fromdividends alone = Dividends / Stock Price



230

is called the ex-dividend date. The ex-dividend date in this example in December11, 1984.

Payment date: The Company mails the checks to the recorded holders onJanuary 2, 1985.

8.7 WHY DO FIRMS PAY DIVIDENDS?

The Miller-Modigliani Hypothesis: Dividends do not affect value

Basis: If a firm's investment policy (and hence cash flows) don't change, thevalue of the firm cannot change with dividend policy. If we ignore personaltaxes, investors have to be indifferent to receiving either dividends or capitalgains.

* Underlying Assumptions:

(a) There are no tax differences between dividends and capital gains.

(b) If companies pay too much in cash, they can issue new stock, with noflotation costs or signaling consequences, to replace this cash.

(c) If companies pay too little in dividends, they do not use the excess cash forbad projects or acquisitions.

* The Tax Response: Dividends are taxed more than capital gains

Basis: Dividends are taxed more heavily than capital gains. A stockholder willtherefore prefer to receive capital gains over dividends.

Evidence: Examining ex-dividend dates should provide us with some evidence onwhether dividends are perfect substitutes for capital gains.

Let Pb= Price before the stock goes ex-dividend

Pa=Price after the stock goes ex-dividend

D = Dividends declared on stock

to, tcg = Taxes paid on ordinary income and capital gains respectively

Assume you are all investors in a stock that you bought a long time ago for $P andyou have the choice between-

(a) Selling before the ex-dividend day, and forsaking the dividend.(b) Selling after the ex-dividend day, and receiving the dividend.



231

The cash flows from selling before then are-

Pb - (Pb - P) tcg

The cash flows from selling after the ex-dividend day are-

Pa - (Pa - P) tcg + D(1-to)

Since the average investor should be indifferent between selling before the ex-dividend day and selling after the ex-dividend day -

Pb - (Pb - P) tcg = Pa - (Pa - P) tcg + D(1-to)

Moving the variables around, we arrive at the following:

Holding other things equal, the price drop on the ex-dividend day will be equal tothe dollar dividend if and only if the marginal investor in the stock faces the sametax rate on dividends and capital gains; it will be less than the dividend if the taxrate on dividends exceeds the tax rate on capital gains; it will be greater than thedividend if the tax rate on dividends is less than the tax rate on capital gains.

If Pb - Pa = D then to = tcg

Pb - Pa < D then to > tcg

Pb - Pa > D then to < tcg

1. Assume that the company that you are analyzing has only wealthy individualinvestors, and that they face a marginal tax rate of 41% on ordinary income, and 28% on capital gains. If the company pays a dividend of $1.00, how much would you expect the price to drop on the ex-dividend day?

What will happen if the capital gains tax rate is lowered to 19.6%, as is being proposed in Congress right now?

The Evidence on Ex-Dividend Day Behavior

The difference between the tax rates on ordinary income and capital gains haschanged has changed substantially over time in the United States.

2. Assume that you are a tax exempt investor and that you know that the price drop on the ex-dividend day is only 90% of the dividend. How would you exploit this differential?



232

( ) Invest in the stock for the long term

( ) Sell short the day before the ex-dividend day, buy on the ex-dividend day

( ) Buy just before the ex-dividend day, and sell after.

Example of dividend capture strategy with tax factors: XYZ company is selling for$50 at close of trading May 3. On May 4, XYZ goes ex-dividend; the dividendamount is $1. The price drop (from past examination of the data) is only 90% of thedividend amount. The transactions needed by a tax-exempt U.S. pension fund forthe arbitrage are as follows:

1. Buy 1 million shares of XYZ stock cum-dividend at $50/share.

2. Wait till stock goes ex-dividend; Sell stock for $49.10/share (50 - 1* 0.90)

3. Collect dividend on stock.

Net profit = - 50 million + 49.10 million + 1 million = $0.10 million

Clearly these profits have to exceed transactions costs for this to be worth it.(Transactions costs have to be less than 10 cents per share)

Example of dividend capture strategy even without tax factors

On May 4, 1988 American Electric Power began trading ex-dividend; the dividend

amount was $0.565. On May 3, 1988 the following transactions were reported.

10:09:30 am 5,500,000 shares traded at $27.25.

10:09:34 am 2,640,000 shares traded at $26.75

10:09:37 am 2,860,000 shares traded at $26.625

The first transaction represented a buy of 5.5 million shares at $27.25 by a Japaneseinsurance company (which were then obligated to pay yields of 7-8% to their policyholders from dividend income) from a U.S. pension fund. The second and third

transactions represent a sell-back by the same company to the same pension fund of 5.5 million shares at a weighted average price of $26.685 (These were special tradeswhere the pension fund agreed to allow the Japanese firm to collect the dividends of $0.565 on the stock).

