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Corporate Finance Lecture Note 2

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Lecture Note 2

Dividend Policy



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What is in This Note?

Overview of Types of DividendsOverview of Forms of DividendsOverview of Dividend PoliciesOverview of Real World Dividend Decisions Reference: Chapter 18 of RWJJ, Chapter 16 of BMA


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Roadmap

Understand dividend types and how they are paidUnderstand why share repurchases are an alternative to dividendsUnderstand dividend policesUnderstand real world dividend decisions



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Types of dividends



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Different Types of Dividends

Many companies pay a regular cash dividend.Public companies often pay quarterly.Sometimes firms will pay an extra cash dividend.The extreme case would be a liquidating dividend.Companies will often declare stock dividends.No cash leaves the firm.The firm increases the number of shares outstanding.



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Standard Method of Cash Dividend

Record Date Date on which company determines existing shareholders.

Ex-Dividend Date () - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock immediately before this date is entitled to a dividend.

Cash Dividend - Payment of cash by the firm to its shareholders.


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Procedure for Cash Dividend

25 Oct.

1 Nov.

2 Nov.

5 Nov.

7 Dec.

Declaration Date

Cum-dividend Date

Ex-dividend Date

Record Date

Payment Date

Declaration Date: The Board of Directors declares a payment of dividends.

Cum-Dividend Date: Buyer of stock still receives the dividend.

Ex-Dividend Date: Seller of the stock retains the dividend.

Record Date: The corporation prepares a list of all individuals believed to be stockholders as of 5 November.



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t: Ex-dividend date

time

Stock price

D: Cash dividend

S0

St

S0- De-rt

S0



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t: Ex-dividend date

time

Stock price

D*(1-dividend tax)

S0

St

S0- (D *(1-dividend tax)) e-rt

S0



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The stock price will decrease proportionally with the amount of cash dividends.



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In-Class Exercise

Ross, Westerfield, and Jaffe Question 1 (pp. 543)Lee Ann has declared a $6 per share cash dividend. Suppose that the capital gains are not taxed, but dividends are taxed at 15% for the representative investor. Lee Ann sells for $90 per share, what do you think the ex-equilibrium dividend price will be?Ans: Aftertax dividend = $6.00(1 .15) = $5.10. The stock price should drop by the aftertax dividend amount, or:Ex-dividend price = $90 5.10 = $84.90



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Forms of Dividends



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Forms of Dividend Payments

Stock Repurchase - Firm buys back stock from its shareholders.

Stock Dividend - Distribution of additional shares to a firms stockholders.

Stock Splits - Issue of additional shares to firms stockholders.


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Repurchase of Stock ( or )

Instead of declaring cash dividends, firms can rid themselves of excess cash through buying shares of their own stock.Recently, share repurchase has become an important way of distributing earnings to shareholders.



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Stock Repurchase versus Dividend

$10

=

/100,000

$1,000,000

=

Price per share

100,000

=

outstanding

Shares

1,000,000

Value of Firm

1,000,000

Value of Firm

1,000,000

Equity

850,000

Assets

Other

0

Debt

$150,000

Cash

sheet

balance

Original

A.

Equity

&

Liabilities

Assets

Consider a firm that wishes to distribute $100,000 to its shareholders.


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$9

=

00,000

$900,000/1

=

share

per

Price

100,000

=

g

outstandin

Shares

900,000

Firm

of

Value

900,000

Firm

of

Value

900,000

Equity

850,000

Assets

Other

0

Debt

$50,000

Cash

dividend

cash

share

per

$1

After

B.

Equity

&

s

Liabilitie

Assets

If they distribute the $100,000 as a cash dividend, the balance sheet will look like this:


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If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:


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Share Repurchase ( or )

Flexibility for shareholdersKeeps stock price higher Good for insiders who hold stock optionsAs an investment of the firm (undervaluation of the stock price)Tax benefits ,(3260),3035 , etc



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In-Class Exercise

Ross, Westerfield, and Jaffe Question 17 (pp. 545)

Lee Ann is considering a cash dividend versus s stock repurchase. In either case 5,000 would be spent. Current EPS is 0.95 per share and the stock price is 40 per share. There are 1,000 shares outstanding. Ignore taxes1. Evaluate the two alternatives on shareholder wealth2. What will be the effect on Lee Anns EPS and PE ratio under these two different alternatives?



