Homemade Dividends

Dividends are the distributed part of a company's profit and are one of the major ways (apart from a share repurchase program) in which a company offers cash rewards to its shareholders. The alternative is to retain the earnings in a hope of faster growth or to save for the rainy day. The company can also choose to offer non - cash rewards to the shareholders through stock - dividends or stock - splits.

I am focusing only on cash dividends here and there are a number of school of thoughts that consider the dividend policy of a company as an (un)important factor affecting its value. It should be remembered from the outset that dividends are always important. The debate is about the dividend policy. What is dividend policy?

Dividend policy is the choice between paying the dividends now or later and the literature offers arguments both for the relevance (for example, the signaling theory, the Walter model, the traditional position advocated by Graham and Dodd) as well as irrelevance of dividend policy (for example, clientele effect, Miller and Modigilani argument). Apart from these clear - cut 'yay' and 'nay' positions, we have some arguments which seek a middle ground. For example, Myron Gordon's classification of firms as 'growth' firms, 'normal' firms and 'declining' firms and the (ir)relevance of dividend policy to each one of them. We also have J. F. Muth's Rational expectations hypothesis. It proposes that what is important is not what really happens but what was expected to happen. For instance, if you expected the company to announce a high dividend but it didn't do so, you may revise your assessment of the company downwards and vice - versa.

In this post, we talk about the concept of homemade dividend (Miller and Modigilani), which simply means creating a personal dividend policy and ensuring the desired cash inflow in a given period(s). For example, if your company is paying more dividend than you need (well, you may want a lesser dividend receipt due to tax implications), you can receive the dividend check and reinvest the money back in the company (by buying additional shares through a DRIPS program) or anywhere else (perhaps in a tax saving scheme). And if your company is paying you less dividend than you need, you can make up for the shortfall by selling some shares.

If you can achieve your desired cash flow position on your own, then it does not matter to you what kind of dividend policy the company is following and unless you are affected, you are indifferent between quitting or staying with the firm. So, you might as well stay [If you stay, you don't cause a ripple. If you leave (and like you, others do too), then there is a selling pressure on the company's stock, causing it to turn southward].

Of course, this is an over - simplified way of looking at things because it does not consider factors like transaction costs and differential taxation treatment of dividend and capital gain income. However, it is important in understanding just how much relevance dividend policy has on its own, without the distortions caused by market imperfections and for that purpose (which is quite important), the procedure is helpful. Why I say this is because once you establish the pure relationship between the dividend policy and the value of a firm, you can then begin to factor in the imperfections and see how this relationship changes as each imperfection creates its own effect. It may very well be that it is the imperfect market conditions that cause the dividend policy to be relevant and without them, any policy does not have enough teeth to make an impact.

One can get a little philosophical here and muse: In a perfect world, no policy is needed. Everything takes care of itself on its own. Wow!!!

In the following video, I demonstrate the concept of homemade dividend:

Homemade Leverage

In the world of finance, leverage means using either fixed cost assets or fixed cost funds. When fixed cost assets are used, the resulting leverage is called the operating leverage and when fixed cost funds are used, we have financial leverage.

We will refer to financial leverage in this post, which is created when a firm (or a person) uses borrowed funds (debt).

Homemade means something personal. Therefore, homemade leverage means personal leverage. Just like when companies borrow and create corporate leverage, individuals, when they borrow on their personal account, create homemade leverage.

Of course, a company can reduce its leverage by retiring some of its debt. Likewise, individuals can undo  the effect of corporate leverage (at least for themselves) by doing the exact opposite of borrowing, that is lending, which practically means investing in an interest bearing security.

The concept of homemade leverage emanates from the Miller and Modigilani propositions on capital structure, where they demonstrate that investors can substitute homemade leverage for corporate leverage, when they move from one firm to another to ensure that their return and risk exposure remains unchanged.

In an ideal world, investors can render the capital structure policy of a firm irrelevant through homemade leverage because they can create their own desired leverage status independent of what the company does.

However, we live in a world that is not perfect or ideal by any means. One of the major assumptions for homemade leverage to work is that individual investors can borrow and lend at the same rate of interest as corporations. We know that this is not possible. Also, the taxation rates applicable to corporate and personal incomes are different. With these imperfections entering in, the mechanism does not work as well as it is presented in theory.

Nevertheless, it should be kept in mind that the motivation for the homemade leverage argument is not to give us some unrealistic ideas but to suggest that the capital structure policy of a company on its own can not have any effect on its value. It is only when the market imperfections appear on the scene, the  capital structure policy of a firm starts making a difference to its value.

In order to impact the value, the corporate policy on how it finances it business must be something that can not be mimicked by individual investors for financing their personal investment in the company. If individual investors can undo the effect of corporate policy by their own actions, it loses relevance. As I said before, in real world, many imperfections enter the picture, preventing individual investors in imitating corporate leverage. If they are to do that, they can only do so at different borrowing and lending terms.

In this post, we are going to assume an ideal world, not because it exists, but because we wish to see if corporate leverage is potent enough on its own to affect a firm's value.  Or is it that the existence of an imperfect world makes the capital structure policy relevant. The underpinning is that if in an ideal world, investors can switch between companies and policies on their own without changing their risk - return profile, capital structure (the mix of debt and equity capital) would then be an irrelevant item on and of its own.

The following two videos explain how the mechanism of homemade leverage works in an ideal world. In the first video, we assume an investor who wants to move from a levered firm to an un - levered firm and in the second one, we look at the opposite case, where an investor wants to move from an un - levered to a levered firm without affecting his / her return, risk and proportional ownership in companies.

Moving from a Levered to an Un - levered firm:

Moving from an Un - Levered to a Levered firm: