Relevance of dividends A. Preference for dividends Uncertainty surrounding future company profitability leads certain investors to prefer the certainty of current dividends Investors prefer large dividends Investors do not like to manufacture homemade dividends, but prefer the company to distribute them directly. 18-6
18-6 Relevance of Dividends Uncertainty surrounding future company profitability leads certain investors to prefer the certainty of current dividends. Investors prefer large dividends. Investors do not like to manufacture homemade dividends, but prefer the company to distribute them directly. A. Preference for dividends
Relevance of dividends B. Taxes on the investor Capital gains taxes are deferred until the actual sale of stock. This creates a timing option. Capital gains are preferred to dividends, everything else equaL. Thus, high dividend- yielding stocks should sell at a discount to generate a higher before-tax rate of return Certain institutional investors pay no tax 18-7
18-7 Relevance of Dividends Capital gains taxes are deferred until the actual sale of stock. This creates a timing option. Capital gains are preferred to dividends, everything else equal. Thus, high dividendyielding stocks should sell at a discount to generate a higher before-tax rate of return. Certain institutional investors pay no tax. B. Taxes on the investor
Relevance of dividends B. Taxes on the investor(continued) Corporations can typically exclude 70% of dividend income from taxation. Thus, corporations generally prefer to receive dividends rather than capital gaIns. The result is clienteles of investors with different dividend preferences. In equilibrium, there will be the proper distribution of firms with differing dividend policies to exactly meet the needs of investors n Thus, dividend-payout decisions are irrelevant. 188
18-8 Relevance of Dividends Corporations can typically exclude 70% of dividend income from taxation. Thus, corporations generally prefer to receive dividends rather than capital gains. The result is clienteles of investors with different dividend preferences. In equilibrium, there will be the proper distribution of firms with differing dividend policies to exactly meet the needs of investors. Thus, dividend-payout decisions are irrelevant. B. Taxes on the investor (continued)
Other Dividend issues Flotation costs Transaction costs and divisibility of securities Institutional restrictions Financial signaling 189
18-9 Other Dividend Issues Flotation costs Transaction costs and divisibility of securities Institutional restrictions Financial signaling
Empirical Testing of Dividend Policy Tax Effect Dividends are taxed more heavily than capital gains, so before-tax returns should be higher for high dividend-paying firms Empirical results are mixed - recently the evidence is largely consistent with dividend neutrality Financial Signaling Expect that increases (decreases)in dividends lead to positive(negative)excess stock returns. Empirical results are consistent with these 18-10 expectations
18-10 Empirical Testing of Dividend Policy Tax Effect Dividends are taxed more heavily than capital gains, so before-tax returns should be higher for highdividend-paying firms. Empirical results are mixed -- recently the evidence is largely consistent with dividend neutrality. Financial Signaling Expect that increases (decreases) in dividends lead to positive (negative) excess stock returns. Empirical results are consistent with these expectations