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In-Class Exercise

1. Dividend per share = 5,000/1,000 shares = 5.00. The ex-dividend stock price will be: 40 5 = 35 per share. Shares repurchased = 5,000/40 = 125 shares

2. If the company pays dividends, the current EPS is 0.95, and the P/E ratio is: P/E = 35/0.95 = 36.84. If the company repurchases stock, we find the EPS under the repurchase is: EPS = 0.95(1,000)/(1,000 125) = 1.0857. The stock price will remain at 40 per share, so the P/E ratio is:P/E = 40/1.0857 = 36.84



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Stock Dividends

Pay additional shares of stock instead of cashIncreases the number of outstanding sharesSmall stock dividendLess than 20 to 25%If you own 100 shares and the company declared a 10% stock dividend, you would receive an additional 10 shares.Large stock dividend more than 20 to 25%



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In-Class Exercise


Lee Anns stock is sold at $25 per share and it declares a 10% stock dividend. How many new shares are issued and how would the equity account change? and if it declares a 25% stock dividend. How many new shares are issued and how would the equity account change.

Common stock ($ 1 par value)10,000Capital surplus180,000Retained earnings586,500Total owner's equity776,500



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In-Class Exercise

Common stock ($ 1 par value)11,000Capital surplus204,000Retained earnings561,500Total owner's equity776,500

Common stock ($ 1 par value)12,500 Capital surplus240,000 Retained earnings524,000 Total owner's equity776,500



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Stock Splits

Stock splits essentially the same as a stock dividend except it is expressed as a ratioFor example, a 2 for 1 stock split is the same as a 100% stock dividend.Stock price is reduced when the stock splits.Common explanation for split is to return price to a more desirable trading range.


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www: Click on the web surfer icon to find out about upcoming stock splits and dividends


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91XXTDR10TDR): TDR16DR.TDR:

9103:96611 4 for 1 stock split

9105:9447 10 for 1 stock split



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Reverse Stock Splits

Stock price is increased when there is a reverse stock split.Common explanation for reverse split is to return price to a more desirable trading range.


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In-Class Exercise


Lee Anns stock is sold at $25 per share and it declares a four-for-one stock split. There are 10,000 shares outstanding. How many shares are outstanding now? and if it declares a one-for-four reverse stock split. How many shares are outstanding now? Ans: four-for-one stock split, New shares outstanding = 10,000(4/1) = 40,000. one-for-four reverse stock split, New shares outstanding = 10,000(1/4) = 2,500.



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Dividend Policy



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What is dividend policy?

Its the decision to pay out earnings versus retaining and reinvesting them. Includes these elements:

1. High or low payout?

2. Stable or irregular dividends?

3. How frequent?

4. Do we announce the policy?


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Roadmap

Dividend Irrelevance TheoryTax Preference TheoryDividends Preference TheoryThe Clientele Effect



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Dividend Irrelevance Theory



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Dividend Irrelevance Theory

dividend policy is irrelevant in the sense that it cannot affect shareholder value Investors are indifferent between dividends and retention-generated capital gains. If they want cash, they can sell stock. If they dont want cash, they can use dividends to buy stock.Modigliani-Miller support irrelevance.Theory is based on no taxes or brokerage costs, hence may not be true


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The Irrelevance of Dividend Policy

A compelling case can be made that dividend policy is irrelevant in the sense that it cannot affect shareholder value.Since investors do not need dividends to convert shares to cash; they will not pay higher prices for firms with higher dividends.In other words, dividend policy will have no impact on the value of the firm because investors can create whatever income stream they prefer by using homemade dividends.



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Homemade Dividends

Bianchi Inc. is a $42 stock about to pay a $2 cash dividend.Bob Investor owns 80 shares and prefers a $3 dividend.Bobs homemade dividend strategy:Sell 2 shares ex-dividend

homemade dividends

Cash from dividend$160

Cash from selling stock$80

Total Cash$240

Value of Stock Holdings $40 78 =

$3,120

$3 Dividend

$240

$0

$240

$39 80 =

$3,120



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Dividend Policy is Irrelevant

In the above example, Bob Investor began with a total wealth of $3,360:

After a $3 dividend, his total wealth is still $3,360:

After a $2 dividend and sale of 2 ex-dividend shares, his total wealth is still $3,360:


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Dividends and Investment Policy

Firms should never forgo positive NPV projects to increase a dividend (or to pay a dividend for the first time).Recall that one of the assumptions underlying the dividend-irrelevance argument is: The investment policy of the firm is set ahead of time and is not altered by changes in dividend policy.



