Principles of Finance with Excel (Основы финансов c Excel)
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PFE Chapter 22, Dividend policy and firm valuation Page 2
Overview
The purpose of this chapter is to study the effect of dividend policy on the value of the
firm:
• What’s a dividend?
• Why might it have an effect on firm value?
• MM dividend irrelevance proposition
• Taxation and dividends: capital gains versus ordinary income
• Empirical evidence?
Finance concepts discussed
• Dividends
• Retained earnings
• Capital gains versus ordinary income
Excel functions used
We use a lot of Excel spreadsheets to put order in things, but truth to tell, this chapter
uses hardly any sophisticated Excel concepts. The one function used is Sum.
PFE Chapter 22, Dividend policy and firm valuation Page 3
22.1. Dividends
John and Mary both own taxi companies. Operationally the taxi companies are exactly
alike: Each company owns the same number of taxis, and has the same income and expenses.
Here are the balance sheets for the two companies:
JOHN'S TAXI COMPANY, MARY'S TAXI COMPANY
Assets Liabilities and equity
Cash 5,000 Debt 10,000
Taxis 20,000 Equity
Stock 5,000
Accumulated retained earnings 10,000
Total assets
25,000
Total liabilities and equity
25,000
John pays himself a dividend
Suppose that John wants some cash and decides to declare a dividend of $3,000. Here’s
the way his balance sheet looks (Mary’s balance sheet is unchanged):
JOHN'S TAXI COMPANY--after dividend
Assets Liabilities and equity
Cash 2,000 Debt 10,000
Taxis 20,000 Equity
Stock 5,000
Accumulated retained earnings 7,000
Total assets
22,000
Total liabilities and equity
22,000
Notice that there are two changes in John’s balance sheet:
• The cash balances decrease from $5,000 to $2,000, reflecting the dividend paid.
• The accumulated retained earnings decrease from $10,000 to $7,000. This is what is
meant by the expression that “dividends are paid out of retained earnings.” We don’t
PFE Chapter 22, Dividend policy and firm valuation Page 4
like this expression, since dividends are paid out of cash; the decrease in retentions
simply reflects the matching change made in the balance sheet.
Here are some finance-type questions you could ask about this situation:
The valuation effects of the dividend
Did the dividend paid by John change the value of his taxi business vis-à-vis Mary’s
business? Obviously not—they both still have the same number of taxis, and Mary has just kept
her cash in the business instead of, as John did, pulling it out. A good way to see this is to to
write the balance sheets in terms of net debt—subtracting the cash from the debt:
JOHN'S or MARY'S TAXI COMPANY--net debt JOHN'S TAXI COMPANY--after dividend
Assets Liabilities and equity
A
ssets Liabilities and equity
Net debt = Debt - cash 5,000 Net debt = Debt - cash 8,000
Taxis 20,000 Equity Taxis 20,000 Equity
Stock 5,000 Stock 5,000
Accumulated retained earnings 10,000 Accumulated retained earnings 7,000
Total assets 20,000 Total liabilities and equity 20,000 Total assets 20,000 Total liabilities and equity 20,000
The asset side of the balance sheet is still worth the same, whether or not the dividend has been
paid.
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On the other hand, the liabilities and equity side of the balance sheet is different—John
has more debt and less equity than Mary.
Perhaps it’s just a capital structure question?
The above balance sheets for the two companies show that—while they are both the same
on the asset side, the dividend has changed the capital structure of the companies. So perhaps
the dividend question is related to the capital structure problem discussed in Chapters 20 and 21.
If so, this suggests
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In a more general context we can ***************
PFE Chapter 22, Dividend policy and firm valuation Page 5
• Dividends might matter if capital structure matters: An after-dividend company (like
John’s) will have a higher debt/equity ratio than a before-dividend company (like
Mary’s).
• If companies with a higher debt/equity ratio have a higher valuation, then companies
should pay dividends.
Now this book takes a definite stand on this question: In the previous chapters we’ve suggested
that the capital structure question is ultimately a question of balancing personal against corporate
taxation. We’ve also suggested that the economic evidence suggests that on balance the taxes
are pretty much of a wash, so that capital structure doesn’t matter.
Though this argument suggests that dividends do not affect the valuation of a company,
there’s another tax aspect to this question—the tradeoff between ordinary income taxes and
capital gains taxes. We discuss this in the next section.
In the meantime: As long as Mary and John’s taxi companies aren’t taxed and as long as
Mary and John aren’t taxed on a personal level, the debt/equity aspects of the dividend decision
shouldn’t affect the valuation of their companies.
