Session 8

Question 1

What is dividend stickiness?

Answer 1

Dividend stickiness refers to the tendency of companies to maintain stable dividends over time, avoiding frequent changes, especially dividend cuts.

• First slide: Most US companies rarely change dividends; when they do, increases are more common than cuts.
• Second slide (2008 crisis): Companies maintained dividends early on but cut or suspended them as the crisis worsened.
• Third slide (GM): Earnings fluctuate, but dividends remain stable, showing companies smooth payouts over time.

Companies do this to maintain investor confidence and avoid stock price drops, only cutting dividends in severe downturns.

Question 2

What is the breakdown of cash flow from operations in terms of borrowing, investment, and stockholder returns?

Answer 2

Question 3

What are the key insights about dividends, earnings, and stock buybacks?

Answer 3

Dividends, Earnings, and Buybacks:

1. Dividends Follow Earnings:

• Earnings are volatile, but dividends rise steadily.
• This shows firms prefer stable payouts.

2. Buybacks Over Dividends:

• Firms increasingly use stock buybacks instead of dividends.
• Buybacks offer more flexibility and tax benefits.

Question 4

What are the key measures of dividend policy and trends in US dividend payout ratios and yields (2014)?

Answer 4

Measures of Dividend Policy:

• Dividend Payout Ratio = Dividends / Net Income → Shows how much earnings are paid out as dividends.
• Dividend Yield = Dividends per Share / Stock Price → Measures the return from dividends alone.

Dividend Payout Ratios in the US (2014):

• Most US firms have payout ratios between 10-50%, but some exceed 100%, meaning they pay more in dividends than their earnings.

Dividend Yields in the US (2014):

• Most companies have low yields (under 4%), with only a few offering high dividend returns.
• US firms generally have lower dividend yields than global firms.

Question 5

How does a company’s dividend policy evolve across different growth stages?

Answer 5

Life Cycle Analysis of Dividend Policy

Start-up & Rapid Expansion (Stages 1 & 2)

• High external funding needs and low internal financing.
• No capacity to pay dividends as profits are reinvested for growth.

High Growth (Stage 3)

• Earnings rise, reducing reliance on external funding.
• Low but possible dividend payments.

Mature Growth (Stage 4)

• Earnings and revenues peak, high internal financing.
• Dividend capacity increases as firms generate more free cash flow.

Decline (Stage 5)

• Earnings and revenues fall, but dividends remain high due to fewer reinvestment opportunities.

Key Insight:

• Young, high-growth firms do not pay dividends since they reinvest profits.
• Mature or declining firms pay more dividends as they have fewer growth opportunities.

Question 6

What are the three schools of thought on dividends?

Answer 6

Three Schools of Thought on Dividends

1. Dividends Don’t Matter (M&M Theory)

• In a perfect market (no taxes, no costs), dividends do not impact firm value.
• Investors can create “homemade dividends” by selling shares.

2. Dividends Are Bad (Tax Disadvantage Theory)

• Dividends are taxed more than capital gains, making them less attractive.
• Firms should reinvest profits or buy back shares instead.

3. Dividends Are Good (Signaling & Investor Preference Theory)

• Stable dividends signal financial strength, attracting investors.
• Some prefer dividends for income stability (e.g., retirees, pension funds).

Bottom Line: Dividend impact depends on taxes, investor preferences, and company stage.

Question 7

What is the Dividends Don’t Matter School (Modigliani-Miller Hypothesis)?

Answer 7

Modigliani-Miller Hypothesis (1961)
States that dividends do not affect a firm’s value under certain assumptions.

Key Ideas:

1. Firm Value is Based on Investment Policy: If a company’s investment decisions remain unchanged, altering dividends does not impact firm value.
2. Higher Dividends Reduce Stock Growth:Paying more dividends means the firm must issue new shares to fund projects => This reduces expected stock price appreciation, but the higher dividend compensates for it.
3. No Preference Between Dividends and Capital Gains: If there are no personal taxes, investors should be indifferent to dividends vs. capital gains.

Underlying Assumptions:
1. No Tax Differences: Investors do not pay higher taxes on dividends compared to capital gains.
1. No Flotation Costs for Issuing Stock: A company can issue new stock without extra costs if it needs cash after paying dividends.
1. No Wasteful Spending with Retained Earnings: Firms that pay fewer dividends do not misuse excess cash on bad investments.

Implication:
* Dividend policy is irrelevant—it does not change firm value in a perfect market.
* In reality, taxes, issuance costs, and investor preferences make dividends matter.

Question 8

What is the Dividends are Bad School (Tax Disadvantage Theory)?

Answer 8

Tax Disadvantage Theory
* This perspective argues that dividends reduce firm value due to their unfavorable tax treatment compared to capital gains.

Key Idea:

• If dividends are taxed more heavily than capital gains, investors prefer capital gains over dividends.
• Companies should avoid paying dividends and instead reinvest profits or buy back shares.

Graph Explanation:
* Historically, dividend taxes have been higher than capital gains taxes.
* This creates a tax disadvantage for dividends, making them less attractive to investors.

Implications for Companies:

• Investors prefer capital gains → Firms should reinvest earnings or use stock buybacks.
• High-dividend firms may have lower stock prices due to tax inefficiencies.
• Tax policies influence dividend decisions, making companies consider whether dividends are worth paying.

Real-World Relevance:
* Many firms today favor stock buybacks over dividends because buybacks increase share prices without immediate taxation.
* Investors in high tax brackets often prefer growth stocks (low dividends) to avoid tax burdens.

Question 9

What is the “Dividends are Good” School and its three main reasons?

Answer 9

The “Dividends are Good” School
This perspective argues that dividends can increase firm value for three main reasons:

1.Clientele Effect

• Some investors (e.g., retirees, pension funds) prefer dividends for regular income.
• Companies that cater to these investors benefit from stable demand for their stock.

2.The Signaling Story

• Dividend increases signal confidence in future cash flows and profitability.
• Investors see stable or growing dividends as a sign of financial strength.

3.Wealth Appropriation Theory

• Paying dividends transfers wealth from debt holders to equity investors.
• This benefits shareholders but may hurt lenders, who prefer companies to retain cash for debt repayment.

Question 10

What is the Balanced Viewpoint on Dividends?

Answer 10

The Balanced Viewpoint on Dividends

Good to pay dividends (or stock repurchases):

• When a company has excess cash and few profitable investment opportunities (low NPV projects: NPV > 0).

Bad to pay dividends:

• When a company needs cash for growth or has high NPV investment opportunities (better use of funds: 0 > NPV).

Key Takeaway:
* Dividends are beneficial in certain cases but not always optimal.
* The decision depends on investor preferences, cash availability, and growth opportunities.