Japanese company: was able to collect dividend income of $0.565*5.5 millionshares= $3.1 mil



233

U.S. pension fund: was able to receive the $3.1 million almost 5 weeks early.

* The wrong reasons for paying dividends

A. The bird in the hand fallacy

Argument: Dividends now are more certain than capital gains later. Hencedividends are more valuable than capital gains.

Counter: The appropriate comparison should be between dividends today and priceappreciation today. (The stock price drops on the ex-dividend day.)

B. The excess cash hypothesis

Argument: The firm has excess cash on its hands this year, no investment projectsthis year and wants to give the money back to stockholders.

Counter: So why does not it just repurchase stock? If this is a one-timephenomenon, the firm has to consider future financing needs. Consider the cost of issuing new stock:

Size of IssueCost of Issue

BondsPreferred

StockCommon Stock

Under $ 1

million 14.0% - 22.0%

$ 1 - $ 1.9

million11.0% - 16.9%

$ 2- $ 4.9

million4.0% - 12.4%

$ 5 -$9.9

million2.4% 2.6% 8.1%

$10 - $ 19.9

million1.2% 1.8% 6.0%

$ 20 - $ 49.9

million1.0% 1.7% 4.6%



234

> $ 50 million 0.9% 1.6% 3.5%

• Are firms perverse? Some evidence that they are not

Some investors clearly prefer to receive dividends. Companies with suchinvestors have to pay dividends to keep them happy.

Citizens Utility is a company which has two classes of stock. Class A gets a stockdividend and can be converted freely into Class B stock. Class B gets a cashdividend and cannot be converted to Class A stock. The stock dividend isgenerally 7% to 13% greater than the cash dividend.

The study found that PB > PA by more than 10%. In other words, the cashdividend shares sold at a premium of 10% over the capital gains shares.

An Updated Study of Canadian companies arrives at similar conclusions.

An updated study of Canadian stocks arrives at similar conclusions; cashdividend shares sell at a premium over stock dividend shares.

Company Premium on Cash Dividend Shares over

Stock Dividend Shares

Consolidated Bathurst19.30%



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Donfasco13.30%

Dome Petroleum0.30%

Imperial Oil12.10%

Newfoundland Light & Power1.80%

Royal Trustco17.30%

Stelco2.70%

TransAlta1.10%

Average 7.54%

3. Clearly some investors like dividends. What types of investors do you think are mostlikely to fall into this category? (You can pick more than one)

( ) Wealthy investors

( ) Institutional Investors

( ) Less well-off investors

( ) Tax-exempt investors

* A clientele based explanation

Basis: Investors may form clienteles based upon their tax brackets. Investors in hightax brackets may invest in stocks which do not pay dividends and those in low taxbrackets may invest in dividend paying stocks.

Evidence: A study of 914 investors' portfolios was carried out to see if their portfoliopositions were affected by their tax brackets. The study found that

(a) Older investors were more likely to hold high dividend stocks and(b) Poorer investors tended to hold high dividend stocks

The following regression captures the determinants of dividend yield

Dividend Yieldt = a + b t + c Aget + d Incomet + e Differential Tax Ratet + t

Variable Coefficient Implies



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Constant4.22%

Beta

Coefficient -2.145Higher beta stocks pay lower

dividends.

Age/1003.131

Firms with older investors payhigher

dividends.

Income/1000-3.726

Firms with wealthier investors

pay lower

dividends.

Differential

Tax Rate -2.849

If ordinary income is taxed ata higher rate

than capital gains, the firm

pays less dividends.

4. Assume that you run a phone company, and that you have historically paid large dividends. You are now planning to enter the telecommunications and media markets.Which of the following paths are you most likely to follow?

( ) Courageously announce to your stockholders that you plan to cut dividends and invest in the new markets.

( ) Continue to pay the dividends that you used to, and defer investment in the new markets.

( ) Continue to pay the dividends that you used to, make the investments in the new markets, and issue new stock to cover the shortfall

( ) Other

Can you find a way out of your dilemma?

• The Signalling Hypothesis

Context: In a world of asymmetric information, firms have to convince investorsabout their future prospects. An increase in dividends is one way to signal goodfuture prospects.



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On average, at least, increases in dividends seem to be viewed as positive signals

and decreases as negative signals.

• Why is the positive reaction to a dividend increase more muted than the negative reaction to a dividend decrease?

An Alternative Story. Dividends as Negative Signals

The problem with signaling stories is that an equally compelling case can bemade for increasing dividends being a negative signal, especially for young, highgrowth firms. There is evidence that earnings growth declines after firms initiatedividends.



238

Extending the effects of dividend changes on stock prices - long term

While dividend increases (decreases) tend to have a positive (negative) effect in theshort term, there seems to be an interesting evening out of returns in the monthafter the announcement.