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Tax Preference Theory



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Personal Taxes and Dividends

To get the result that dividend policy is irrelevant, we needed three assumptions:No taxesNo transactions costsNo uncertaintyIn the United States, both cash dividends and capital gains are taxed at a maximum rate of 15 percent.Since capital gains can be deferred, the tax rate on dividends is greater than the effective rate on capital gains.This could cause investors to prefer firms with low cash dividends.


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The dividend and capital gains tax rates are subject to change at the discretion of Congress.


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Firms without Sufficient Cash

In a world of personal taxes, firms should not issue stock to pay a dividend.

Firm

Stock

Holders

Cash: stock issue

Cash: dividends

Gov.

Taxes

Investment Bankers

The direct costs of stock issuance will add to this effect.



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Firms with Sufficient Cash

The above argument does not necessarily apply to firms with excess cash.Consider a firm that has $1 million in cash after selecting all available positive NPV projects.Select additional capital budgeting projects (by assumption, these are negative NPV).Acquire other companiesPurchase financial assetsRepurchase shares



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Taxes and Dividends

In the presence of personal taxes:

A firm should not issue stock to pay a dividend.

Managers have an incentive to seek alternative uses for funds to reduce dividends.

Though personal taxes mitigate against the payment of dividends, these taxes are not sufficient to lead firms to eliminate all dividends.



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Dividends Preference Theory



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2317(TW) (2) 4.5


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Real-World Factors Favoring High Dividends

Desire for Current Income: Retired investorsBehavioral FinanceIt forces investors to be disciplined.Agency CostsHigh dividends reduce free cash flow.



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Behavioral Finance-Dividends

A natural rule people might create to prevent themselves from over consuming their wealth is only consume the dividend, but dont touch the portfolio capital. In other words, people may like dividends because dividends help them surmount self-control problems through the creation of simple rules.



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Implications of 3 Theories for Managers

Theory

Implication

Irrelevance

Any payout OK

Dividends preference

Set high payout

Tax preference

Set low payout

But which, if any, is correct???


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Which theory is most correct?

Empirical testing has not been able to determine which theory, if any, is correct.Thus, managers use judgment when setting policy.Analysis is used, but it must be applied with judgment.


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The Clientele Effect



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The Clientele Effect

Clienteles for various dividend payout policies are likely to form in the following way:

Group

Stock Type

High Tax Bracket Individuals

Low Tax Bracket Individuals

Tax-Free Institutions

Corporations

Zero-to-Low payout

Low-to-Medium payout

Medium payout

High payout

Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy.



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Whats the clientele effect?

Different groups of investors, or clienteles, prefer different dividend policies.Firms past dividend policy determines its current clientele of investors.Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies.


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The Dividend Decision



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What We Know and Do Not Know

Corporations smooth dividends.Fewer companies are paying dividends.Dividends provide information to the market.Firms should follow a sensible policy:Do not forgo positive NPV projects just to pay a dividend.Avoid issuing stock to pay dividends.Consider share repurchase when there are few better uses for the cash.



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The Dividend Decision: Lintners Stylized Facts

1. Firms have longer term target dividend payout ratios.

2. Managers focus more on dividend changes than on absolute levels.

3. Dividends changes follow shifts in long-run, sustainable levels of earnings rather than short-run changes in earnings.

4. Managers are reluctant to make dividend changes that might have to be reversed.

5. Firms repurchase stock when they have accumulated a large amount of unwanted cash or wish to change their capital structure by replacing equity with debt.

(How Dividends are Determined)


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Attitudes concerning dividend targets vary

Dividend Change


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Dividend changes confirm the following


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Conclusion

What are the dividend polices?Which dividend policy favors high (low) dividend payouts?What is the Modigliani-Miller Propositions about dividend polices?What are the Lintners Stylized Facts about dividends decisions?


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The dividend and capital gains tax rates are subject to change at the discretion of Congress.

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18

share

42

$

shares

80

360

,

3

$

=

240

$

share

39

$

shares

80

360

,

3

$

+

=

80

$

160

$

share

40

$

shares

78

360

,

3

$

+

+

=

1

1

EPS

ratio

target

dividend

target

DIV

=

=

0

1

0

1

DIV

-

EPS

ratio

target

change

target

DIV

-

DIV

=

=

(

)

0

1

0

1

DIV

-

EPS

ratio

target

rate

adjustment

change

target

rate

adjustment

DIV

-

DIV

=

=

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