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for the following types of firms
a. Small companies with substantial investment needs.
b. Large companies with significant insider holdings.
c. Large companies with significant holdings by pension funds (which are tax exempt)
and minimal investment needs.

A Proof of Dividend Irrelevance
To provide a formal proof of irrelevance, assume that LongLast Corporation, an
unlevered firm manufacturing furniture, has operating income after taxes of $ 100
million, growing at 5% a year, and that its cost of capital is 10%. Further, assume that
this firm has reinvestment needs of $ 50 million, also growing at 5% a year, and that
there are 105 million shares outstanding. Finally, assume that this firm pays out residual
cash flows as dividends each year. The value of LongLast Corporation can be estimated
as follows:


Free Cash Flow to the Firm = EBIT (1- tax rate) “ Reinvestment needs
= $ 100 million - $ 50 million = $ 50 million
Value of the Firm = Free Cash Flow to Firm (1+g) / (WACC - g)
= $ 50 (1.05) / (.10 - .05) = $ 1050 million
Price per share = $ 1050 million / 105 million = $ 10.00
Based upon its cash flows, this firm could pay out $ 50 million in dividends.
Dividend per share = $ 50 million/105 million = $ 0.476
Total Value per Share = $ 10.00 + $ 0.48 = $10.476
The total value per share measures what stockholders gets in price and dividends from
their stock holdings.
Scenario 1: LongLast doubles dividends
To examine how the dividend policy affects firm value, assume that LongLast
Corporation is told by an investment banker that its stockholders would gain if the firm
paid out $ 100 million in dividends, instead of $ 50 million. It now has to raise $ 50
million in new financing to cover its reinvestment needs. Assume that LongLast
Corporation can issue new stock with no issuance cost to raise these funds. If it does so,
the firm value will remain unchanged, since the value is determined not by the dividend
paid but by the cash flows generated on the projects. Since the growth rate and the cost of
capital are unaffected, we get:
Value of the Firm = $ 50 (1.05) / (.10 - .05) = $ 1050 million
The existing stockholders will receive a much larger dividend per share, since dividends
have been doubled:
Dividends per share = $ 100 million/105 million shares = $ 0.953
In order to estimate the price per share at which the new stock will be issued, note that
after the new stock issue of $ 50 million, the old stockholders in the firm will own only
$1000 million of the total firm value of $ 1050 million.
Value of the Firm for existing stockholders after dividend payment = $ 1000 million
Price per share = $ 1000 million / 105 million = $ 9.523
The price per share is now lower than it was before the dividend increase, but it is exactly
offset by the increase in dividends.
Value accruing to stockholder = $ 9.523 + $ 0.953 = $ 10.476


Thus, if the operating cash flows are unaffected by dividend policy, we can show
that the firm value will be unaffected by dividend policy and that the average stockholder
will be indifferent to dividend policy, since he or she receives the same total value (price
+ dividends) under any dividend payment.
Scenario 2: LongLast stops paying dividends
To consider an alternate scenario, assume that LongLast Corporation pays out no
dividends and retains the residual $50 million as a cash balance. The value of the firm to
existing stockholders can then be computed as follows:
Value of Firm = Present Value of After-tax Operating CF + Cash Balance
= $ 50 (1.05) / (.10 - .05) + $ 50 million = $1100 million
Value per share = $ 1100 million / 105 million shares = $10.48
Note that the total value per share remains at % 10.48. In fact, as shown in Table 10.1,
the value per share remains $10.48, no matter how much the firm pays in dividends.
Table 10.1: Value Per Share to Existing Stockholders from Different Dividend Policies
Value of Firm Dividends Value to Existing Price Dividends Total Value
(Operating CF) Stockholders per share per share per share
$1,050 $ - $1,100 $ 10.48 $ - $ 10.48
$1,050 $ 10.00 $1,090 $ 10.38 $ 0.10 $ 10.48
$1,050 $ 20.00 $1,080 $ 10.29 $ 0.19 $ 10.48
$1,050 $ 30.00 $1,070 $ 10.19 $ 0.29 $ 10.48
$1,050 $ 40.00 $1,060 $ 10.10 $ 0.38 $ 10.48
$1,050 $ 50.00 $1,050 $ 10.00 $ 0.48 $ 10.48
$1,050 $ 60.00 $1,040 $ 9.90 $ 0.57 $ 10.48
$1,050 $ 70.00 $1,030 $ 9.81 $ 0.67 $ 10.48
$1,050 $ 80.00 $1,020 $ 9.71 $ 0.76 $ 10.48
$1,050 $ 90.00 $1,010 $ 9.62 $ 0.86 $ 10.48
$1,050 $ 100.00 $1,000 $ 9.52 $ 0.95 $ 10.48
When LongLast Corporation pays less than $ 50 million in dividends, the cash accrues in
the firm and adds to its value. The increase in the stock price again is offset by the loss of


