- CFA Exams
- 2023 Level II
- Topic 4. Corporate Issuers
- Learning Module 18. Analysis of Dividends and Share Repurchases
- Subject 2. Dividend Policy and Company Value: Theory
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Subject 2. Dividend Policy and Company Value: Theory PDF Download
Do dividends matter to a company's shareholders?
Dividends are Irrelevant
The dividend irrelevance theory holds that a firm's dividend policy has no effect on either the value of its stock or its cost of capital. Miller and Modigliani (MM) argued that the firm's value is determined by its basic earning power and its business risk. The value of the firm depends only on the income produced by its assets, not on how this income is split between dividends and retained earnings. 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.
- If an investor wants higher dividends, he can simply get cash by selling an appropriate fraction of his shares.
- If an investor wants lower dividends, he can use part of the cash dividends he receives to buy more shares.
- Thus, investors can create their own dividend policy, regardless of the firm's dividend policy.
- If investors can buy/sell shares without costs, they do not need dividends to convert shares to cash.
- Investors will not pay higher prices for firms with higher dividend payouts. Therefore, dividend policy is irrelevant.
Any shareholder can construct his or her own dividend policy. 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. This is the concept of "homemade dividend".
In the real world, there are market imperfections that create some problems for MM's theory, and dividend policy may well be relevant.
- There are transaction costs because a company issuing new shares would incur flotation costs.
- A shareholder selling shares to create a homemade dividend would incur transaction costs and capital gains taxes. He would also incur taxes on cash dividends in most countries.
- Selling shares on a periodic basis to create a stream of dividends over time can be problematic when equities are volatile. For example, some people don't want to sell shares when prices are low.
Dividend Policy Matters: The Bird in the Hand Argument
The bird-in-the-hand theory holds that the firm's value will be maximized by a high dividend payout ratio, because investors regard cash dividends (D1/P0) as being less risky rather than potential capital gains (g): ks = D1/P0 + g. In other words, an investor would rather receive a tangible benefit now, such as a dividend, than deferring that benefit until later and maybe enjoying an increase in the share price.
Therefore, investors prefer dividends to capital gains, and pay higher prices for firms with higher dividend payouts. Hence, the required rate of return on equity (ks) decreases as dividend payout increase.
From equation ks = D1/P0 + g, we can get: P/E1 = (D1/E1) / (ks - g). The initiation of a dividend results in a higher P/E by reducing the spread between the company's required rate of return and its expected growth rate using a constant growth dividend discount model.
Dividend Policy Matters: The Tax Argument
In the U.S. and several other countries, dividends are taxed more heavily than capital gains. Therefore, the tax aversion theory states that investors prefer to have companies retain earnings rather than pay them out as dividends.
- Presumably, any growth in earnings would translate into a higher P/E.
- If a company lacked growth opportunities sufficient to consume its annual retained earnings, it should repurchase shares.
However, tax law often precludes companies from the accumulation of excess earnings and restricts share purchases if it appears to be an ongoing event such as in lieu of payment of dividends. Also be noted that since 2003 both dividends and long-term capital gains in the U.S. are both taxed at 15%.
Learning Outcome Statementscompare theories of dividend policy and explain implications of each for share value given a description of a corporate dividend action;
CFA® 2023 Level II Curriculum, Volume 3, Module 18
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