tr , P N : i] o

S s@

- H <

?-

@ o

il

=.
-

ot

rl

sl
EI

:lxt

-l

NI
<t
YI
dl

+l

=i

l
Nl
*l
Ei
l

Ffd

- o

o = -*.8'E
E FX
- r6 oq
I
=

d
'o
O

rl
m 5 " e
l
6 c r
*l ^+o i

;l llH B
qi r g *
gl E3cs

D ?

2l

il ;

ZF
gE6
l
E
pl
@ o @Q

l l l l l
ot.
g.l E' E F's. Po
o o o I
3l
gl
ro o Ix dr
ol

ol
FI

-t

Tt t + +

lt

S.++H+
@ @ @ .i o

o
\

c F 1

r:E
; "-'

E3l'
-99'fi
o<;rr!

q o x j6r
1^:I-i.i"='

.t aai

aC6<=

8-

=.

it

='

?r*H
E
f
eri?
;.
*i* : e

*o

"sB'[E?
9?6e;p.

\JI

6s

<
e

xg

Eg
-wx=

<5aS

-e
<6

:o6

=^

*i
;.F

*E

I
;2

8
'88

il

FD

---=ooUtt

996oHo
==^xx<
ooXoi@X
r

N'

5 s

'5

847;Sr

as 9

Y o

== da:
F
#
--"'xYo

!3i.=.q
q ! 6I +;
g -'-9I

Q-oq'=:;(joieo
^oTI-3
,=p=x*

(D

i<

=s

i'E'a-*E
*5
<:
? O
.5:c

xa;

P: F? *V) i
=_cr=

(,r

.i

xw

s=

;r

te;g ,t
r/'\
vi;
Y( '.+< -.5-.X
''
=1
9ea:E+3
e
:
d51F@"c
]:
illt
U) ,i- z) 38"; fs'E : z
9{ g:5:*'g s=
"=(
' i 3
*i
v x1d3f
o
d 9.c 5.Tq,9
8
tFgaiE
:
ililil

{rn
=S.gbg.
=*- a?ir= i<

EFe*i==
7A
*ij
E*qEd;K

6= -H
I=

3F
-j

S*

:.E

si

F9
s
ii o

e.X J

i'. E s
EF i

6S=

.E;:

* 3..S
*r''*Sl
+j s 1.EFF- ;s
o :-

l-'
EF-T

#H f f g 1s
n';+alo
3=?8.-;:
-El5o.dj

s\
G

\>\

ft\

R.

1--

rJ

s
\

R.

g
s lE
f;:?i
?aFe*
3r
O3$t
tr)
.!
r

iHg;e $ii
t*iiE;1 gS3: e 3Se
*rrsiF E ; e - "o
EHHi$;' +l.s
3gsa +li
sqri
iEg
: "**
d?
E',frE0
jjj
='.3

55*FE
i
, x 5
o :j

iggd=
'E*, Fl
se3.>
af
lll
;
g 3 *eE E F

tFf+5i*r3*igFF#

- I

glilIgggErggg

ggllglIilalig

*lli$ril*liEii

S.

546

THE IRRELEVANCE OF DIVIDEND POLICY IN A WORLD WITHOUT

DTvTDEND PoLIcY: THEoRY

(15.1) are multiplied by the current number of
by rearranging terms, we have

If the numerator and denominator of

shares outstanding, ndr), then

vt(t):

Div,(+1)+nl)Pf+1)

1)

l4()

= total dollar dividend payment

the market value of the firm

in order to rewrite

2. Sources and Uses of Funds

There are two majoJ sources of funds for an all-equity firm. First, it receives
cash from operations, dr + 1). Second, it may choose to issue new shares,
m,(t + \F,( + l, *h"tt mt(t + l) is the number of new shares' There are also two
.uior utti of funds: dividends paid out, bivt(r + 1), and planned cash outlays for
inv;stment, I-r( + l).2 By definition, sources and uses must be equal' Therefore we
have the foilowing identity:

Nolr(r+ r)+m,(t+ l),Pr(t+ 1)= i,1+ 1)+6i(+

(1s.3)

1)'

we can use this fact to rewrite the numerator of the valuation_equation

Calling the numerator of (15.2) the dollar return to shareholders, Rr('

+ t) : 6i,1r +

1)

r4r().Fr(

(15.2).

1)' we have

+ l).

(15.4)

we know that if new shares are issued, the total numbef of shares outstanding at
the end of the period, n(t
m(

1),

will be the sum of current shares' n(t), and new shares,

1):

n'(t

l):

ni1)

+ mt(t + l).

(1

5.5)

Using (15.5), we can rewrite (15.4) as

,p+

t:6ilt+

1)

+nr(+ l)Fr(t 1-t)-m,(t + l)Fi(+

1)'

(ls'6)

Finally, taking Eq. (15.3), which establishes the identity of the sources and uses of
funds,'to subsiitute for n,(t + l)Fi(t + 1) in the above equation, we obtain
,(r

*n,i, nrfnt

n.(

l)Fr(r

1). Therefore the

valuation equation (15.2) may be

(15.8)

It is no accident that dividends do not appear in the valuation equation (15.g).

Given that there are no taxes, the firm can choose any dividend policy whatsoever

n(t)Pt(t).

Hence the value of the firm is seen to be equal to the discounted sum of two cash
flows: any dividends paid out, Div,(l * 1), and the end-of-period value of the firm'
To show that the present value of the firm is independent of dividend payout, we

,(

l):

541

3. Vluation and the Irrelevancy of Dividend Payout

: nl|divl + 1)'

shall examine the sources and uses of funds for the two firms
(15.2) in a way that is independent of dividends.

(rs.2)

l+p(+1)

where

Div,(t

wherc V,1t
rewritten

TAXES

t): ,( + t)+ir|+t)_ it+ l)+d,( + 1)-6iv,(+

: d,( + 1)- (t + 1) + 4(t + 1),

1)

(1s.7)

assuntes, for thc sake of convenience, tlat sources and uses of funds from balance sheet

without affecting the stream of cash flows eceived by shareholders. It could,

e.g., elect

to pay dividends in excess of cash flows from operations and still be able to unertake
any planned investment. The extra funds needed are supplied by issuing new equity.
on the other hand, it could decide to pay dividends less than the amount of cash
left over from operations after making investments. The excess cash would be used
to repurchase shares. It is the availability of external financing in a world without
information asymmetry or transactions costs that makes the value of the firm independent of dividend policy.
we can use Eq. (15.8) to prove that two firms that are identical in every respect
except for their current dividend payout must have the same value. The equation has
four terms. First, the market+equired rate of return, p, must be the same because both
firms have identical risk, dr14 : drp, for all . Second, currenr cash flows from
operations and current investment outlays for the two firms have been assumed to be
identical:

o*r,1r

: dr,1r, ir:

i,1t.

