6. Dividend Policy

Question 1

I. Main indicators in dividend policy.

Answer 1

1. Dividend per Share (DPS)
2. Dividend Yield (tends to be constant in most of the companies)
3. Payout-Ratio (It compares economic flows w/ cash-flows)

Question 2

II. Why are dividend policies important?

Answer 2

It reduces uncertainty of shareholders, which reduces their required rate of return, thus, the cost of capital.

Question 3

II. What are the 2 main dividend policies?

Answer 3

Main dividend policies:
1. Residual Policy
- Shareholders must be paid with what is left in the end,
more earnings represent higher dividends
- it is based on the Payout-Ratio, one year in advance, and set a % to pay dividends to shareholders.
- There is volatility of dividends

2. Stabilization Policy
   - More predictable than the Residual Policy, the company defines that it is going to pay at least the same number of dividends as the previous year.
   - Signalling information content of dividends
   - Volatility of Returns

Question 4

II. Are there evidences of stabilization policies?

Answer 4

Yes. Since DPS is usually more stable than RPS, everytime there is an increase in DPS, that means that the company expects to perform very good in the future.

Question 5

II. What is the main problem regarding the stabilization policy?

Answer 5

Evidence shows that the stabilization policy leads to more “sticky” dividnds, becaus of that, managers will try to mantain the same DPS throught the time, this can have a huge impact on the performance of the company, and may lead to a worse situation that a decrease in DPS.

Question 6

III. What are share repurchases?

Answer 6

Share repurchases is an alternative to cash dividends.

Similarities with cash dividends?
- It reduces the cash-flows available for investments
- leads to a reduction in equity book value and market value, and because of that affects the capital structure
- has an information content, and signaling to the markets
- minimizes agency costs in the relationship between managers and shareholders

Question 7

III. What are the differences between cash dividends and share repurchase?

Answer 7

Share repurchase:
- Reduces the nº of tradable shares
- Do not generate a reduction in market share prices
- Do not necessarily distribute the funds in a proportional way (shareholders have that option)
- can be subject to a different taxation regime

Note: Regarding taxation regime, the taxes applied to dividends can be different from the one’s applied to capital gains.

Question 8

III. Name 5 advantages of share repurchases over cash dividends.

Answer 8

5 advantages of share repurchase:
- They contribute to increase management power (important in a takeover)
- They do not commit the company to a dividend policy
- Contribute to support stock market price, facing a decreasing trend
- Can have tax benefits
- Do not reduce the value of managers stock option

Question 9

IV. Name the three lines of thought on the effect of dividend policy.

Answer 9

Three lines of thought on the effect of dividend policy :
1. Dividend policy is irrelevant for company value: Miller & Modigliani
2. Dividends reduce company value
3. Dividends increase company value

Question 10

IV. Explain the Miller & Modigliani dividend policy theory.

Answer 10

According to Miller & Modigliani, dividend policy is irrelevant if:

1. Capital markets are perfect (markets without frictions)
   - Small frictions: Transaction costs, Issuing costs and Irrationality
   - Big frictions: Taxes, Agency, Information
2. Investors are rational.
   - They are wealth maximizers
   - They are indifferent to dividends and capital gains

Question 11

IV. Explain the “dividends destroy value” theory.

Answer 11

“Dividends destroy value” theory

This theory points to the fact that, usually, dividends are exposed to higher tax levels than capital gains.

Although taxes do not affect investors in the same way, and vary according to the different countries, even if the tax rate is the same, capital gains offer an advantage, since taxes can be deferred.

Investors prefer:
Capital gains or stock repurchases.

Question 12

IV. Regarding the “dividends create value” line of thought, what are the main theories regarding this.

Answer 12

Main theories showing that dividends create value:

• The clientele effect
• Signaling Theory
• Change in the financing mix
• Reduction of agency costs
• Transaction costs

Question 13

IV. Explain the Clientele Effect .

Answer 13

Clientele Effect:

• Some investors prefer dividends, they prioritize regular payments and do not suffer the tax disadvantage
• The company might benefit from paying dividends if it’s shareholders are also investors

Question 14

IV. Explain the Signalling Theory.

Answer 14

Signalling theory:

• Since there is asymmetric information, dividends can work as a (good) sign.
• For instance, the announcement of dividends tends to be viewed by investors as a signal that the company expects to maintain its capacity to generate (additional) cash-flows in the future.

Question 15

IV. Explain the “Change in the financing mix” point of view.

Answer 15

“Change in the financing mix” point of view:

• Dividends can be used to change the capital structure,
• When the optimal capital structure requires a debt increase, higher dividends hep to reach it.
• Dividend payments are a mean for shareholder to expropriate creditors wealth (agency costs)

Question 16

IV. Identify the main arguments use in order to prove that dividends contribute to the:
1. Reduction of Agency costs
2. Transaction costs

Answer 16

Dividends contribute to the:

1. Reduction of Agency costs
   - According to the Jensen´s theory of free cash-flow (1986),
   shareholders do not approve the excess of FCF available to managers, as a result of little dividend distribution
   - An increase in dividends will discipline/control management
2. Transaction Costs
   - Dividends are better when fixed costs are high for shareholders
   - Dividend payments may lead to new shares issues, which can increase issuing costs.

Question 17

V. Name some advantages and disadvantages of dividend payments.

Answer 17

Advantages of dividend payments:
- They are valued by investors aiming to receive regular cash-flows
- They allow managers to reduce guarantees to creditors
- Contribute to discipline management
- Allow managers to signal their optimism about future performance

Disadvantages of dividend payments:
- Lead to higher taxation on investors’ returns
- Reduce available funds, forcing the company to incur in high issuing costs
- Dividend cuts are very difficult to make without affecting share prices

Question 18

V. What are the main conclusions about dividend policy?

Answer 18

Main conclusions about dividend policy:
- Managers give much importance to dividend policy
- Usually, companies don’t use a Residual dividend policy
- There is not enough ground to state that a dividend policy creates value