Page 22 - FINAL CFA II SLIDES JUNE 2019 DAY 6

LOS 22.b: Compare theories of dividend policy and explain
implications of each for share value given a description of a READING 22: DIVIDENDS AND SHARE REPURCHASES: ANALYSIS
corporate dividend action.

MM Dividend irrelevance: Dividend has no effect on value or its cost of capital. MODULE 22.1: THEORIES OF DIVIDEND POLICY

Recall MM’s ‘homemade’ dividends?: If cash dividend is too big, you can just take Only holds in a perfect world with no taxes, no brokerage costs, and
the excess cash received buy more of the firm’s stock, otherwise - if too small, you infinitely divisible shares. Also note that MM pertains to the firm’s total
can sell some stock to get the cash flow you want. The combination of the value payout policy (rather than to the narrower dividend policy).
of your investment in the firm and your cash in hand will be the same.

Bird-in-hand (dividend preference theory) argument for dividend policy: Myron Gordon and John Lintner, however, argue that dividend yield decreases
as the dividend payout increases. Why? When measuring total return, the dividend yield component, D / P , has less risk than the growth component g.
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Investors place a higher value on a dollar of dividends that they are certain to receive than on a dollar of expected capital gains.
Tax aversion theory. In countries where dividends are taxed at higher rates than capital gains, investors will prefer to not receive dividends. Taken to the
extreme, they would rather have a zero dividend payout ratio in order to avoid higher tax rates.

In the real world, tax laws often prevent companies from accumulating excess earnings, making dividend payments necessary!

Conclusions from the three theories.
• Higher tax rates do result in lower dividends but in the USA, tax rates for dividends and capital gains now same, hence tax aversion theory irrelevant;
• Empirical support exists for “bird-in-the-hand” theory as specific groups of investors do prefer dividend paying stocks as they see these as less risky;
• But MM counter-argues that different dividend policies appeal to different clienteles, and as all types of clients are active in the marketplace, dividend policy
has no effect on company value if all clienteles are satisfied.

LOS 22.c: Describe types of information (signals) that dividend initiations, increases, decreases, and omissions may convey.
The information conveyed by dividend initiation is ambiguous:
• Could mean that a company is optimistic about the future and is sharing its wealth with stockholders—a positive signal.
• Could mean that a company has a lack of profitable reinvestment opportunities—a negative signal.
An unexpected dividend increase can signal that future business prospects are strong and that managers will share the success with shareholders.
Companies with a long history of dividend increases, such as GE and Exxon Mobil, are dominant in their industries and have high ROA, and low D/E ratios
Unexpected dividend decreases or omissions are negative signals that current dividend can be maintained. In rare instances, however, a dividend
decrease or omission could be a positive sign. Management may be reinvesting for better prospects.