Finally, the end-of-period values of the two firms depend only on future investments,
dividends, and cash flows from operations, which also have been assumed to be

identical. Therefore the end-of-period values of the two firms must be the same:

t,,o: 7,tt
consequently, the present values of the two firms must be identical regardless of their
current dividend.payout. Dividend policy is irrelevant because it has no effect on
shareholdes' wealth in a world without taxes, information asymmetry, or transactions costs.
Note that the proof of the irrelevancy of dividend policy was made using a multi_
period model whose returns were uncetain. Therefore it is an extremely genral argument. In addition to providing insight into what does not affect the value of the fiim,
it provides consideable insight into whaf does affect value. The value of the firm
depends only on the distribution of future cash flows provided by investment decisions. The key to the Miller-Modigliani argument is that investment decisions ae
completely independent of dividend policy. The fim can pay any level ofdividends it
wishes without affecting investment decisions. If dividends plus desired investment
outlays use more cash flow than is provided from operations, the firm should seek
extefnal financing (e.g., equitv). The desire rn nreintoi- q la',-l ^r a:-.:)-'- )-

548

DIVIDEND POLICY: TI{EORY

NOlz-

Vs

12 =

...

NOIl-/1 NOll +rIy-12

X-l

.NOtr

!_o

Table 15.1

.\ 4 -

IN

Cuh

Time

Pqiod

tl

1. The Valuation of an All-Equity Firm with Growth

Figure 15.1 uses the time line as a graphic representation of the pattern of cash
flows earned by a growing firm. Note that there is a current level of cash flow, NOI',
that is assumed to be received at the end of each year forever. If the firm made no
new investments and only maintai4ed its curent level of capital stock, it would receive cash flows each yearequal to dlr, but it t"ould not be growing. Growth comes
from new investment, not replacement investment- The value of new investment depends on the amount of investment, 1,, and its rate of return, r,.
We can extend the valuation equation (15.8) by assuming that the discount rate,
p, does not change from time period to time period. This is reasonable if all new
projects have the same risk as those that the firm currently holds. Equation (15.8) is3

NOLt

- r.

l+p

v.

l+p

n:*:'i;".T?#* *ffrl +-

-!L

5e)

A reasonable assumption is that in any time period the value of the firm, 4, is finite.4
Therefore, given a model with an infinite horizon, we have

- I,
h:JT,!, NoI.
0+py
3

The tilds (-) are dropped for notational convenienc. Also noto thal

After all, no one has obseved a

NOIr=N9,*"tt.
fim

with infinite value as yet,

(1s.10)

N-

(15.1 1)

-;,

Equation (15.10) is the same formula used in Chapter 2 on capital budgeting. The
present value of the firm is the sum of the discounted cash flows from operations less
the new investment outlays necessary to undertake them.
Referring to Fig. 15.1, we can see that the average return on investment, r,, is
assumed to continue foreve at a constant rate. This is a perfectly reasonable assumption because if the capital budgeting decision is made correctly, each project will return enough cash to cover payments to suppliers ofcapital and to recover the initial
investment. Thus the cash flows are sufficient to provide any needed replacement
investment to sustain the project at a constant level forever. The stream of cash flows
for the growing firm in Fig. 15.1 is given in Table l5.l falso Eq. (15.11)].
Substituting (15.11) into (15.10), we can express the present value ofthe growing

firm

as

,,

NOI1

-Ir -,
'o- t+p

12

NOIr lrrlr-

{r*op--

NOI1

+rrIr + r2l2-13

1t*rp-

lv-1

r...rE

(15.8)

Given a constant discount rate, p, the valuation model can be extended to N periods
as follows:

-12
-13

NOI':91r + | r,l,
.= I

The Mille-Modigliani argument that the value of the firm is independent of dividend
policy also extends into a world with corporate taxes but without personal taxes. In
this section the valuation model [Eq. (15.8)] is extended to include corporate taxes
and a growing stream ofcash flows. The result is a valuation model that has realistic
features and hence may be usefully applied to real-world valuation problems. Chapter
16 will expand on the usefulness ofthe valuation model by means ofan example.

'u

DIYIDEND POLICY

-Ir

NOI.:6, +rJr+rzl2

B. VALUATION, GROWTH, AND

Outfo,

Crch Inflow

NOIr
NOI, = NgJt .r rtt

Figure l5.l
Time pattern ofcash flows for a growing firm.

l/

POLICY 549

VALUATION, GROWTH, AND DIVIDEND

NOI'+ lryI,-ln
(1

(rs.t2)

p)N

This extended equation can be simplified greatly. First, rewrite

it

by rearranging

terms as follows:

NOI1 NOIr
,,
vo :
*
I + p tti+..

NOI,

+6.r

pN

t,
rrf
,..., ' (1 ', - t plI
' ''L(t + p\' ,' {t+', o''
+p)n t+
.r,[u+tF + t+fr+ +(r+;F-#t].
This result can be generalized as

:,i

#h.,i

.[(,,

d;) - #r]

(15.13)

550

VALUATION, GROWTH, AND DIVIDEND

DTVIDEND PoLIcY: THEoRY

term is an infinite annuitY

We can simplify Eq. (15.13) by recognizing that the-first
with constant payments of NOI, per period' Therefore

.. A NOIr
;'*,=,

NOI1

(1Trl p

Table 15.2
$A t/

/of

1
Firm 2
Firm 3
Firm

(1s.14)

'

POLICY 55

Next, the second term in (15.13) can be simplified as follows:

10,000
30,000
100,000

20
10
5

2,000
3,000
5.000

9,090
o

-45,454

grrln-trl

.!*'tt * pr: I +e ,4,1+ '

Another feature of Eq. (15.16) is that it is derived directly from Eq. (15.g), and
in both we have the result that dividend policy is irrelevant in a world without taxes,
information asymmetry, o transactions costs. All that counts is cash flows from

(15.1s)

1'-r,lrt

(1+pl,l*6;7: $ +dn

investment.

a simplified expression
Substituting (15.14) and (15.15) back into (15'13), we obtain
lor the present value of the firm:

.. [NoI,,*,=,"l\pd+py)$ ,f/ ', \- t +t ,l]

%:'l'*t
il )J
o

NOI,t)- S l,(r,p

Pl

',?1 p$+Pl"

Value of assets in place + value offuture

growth'

(15'16)

2. Why Darnings per Share Growth Maximization

Is an InaPProPriate Goal

into the- m^uch

This form of valuation equation provides important insights
present value of a firm
uuur.J ir.* growth stock.The first ter in Eq' (15'16) is the
an infinite stream of conthat makes n-o new investments. It is the presnt value of
that is not growing' It is
a
firm
of
value
is
the
it
words
stant cash flows. In other
investments?
itt" nulu" of assets in place. But what about the fim that makes new (15'16)' It
prc*r, value of new investment is shown in the second term of Eq'