The dividend doesn’t affect the enterprise value
Here’s another way of thinking about this question: Suppose that both John and Mary are
thinking about selling their taxi companies. The “taxi part” of the business is worth $40,000
(this doesn’t include the cash balances on the books). John and Mary have slightly different
strategies about how to sell the business: John intends to first pay himself a dividend and then
sell the business, whereas Mary intends to sell the business first without taking a dividend. Here
are the calculations:
PFE Chapter 22, Dividend policy and firm valuation Page 6
Mary sells her taxi company for $40,000 John sells his taxi company for $40,000
Sale price 40,000 Sale price 40,000
Pay back net debt 5,000 Pay back net debt 8,000
Net to equity 35,000 Net to equity 32,000
Book value of equity 12,000 Book value of equity 12,000
Taxable gain 23,000 Taxable gain 20,000
Taxes on gain (0%) 0 Taxes on gain (0%) 0
Net to Mary from sale 35,000 Net to John from sale 32,000
Add back dividend 0 Add back dividend 3,000
Taxes on dividend (0%) 0 Taxes on dividend (0%) 0
Total 35,000 Total 35,000
Clearly it doesn’t matter.
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Who cares where the money is as long as it’s there?
This is really what it’s all about—who cares whether the money is in the taxi company or
in the individual bank account of the owner? Of course you can think of many answers to this
question which make it appear that it does matter:
• Taxes: If the company and its owners pay different tax rates, perhaps dividends are
worthwhile (or not—read on).
• Trust: If there are multiple owners of the company, maybe you want the money in your
hands as opposed to leaving it in the company. Economists call this “agency costs”—an
agent being someone you’ve hired to do your work for you (that is, the manager). The
agency cost argument for paying dividends suggests that you and your manager may have
different goals; if the manager’s goal includes wasting your money, then maybe you
should get the money out of his hands by paying a dividend.
•
Miller and Modigliani’s “dividend irrelevance” proposition (1961)
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Although—to anticipate the next section, the assumption that there are no taxes is critical to this argument.
PFE Chapter 22, Dividend policy and firm valuation Page 7
The enterprise value of the firm—the sum of the values of the operating current assets
and fixed assets—is not affected by dividend policy. On the other hand, an increased
dividend implies a corresponding decrease in the market value of the firm’s equity.
22.2. Taxes!
In the above section we’ve made two points:
• The value of the “taxi part” of the business—the enterprise value—is not affected by the
dividend policy of John and Mary’s taxi business
• The proceeds—dividends plus gains from selling the business—to John and Mary are
exactly the same, independent of their dividend policy.
Now look at the second point again, and suppose that we introduce taxes. We’ll assume that
dividends are taxed as “ordinary income” at a rate of 30% and that the gains from selling the
business are taxed at a capital gains tax rate of 15%.
We’ll start with John, who sells his taxi company for $40,000 right after he’s paid
himself a $3,000 dividend. As the calculation below shows, John’s net from the sale of the
company is $31,1000:
PFE Chapter 22, Dividend policy and firm valuation Page 8
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FG H I
Assets Liabilities and equity
Net debt = Debt - cash 8,000
Taxis 20,000 Equity
Stock 5,000
Accumulated retained earnings 7,000
Total assets 20,000 20,000
Capital gains tax 15%
Dividend tax 30%
John sells his taxi company for $40,000
Sale price 40,000
Pay back net debt 8,000
Net to equity 32,000 <-- =G16-G17
Book value of equity 12,000 <-- =SUM(I7:I8)
Taxable gain 20,000 <-- =G18-G19
Taxes on capital gain (15%) 3,000 <-- =$G$12*G20
Net to John from sale 29,000 <-- =G18-G21
Add back dividend 3,000
Taxes on dividend (30%) 900 <-- =$G$13*G24
Total 31,100 <-- =G22+G24-G25
JOHN'S TAXI COMPANY--after dividend
Now Mary: She also sells her company, but she hasn’t paid herself a dividend. Her net
is higher:
PFE Chapter 22, Dividend policy and firm valuation Page 9
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AB C D
Assets Liabilities and equity
Net debt = Debt - cash 5,000
Taxis 20,000 Equity
Stock 5,000
Accumulated retained earnings 10,000
Total assets 20,000 Total liabilities and equity 20,000
Capital gains tax 15%
Dividend tax 30%
Mary sells her taxi company for $40,000
Sale price 40,000
Pay back net debt 5,000
Net to shareholders (Mary) 35,000 <-- =B16-B17
Book value of equity 15,000 <-- =SUM(D7:D8)
Taxable gain 20,000 <-- =B18-B19
Taxes on capital gain (15%) 3,000 <-- =$B$12*B20
Net to Mary from sale 32,000 <-- =B18-B21
Add back dividend 0
Taxes on dividend (30%) 0 <-- =$B$13*B24
Total 32,000 <-- =B22+B24-B25
MARY'S TAXI COMPANY
The reason for the difference between John’s net of $31,100 and Mary’s net of $32,000 is
that dividends are taxed. By not paying herself a dividend, Mary has saved herself $900 =
30%*3,000 of taxes on her dividends.
