An Illustration of the Drre Oevance of Dividend Policy

A powerful argument can be made that dividend policy does not matter. We illustrate this by considering the simple case of Wharton Corporation. Wharton is an all-equity firm that has existed for 10 years. The current financial managers plan to dissolve the firm in two years. 'Ihe total cash flows the firm will generate, including the proceeds from liquidation, are SI0.000 in each of the next two years.

Current Policy: Dividends Set Equai to Cash Flow At the present time, dividends at each date are set equal to the cash flow of SI0.000. There are 100 shares outstanding, so the dividend per share will be $100. In Chapter 7, we showed that the value of the stock is equal to the present value of the future dividends. Assuming a 10 percent required return, the value of a share of stock today, P,h is:

The firm as a whole is thus worth 100 X $173.55 = 517,355.

Several members of the board of Wharton have expressed dissatisfaction with the current dividend policy and have asked you to analyze an alternative policy.

Alternative Policy: Initial Dividend Greater than Cash Flow Another policy is for the firm to pay a dividend of SI 10 per share on the first date (Date 1), which is, of course, a total dividend of SI 1,000. Because the cash flow is only $10,000, an extra $1,000 must somehow be raised. One way to do this is to issue SI,000 worth of bonds or stock at Date 1. Assume that stock is issued. The new stockholders will desire enough cash flow at Date 2 so that they earn the required 10 percent return on their Date 1 investment.

What is the value of the firm with this new dividend policy? The new stockholders invest $1,000. They require a 10 percent return, so they will demand $1,000 X 1.10 = $1,100 of the Date 2 cash How, leaving only $8,900 to the old stockholders. The dividends to the old stockholders will be:

Date 1 Date 2

Aggregate dividends to old stockholders $11,000 $8,900

Dividends per share 110 89

The present value of the dividends per share is therefore:

_ _ $110 89 _ S173 55 p° ~ 17m + iTTo^ " 5173 55

This is the same value we had before.

The value of the stock is not affected by this switch in dividend policy even though we had to sell some new stock just to finance the dividend. In fact, no matter what pattern of dividend payout the firm chooses, the value of the stock will always be the same in this example. In other words, for the Wharton Corporation, dividend policy makes no difference. The reason is simple: Any increase in a dividend at some point in time is exactly offset by a decrease somewhere else, so the net effect, once we account for time value, is zero.

The Secrets Of Winning Business Grants

The Secrets Of Winning Business Grants

Why Some Grant Applications Almost Always Win A Double Take And Get Approved More Often! How To Write A Winning Grant Application In One Evening. Are you looking to secure extra money for your business venture?

Get My Free Ebook

Post a comment