A Changed Dividend Policy

DIVIDEND POLICY _______________________
A corporation is not legally obligated to declare a dividend of any
specific amount. Thus, the board of directors actually has a
specific decision every time a dividend is declared. However, once
the Board declares a dividend, the corporation is legally obligated
to make the payments. Therefore, a dividend should not be declared
unless a corporation is in a financial position to make the
payment.
The expectation of receiving dividends (broadly defined as any
distribution of value) ultimately determines the market value of
the common stock. By declaring a dividend, the board of directors
is not only turning over some of the assets of the corporation
to its stockholders, but it may be influencing the expectations
stockholders have about the future dividends they can expect
from the corporation. If expectations are affected, the dividend
decision and the underlying dividend policy will have a short term
impact on the value the market places on the common stock of
the corporation.
Many financial experts believe that a highly stable but growing
dividend is advantageous to a company. The most common reason
stated for this belief is that stockholders prefer a steady income
from their investments. There is at least one other important reason
for thinking that a highly variable dividend rate may not be in the
best interest of a company. In the long run, the value of a share of
stock tends to be determined by the discounted value of the expected
dividends. Insofar as this is the case, a widely fluctuating
dividend rate will tend to make it difficult for stockholders to determine
the value of the stock to them and as a result, the stock is
likely to sell at a somewhat lower price than comparable stocks
paying the same average dividend through time, but making the
payments at a steady rate. This conclusion assumes investors are
risk averse.
Reasons for Paying Dividends
There have been two rules of thumb with respect to dividend policy
of publicly held corporations; first, that it is necessary for the firm to
pay cash dividends to common stockholders and second, the dividends
through time must increase. It is far from obvious that the
above policies are optimum from the point of view of maximizing
the well-being of stockholders. In this chapter we consider the effect
of different dividend policies on the well-being of the common
stockholders. Private equity capital offers complete flexibility regarding
dividend policy.
The board of directors of an average publicly owned company
knows that a significant percentage of its investors want dividends
and others do not. Unfortunately, what the company knows is frequently
wrong. With private equity capital the desires of the stockholders
are more easily determined and their objectives are more
likely to be identical. The private equity shareholders are likely to
want capital gains and are likely to want these capital gains realized
in the future, not realized now.
The primary reasons for paying dividends are:
■ Zero tax investors (or low tax)
■ Have done it in the past
■ Trust legal list
■ Few good investments (too much cash)
■ Raiders
■ Do right by investors (investors need cash for consumption)
If investors do not pay taxes (or have a very low tax rate),
then cash dividends are a sensible way of a corporation's distributing
cash.
The argument that a corporation should increase its dividend
payment because it has done so in the past finds its justification in
the fact that investors wanting dividends would incur transaction
costs switching investments if the policy were changed.
If a firm does not have good investment alternatives, it should
consider a dividend. All investors have opportunity costs for money.
They can invest the funds to earn an expected return consistent with
what the market has to offer. The corporation should distribute the
cash to its stockholders if it cannot invest it to beat the investor's
opportunity cost.
The attitudes of investors are important factors to be considered.
Consistently increasing dividends are generally welcomed by investors
as indicators of profitability and safety. Uncertainty is increased
by lack of dividends or dividends that fluctuate widely. Also
dividends are thought to have an informational content; that is, an increase
in dividends means that the board of directors expects the firm
to do well in the future. Another important reason for the payment of
dividends is that a wide range of investors need the dividends for
their holdings, this latter transaction has relatively high transaction
costs compared to cashing a dividend check. The presence of investors
desiring cash for consumption makes it difficult to change the
current dividend policy, even where such a change is dictated by the
logic of the situation. Though one group of investors may benefit
from a change in dividend policy, another group may be harmed.
While we will see that income taxes tend to make a retention policy
more desirable than cash dividends, the presence in the real world of
zero tax and low tax investors dictates that we consider each situation
individually and be flexible in arriving at a distribution policy.
Reasons for Not Paying Dividends
The motivations for not paying cash dividends are:
■ There are better forms of distribution than cash dividends, given
tax considerations. ■ There are transaction costs with an
investor receiving cash and
then having to reinvest. ■ The firm has transaction costs if it
needs to raise an equivalent
amount of cash to substitute for the dividend. ■ Retention may
be better than a dividend when the firm has good
investments and the tax law favors retention compared to cash
dividends.
The advantage of private equity is that the cash distribution decision
can be made purely on the grounds of maximizing the value
of the firm's common stock values.
Irrelevance of Dividend Policy
Let us assume that there are:
■ No transaction costs
■ No taxes
Miller and Modigliani (1961) argue that with no income taxes
and other well defined assumptions (such as perfect knowledge
and certainty) a dollar retained is equal in value to a dollar distributed;
thus dividend policy is not a relevant factor in determining
the value of a corporation. However, when taxes are
allowed in the analysis, dividend policy very much affects the
value of the stockholders' equity. In practice, corporations appear
to be influenced in setting dividend policy by the behavior
of other corporations, and by a desire to have a relatively stable
dividend.
The theoretical solution is for a corporation to invest in all desirable
investments. If any cash is left over after the investments
are made, the excess cash is distributed to the stockholders. In the
real world, the dividend is frequently considered to be a firm
obligation, and this obligation will affect the amount available for
dividends.
Since private equity capital is most beneficial for investors in
the higher tax brackets, we will assume for the investors a .396
tax rate on ordinary income and a .20 tax rate on long term capital
gains.
The Value: One-Period Horizon
Assume a firm pays a $1 dividend and the investor nets after tax
(1 - tp ) and invests to earn an after tax return of rp so that after one
year the investor has:
With retention by the corporation of the $ 1 where the corporation
earns r and then pays a dividend the investor has:
There is indifference for dividends and retention if r = rp . If r is
larger than rp , then retention is better than an immediate dividend.
