Written Questions Seminar 6: Dividend Policy and Option Valuation

Variables Influencing the Value of an Option

The value of a call option is determined by several underlying variables, each influencing the option's worth in specific ways:

  • The Value of the Underlying Share: There is a direct relationship between the price of the underlying asset and the value of a call option. The value of a call option will be greater the higher the current market value of the underlying share.

  • The Exercise Price: This is the price at which the option holder can purchase the underlying share. The value of the call option will be greater if the exercise price is lower, as the potential for profit (the difference between the market price and the exercise price) increases.

  • The Prevailing Rate of Interest: The purchase of a call option can be conceptualized as purchasing a share on deferred terms. Because the investor does not have to pay the full price of the share immediately, there is an opportunity cost advantage. The funds not spent initially could be invested at the prevailing rate of interest to generate savings. Thus, higher interest rates generally increase the value of call options.

  • The Time to Expiry: A longer duration until the option expires increases its value for two reasons:

    • It provides a greater opportunity for the underlying share price to rise significantly.

    • It reduces the present value (PVPV) of the exercise price that must be paid in the future.

  • The Variability of the Underlying Share: The volatility or riskiness of the security is a key driver of value. The more risky or variable the underlying security, the more valuable the option becomes because there is a higher probability of the price reaching extreme highs.

  • Dividends: The payment of dividends can also affect the value of an option (typically decreasing the value of a call option as the share price drops by the dividend amount on the ex-dividend date).

Reasons for a Zero-Dividend Policy

Many companies choose not to distribute dividends to their shareholders. Below are five primary reasons for adopting such a policy:

  • Unstable Profits:

    • Companies without a consistent or stable profit history are more likely to avoid dividend payments.

    • A primary concern is the risk of being forced to cut dividends in the future if profits dip. Cutting a dividend sends a negative "signal" to the market, often leading to a significant drop in share price. To avoid this negative response, unstable firms often prefer not to start paying dividends at all.

  • Corporate Growth:

    • Rapidly expanding companies generally pay low or no dividends to prioritize the financing of expansion.

    • These growth-oriented firms require significant funds for investment and choose to retain earnings as a more efficient way to fund growth compared to distributing cash and then seeking external capital.

  • Difficulty Accessing Capital Markets and External Finance:

    • Small companies, in particular, often have limited access to capital markets or other forms of external finance.

    • If a company finds it difficult or expensive to raise funds externally, it must rely almost exclusively on retained earnings to meet its investment needs, necessitating a zero-dividend policy.

  • Debt Repayment and Gearing:

    • A company's level of gearing (leverage) and the presence of redeemable debt influence dividend decisions.

    • Repaying heavy debt requires significant cash flow. Companies with redeemable debentures may choose low or no dividend payments to ensure they have sufficient funds to redeem their debt obligations when they come due.

  • Lack of Liquid Funds:

    • Cash dividends require actual liquid resources. Even a highly profitable company may lack the cash to pay dividends if its resources are tied up in illiquid assets like inventory or receivables.

    • If bank overdraft facilities are unavailable or restricted, the company may be forced to forgo dividend payments despite being profitable.

Modigliani and Miller (MM) Dividend Irrelevancy Theory

According to the Modigliani and Miller theory, dividend policy is irrelevant to the value of a share. This suggests that whether a firm pays high, low, or no dividends, it does not impact the total value of the company or the share price.

Core Philosophy

MM argue that the value of a company is solely dependent on the expected future earnings generated by its investment choices (asset productivity), rather than how those earnings are distributed. Shareholder wealth remains unaffected by the distribution method.

Underlying Assumptions and Their Relevance

  1. Perfect Capital Markets:

    • Rational Investors: Investors make logical decisions to maximize wealth.

    • No Transaction or Flotation Costs: The market operates without frictions like brokerage fees. MM argue that if investors need cash, they can create "homemade dividends" by selling a portion of their shares. In the real world, transaction costs make this expensive, leading investors to prefer direct dividends.

    • No Taxes: The theory assumes tax neutrality. In reality, capital gains are often taxed at lower rates than dividends, and the tax is deferred until the sale of the asset. This real-world friction causes investors to favor low-dividend stocks to minimize or delay tax liabilities.

    • Equal and Costless Access to Information: Information is symmetric and free. If information is not free, dividend changes act as a "signal." For example, a dividend cut might be misinterpreted by investors as a sign of financial failure, causing the share price to drop.

    • Equal Borrowing and Lending Rates: All participants can borrow and lend at the same single rate of interest.

  2. Fixed Investment Policy:

    • The company’s asset base is constrained by a predetermined policy. This ensures the focus remains on cash distribution. Paying a dividend forces the firm to replace that cash by issuing new shares, which dilutes the value of existing shares, effectively canceling out the benefit of the dividend.

  3. Homogeneous Expectations:

    • All market participants share identical financial forecasts and risk assessments. This removes any disagreement regarding stock valuation, ensuring the stock is valued identically regardless of the dividend payout.

  4. Perpetuities:

    • The theory often assumes cash flows or firms exist as perpetuities.

Schools of Thought on Dividend Policy and Company Value

Whether dividend policy affects company value depends on which school of academic thought is followed.

1. The Modigliani-Miller School (Dividend Irrelevance)

  • The Reason: Value creation is driven entirely by corporate asset productivity and investment policy.

  • The Logic: In a perfect market, dividends change nothing. Shareholder wealth is identical whether it exists as cash received or as growth in share value.

  • Homemade Dividends: Investors do not rely on corporate policy for income. If they want cash, they can manufacture a "homemade dividend" by selling a small fraction of their holdings.

  • The Trade-Off: Paying a dividend drains cash. To replace this cash for investments, the firm must issue new shares. This issuance dilutes the value of original shares, making the dividend benefit a "mere accounting illusion."

2. The Traditional / Real-World School (Dividend Relevance)

  • The Reason: Market imperfections—such as taxes, transaction costs, and asymmetric information—directly impact investor behavior and firm value.

  • The Logic: In the real world, dividend policies can create or destroy value through various effects:

    • Signaling Effect: Because investors lack full visibility into a company's internal health, a dividend increase serves as a trusted signal for strong future profits, which increases the share price.

    • Clientele Effect: Certain investor groups, such as retirees or pension funds, require steady, predictable income. Firms that maintain stable dividends attract this loyal "clientele," which maintains high demand for the stock.

    • Agency Costs: Retaining too much excess cash allows managers to waste money on suboptimal projects. Regular dividend payments force managers to return to the public markets to raise new funds, subjecting them to external scrutiny and protecting company value.

  • Conclusion: Since real-world markets are imperfect (filled with "frictions"), an optimal dividend policy is necessary to maximize shareholder wealth.