# 18_Oheads - Lecture Notes 18 Dividend Policy An Irrelevance...

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1 Lecture Notes 18 Dividend Policy An Irr ele v ance Pr oposition • For simplicity we discuss only all-equity firms with the number of shares outstanding = N . • Sources of capital equal operating cash flow CF t and, if N t > 0, new capital raised P t N t . • Uses of capital equal net investment A t , dividends D t and, if N t < 0, shares repurchased. Hence: CF t + P t N t = A t + D t (1) so new capital is needed to raise D t without changing investment. • Consider the all-equity firm with financial details as in Table 1.

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2 • If the firm pays out as dividends all cash flows remaining after accepting all positive NPV projects then we would have: • Suppose management considers a \$3,000 cash dividend instead. To hold investment unchanged, the firm must raise \$1,000 in new equity and return firm market value to \$40,000. Table 1: Data for example Variable firm market value, V \$42,000 shares outstanding, N t 1,000 current share price, P t \$42 cash flow from operations, CF t \$10,000 net new investment, A t \$8,000 cash dividend, D t = CF t A t \$2,000 Table 2: Effects of dividend payment Variable dividend per share, d t = D t / N t \$2 value after payout V ' = V D t \$40,000 ex-dividend share price P ' = V '/ N t \$40 shareholder wealth per share, P '+ d t \$42
3 • Old shareholders are indifferent between the two policies. New shareholders pay \$39 for a share that is worth \$39. • If old shareholders wish to retain their investment rather than consume the dividends, they could buy some new shares. • Just as “homemade leverage” by shareholders substitutes for firm leverage, so too share purchases or sales can amount to “homemade dividend policy” that offsets what firms do. Table 3: Effects of new dividend policy Variable firm market value, V \$42,000 market value after payout V ' = V D t \$39,000 dividend per share, d t = D t / N t \$3 ex-dividend share price P ' = V '/ N t \$39 cash flow from operations, CF t \$10,000 net new investment, A t \$8,000 new equity raised, P t N t = A t + D t CF t \$1,000 new shares issued = N t = 1000/39 25.64 ex-dividend share price = 40000/1025.64 \$39 original shareholders’ wealth per share \$42

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4 Numerical Example 1 • While the idea of “homemade dividend policy” substituting for firm policy is straightforward, the dividend irrelevance proposi- tion can have implications that at first sight do seem surprising.
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## This note was uploaded on 12/20/2011 for the course ECON 448 taught by Professor Bejan during the Spring '06 term at Rice.

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18_Oheads - Lecture Notes 18 Dividend Policy An Irrelevance...

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