cash flows from dividends. When it pays out more, the price decreases but is exactly
offset by the increase in dividends per share.
Note, though, that the value per share remains unchanged because we assume that
there are no tax differences to investors between dividends and capital gains, that firms
can raise new capital with no issuance costs, and that firms do not change their
investment policy. These assumptions eliminate the costs associated with paying either
more in dividends or less.

Implications of Dividend Irrelevance
If dividends are, in fact, irrelevant, firms are spending a great deal of time
pondering an issue about which their stockholders are indifferent. A number of strong
implications emerge from this proposition. Among them, the value of equity in a firm
should not change as its dividend policy changes. This does not imply that the price per
share will be unaffected, however, since larger dividends should result in lower stock
prices and more shares outstanding. In addition, in the long term, there should be no
correlation between dividend policy and stock returns. Later in this chapter, we will
examine some studies that have attempted to examine whether dividend policy is in fact
irrelevant in practice.
The assumptions needed to arrive at the dividend irrelevance proposition may
seem so onerous that many reject it without testing it. That would be a mistake, however,
because the argument does contain a valuable message: Namely, a firm that has invested
in bad projects cannot hope to resurrect its image with stockholders by offering them
higher dividends. In fact, the correlation between dividend policy and total stock returns
is weak, as we will see later in this chapter.

The “Dividends Are Bad” School
In the United States, dividends have historically been taxed at much higher rates
than capital gains. Based upon this tax disadvantage, the second school of thought on
dividends argued that dividend payments reduce the returns to stockholders after personal
taxes. Stockholders, they posited, would respond by reducing the stock prices of the firms
making these payments, relative to firms that do not pay dividends. Consequently, firms
would be better off either retaining the money they would have paid out as dividends or


repurchasing stock. In 2003, the basis for this argument was largely eliminated when the
tax rate on dividends was reduced to match the tax rate on capital gains. In this section,
we will consider both the history of tax-disadvantaged dividends and the potential effects
of the tax law changes.6

The History of Dividend Taxation
The tax treatment of dividends varies widely depending upon who receives the
dividend. Individual investors are taxed at ordinary tax rates, corporations are sheltered
from paying taxes on at least a portion of the dividends they receive and pension funds
are not taxed at all.

Since the inception of income taxes in the early part of the twentieth century in
the United States, dividends received on investments have been treated as ordinary
income, when received by individuals, and taxed at ordinary tax rates. In contrast, the
price appreciation on an investment has been treated as capital gains and taxed at a
different and much lower rate. Figure 10.10 graphs the highest marginal tax rate on
dividends in the United States and the highest marginal capital gains tax rate since 1954
(when capital gains taxes were introduced).

6 Adding to the uncertainty is the fact that the tax changes of 2003 are not permanent and are designed to
sunset (disappear) in 2010. It is unclear whether the tax disadvantages of dividends have disappeared for
the long term or only until 2010.