• The Wealth Transfer Hypothesis

Basis: Dividends are one way stockholders can transfer wealth frombondholders to themselves. Since bondholders anticipate this, they writeconstraints into bond covenants and stockholders who do not pay dividends willactually be transferring wealth to bondholders.

CAR: Cumulative Abnormal Return (Actual Return - Expected Return: CAPM)

* Management Beliefs about Dividend Policy

Statement of Management

Beliefs Agree No

Opinion Disagree

1. A firm's dividend 61% 33% 6%



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payout ratio affects the

price of the stock

2. Dividend payments

provide a signaling device

of future prospects 52% 41% 7%

3. The market uses

dividend announcements

as information for

assessing firm value.

43% 51% 6%

4. Investors have

different perceptions of

the relative riskiness of

dividends and retained

earnings.

56% 42% 2%

5. Investors are basically

indifferent with regard to

returns from dividends

and capital gains.

6% 30% 64%

6. A stockholder is

attracted to firms that

have dividend policies

appropriate to the

stockholders' tax

environment.

44% 49% 7%

7. Management should be

responsive to

shareholders' preferences

regarding dividends.

41% 49% 10%

8.8 DETERMINANTS OF DIVIDEND POLICY

A. Investment Opportunities



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Basis: Other thing remaining equal, a firm with more investment opportunities willpay a lower fraction of its earnings as dividends than a stable firm.

Proxy for investment opportunities: Growth rate in firm's assets; CapitalInvestment;

Testable proposition: A firm with higher growth rates in assets or earnings, andgreater capital investment needs will pay out a lower fraction of its earnings asdividends

B. Stability in earnings

Basis: Other things remaining equal, a firm with more stable earnings will pay out ahigher fraction of its earnings as dividends than a firm with variable earnings

Proxy for variability in earnings: Variance in EPS

Testable proposition: A firm with higher variance in EPS will have a lower dividendpayout ratio

C. Alternative sources of capital

Basis: Other things remaining equal, a firm which can issue new stock or bonds atlow cost (such as underwriting commissions) will be more likely to have a highdividend payout ratio.

Proxy for cost of issue: Size of the firm

Testable proposition: A smaller firm will almost invariably have a higher issuancecost than a larger firm in issuing new stock and debt. It will therefore be less likelyto have a high payout ratio.

D. Constraints

Basis: Firms which have borrowed large amounts of debt usually have severalconstraints on their dividend policy and will therefore follow more conservativedividend policies

Proxy for leverage: Debt ratio

Testable proposition: A firm with a high debt ratio will very seldom be able to makemajor changes in its dividend policy because of constraints on payout.

E. Signaling Incentives



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Basis: Firms which are undervalued may use dividend increases as signals to themarket

Proxy for undervaluation: Price/ Value ratios

Testable proposition: As the ratio of price to value decreases dividend increases willbecome more frequent.

F. Stockholder characteristics

Basis: Firms which have acquired a reputation as high dividend yield firms alsoacquire stockholders who desire high dividends. Consequently they cannot suddenlyshift policy. Testable proposition: The past history of a company's dividend policy isusually be a good indication of what it will do in the future.

BOEING: SUMMARY OF DIVIDEND ANALYSIS



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Average

Standard Deviation

Maximum Minimum

Free CF to Equity $350.47 $366.99 $879.19 ($176.57)

Dividends+Repurchases

$237.60 $87.38 $374.00 $134.00

Dividend Payout Ratio 29.05%

Cash Paid as % of

FCFE 67.79%

ROE 12.38%

Required Return 16.32%

ROE - Required return -4.92% 11.83% 18.84% -20.65%

MERCK: SUMMARY OF DIVIDEND POLICY

Average Standard Deviation

Maximum Minimum

Free CF to Equity $807.36 $474.51 $1,457.64 $57.78

Dividends+Repurchases $512.40 $317.05 $1,086.00 $213.00


Cash Paid as % of FCFE 63.47%

ROE 35.14%



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ROE - Required return 17.84% 18.42% 49.07% -10.44%

BP: SUMMARY OF DIVIDEND POLICY ANALYSIS


Maximum Minimum

Free CF to Equity $571.10 $1,382.29 $3,764.00 ($612.50)

Dividends+Repurchases $1,496.30 $448.77 $2,112.00 $831.00


Cash Paid as % of

FCFE 236.83%

ROE 13.22%


ROE - Required return -1.67% 11.49% 20.90% -21.59%

T HE LIMITED: SUMMARY OF DIVIDEND ANALYSIS


Maximum Minimum

Free CF to Equity ($34.20) $109.74 $96.89 ($242.17)

Dividends $40.87 $32.79 $101.36 $5.97

Dividends+Repurchases $40.87 $32.79 $101.36 $5.97




Cash Paid as % of

FCFE -119.52%

ROE 21.81%


ROE - Required return 1.69% 19.07% 29.26% -19.84%

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