3. The Value of an All-Equity Firm that Grows

at a Constant Rate Forever
Equation (15.16) is elegant but somewhat cumbersome to use.s It has two useful
variations. The first, which is developed below, assumes that the firm experiences a
constant rate of growth forever. we shall call it the infinite constant growth moilel.
The second, developed later on, assumes that the firm can maintain a supernormal
rate of growth (where r, > p) for a finite period of time, T, and realizes a nomal
rate of growth thereafter. It is called the finite supernormal growth mod.el.
The constant growth model can be derived from Eq. (15.16) if we assume that a
constant fraction, K, of earnings is retained for investment and the average rate of
return, r,, on all projects is the same. The fraction of earnings to be retained for
investment is usually called the retention ratio; however, there is no reason to restrict
it to be less than 100% of cash flows from operations. Rather than calling K the
retention rate, we shall call ittlte inuestment rate. As was mentioned in the first section of this chapter, the firm can invest more than cash flow from operations if it
provides for the funds by issuing new equity. If investment is a constant proportion
of cash flows, we have

iL

rrew investment depends

(2) the difference between the
on two things: (1) the amount of investent made and
rate of return'
u*.ug. ,ut""of'rturn on the investment, r', and the market-required
they
value-unless
to
anything
add
do
not
they
grow,
but
p. TltJ uss"t, of a firm may
for assets of equivalent
earn a rate of return greatei than what tre market requires
of return (i'e''
;irk. F"; example, srftposing that the market requires a l0% rate
15'2'
in
Table
given
situations
p : l}%),.onrid". the ihree
:
But which firm
Firm 3 has the greatest "growth" ii earnings (ANOI 5'000)'
1 does' The reason is that it is the
firm
Obviously,
val-ue?
in
incrse
greatest
the
has
rate.of
lnlynrti that has new investments that eam more than the required market
maximize
..ii.r 10%. Therefoe the objective of a firm should ur be to simplythe
market
"fit *-ings or cash flows' The objective should be to maximize

i, if,, pr"t"nt value of expected future growth' The tal.ue-of

gr"*ii

1,: K(NOIJ.

(15.17)

And if the rate of return on investment, r,, is the same for every project, then

NOI':NOI'-'+rI'-t
: NOI_r * TKNOI,_,
: NOI,-r(1 + rK).
By successive substitution, we have

NOI,: 9J,11 + rK)'-l

5

However, do not undeestimate the usefulness of Eq. (15.16).

valuation models. ep AIaaD 'l;^L - ^ ----- I

It

(15.18)

is the basis for most commonly

u;

552

DTVTDEND PoLrcY: THEoRY

VALUATION, GROWTH, AND DIVIDEND

Note that rK is the same as the rate of growth, g, for cash flows. In other words, NOI
in the tth time period is the future value of NOI in the first time period, assuming
that cash flows grow at a constant rate, g:

Given these facts and the necessary condition that g < p, the infinite growth model,
Eq. (15.21), can be rewritten as

,,

NOI':N6t11 *'Y-t'
By substituting (15.17) into (15.16) and maintaining the assumption that r, = ,

1rys

POLICY 553

Div,

(ls.21a)

p-g

which is the Gordon growth model.

have

/o:NOIt *;' KNot'(r

-P).
Q ,?t p(l + p)'

(15.1e)

Then by using (15.18) in (15.19) we obtain

n":y*,.,*o,,(ry,

),i(f,#
-Y['.+#,i("i)']

lf rK < p, then the last term in

(15.20)

(1s.20)

will have a finite limit:6

;'*,(*+)':=t*

iff p>rK

(15.20a)

Substituting (15.20a) into (15.20) and simplifying, we have an equation for the value
of the firm, assuming infinite growth at a rate less than the market rate of return, p:

y_NoIrfr_K(r-p) l+Krl
p l'' t+Kr p-rKf
Norl(l
- K).
_
p-Kr

5.21)

Equation (15.21), rewritten in a somewhat different form, is frequently referred

to as the Gordon growth model. Nofe that since K is the investment rate (although
K need not be less than one), the numerator of(15.21) is the same as dividends paid

at the end of the first time period:

NOIl(l-K) :Divr.

Q.

s:u+u2+...+Yn.
Multiplying this by U and subtracting ihe resuit from the above, we have

s=ul0-q-uN+Ll0-u).
The second tem approaches zero in the limit as N approaches infinity.
of U, we get (15.20h).

Dividend Payout

This form of the valuation model can be usod to illustrate the reltionship between the result that the value ofthe firm is independent ofdividend policy and the
assumption that investment decisions should never be affected by dividend payout.
A commonly made error is to impcitly assume that there is some relationship
between the amount of cash flow retained and the amount of investment the firm
undetakes. Suppose we take the partial derivative of Eq. (15.21) with respect to
changes in the investment rate, K:

)Vo
ax:

NOI,(r
-o

p)

,*y ' u'

This suggests that if the rate of return on investments, r, is greater than the marketrequired rate of return, p, the value of the firm will increase as more cash flow is
retained, and presumably the increased amount of retained cash flow implies lower
dividend payout. This line of reasoning is incorrect for two reasons. First, the amount
of cash flow retained has nothing to do with dividend payout. As was shown in the
sources and uses offunds, identity (15.3), the firm can arbitrarily set dividend payout
at any level whatsoever, and if the sum of funds used for dividends and investment
is greater than cash flows from operations, the firm will issue new equity. Second,
the investment decision that maximizes shaeholder wealth depends only on the
market-required rate of return. The amount of cash flow retained could exceed the
amorjnt ofinvestment, which would imply that shares would be repurchased. Therefore there is no reiatiooship between the value of the firm and either dividend payout
or cash flow retention.

5. The Bird-in-Hand Fallacy

Also, as was shown earlier, the product of the investment rate and the average rate
of return on investment is the same as the growth :c:te, g, in cash flows; therefore

Kr:

4, Independence between Investment Plans and

By substituting

brck the deflnition

A more sophisticated argument for a relationship between the value of the firm
and dividend payout is that although the dividend decision cannot change the
present value of cash payments to shareholders, it can affect the temporal pattern
of payouts. Suppose that investors view distant dividend payments as riskier than
current payments, might they not prefer a bird in the hand to two in the bush? We
can represent this argument mathematically by assuming that higher investment
rates mean lower current dividend payout, more risk, and therefore an increase in
the market rate of return, p, as a function of the investment rate, K. A simple example
would be to specify the relationship as

p:d+8K2,

p>0.

