Reinhard Windisch PS Corporate Finance

Essay: The Dividend Puzzle

But now switch to the situation there enough extra cash is available to pay a dividend. What are the alternatives to pay a dividend? The company manager could try to realise another positive NPV project (1). But normally, when we talked about extra or excess cash, all relevant positive NPV projects should be already realised. So managers could easily tend to negative NPV projects (for different reasons), if the amount of “Free Cash Flow” is high. One could acquire other companies (2) if the excess cash is high enough. However, such an acquisition often implies a lot of extra cost which decreases the efficiency. So an acquisition should be done for strategy or real profit purpose, but not just to avoid dividend payment. Financial assets could be purchased (3), which can be a good alternative to dividends, mainly depending on personal and corporate tax rates (this point is mentioned here without further proof, because the decision to invest in financial assets or to pay a dividend is a complex one). The last alternative to point out here is the repurchase of shares (4). Although there are different possible reasons for a repurchase, like offsetting a dilution due to stock option exercising, the flexibility aspect of repurchases compared to dividends (a constant or increasing dividend for many years can be seen as a kind of obligation against the stockholder),or an individual manager preference because of stock option compensation, the tax advantage of a repurchase is the strongest argument here. The reason for this tax advantage will be shown within the next section. Finally it should be stated here, that stock repurchase is generally the preferred alternative to a dividend payment.

In the previous sections we already mentioned taxes for several times. So in the following part we will have a more detailed look at the impact of taxes to the dividend policy of a company. Let us first consider a case there we have positive earnings (after corporate taxes) which could be either paid out as dividends or held in the company increasing the capital, so that the investor could make a profit by selling the stock at a higher price. We already mentioned that under absence of taxes the investor will be indifferent between these two possibilities. In reality the investor has to pay a tax on the dividend income or on the capital gain. For high income individuals there are differential tax rates in favor of capital gains. But also with the same tax rate capital gains are normally preferred, because the tax on dividends has to be paid immediately in contrary to capital gains, there the stockholder is given a valuable timing option. On the other hand for corporate investors 70 percent of the dividend income is tax exempt (at least in the USA) and institutional funds, such as retirement and pension funds,

2/6

Reinhard Windisch PS Corporate Finance

Essay: The Dividend Puzzle

don’t pay a tax for dividends or capital gains at all. So we have different tax situations for different clienteles of investors, causing different preferences for dividend- or non-dividendpaying stocks. For that reason it would be best for a company to match it’s dividend policy to the preferences of it’s potential investors. Up to now we considered the case there we either pay out dividends or just keep the earnings in the company. In the previous section we mentioned that repurchase of shares is also a very good alternative to pay out dividends. So let us know consider the tax situation with a stock repurchase. If the investor sells back parts of his shares to the company, only the profit of the sale (sale-value minus current stock price) will be taxed. Because of the repurchase a capital gain will occur to the other stocks, which will be not taxed before the investor decides to sell the rest of his shares. So even with the same tax rates on capital gain and dividend income there will be again a present value advantage for the investor when the company distributes unused funds via a stock repurchase.

If we now summarize the preceding capitals we would come more or less to the conclusion, that a company with excess cash should prefer to repurchase their own shares instead of paying out dividends (there are some rules from the SEC and IRS to avoid too high amounts of repurchases for tax saving reasons, which will not be considered here). But in reality there are many firms which pay out parts or most of their earnings in form of dividends. So there should be some good reasons for that kind of dividend policy, what we try to find out in the following sections.

One often mentioned reason, why dividend payments of companies are still so popular is the (costly) signalling function, which enables manager to transfer their private information to the shareholders. The earliest models here are those of Bhattacharya (1979, 1980), followed by models of Heinkel (1978) and Miller and Rock (1985), in which the signal is the dividend payment adjusted by stock issues. The cost of the signal is specified as the resulting nonoptimal investment policy due to the dividends. Another approach to the signalling function but in a different way comes from Brennan and Thakor (1990). They think that the stock price itself is not a perfect aggregator of private information, so to get well informed is not costless any more. From this follows, that at a repurchase the investor has to pay extra money to get an idea if the repurchase price is greater than the true share value or not. So especially for small fund distributions a dividend payment seems to be better than a share repurchase, even in existence of taxes.

3/6