Dividend Controversy

What is Dividend?

The term dividend usually refers to a cash distribution of earnings. If a distribution is made from
sources other than current or accumulated retained earnings, the term distribution rather than
dividend is used. However, it is acceptable to refer to a distribution from earnings as a dividend
and a distribution from capital as a liquidating dividend. Dividend can be paid in
 Cash or,
 Stock
Another alternative to cash dividend is stock repurchase.

Cash Dividends

1. Regular cash dividends: Commonly four times a year in U.S and once in Bangladesh.
2. Extra dividends: May or may not be repeated in future.
3. Special dividends: Similar to “extra” but the name usually indicates it is unusual or one-
time event and won’t be repeated.
4. Liquidating dividends: If some or all of the business has been liquidated and payment is
made.
A cash dividend reduces corporate cash and retained earnings, except in the case of a liquidating
dividend (which may reduce paid-in-capital).

Method of dividend payment

The decision whether or not to pay a dividend rests in the hands of the board of directors of the
corporation.
1. Declaration date: On January 15 (the declaration date), the board of directors passes a
resolution to pay a dividend of $1 per share on February 16 to all holders of record on
January 30.
2. Ex-dividend date: Two business days before the date of record. Wednesday, January 28,
is the ex-dividend date. Before this date, the stock is said to trade “with dividend” or
“cum dividend.” Afterword the stock trades “ex dividend.”

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 3. Date of record: The Corporation prepares a list on January 30 of all individuals believed
to be stockholders as of this date. The word believed is important here, because the
dividend will not be paid to those individuals whose notification of purchase is received
by the company after January 30. These are holders of record.
4. Date of payment: The dividend checks are mailed to the stockholders on February 16.

Dividend Irrelevance Theory

It has been argued that dividend policy has no effect on either the price of a firm’s stock or its
cost of capital. If dividend policy has no significant effects, then it would be irrelevant. The
principal proponents of the dividend irrelevance theory are Merton Miller and Franco
Modigliani (MM). They argued that the firm’s value is determined only by its basic earning
power and its business risk.

To understand MM’s argument that dividend policy is irrelevant, recognize that any shareholder
can in theory construct his or her own dividend policy. For example, if a firm does not pay
dividends, a shareholder who wants a 5 percent dividend can “create” it by selling 5 percent of
his or her stock. Conversely, if a company pays a higher dividend than an investor desires, the
investor can use the unwanted dividends to buy additional shares of the company’s stock which
is known as “Homemade Dividends.” If investors could buy and sell shares and thus create their
own dividend policy without incurring costs, then the firm’s dividend policy would truly be
irrelevant. Note, though, that investors who want additional dividends must incur brokerage costs
to sell shares, and investors who do not want dividends must first pay taxes on the unwanted
dividends and then incur brokerage costs to purchase shares with the after-tax dividends. Since
taxes and brokerage costs certainly exist, dividend policy may well be relevant.

In developing their dividend theory, MM made a number of assumptions,

1. There are neither taxes nor brokerage fees, and no single participant can affect the market
price of the security through his or her trades. Economists say that perfect markets exist
when these conditions are met.
2. All individuals have the same beliefs concerning future investments, profits, and
dividends.
3. The investment policy of the firm is set ahead of time, and is not altered by changes in
dividend policy.
Obviously, taxes and brokerage costs do exist, so the MM irrelevance theory may not be true.
However, MM argued (correctly) that all economic theories are based on simplifying
assumptions, and that the validity of a theory must be judged by empirical tests, not by the
realism of its assumptions.

Illustration of the Irrelevance Theory

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Bristol is an all-equity firm that has existed for 10 years. The current financial managers know at
the present time (date 0) that the firm will dissolve in two years. The total cash flow the firm will
generate, including proceeds from liquidation, will be $10,000 in each of the next two years.

Current Policy: Dividends set equal to cash flow-At the present time, dividends (Div) at each
date are set equal to the cash flow of $10,000. There are 100 shares outstanding, so the dividend
per share is $100.