554

IF

PoLIcY: THEoRY

DTVTDEND

VALUATIoN, GRowTH, AND DIVIDEND

I

PoLIcY

555

Then we would have

avo

-?pK+!-o.),
@*fK-rK)'

_Nott(pKz

AK

d.+ BKz

: N;I'

_rK>0.
',,

This function will have a maximum where

NOI'ffK2 -2PK+
To

see the

Substituting (15.21b) into (15.20) yields

r-a):Q.

ii

As long as

last term

Kr

6. Finite Supernormal Growth Model for

?_The

n,:Y['.H,\

(l.Tf)]

+ df.

(ls.24)

:r+? *i,(f)o"'t*ro

A:l+Ktt *o

l=K'-P.
1

Therebrethecore"tapproximation,r

1+rA=

r-r(o-:":\.
\t+P)

appoximarion, asume that the investmcnl rate, K, is 50%, rhe rate

of
::l::lT_r11,-1P-"jl]igitl
rerum
on rnyestmcnt' r' is 1l:he
202. and.the_market-required rare of etun is tsz. igir" rs.'i, pii
l(l + Ktll{.l + p)1. We can see visually that t" rini up-p,i"iilr.*"onur".
"
"i

We can then expand the sum:

S:U+U2+"'+Ur.
Multiplying thiq by U and subtracting the result, we have
S - US: U - (Jr*1.
Solving for S and substituting back for U, we obtain
[(1 +

p * *t6'7[-r:-P
' Lp1+dl1'

Solving for A, we have

as follows. Let

NoIr

ffi':,' *ar:i ([)or-.a"

r:

+ KrXl + p)]

(1s.23)

expansion en be used- to a"tu" th

+ A. Then, recalling that Kr = c, we haye

(15.20)

p, which
Instead, growth lasts for only years. After year ?, we assume that
means that the second term adds nothing to the present value of the firm. Whenever
a firm is earning a rate of return just equal to its cost of capital, the net present
value of investment is zero. The summation term in Eq. (15.20) can be evaluated

[(1

p, and T is small, we can approximate the

inomial

(1 + p;

To derive the finite growth model we start with Eq. (15.20). Note that the summation is no longer infinite:

1-U

(ts.22)

By substituting the approximation (15.23) into the varuation

equation (r5.22), we have
an approximate valuation fomula for finite supernormal g.o*th,t

Perhaps the most useful variation of the valuation equation is one that assumes

IJ -TJT+I

(+f)J}

K("
Not'
/o: NOI'
=l)r14-lr'\ p
p * p_Kr'\t+p)

that the rate of return on investment is greater than the market-required rate of
return for a finite number of years, T, and from then on is equal to the marketrequired rate of return. In other words the firm experiences supernormal growth
for a short period of time, then settles down and grows at a rate that is equal to
the rate of growth in the economy. Obviously a firm cannot grow faster than the
economy forever or it would soon be larger than the economy.

(+f,)'-1-r(--!!)

an

[(1 + rK)10

#1,

is approximately equal to

AlFEquity Firm

u:

as?

error in this line of reasoning, we need only to return to our understanding

of vahation under uncertainty. The risk of the firm is determined by the riskiness
of the bash flows from its projects. An increase in dividend payout today will result
in an equivalent drop in the ex-dividend price of the stock. It will not increase the
value of the firm by reducing the riskiness of future cash flows.

{,

Kr)/(l + p)]rrl

(ff''

o
0.9

('#)' ,
.9565

.9t49

.8',152

.83'71
.8007

4
5

7. Finite Supernormal Growth Model for a Firm

with Debt nd Taxes

Up to this point, we have maintained the assumption that we are dealing with
an all-equity firm in a world without taxes. To extend the above valuation equation
into a world where firms have debt as well as equity and where there are corporate
taxes, we can rely on the results obtained in Chapter 13. The value of a levered firm
with finite supernormal growth can be written as follows:

r-WACC I .[
-. NOl,(l
'.7 -.) + r"B + K[NoI,(l - a)]rlwAcc(l
+ wAcc)_1, tts.zsl
where

:
:
:
K:
T:
r:
p:

NOI

WACC
B

is provided by Farrar and Selwyn [1967] and extended into a market equilibrium
framework bY Brennan [1970]'ro
Farrar and Selwyn use partial equilibrium analysis and assume that individuals
attempt to maximize their after-tax income. Shaeholders have two choices. They can
own shares in an all-equity firm and borrow in order to provide personal leverage,
or they can buy shares in a levered firm. Therefore the first choice is the amount of
personal versus corporate leverage that is desired. The second choice is the form of
paym"nt to be made by the firm. It can pay out earnings as dividends, or it can retain
arnings and allow shareholders to take their income in the form of capital gains.
Shareholders must choose whether they want dividends or capital gains.
If the firm pays out all its cash flows as dividends, the ith shareholder will receive
the following after-tax income, if:

i :

end-of-year net operating profits,

weighted average cost of capital

: pll -

c"B/(B

S)],

market value of debt,

i! :
> WACC,

the average rate ofreturn on investment,

the cost ofequity capital for an all-equity firm.

The first two terms in (15.25) are the value of a levered firm with no growth, i.e., the
'?alue
of assets in place. They are the same as Eq. (13.3), the Modigliani-Miller result
that assumes that firms pay corporate taxes but are not growing. The third term in
Eq. (15.25) is the value ofgrowth for the levered firm. It depends on the amount of
investment, /, : K(NOIJ, the difference between the expected average rate of return
on investment and the weighted average cost of capital, r - WACC, and the length of
time, T, that the new investment is expected to earn more than the weighted average
cost of capital.
Equation (15.25) is used in Chapter 16 as the basis fo the valuation ofBethlehem
Steel. Note, however, that even in this model (which is the most realistic of those
developed so far in this chapter) dividend payout is not relevant for determining the
value of the rm.

C. DIVIDEND POLICY IN A WORLD WITH

PERSONAL AND CORPORATE TAXES
Up to this point the models of firms that have been introduced assume a world with
only corporate taxes. What happens when personal taxes are considered? In particular, how is dividend policy affected by the important fact that in the United States
the capital gains tax is less than the personal income tax?e An answer to this question
e The 1986 tax code nominally makes the capital gains rafe equal to the ordinary income rate. However,
capital gains taxos are still lcs than ordinary taxes in effect, because capital gains can be deferred indefinitely, whereas taxes on ordinary income cannot.

rD)(r

t")

rD,l(r

- t ),

(15.26)

where

investment rate,
the number of years that r

tto"r

the uncertain income to the

ith individual if corporate income is received

as dividends,

:
r:
D" :

O*I

De:

ttre uncertain cash flows from operations provided by the firm,

the borrowing rate, which is assumed to be equal for individuals and firms,

corporate debt,
personal debt held by the

lth individual,

r" = the corporate tax rate,

rri : lbe personal income tax rate of the ith individual.
The first term within the brackets is the after-tax cash flow of the firm, which is
fid - rD)(l - z"). All of this is assumed to be paid out as dividends. The before-tax
income to the shareholder is the dividends received minus the interest on debt used
to buy shares. After subtracting income taxes on this income, we are left with Eq.
(ts.26).