Barring a brief period after the 1986 tax reform act, when dividends and capital gains
were both taxed at 28%, the capital gains tax rate has been significantly lower than the
ordinary tax rate in the United States. In 2003, the tax rate on dividends was dropped to
15% to match the tax rate on capital gains, thus nullifying the tax disadvantage of
There are two points worth making about this chart. The first is that these are the
highest marginal tax rates and that most individuals are taxed at lower rates. In fact, some
older and poorer investors may pay no taxes on income, if their income falls below the
threshold for taxes. The second and related issue is that the capital gains taxes can be
higher for some of these individuals than the ordinary tax rate they pay on dividends.
Overall, though, wealthier individuals have more invested in stocks than poorer
individuals, and it seems fair to conclude that individuals have collectively paid
significant taxes on the income that they have received in dividends over the last few


Institutional Investors
About two-thirds of all traded equities are held by institutional investors rather
than individuals. These institutions include mutual funds, pension funds and corporations
and dividends get taxed differently in the hands of each.
Pension funds are tax-exempt. They are allowed to accumulate both dividends and

capital gains without having to pay taxes. There are two reasons for this tax
treatment. One is to encourage individuals to save for their retirement and to
reward savings (as opposed to consumption). The other reason for this is that
individuals will be taxed on the income they receive from their pension plans and
that taxing pension plans would in effect tax the same income twice.
Mutual funds are not directly taxed, but investors in mutual funds are taxed for

their share of the dividends and capital gains generated by the funds. If high tax
rate individuals invest in a mutual fund that invests in stocks that pay high
dividends, these high dividends will be allocated to the individuals based on their
holdings and taxed at their individual tax rates.
Corporations are given special protection from taxation on dividends they receive

on their holdings in other companies, with 70% of the dividends exempt from
taxes7. In other words, a corporation with a 40% tax rate that receives $ 100
million in dividends will pay only $12 million in taxes. Here again, the reasoning
is that dividends paid by these corporations to their stockholders will ultimately
be taxed.

Tax Treatment of Dividends in other markets
Many countries have plans in place to protect investors from the double taxation
of divided. There are two ways in which they can do this. One is to allow corporations to
claim a full or partial tax deduction for dividends paid. The other is to give partial or full
tax relief to individuals who receive dividends.

7 The exemption increases as the proportion of the stock held increases. Thus, a corporation that owns 10%
of another company™s stock has 70% of dividends exempted. This rises to 80% if the company owns
between 20 and 80% of the stock and to 100% if the company holds more than 80% of the outstanding


Corporate Tax Relief
In some countries, corporations are allowed to claim a partial or full deduction for
dividends paid. This brings their treatment into parity with the treatment of the interest
paid on debt, which is entitled to a full deduction in most countries. Among the OECD
countries, the Czech Republic and Iceland offer partial deductions for dividend payments
made by companies but no country allows a full deduction. In a variation, Germany, until
recently, applied a higher tax rate to income that was retained by firms than to income
that was paid out in dividends. In effect, this gives a partial tax deduction to dividends.
Why don™t more countries offer tax relief to corporations? There may be two
factors. One is the presence of foreign investors in the stock who now also share in the
tax windfall. The other is that investors in the stock may be tax exempt or pay no taxes,
which effectively reduces the overall taxes paid on dividends to the treasury to zero.

Individual Tax Relief
There are far more countries that offer tax relief to individuals than to
corporations. This tax relief can take several forms:
Tax Credit for taxes paid by corporation: Individuals can be allowed to claim the

taxes paid by the corporation as a tax credit when computing their own taxes. In
the example earlier in the paper, where a company paid 30% of its income of $
100 million as taxes and then paid its entire income as dividends to individuals
with 40% tax rates the individuals would be allowed to claim a tax credit of $ 30
million against the taxes owed, thus reducing taxes paid to $ 10 million. In effect,
this will mean that only individuals with marginal tax rates that exceed the
corporate tax rate will be taxed on dividends. Australia, Finland, Mexico,
Australia and New Zealand allow individuals to get a full credit for corporate
taxes paid. Canada, France, the U.K and Turkey allow for partial tax credits.
Lower Tax Rate on dividends: Dividends get taxed at a lower rate than other

income to reflect the fact that it is paid out of after-tax income. In some countries,
the tax rate on dividends is set equal to the capital gains tax rate. Korea, for
instance, has a flat tax rate of 16.5% for dividend income.


In summary, it is far more common for countries to provide tax relief to investors
than to corporations. Part of the reason for this is political. By focusing on individuals,
you can direct the tax relief only towards domestic investors and only to those investors
who pay taxes in the first place.


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