1 and date 2

Date1 Date 2

P0 = D1 / (1+R) 1 + D2/ (1+R) 2 Whole firm value = $ 173.55*100

=$100/1.1 + $100/1.12 = $ 17355
=$ 173.55

Alternative Policy: Initial dividend greater than cash flow

Date1
Date 2

Date1 Date 2
P0 = D1 / (1+R) + D2/ (1+R) 2
1

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 =$110/1.1 + $89/1.12
=$ 173.55
Because the cash flow is only $ 10,000, an extra $ 1000 must somehow be raised. Assume we
issue $1000 worth of 10 stocks.

Date1

Date 2

P1 = P0 (1+R)1
= $100 (1.1)1
= $110
Test of Irrelevance

You can test your knowledge of this material by examining these true statements:
1. Dividends are relevant.
2. Dividend policy is irrelevant.
The first statement follows from common sense. Clearly, investors prefer higher dividends to
lower dividends at any single date if the dividend level is held constant at every other date. In
other words, if the dividend per share at a given date is raised while the dividend per share for
each other date is held constant, the stock price will rise. This act can be accomplished by
management decisions that improve productivity, increase tax savings, or strengthen product
marketing. In fact, you may recall that the value of a firm’s equity is equal to the discounted
present value of all its future dividends.

The second statement is true. Dividend policy merely establishes the trade-off between dividends
at one date and dividends at another date. Once we allow for the time value, the present value of
the dividend stream is unchanged. Thus, in this simple world, dividend policy does not matter.
That is, managers choosing either to raise or to lower the current dividend do not affect the
current value of their firm.

Should dividends be financed by new stock issue?

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Assume that dividends are taxed at the owner’s personal tax rate of 30 percent. The firm still
receives $100 upon issuance of stock. However, the $100 dividend is not fully credited to the
entrepreneur. Instead, the dividend payment is taxed, implying that the owner receives only $70
net after tax. Thus, the entrepreneur loses $30.

Though the example is clearly contrived and unrealistic, similar results can be reached for more
plausible situations. Thus, financial economists generally agree that, in a world of personal taxes,
one should not issue stock to pay a dividend.

The direct costs of issuance will add to this effect. Investment bankers must be paid when new
capital is raised. Thus, the net receipts due to the firm from a new issue are less than 100 percent
of total capital raised. These costs are examined in a later chapter. Because the size of new issues
can be lowered by a reduction in dividends, we have another argument in favor of a low-
dividend policy.

New issues increase the outstanding supply of the stock, putting downward pressure on the
market price of existing shares. Therefore, to the extent that dividends are financed by new
issues, an increase in dividends may well contribute to a stock-price reduction.

In spite of all the above consequences managers of large corporations may be forced to issue new
stock to finance dividends to maintain dividend stability.

How management decide on the payout?

John Lintner held a classic series of interviews with corporate managers regarding their payout
policies. The summarized result is:
1. Firms have long-run target dividend payout ratios. This ratio is the fraction of earnings
paid out as dividends.
2. Managers focus more on dividend changes than on absolute levels. Thus paying a $2
dividend is an important financial decision if last year’s dividend was $1 but no big deal
if last year’s dividend was $2.
3.
Logics behind a low payout

There are three tax-related reasons for thinking that investors might prefer a low dividend payout
to a high payout (Tax preference theory):
(1) Long-term capital gains are taxed at a rate of 20 percent, whereas dividend income is
taxed at effective rates that go up to 39.6 percent. Therefore, wealthy investors (who own
most of the stock and receive most of the dividends) might prefer to have companies
retain and plow earnings back into the business. Earnings growth would presumably lead

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 to stock price increases, and thus lower-taxed capital gains would be substituted for
higher-taxed dividends.
(2) Taxes are not paid on the gain until a stock is sold. Due to time value effects, a dollar of
taxes paid in the future has a lower effective cost than a dollar paid today.
(3) If a stock is held by someone until he or she dies, no capital gains tax is due at all—the
beneficiaries who receive the stock can use the stock’s value on the death day as their
cost basis and thus completely escape the capital gains tax.