Alternatively, the firm can decide to pay no dividends, in which cas we assume
that all gains are realized immediately by investors and taxed at the capital gains
rate.rr In this event the after-tax income of a shareholder is

ii : tdl -

rD"){l

?"X1

tr)

rDo(r

- cn),

(15.21)

where

i1

uncertain income to the ith individual if corporate income is received

capital gains,

-_ tne

?ri:

the capital gains rate for the

as

ith individual.

r0
More recently Miller and Scholes [1978] have also considered a world with dividends and taxes. The
implications of this paper are discussed later on in this chapter.
rr Obviously there is the third possibility that earnings re translated into capital gains and the capital
gains taxes are defered to a latr date. This possibility is considered in Farrar and Selwyn [1967]; it does
not change their conclusions.

r'
Now the individual pays a capital gains tax rate on the income from the firm and
leducts after-tax interest expenses on personal debt. The corporation can implement
.he policy of translating cash flows into capital gains by simply repurchasing its
hares in the open market.
We can rewrite Eq. (15.27) as follows:

g = 1r -rD)(I -t")-rDr,f(t _ rg)*rDo(zo-toi).

'ate on capital gins is less than the personal tax rate (rn < toi), individuals will prebr capital gains to dividends for any positive operating cash flows, rate of interest,
md level of debt (personal or corporate). The ratio of the two income streams,

[(o*I

rD"Xl

-r.)-

rDo,](l

0,)

+ rDr,(r, - r,) _ ,
-r,

I
E

(15.28)

irom Eqs. (15.26) and (15.28) the advantage to investors of receiving returns in the
brm of capital gains rather than dividends should be obvious. So long as the tax

if _
?=

further. He shows that if the borrowing rate on debt is "grossed up" so that the

/r{ro.l
\tr.z>J

F
*{i

rf
$g.
.F,

s greater than one if tr 1 xpi. In general the best form of payment is the one that
s subject to least taxation. The implication, of course, is that corporations should
rever pay dividends. Ifpayments are to be made to shareholders, they should always
re made via share repurchase. This allows shareholders to avoid paying income tax
'ates on dividends. Instead, they receive their payments in the form of capital gains
hat are taxed at a lower rate.
What about debt policy? Again the same principle holds. The debt should be
teld by the party who can obtain the greatest tax shield from the deductible interest
)ayments. This is the party with the greatest marginal tax rate. If the firm pays out
ll its cash flow in the form of dividends, the favorable tax treatment of capital gains
s irrelevant. In this case we have the familiar Modigliani-Miller [1963] esult that
he value of the firm is maximized by taking on the maximum amount of debt (see
Jhapter 13). Proof is obtained by taking the partial derivative of Eq. (15.26) with
'espect to personal and corporate debt and comparing the results.
Debt policy becomes more complex when the corporation repurchases shares inrtead of paying dividends. Taking'the partial derivatives of the capital gains income
:quation, (15.27), we obtain

Corporate

debt:

Personal

debt:

#:
o*:
dD pi

-,nt

-,r(t

- ri.

t")(I

- t),

(15.30)

(1s.3 1)

.ftheeffective tax rate on capital gains is zero (as Miller [1977] suggests), then per;onal debt will be preferred to corporate debt by those individuals who are in marlinal
ax backets higher than the marginal tax bracket of the rm. This result allows the
rcssibility of clientele effects where low-income investors prefer corporate debt and
righ-income investors prefer personal debt. Miller [1977] takes this argument even

rl
#
1l

after-tax rate on debt equals the after-tax rate on other.sources ofcapital, the marginal
investor will be indifferent between personal and corporate debt.12
Empirical evidence about the existence of debt clienteles is discussed in Chapter
1. Some clientele efects are obvious. For example, high tax bracket individuals hold
tax-free municipal bonds, whereas low tax bracket investors like pension funds (which
pay no taxes) prefer to invest in taxable corporate bonds. A much more subtle question, however, is whether investors discriminate among various corporate debt issues,
i.e., do high tax bracket investors choose lowleverage firms?
Brennan [1970] extends the wok ofFarrar and Selwyn into a general equilibrium
framework where investors are assumed to maximize their expected utility of wealth.
Although this framework is more robust, Brennan's conclusions are not much different from those of Farrar and Selwyn. With regard to dividend payout Brennan concludes that "for a given level of risk, investors require a higher total return on a
security the higher its prospective dividend yield is, because of the higher rate of tax
levied on dividends than on capital gains." As we shall see in the next chapter, this
statement has empirical implications for the CAPM. It suggests that dividend payout
should be included as a second factor to explain the equilibrium rate of return on
securities. If true, the empirical CAPM would become

tr
tf

R,

fll
f

R7,

6o

+ rpt, + 6rl(div t,lP." - R/J] +

dj,,

(rs.32\

where

:
:
z :
f, :
div,fP, :
drr :
R, :
o

a constant,

influence of systematic risk on R;,

influence ofdividend payout on R,
lhe systematic risk of the
the dividend yield of the

jth security,
jth security,

a random erro term,

the risk-free rate.

If the dividend yield factor turns out to be statistically significant, then we might conclude that dividend policy is not irrelevant. Direct empirical tests of the relationship
between dividend yield and share value are discussed in Chapter 16.
A paper by Miller and Scholes [1978] shows that even if the tax on ordinary
personal income is greter than the capital gains tax, many individuals need not pay
more than the capital gains rate on dividends. The implication is that individuals
will be indifferent between payments in the form of dividends or capital gains (if the
firm.decides to repurchase shares). Thus the firm's value may be unrelated to its dividend policy even in a world with personal and corporate taxes.

12

The reader is referred to Chapter 13 for a complete discussion of this point.

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UI V I'TI

rather than to make up the shottfall of funds through external financing. (5) Shareholder disagreement over internally financed investment policy will be more likely
the greater the amount ofinternally generated funds relative to the firm's investment
opportunities. In these cases, firms are more likely to experience takeover attempts,
proxy fights, and efforts to "go private." Given these tax-induced shareholder conflicts, diffuse ownership is more likely for externally financed firms than for internally
finanoed firms.

