Dividend Policy Flashcards
If investors do not like dividends because of the extra taxes that they attract, how would you expect the stock price to behave on the ex-dividend date? (Ignore arbitrageurs)
- a) fall by LESS than the amount of the dividend
Imagine an investor who bought a share of common stock some time ago at a price of $10. The stock is now selling for $20 (with dividend) and will pay a $1 dividend. Assume dividends are taxed at a rate of 30% and capital gains are not taxed. Our investor should be indifferent between selling his/her stock on the last with-dividend day, or on the ex-dividend day. Selling on the last with-dividend day produces a $ 20 cash flow. Selling on the ex-dividend day yields $ P + $ 0.70 (the after-tax dividend), where P is the ex-dividend price. Since 20= P + 0.70 ==> P = $19.30
TRUE / FALSE Interest on municipal bonds is not taxed; therefore municipals offer lower pre-tax yields.
TRUE
TRUE / FALSE Dividends are sent to all shareholders who are registered on the ex-dividend day. [div are sent to Sh registered on the record date, which tends to be 1 day before the ex-div day]
FALSE
Assume that investors in Vetsland, an idyllic little European country, PREFER dividends because they are taxed less than capital gains. Imagine an investor in such a country bought a share of common stock some time ago at a price of VCU 10 (VCU= Vets Currency Unit, the local currency in Vetsland). The stock is now selling for VCU 20 (with dividend) and will pay a VCU 2 dividend per share. Further assume that in that country, dividends are not taxed and capital gains are taxed at a rate of 30%. What would be the ex-dividend stock price that makes Vetsland investors indifferent between selling the stock on the last with-dividend day, or on the ex-dividend day?
Imagine an investor who bought a share of common stock some time ago at a price of $10. The stock is now selling for $20 (with dividend) and will pay a $2 dividend. Assume dividends are not taxed and capital gains are taxed at a rate of 30%. Our investor should be indifferent between selling the stock on the last with-dividend day, or on the ex-dividend day. Selling on the last with-dividend day produces a cash flow of [$20 – (.3)($10)=$17]. Selling on the ex-dividend day yields [P – (.3)(P-$10) + 2], where P is the ex-dividend price. Since 17= P + 2 –(.3)(P-10) ==> P =$17.14
You can also use the formula (Px-1 -Px)/D = (1-tD)/(1-tCG) set tD=0 and solve for Px
TRUE / FALSE “Dividends financed by the sale of new equity will dilute the position of the old stockholders. This dilution in and of itself is a sufficient reason to argue in favor of a lower optimal dividend payout if one wishes to maximize shareholder wealth”
FALSE [It is true that equity financed dividends will dilute the position of old SH, but this loss is offset by the higher cash dividend that old SH get. On net, SH wealth is unaffected (at least in an MM world).]
Suppose company XYZ has $2 million in excess cash. The company is considering investing the cash in one-year Treasury Bills paying 5% interest, and then, when that investment matures, using the cash to pay a dividend in one year. Alternatively, the firm can pay a dividend immediately. Assume that XYZ faces a 35% corporate tax rate. You are the manager of a pension fund (which does not pay taxes on investment income), and the fund is a major shareholder of XYZ. When you next plan to play golf with the CFO of XYZ, what advice will you give him?
If XYZ pays an immediate dividend, its shareholders receive the cash today, and if you are a pension fund, you can invest the money tax-free on your own for a year, earning $2.1 million at the end of next year. If XYZ invests the cash instead, it will owe 35% in taxes on the interest income, which will reduce the dividend the company will be able to pay next year to only $2,000,000+ $2,000,0000.05(.65)=$2,065,000
TRUE / FALSE “Dividends financed by the sale of new equity will dilute the position of the old stockholders. This fact by itself tends to lower the optimal dividend payout”.
It is true that equity financed dividends will dilute the position of old SH, but this loss is offset by the higher cash dividend that old SH get. On net, SH wealth is unaffected (at least in an MM world).