Because of these tax advantages, investors may prefer to have companies retain most of their
earnings. If so, investors would be willing to pay more for low-payout companies than for
otherwise similar high-payout companies.
EXAMPLE
The Regional Electric Company has $1,000 of extra cash. It can retain the cash and invest it in
Treasury bills yielding 10 percent, or it can pay the cash to shareholders as a dividend.
Shareholders can also invest in Treasury bills with the same yield. Suppose the corporate tax rate
is 34 percent, and the individual tax rate is 28 percent. How much cash will investors have after
five years under each policy?

If dividends are paid now, shareholders will receive

$1,000 * (1 * 0.28) = $720

today after personal tax. Because their return after personal tax is 7.2 percent, they will have

$720 * (1.072)5 = $1,019.31 (1)

in five years. If Regional Electric Company retains the cash to invest in Treasury bills and pays
out the proceeds five years from now, the firm will have

$1,000 * (1.066)5 = $1,376.53

in five years.
If this is paid as a dividend, the stockholders will receive
$1,376.53 * (1- 0.28) = $991.10 (2)

after personal taxes at date 5. The result in formula (1) is greater than that in (2), implying that
cash to stockholders will be greater if the firm pays the dividend now.

This example shows that, for a firm with extra cash, the dividend-payout decision will depend on
personal and corporate tax rates. If personal tax rates are higher than corporate tax rates, a firm
will have an incentive to reduce dividend payouts. However, if personal tax rates are lower than
corporate tax rates, a firm will have an incentive to pay out any excess cash as dividends.

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There is a quirk in the tax law benefiting firms that invest in stock rather than bonds. For a
company investing in less than 20 percent of the stock of other firms, 70 percent of the dividends
received are excluded from corporate tax. The exclusion is 100 percent if a company owns 80
percent or more of the stock of another firm. It is 80 percent if a company holds more than 20
percent and less than 80 percent of another company. If Regional Electric invested $1,000 in a
one-year preferred stock yielding 10 percent, only $30 of the $100 in dividends would be subject
to tax. Corporate tax would be

$30 * 0.34
= $1,000 * 0.10 * 0.3 * 0.34
= $10.20
Thus, Regional Electric would have

$1,000 * 1.10 - $1,000 * 0.1020

=$1,100 - $10.20 = $1,089.80

at the end of one year. Regional is being taxed at an effective rate of 0.30 * 0.34 = 10.2%.
At the end of five years, Regional would have

$1,000 * [1 + 0.10 * (1 - 0.30 * 0.34)] 5

= $1,000 * [1 + 0.10 * (1 - 0.1020)] 5
= $1,537.21
If this is paid as a dividend, the stockholders would receive

$1,537.21 * (1 - 0.28) = $1,106.79 (3)

Because individual investors are not allowed this dividend exclusion, they would receive the
same amount whether they invested date 0 dividends in 10-percent T-bills or 10- percent
preferred stock. Because the result in equation (3) is greater than the one in (2), Regional should
invest in preferred stock rather than pay a dividend at date 0.

Moreover, due to flotation costs and dividend restrictions included in bond indenture sometimes
payouts need to be lower.

Factors favoring a high payout

1. Desire for current income: Benjamin Graham, David Dodd, and Sidney Cottle have
argued that firms should generally have high dividends because, “The discounted value
of near dividends is higher than the present worth of distant dividends.”

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 2. Uncertainty resolution: In the Bird-in-the-Hand theory of Myron Gordon and John
Lintner argued that a high-dividend policy benefits stockholders because it resolves
uncertainty. Gordon states that investors price a security by forecasting and discounting
future dividends. According to Gordon, forecasts of dividends to be received in the
distant future have greater uncertainty than do forecasts of near-term dividends. Because
the discount rate is positively related to the degree of uncertainty surrounding dividends,
the stock price should be low for those companies that pay small dividends now in order
to remit higher dividends at later dates.

3. Tax and legal benefits from high dividends

a. Corporate investors: A significant tax break on dividends occurs when a

corporation own stock in another corporation.
b. Tax exempt investors: Some largest investors like pension funds, endowment
funds, and trust funds are legally exempted from tax on dividend gain.

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