2. Theories Based on the Informativeness of

Dividend Payout
Ross [1977] suggests that implicit in the Miller-Modigliani dividend irrelevancy
proposition is the assumption that the market knows the (random) return stream of
the firm and values this stream to set the value of the firm. What is valued in the
marketplace, however,is the perceiud stream of returns for the firm. Putting the issue
this way raises the possibility that changes in the capital structure (or dividend payout) may alter the market's perception. In the terminology of Modigliani and Miller,
a change in the financial structure (or dividend payout) of the firm alters its perceived
risk class even though the actual risk class remains unchanged.
Managers, as insiders who have monopolistic access to information about the
firm's expected cash flows, will choose to establish unambiguous signals about the
firm's future if they have the proper incentive to do so. We saw, in Chapter 14, that
changes in the capital structure of the firm may be used as signals. In particular, Ross
[1977] proved that an increase in the use of debt will represent an unambiguous
signal to the marketplace that the firm's prospects have improved. Empirical evidence
sems

TOWARD A THEORY OF OPTIMAL DIVIDEND

TUIIU I: I HbUKY

to confirm the theory.

The signaling concept is easily applied to dividend policy as well as to financial

structure. We shall see that a possible benefit of dividends is that they provide valuable signals. This benefit can be balanced against the costs of paying dividends to
establish a theory of optimal dividend policy.
A firm that increases dividend payout is signaling that it has expected future cash
flows that are sufficiently large to meet debt payments and dividend payments without increasing the probability of bankruptcy. Therefore we may expect to find empirical evidence that shows that the value of the firm inceases because dividends are
taken as signals that the firm is expected to have permanently higher future cash
flows. Chapter 1 reviews the empirical evidence on dividends as signals.
Bhattacharya [1979] develops a model closely related to that of Ross that can be
used to explain why firms may pay dividends despite the tax disadvantage of doing
so. If investors believe that firms that pay greater dividends per share have higher
values, then an unexpected dividend increase will be taken as a favorable signal. Presumably dividends convey information about the value of the firm that cannot be
fully communicated by other means such as annual reports, earnings forecasts, or
presentations before security analysts. It is expensive for less successful firms to mimic
the signal because they must incur extra costs associated with raising external funds

POLICY 565

in order to pay the cash dividend.l6 Hence the signaling value ofdividends is positive and can be traded ofl against the tax loss associated with dividend income (as
opposed to capital gains). Even firms that are closely held would prefer to pay dividends because the value induced by the signal is received by current owners only
when the dividend message is communicated to outsiders. One of the important implications of this signaling argument is that it suggests the possibility of optimal dividend policy. The signaling benefits from paying dividends may be traded off against
the tax disadvantages in order to achieve an optimal payout.
Hakansson [1982] has expanded the understanding ofinformative signaling to
show that in addition to being informative at least one of three sufficient conditions
must be met. Either investors must have different probability assessments of dividend
payouts, or they must have differing attitudes about how they wish to allocate consumption expenditures over time, or the financial markets must be incomplete. All
three of these effects may operate in a complementary fashion, and all three are
reasonable.

Miller and Rock [1985] develop a financial signaling model founded on the concept of "net dividends." It is the first theory that explicitly combines dividends and
external financng to show that they are merely two sides of the same coin. The
announcement that "heads is up" also tells us that "tails is down." As was pointed
out in the original Miller-Modigliani [1961] article, every firm is subject to a sources
and uses of funds constraint:

NOI +,nP

AB

:1

+ Div.

(15.36)

Recall that sources of funds are NOI, the firm's net operating income; nP, the profrom an issue of external equity (the number of new shares, m, times the price
per share, PI and AB, the proceeds from new debt. Uses of funds are investment, I,
and dividends, Div. The sources and uses constraint can be rearranged to have net
cash flows from operations on the left-hand side and the firm's "net dividend" on the
ceeds

right-hand

side:

NOI-I:Div-

A,B-mP.

(15.37)

Now imagine a model where time 1 is the present, time 0 is the past, and time 2

is

the future. The present value of the firm, cum dividend, is the value of the current
dividend, Divr, plus the discounted value ofcash flows (discounted at the appropdate
risk-adjusted rate, k):

4=Divr.ffi

15.38)

16
This suggests that dividend payout and debt level increases are interrelated signals. A firm that simultaneously pays dividends and borrows nay be giving a diferent signal than if it had made the same
dividend payment without borrowing.

566

DTVTDEND

pol-rcy: THEoRy

TOWARD A THEORY OF OPTIMAL DIVIDEND

original shareholders'wealth is the value ofthe firm minus the market value ofdebt
and new equity issued:
St

Using the sources and

Vt -AB,

u,

. ffi

LB,

mPr.

s,-E(sl)=r,[t.#]

(15.39)

:
(1s.40)

Without any information asymmetry, this is just the original Miller-Modigliani proposition that dividends are irrelevant. All tlrat counts is the investment decision.
If there is information asymmetry, Eq. (15.40) must be rewritten to show how
market expectations are formed. If future earnings depend on current investment,
then we can write that net operating income is a function of the amount of investment
plus a random error term,

NOI, :/(10) + e,,

NOI, =/(11) + er,
where e , and e, are random error terms with zero mean, i.e., E(er) : E(eJ : 0. We
also adopt the special assumption that the expectation of e, given e, is not necessarily
zefo'.

E(erlet)

persistence coefficient, 0 < I < l, the market is assumed to

only partially adjust to new information (the first-period error). If we use the notation
Eo to remind us that the current value of the firm is based on preannoutrcement
information, then the current expected value of shareholders' wealth is

Eo(I,)

YP

:f(to)_rr*H.

+ e,

EoNor,)][l

. #]

(15.43)

Equation (15.43) says that the announcement effect on shareholders'wealth will depend on the "earnings surprise." Thus we would expect that unexpected changes in
earnings will be correlated with share price changes on the announcement date.
Miller and Rock go on to show that the earnings, dividend, and financing announcements are closely related. Assuming that the expected and actual investment
decisions are at an optimum level, and are therefore equal, then the difference between
the actual and net dividends is

Div, -AB,

-ttttPt-

Eo(Div,

- LB1-mrPr) =NOI' -11 - [(NOI') -ir]

: NOIr - E(NOII}

Thus the earnings surprise and the net dividend surprise can convey the same information. The financing announcement efect is merely the dividend announcement
effect, but with the sign reversed. An unexpected increase in dividends will increase
shareholders' wealth, and an unexpected issue of new equity or debt will be interpreted as bad news about the future prospects of the firm'
The Miller-Rock signaling approach shows that announcement effects (including

+ffi
- * N##
- 1, * t!##

appendages.

One problem that the above theories have in common is that although they
explain how an optimal dividend policy may arise, none of them can successfully
.*plain c.orr-rectional differences in dividend payouts across firms.l7

Optimal Dividend Payout

(1s.41)

Sr:NOIr -1,

: f(I

3. Agency Costs, External Financing, and

The corresponding postannouncement value of the firm is

= f(to) + e,

[Norl

earnings surprises, unexpected dividend changes, and unexpected external financing)

emerge naturally as implications of the basic valuation model rather than as ad hoc

yer.

