Page 23 - FINAL CFA II SLIDES JUNE 2019 DAY 6

LOS 22.d: Explain how clientele effects and agency READING 22: DIVIDENDS AND SHARE REPURCHASES: ANALYSIS
costs may affect a company’s payout policy.
Clientele effect : Different groups (individuals, institutions, and corporations) desire MODULE 22.1: THEORIES OF DIVIDEND POLICY
different levels of dividends: Why?
• Tax considerations. High-tax-bracket investors (like some individuals) tend to
prefer low dividend payouts, while low-tax-bracket investors (like corporations
and pension funds) may prefer high dividend payouts.

In the presence of differential tax rates on dividends (T ) and capital gains (T CG ), investors would be indifferent between receiving:
D
• $D in dividends or
• $D (1 − T ) / (1 − T CG ) in capital gains. In other words, when the stock goes ex-dividend:
D

EXAMPLE: Dividends vs. capital gains: Consider a firm that is planning to declare €12
in dividends. The tax rates for a marginal investor are: T CG = 15% and T = 30%.
D
Compute the expected drop in share price when the stock goes ex-dividend.

Answer: Expected drop in stock price = 12 × (1 − 0.30) / (1 − 0.15) = €9.88. Meaning? Suppose the tax rate on capital gains T CG = 25%. If the stock price of a
company falls by 85% of the dividend amount on average when the stock goes
ex-dividend, what is the tax rate on dividends for a marginal investor in
Investors would be indifferent between €12 in dividends and €9.88 in capital gains.
that stock? ΔP = D(1 − T ) / (1 − T )
CG
D
• Requirements of institutional investors. For legal or strategic reasons, some institutional investors will invest 0.85 = 1(1 − T ) / (1 − 0.25)
D
only in companies that pay a dividend or have a dividend yield above some target threshold. Examples are
dividend-focused mutual funds and some trusts that are required to hold dividend-paying stocks. T = 0.3625 = 36.35%
D
• Individual investor preferences. Some prefer to buy stocks so they can spend the dividends while preserving the principal.

Does existence of dividend clienteles contradict dividend No! A firm’s dividend policy would attract a certain clientele. After that, changes in the policy
irrelevance theory? would have no impact as the firm would be simply swapping one clientele for other.

Agency Costs

Between shareholders and managers: Reflect the inefficiencies due to divergence of interests (“empire building”). To reduce, increase the payout of free cash flow as
dividends. Growing firms to retain a larger proportion of earnings but mature firms in relatively non-cyclical industries should not hoard cash but pay higher dividends!

Between shareholders and bondholders: When there is risky debt outstanding, shareholders can pay themselves a large dividend, leaving the bondholders with a lower
asset base as collateral. Resolved via provisions in the bond indenture (restrictions on dividend payment, maintenance of certain balance sheet ratios, and so on).