Assume rp = .0604 and r = .10. We would expect retention to be
better than an immediate dividend. Assume the firm has $100 available.
With a dividend the investor has after one year:
100(1 - tp)(l + rp) = 60.40(1.0604) = $64.048
If the firm retains for one year and earns .10 and then pays a
dividend, the investor has:
100(1.10)(1-.396) = $66.44
If the firm could earn only r = rp = .0604, the investor would
again have $64.048.
100(1.0604)(.604) = $64.048
The relationships hold if there are n time periods instead of
one. If rp = r there is indifference for dividends and retention. If
the firm retains and does not pay a cash dividend, the required return
is reduced if there is a capital gain.
The Value with a Dividend: Five-Year Horizon
Assume a firm has $100 that it can either invest or pay a dividend.
The investor can earn a return of .0604 after investor tax on investments
in the market.
The investor nets $60.40 after tax from the $100 dividend
and after five years the investor who invests in the market will
have $80.98:
60.40(1.0604)5 = $80.98
The Value with Retention and Sale
Now assume the firm reinvests the $100 for five years and earns .10
per year. After five years the firm will have $161.05:
100(1.10)5 = $161.05
Assume the firm is sold at time 5 for $161.05 and the investor is
taxed at .20:
(1-.20)(161.05) = $128.84
This strategy is consistent with the manner in which private equity
is managed. The advantage of the retention strategy compared
to a dividend is $47.86 for the example or an increase of .59 above
the future value with the annual dividend.
Most corporations have a mixed strategy of paying out a percentage
of their earnings and retaining the remainder. Thus the
actual difference in value for a typical dividend-paying corporation
will not be as dramatic as for the example. But if we consider
the change in value for the dividend component only, the example
is accurate.
With the corporation retaining all the $100 of earnings the investor
gives up $60.40 at time 0 and gets $128.84 at time 5. This is
an IRR for the investor of .164.
60.40(1 + IRR)5 = $128.84
IRR = .164
The advantage of the retention strategy is highlighted by the fact
that in a situation where the corporation can earn only .10 (after
corporate tax and before investor tax), the investor earns .164 from
the corporation after all taxes following a retention strategy rather
than a dividend strategy.
Next, we want to consider the effect of lengthening the planning
horizon from five years to 10 years.
A Ten-Year Horizon with Sale of Corporation
First assume the firm pays out the $100 as a dividend and the investor
nets $60.40 after the .396 tax. After 10 years the investor
will have $108.58.
60.40(1.0604)10 = $108.58
If the firm retains $100 for 10 years earning .10 per year and
then the firm is sold, the investor nets
100(1.10)10(1-.20) = $207.50
The advantage of retention is $98.92, which is a .91 increase
over $108.50, the future amount with a dividend.
If the corporation retains, the investor gives up $60.40 at time 0
and then nets $207.50 after tax at time 10. This is an IRR of .131.
60.40(1 + IRR)10 = 207.50
IRR = .131
This IRR is smaller than with the shorter time horizon. But let
us consider the present value. With a five-year horizon the present
value of the $47.86 advantage of retention is $35.70.
PV = (1.0604)-5 47.86 = $35.70
With a 10-year horizon the present value of the $98.22 advantage
of retention is $55.03:
PV = (1.0604)-10 98.22 = $55.03
The present value of the advantage of retention increases as the
horizon is increased, but the IRR earned by the investor decreases if
the corporation retains rather than pays a dividend and the horizon
is increased.
Dividends of Many Periods
In the preceding example we consider only the dividend of one year.
But assume a $100 dividend for five years (first dividend is at time 0).
The future value for five years is:
Future value = [100(1.0604)5 + 100B(4, .0604)(1.0604)5](1 - .396)
TABLE 4.1 Value at Time 5
Time Value at Time 5
0 100(1.10)5 $161.05
1 l00(l.l0)4 146.41
2 100(1.10)3 133.10
3 100(1.10)2 121.00
4 l00(l.l0)1 110.00
Value $671.56
Future value = [134.08 + 346.19(1.3408)].604 = $361.33
If the corporation retains $100 a year for five years and earns .10
per year it will have $671.56 at time 5 (see Table 4.1). The investor
will net after tax $537.25:
(1-.2)671.56 = $537.25
The advantage of retention compared to dividends is now
$175.92 or an increase of
CONCLUSIONS__________________________
Private equity is not likely to attract investors who want the corporation
to pay cash dividends. The advantages of retention and then
capital gains compared to immediate cash dividends are very large
for investors paying a high tax rate.
Private equity allows a corporation to follow a 100 percent retention
policy without harming those investors who want cash
dividends. The cash dividend preferring investors should place
their funds elsewhere. The strategy for firms with private equity
capital is to avoid cash dividends and have the investors benefit
from future capital gains.
A board of directors acting in the interests of the stockholders of
a public corporation sets the dividend policy of a firm to please
many different types of investors. The ability of an investor to defer
income taxes as a result of the company's retaining earnings is an
important consideration. In addition, the distinction between ordinary
income and capital gains for purposes of income taxation by
the federal government accentuates the importance of the investors
knowing the dividend policy of the firms whose stock they are considering
purchasing or have already purchased. Some investors face
zero or low tax rates and have different objectives from the high tax
rate investors. This means that a corporation (and its board) has a
responsibility to announce its dividend policy, and attempt to be
consistent in its policy, changing only when its economic situation
changes significantly.
Private equity simplifies the task of a firm's board of directors
since the equity investors are likely to have similar investment objectives.
There is value added since the board of directors does not
have to follow a distribution policy aimed at pleasing the average
investor, given a narrow range of preferences among the private equity
investors.