If 7 is interpreted as a

E(s,: o6r)

567

Subtracting (15.41) from (15.42) gives the announcement efect

uses constraint, Eq. (15.37), we have

sr:Norr-r,*ul\oi,,.

POLICY

11

(ts.42)

Rozeff [1982] suggests that optimal dividend policy may exist even though we
ignore tax considerations. He suggests that coss-sectional regularities in corporate
dividend payout ratiosrs may be explained by a trade-off betwen the flotation costs
of raising external capital and the benefit of reduced agency costs when the firm increases its dividend payout. It is not hard to understand that owners prefer to avoid
paying the transactions costs associated with external financing.
As discussed earlier (Chapter 14, section B.4), there are agency costs that arise
when owner-managers sell portions of their stockholdings to so-called outside equity
r? A posible exaption is the work of Miller and Rock
[1985], which suggsts that the oext theory shows
better promis in this regard.
r8 The payout ratio is the tatio of dividends to net income.

568

DTvTDEND

por,rcy: THEoRy
OTHER DIVIDEND POLICY

owners. The outsiders *t|l,*lrr" e,x

ante, for the potential problem that
owner_
managers may increase their personar
weart at the ex'pense ofoutsiders
by means of
more perquisites or shirking. To decrease

ne

Th-us a wealth-maximizing firm

mnrmrzes agency

cosrs.

wifl

b. f"r;i;;;;;;;:
".pi "" "piirn"i.", tttonngAol-iile nglicr rhat

Dividend payments may well seve as

a means of moniroringro, uoingii'":a
agement performance. Although greater
dividenJ puyou, i_pti". costly external
fi_
nancing, the very fact that the firm mur,
eo ,o ih. ;;
mu.k"t, implies that it will
come under greater scrutiny. For exampri
u"rt, *iiirio"r.
;i;;
creditworrhiness of rhe fir;' r" ,tr.
*"t,r'*;l';;h"rg, " ""r";i;;;;;
commission w'r require prospectus filings for new
equity irru.r. ffrrs *irlde suppliers of capital
help
to monitor the owner-manag"r on tenarrof
ou,rt..q"-,y
of course, audited
financial statements are a substitute_means
for rupplyi'g "*"ers.
the same information, but
they may.not be a perfect substitute
for tt. "aau"rJu'.y;
.llationship between the firm
--'vvqr r!
and suppliers of new capital.
Because of the tansactions costs
of external financing Rozeff arso argues
that
the variabilitv of a firm's cash_flows rill
payout. consider rwo
firms with the same averase cash flows
"."il,r'JJi"nd
across
tlrnl Uui -if.r"nt variability. The firm
with geater voratility *i borrow in bad years
un;-;y in good. It wi, need to
nnance externarry more often. consequenty,
i, *iii,."'J," have a lower dividend
payout ratio.
Rozetr [19821 selected a sample of 1000
nonregulated firms in 64 different industries and examined their averge_diuid"nd
put;;t-;;;ios during the 1974_1980
interval' Five proxy variables were chosen
," tri'rtirii.".y. The results ae shown
in Table r5'4: The independenr variables
cnowi
are an artempt to
measure the effect of costlv external
""'Row2
nancing. fi..r-tn1t
grow faster can reduce
their need ro use exremal fiancing
by payin;l&;;;d.rds. GRoWI
measures the
growth rate in evenues between
tglc in-tgg, rt.;;;; cRow2 is varue Line,s
foecast of the growth of sales revenue
over the five-year period 1979-19g4. Both
variables are negativerv related-to
di"id.J p;;;;i';;;..
statistically significanr.
.The variables INS and STOCK
ur. pro*i.ri;;;;lgJn;; relationship. rNS
is rhe
percenrage of the firm held by
insiders. Dividend o^tJ i; negativery
related to the
percentage of insiders because given
l"y:.;;;;'g;f,riutsiers
there is less need
to pay dividends to reduce agency costs.re
"
" tt..it", "nd, ifthe distribution of
outsider holdings is diffuse' rh.o
ug.n.y costs will be higher; hence one wourd
expect
srocK' the number or.."trtoii..r.',"
p"rr".iy"'.'Jt'u,"0 ,o dividend payout.
Both INS and STOCK are statistically
,igninJu't
uni'oiir,. pr.oi"t.a sign. Finally,
-oii.
the variable BETA measures ttt"
,irLin.r,
.* Trtor"iction thar riskier firms
have lower dividend payout is
*rin"Juy ir," .";;;:.;;;.t"

l"

tn

tntt

r"t",tonrntO

prcler to rake rheir rerurn in

rhe form of

""pit"f

g"in..i.it;; il;il;:.

569

Table 15.4 Cross-Sectional Diviilend Payout Regressions

oni[

find it in their own interest to agree to incu ",

"narg", "*"..-n,"i",Tjil,i
monitoing
or bonding costs if such
costs a less than the ex ante charge
that ou,rl.rr^*ulA

rssuFs

CONSTANT N,S GROWL GROW2 BETA STOCK Rz D.W. F-statistic

(1)
(2)
(3)
(4)
(5)

47.81

0.090

-0.32r -0.526
(12.83) (-4.10) (-6.38) (-6.43) (-17.05)
24.73 -0.068 -0.474 -0.758
(6.27',) (-2.7s) (-8.44) (-8.28)

70.63
(40.35)
39.56 - 0.116
(10.02)

(-4.92)

(0.24)

-0.102
(-3.60)

1.03

-26.543

-0.402
(-7.58)

-0.603 -25.409
(-6.94) (- 15.35)
- 33.506
(-21.28)

2.584
(7.73\

0.48

1.88

185.47

2.517

0.33

1.79

t23.23

0.4r

1.88

231.46

0.39

1.80

218.10

o.t2

1.60

69_33

,u:,
3.15

(8.82)
3.429

(7.97)

t-statisti6 are shown in parentheses under estimated values of the regression coemcients. R2 is adjusted
for degres of freedom. D.W. is Durbin-Watson statistic.
From M. Rozeff, "Crowth, Beta, and Agency Costs as Deteminants of Dividend Payout Ratios," Jo&rru
of Financial Research,Fall 1982,249-259. Reprinted with permission

The best regression in Table 15.4 explains 48% ofthe cross-sectional variability
in dividend payout across individual firms. Although the results cannot be used to
distinguish among various theories of optimal dividend policy, they are consistent
with Rozeff's predictions. Furthermore, the very existence of strong cross-sectional
regularities suggests that there is an optimal dividend policy.