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This analysis suggests that dividends might matter if there is both a dividend tax and a
capital gains tax: In this case you shouldn’t pay dividends.
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In any case both John and Mary are going to pay the same capital gains taxes. This is because a dividend, paid out
of cash, reduces the firm’s equity and increases the firm’s net debt. The result, as you can confirm from the
examples, is that the capital gain to the firm’s shareholders is independent of the dividend.
PFE Chapter 22, Dividend policy and firm valuation Page 10
What if John really needs the money? Solution 1: pay a bonus
Suppose for some reason John really needs the money now. Then he should pay himself
a bonus, which is a tax-deductible expense for the company:
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AB C DEF G H I
Assets Liabilities and equity
A
ssets Liabilities and equity
Cash 2,000 Debt 10,000 Cash 3,200 Debt 10,000
Taxis 20,000 Equity Taxis 20,000 Equity
Stock 5,000 Stock 5,000
Accumulated retained earnings 7,000 Accumulated retained earnings 8,200
Total assets 22,000 Total liabilities and equity 22,000 Total assets 23,200 Total liabilities and equity 23,200
Corporate tax rate 40% Corporate tax rate 40%
Capital gains tax 15% Capital gains tax 15%
Dividend tax 30% Dividend tax 30%
John sells his taxi company for $40,000 John sells his taxi company for $40,000
Sale price 40,000 Sale price 40,000
Pay back net debt 8,000 <-- =D4-B4 Pay back net debt 6,800 <-- =I4-G4
Net to equity 32,000 <-- =B17-B18 Net to equity 33,200 <-- =G17-G18
Book value of equity 12,000 <-- =SUM(D7:D8) Book value of equity 13,200 <-- =SUM(I7:I8)
Taxable gain 20,000 <-- =B19-B20 Taxable gain 20,000 <-- =G19-G20
Taxes on capital gain (15%) 3,000 <-- =$B$13*B21 Taxes on capital gain (15%) 3,000 <-- =$B$13*G21
Net to John from sale 29,000 <-- =B19-B22 Net to John from sale 30,200 <-- =G19-G22
Add back dividend 3,000 Add back dividend 3,000
Taxes on dividend (30%) 900 <-- =$B$14*B25 Taxes on dividend (30%) 900 <-- =$B$14*G25
Total 31,100 <-- =B23+B25-B26 Total 32,300 <-- =G23+G25-G26
JOHN'S TAXI COMPANY--after dividend JOHN'S TAXI COMPANY--after bonus
When John pays himself a bonus, it comes out of cash but gets tax deductibility. Here’s
what happens to the cash balances:
Initial cash balances $5,000
After-tax cost of bonus to
company
$1,800 The company pays John a $3,000 bonus, which is
an expense for tax purposes. At the company’s
40% corporate tax rate, the after-tax cost of the
bonus is
(
)
1 40% *3,000− .
Cash on hand after bonus $3,200
This little trick (the tax deductibility of the bonus) is actually more profitable than Mary’s
not paying a dividend at all (compare John’s net of $32,300 to Mary’s net of $32,000).
However, whether a bonus is better than no bonus depends on the corporate versus the ordinary
income tax rate. In the example below the corporate rate is 30%, which is less than John’s
PFE Chapter 22, Dividend policy and firm valuation Page 11
ordinary income tax rate; he’d be better off by not paying himself a bonus (or a dividend) and
selling the company.
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FG H I
Assets Liabilities and equity
Cash 2,900 Debt 10,000
Taxis 20,000 Equity
Stock 5,000
Accumulated retained earnings 7,900
Total assets
22,900
Total liabilities and equity
22,900
Corporate tax rate 30%
Capital gains tax 15%
Ordinary income tax rate 40%
John sells his taxi company for $40,000
Sale price 40,000
Pay back net debt 7,100 <-- =I4-G4
Net to equity 32,900 <-- =G17-G18
Book value of equity 12,900 <-- =SUM(I7:I8)
Taxable gain 20,000 <-- =G19-G20
Taxes on capital gain (15%) 3,000 <-- =$B$13*G21
Net to John from sale 29,900 <-- =G19-G22
Add back bonus 3,000
John's taxes on bonus (40%) 1,200 <-- =$G$14*G25
Total 31,700 <-- =G23+G25-G26
JOHN'S TAXI COMPANY--after bonus
What if John really needs the money? Solution 2: repurchase stock
Maybe John needs the money but can’t, for some reason pay himself a bonus. In this
case, he should—instead of paying himself a dividend—get the company to repurchase some
stock from him. Suppose that John convinces the management of the company (himself!) to buy
back $3,000 of stock. Suppose that after this repurchase of equity, John sells the company.
Finally, suppose that all of the $3,000 repurchase of stock is taxed to John a capital gain (this is