* 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 dividend payments

* 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?

Three Schools Of Thought On Dividends

1. If

(a) there are no tax disadvantages associated with dividends

(b) companies can issue stock, at no cost, to raise equity, whenever needed

Dividends do not matter, and dividend policy does not affect value.

2. If dividends have a tax disadvantage,

Dividends are bad, and increasing dividends will reduce value

3. If stockholders like dividends, or dividends operate as a signal of future prospects,

Dividends are good, and increasing dividends will increase value

The balanced viewpoint

If a company has excess cash, and few good projects (NPV>0), returning money to stockholders (dividends or stock repurchases) is GOOD.

If a company does not have excess cash, and/or has several good projects (NPV>0), returning money to stockholders (dividends or stock repurchases) is BAD.

PAYMENT PROCEDURES

* Significant Dates

Declaration date. The dividend is declared at a board of directors meeting. On this date the directors issue a statement similar to the following: On November 15, 1984, the directors of the XYZ corporation met and declared a regular quarterly dividend of 50 cents per share, plus an extra dividend of 25 cents per share, payable to the holders of record on December 15, payment to be made on January 2, 1985.

Holder-of-record date. At the close of the business on the holder-of-record date, December 15, the company closes its stock transfer books and makes up a list of the shareholders on that date. These shareholders will receive the dividends

Ex-dividend date. Suppose you buy 100 shares on December 13, 1984. Will the company be notified in time? To avoid conflict, the brokerage industry has set up the convention of declaring that the right to the dividend remains with the stock until 4 days prior to the holder-of-record date; on the fourth day before the record date the right to the dividend no longer goes with the stock. This date is called the ex-dividend date. The ex-dividend date in this example in December 11, 1984.

Payment date. The company mails the checks to the recorded holders on January 2, 1985.

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, the value of the firm cannot change with dividend policy. If we ignore personal taxes, investors have to be indifferent to receiving either dividends or capital gains.

* 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 no flotation costs or signalling consequences, to replance this cash.

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

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

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

Evidence. Examining ex-dividend dates should provide us with some evidence on whether 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 and you 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.

The cash flows from selling before then are-

P b — (P b — P) t cg

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

P a — (P a — P) t cg + D(1-t o )

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

P b — (P b — P) t cg = P a — (P a — P) t cg + D(1-t o )

Moving the variables around, we arrive at the following:

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

If P b — P a = D then t o = t cg

P b — P a < D then t o > t cg

P b — P a > D then t o < t cg

1. Assume that the company that you are analysing has only wealthy individual investors, 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 has changed 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?

( ) 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 dividend amount is $1. The price drop (from past examination of the data) is only 90% of the dividend amount. The transactions needed by a tax-exempt U.S. pension fund for the 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 Japanese insurance company (which were then obligated to pay yields of 7-8% to their policy holders 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 trades where 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 million shares= $3.1 mil

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. Hence dividends are more valuable than capital gains.

Counter. The appropriate comparison should be between dividends today and price appreciation 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 projects this year and wants to give the money back to stockholders.

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