E. OTHER DTVIDEND POLICY ISSUES

1. Dividends, Shares Repurchase, and Spinoffs
from the Bondholders' Point of View
Debt contracts, particularly when long-term debt is involved, frequently restrict
a firm's ability to pay cash dividends. Such restrictions usually state that (1) future
dividends can be paid only out of earnings generated after the signing of the loan
agreement (i.e., future dividends cannot be paid out of past retained earnings) and
(2) dividends cannot be paid when net working capital (current assets minus current
liabilities) is below a prespecified amount.
One need not restrict the argument to only dividend payout. When any of the
assets ofa corporation are paid out to shareholders in any type ofcapital distribution,
the effect is to "steal away" a portion ofthe bondholders'collateral. In effect, some
of the assets that bondholders could claim, in the event that shareholders decide to
default, are paid out to shareholders. This diminishes the value ofdebt and increases
the wealth of shareholders.
Of course, the most common type of capital distibution is a dividend payment.
A portion of the firm's assets is paid out in the form of cash dividends to shareholders. The most extreme example of defrauding bondholders would be to simply
liquidate the assets of the firm and pay out a single, final dividend to shareholders,

570

DTVTDEND

thereby leaving bondholders with a claim to nothing. For this very reason, most
bond
indentures explicitly restrict the dividend policy of shareholders. usually dividens
cannot exceed the current earnings of the firm, and they cannot be paid oui ofretaineJ
earnings.
other types of capital distributions are share repurchase and spinoffs. share repurchase has exactly the same effect as dividend payment except that the form
of
payment is capital gains instead ofdividend income. The conventional procedure
for
a spinoff is to take a portion of a firm's assets, often a division relativily un."lat"
to the rest of the firm, and ceate an independent firm with these assets. ih. i.npo.tant fact is that the shares of the new entity are distrbuted solely to the sharehoders
of the parent corporation. Therefore, like dividend payment o. ,hur" repurchase,
this
may be used as a technique for taking collateral from bondholders. mpirica evidence on the effects ofrepurchases and spinoffs is covered in Chapter 16.
It is an interesting empirical question whether or not any diviend payment, no
matter how large it is, will affect the maket value of bonds. one would eipect ihat
the maket price of bonds would reflect the risk that future dividend paymenis would
lower the asset base that secures debt.2. However, as changes in the dividend payments are actually realtzed, there may be changes in the expectations of the bnholdes, which in tun would be reflected in the market price of bonds. All other
things being equal, we may expect that higher dividend payments or share repurchases
will be associated with a decline in the market value of debt. However, ,u."ly do ,.
have a situation where all other things are equal. For example, if announcements
about dividend changes are interpreted as information about iuture cash flows, then
a dividend increase means that current debt will be more secure because of the anticipated higher cash flows, and we would observe dividend increases to be positively
correlated with inceases in the market value of debt.

2. Stock Dividends and Share Repurchase

Stock dividends are often mentioned as part of the dividend policy of the firm.
However, a stock dividend is nothing more than a small stock split. it simply increases the number of shares outstanding without changing any of th. underiying
risk or eturn characteristics of the firm. Therefore we mighl exiect that t as iittli
or no effect on shareholders'wealth except for the losses associated with the clerical
and transactions costs that accompany the stock dividend. Recall, however, that the
empirical evidence in chapter 11 indicated that stock dividend announcements are
in fact accompanied by statistically significant abnormal returns on the announcement date. So far, no adequate explanation has been provided for this fact, although
Brennan and copeland [1987] suggest that stock dividends may be used to force tie
early conversion of convertible debt, convertible preferred, or warrants, because these
securities are frequently not protected against stock dividends.

2oDividendpaymentsdonotnecessarily"h"ng"th"".,"t"ffi
in order to pay dividends, thee is an asset efect. However, it is not ecessary. oi""",
aho be,paid by issuing new debt or equity. In this case, assts remain uaffected, aa tne iniena
"""
ecision
purely
is
frnancial in nature.
a1e rgduce!.

SUMMARY 57I

por.rcy: THEoRy

Another question that often arises is whether share repurchase is preferable to

dividend payment as a means of distributing cash to shareholdes. Share repurchase
allows shareholders to receive the cash payment as a capital gain rather than as
dividend income. Any shareholder who pays a higher tax rate on income than on
capital gains would prefer share repurchase to dividend payment. But not all classes
ofihareholders have this preference. Some, like tax-free university endowment funds,
are indifferent to income versus capital gains, whereas others, such aS corporations
with their dividend exclusions, would actually prefer dividends.
To see that share repurchase can result in the same benefit per share, consider
the following example. The Universal Sourgum Company earns $4.4 million in 1981
and decidesio pay out 50%, or $2.2 million, either as dividends or repurchase. The
company tras 1,IOO,OOO shares outstanding with a market value of $22 per share' It
can pay dividends of s2 per share or repurchase shares at $22 each. We know that
the maiket price for repurchase is $22 rather than $20 because $22 will be the price
per share afier repurchase. To demonstrate this statement, we know that the current
value of the (all-equity) firm is $24.2 million. For $2.2 million in cash it can repurchase
100,000 shares. Therefore after the repurchase the value of the firm falls to $24.2 2.2:$22 million, and with 1,000,000 shares outstanding the price per share is $22'
Thus, in theory, there is no price effect from repurchase.
A comparison of shareholders' wealth before taxes shows that it is the same with
either payment technique. If dividends are paid, each shareholder receives a $2 dividend, n the ex-dividend price per shae is $20 ($22 million -: 1.1 million shares).
Alternately, as shown above, each share is worth $22 under repurchase, and a shareholder who needs cash can sell off a portion of his or her shares. The preferred form
(dividends versus repurchase) wili depend on shareholders' tax rates.
of payment
In the example shown above there is no price effect from share repurchase. However, recent emplrical studies of repurchases via tender offers have found a positive
announcement effect. These studies are discussed in detail in Chapter 16'

STII\4MARY
Several valuation models with or without growth and with or without corporate taxes
have been developed. Dividend policy is irelevant in all instances. It has no effect
on shareholders'wealth. When personal taxes are introduced we have a result where
dividends matter. For shareholders who pay higher taxes on dividends than on capital
gains, the preferred dividend payout is zero; they would rather have the company
istribute ash payments via the share fepurchas mechanism. Yet corporations do
pay dividends. The Rozeff [1982] paper suggests that there appear to be strong crossiectionai regularities in dividend payout. Thus there may be optimal dividend policies
that result fiom a trade-off between the costs and benefits of paying dividends. The
list of possible costs includes (1) tax disadvantages of receiving income in the form
of diviends rather than capital gains, (2) the cost of raising external capital if dividends are paid out, and (3) ihe foregone use of funds for productive investment. The
possible benefits of dividend payout are (1) higher perceived corporate value because