5. Homemade Dividends

What if some shareholders prefer a different dividend policy than the one pursued by the firm? 

Let's take the case where the firm decides to pay a smaller initial dividend of 4 instead of 10 per share. Now suppose a shareholder who owns 1 share was planning on spending the originally expected dividend of 10 to buy a piece of land. With the revised dividend policy, the shareholder does not receive sufficient funds to buy the land. What can she do?

  

Remember from before that the firm's shares trade at 16 after the revised dividend payment (P*) and that the expected dividend in one year under that policy is 17.6, as opposed to an originally expected dividend of 11 in one year.

 

To close her funding gap of 6, the shareholder could sell parts of her holdings. More specifically, if she sells 37.5% of her share right after the dividend payment, she will collect the required 6 to close the funding gap (0.375 × 16 = 6):

 

Total payout0 = Div0 + Share sales proceeds = 4 + 0.375 × 16 = 10.

 

After the transaction, she will therefore own 62.5% (= 1 - 0.375) of a share. Consequently, in one year, she will be entitled to 62.5% of that share's dividend of 17.6, namely 11:

  

Total payout1 = 0.625 × Div1 = 0.625 × 17.6 = 11.

   

Not surprisingly, this exactly corresponds to the expected dividend of year one under the original payout policy. By selling parts of her shareholdings today, the shareholder managed to replicate the firm's original payout policy on her own. Under the strict assumptions that we made at the beginning of this section, these homemade dividends have the exact same value as the firm's original dividend policy.

  

It is easy to show that the same conclusion applies for a situation where the initial dividend exceeds the shareholder's liquidity needs. To do so, we can revisit the case where the firm pays a larger initial dividend of 16 instead of 10 per share.

  • If the shareholder only desires a cash consideration of 10, she can reinvest the remaining proceeds and buy more of the firm's stocks.
  • As we have seen in the discussion of the example, the stock price will drop to 4 after the larger initial dividend. 
  • The shareholder therefore buys 1.5 additional shares with her excess dividend of 6 (1.5 × 4 = 6).
  • The total payout today, therefore is 10:
      
    Total payout0 = Div0 - Purchase price of shares = 16 - 1.5 × 4 = 10.
     
  • After the transaction, she will therefore own a total of 2.5 shares. In one year, she expects to collect a dividend of 4.4 per share, as per the example. Therefore, the total payout in 1 year will, again, be 11, which is equal to the originally expected dividend:
     
    Total payout1 = 2.5 × Div1 = 2.5 × 4.4 = 11.

   

Consequently, by buying and selling parts of their holdings, shareholders can, in principle, design their own payout policies that cater to their specific liquidity needs. They do not need the firm to do that for them. 

Obviously, this only works so perfectly under the strict assumptions that we have made, in particular the assumptions that there are no taxes, that shares (and fractions thereof) can be bought and sold freely, and there are no transaction costs. If these assumptions are violated, homemade dividends will work less perfectly.