An option pricing approach to corporate dividends and the capital investment financing decision

• DOI: http://doi.org/10.1002/rfe.1060
• Published date: 01 October 2019
• Author: Don M. Chance
• Date: 01 October 2019

Rev Financ Econ. 2019;37:541–553. wileyonlinelibrary.com/journal/rfe

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© 2019 University of New Orleans

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INTRODUCTION

The three principal corporate financial decisions are the capital investment decision, the capital structure decision, and the

dividend decision. Option pricing theory has provided a rich framework for the analysis of the capital structure decision. In this

paper, we provide an option pricing approach to understanding the interface between the dividend decision and the decision of

how to finance the planned capital investment of the firm. We approach the problem by using options to value dividends and

showing how this value interacts with the financing decision.

The price of a stock is widely accepted to be the value of its infinite stream of dividends. Many stock valuation models, such

as the classic dividend discount model that came from the early work of Williams (1938) and Gordon (1959), are simplified

by decomposing the model into the value of one or more upcoming dividends with the remaining dividends subsumed within

a capital gains component. This approach is more or less mandatory or it would be necessary to specify an extremely long, if

not infinite, series of dividends.

There are other strong justifications for the need to decompose a stock price into a series of specified dividends during an

upcoming finite period. For example, equity valuation models that incorporate differential taxation of dividends and capital

gains would require such a dichotomy. Since dividends are often viewed as a tangible signal of the opinions of corporate man-

agement, financial analysts and market observers are also interested in knowing how much of the stock price is accounted for

by the value of one or more upcoming dividends. In recent years, many ETF and mutual fund investment strategies are geared

toward identifying high dividend‐paying firms. Stock indexes based on high‐yielding equities, such as the Morgan Stanley

MSCI USA High Dividend Yield Index and the STOXX family of maximum dividend indexes, have been recently developed.

Received: 11 January 2019

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Revised: 19 January 2019

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Accepted: 22 January 2019

DOI: 10.1002/rfe.1060

ORIGINAL ARTICLE

An option pricing approach to corporate dividends and the

capital investment financing decision

Don M.Chance

James C. Flores Endowed Chair

of MBA Studies and Professor of

Finance,Department of Finance,Louisiana

State University, Baton Rouge, Louisiana

Correspondence

Don M. Chance, James C. Flores Endowed

Chair of MBA Studies and Professor of

Finance, Department of Finance, Louisiana

State University, 2909 BEC, Baton Rouge,

LA 70803.

Email: dchance@lsu.edu

Abstract

In light of a growing trend toward viewing dividends as an investable asset class, this

article opens up a new perspective on their valuation. We show that dividends can be

viewed as options on the cash flow of the firm. That is, a firm either pays zero divi-

dends, in which case the option expires out‐of‐the‐money, or it pays a positive divi-

dend, the value of which corresponds to the option's moneyness. The exercise price

is determined by the capital budget, the flexibility of the company to use external

financing, and whether it has minimum and maximum dividends. The model is also

capable of accommodating a stochastic capital budget, which allows for uncertain

growth opportunities and their correlation with the firm's cash flows. We also present

an application of the model using actual data for a large multinational company.

KEYWORDS

contingent claims, dividend policy, dividends, options

JEL CLASSIFICATION

G35; G32; G31; G13