PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY
Remember that dividend irrelevance depends critically on a company being able to fund its investment
either by retaining corporate profits or by paying out profits as dividends and replacing the cash by issuing
new shares. As long as share issues are costless, investors are indifferent as to whether they receive
returns in the form of capital gains (on non-dividend-paying shares) or as cash dividends on shares.
If issuing securities entails large costs, however, all parties should prefer a full-retention strategy. In
theory, a company should never both pay dividends and raise funds for investment by issuing new shares.
Because many large companies do just that, it is obvious that transaction costs alone do not explain
observed dividend policy.TO DIVIDEND OR NOT TO DIVIDEND?
Like many business students, you may be an active
investor already or plan to become one soon. You
may have wondered whether it is better to buy the
shares of companies that pay cash dividends or to
purchase shares of similar companies that do not
pay dividends, but instead reinvest all profits in the
company. So: should you buy dividends or not?
To show how taxes have an impact on your
investment decision, let’s assume that you invest
$10,000 today into either of two shares that are
very similar, except that one company, High Pay (or
HP) pays out all its earnings as dividends, while the
second company, No Pay (or NP) reinvests all profits
and pays no dividends. Further assume that you
plan to hold these shares for five years, that each
share currently sells for $10 per share (so you buy
1,000 shares of either company that you choose),
and that the expected annual, pre-tax return on
each share will be 7% per year over your five-year
holding period. Finally, assume that your personal
income tax rate on dividends and capital gains is
currently 5%, but will jump to 15% in two years
and remain at 15% for the final three years of your
investment horizon. Which investment will yield the
most money in five years, when you are ready to
buy your first dream home?
Computing the net payoff 10 years from now for
the non-dividend-paying shares of NP is very easy –
you will make only one investment (today) and will
only pay (capital gains) tax once, at a 15% rate, five
years from now on the investment’s appreciation.
Pre-tax payoff for NP in five years:
= $10,000.00 × (1.07)^5
= $14,025.52After-tax payoff for NP in five years:
= $14,025.52 – [($4025.52) × (0.15)]
= $13,421.69
Computing the net payoff five years from now
for the dividend-paying shares of HP is mechanically
more difficult, because each year you will receive a
cash dividend that will be taxed at your personal tax
rate of 5% for years 1 and 2, and then 15% for years
3–5. For simplicity, assume that dividends are paid
once per year, at year end, and that you reinvest all
after-tax net dividends received in new shares of HP at
$10 per share (assume you can buy fractional shares).
The equations below detail the end-of-year (EOY)
after-tax value of your HP investment for years 1–5.EOY1 after-tax value = $10,000.00 + $700.00 × (0.95)
= $10,665.00
EOY2 after-tax value = $10,665.00 + $746.55 × (0.95)
= $11,374.22
EOY3 after-tax value = $11,374.22 + $796.20 × (0.85)
= $12,050.99
EOY4 after-tax value = $12,050.99 + $843.57 × (0.85)
= $12,768.02
EOY5 after-tax value of HP investment
= $12,768.02 + $893.76 × (0.85)
= $13,527.72This process shows that you would have
$106.03 ($13,527.72 – $13,421.69) more in total
after-tax value at the end of five years from investing
in the high-pay-dividend shares than you would if
you invested in the no-pay-dividend shares, if all
the assumptions are valid. So HP is the preferred
investment.finance in practice