Lecture 10: Corporate Equity, Earnings and Dividends

The Corporation

• [1611] A body corporate legally authorized to act as a single individual, an artificial person created by royal charter, prescription, or act of legislature, and having authority to preserve certain rights in perpetual succession. (OED)

• Compare publicani of ancient Rome, essentially corporations (though the most prominent were private collecting agencies for taxes)

For-Profit vs. Non-Profit

• For-profit corporation is owned by shareholders, equal claim after debts paid, subject to corporate profits tax.

• Non-profit is not owned, self-perpetuating directors. Not subject to corporate profits tax.

Common vs. Preferred Stock

• Common stock: dividend is at discretion of firm, subject to legal restrictions

• Preferred stock: Specified dividend does not have to be paid, but firm cannot pay dividend on common stock unless all past preferred stock dividends are paid.

• Corporate bonds: Firm is contractually obligated to pay coupons and there is a maturity date when principal must be paid.

Limited Liability

• Even publicani had some form of limited liability sometimes

• New York State legislature made limited liability standard for all corporations, 1811

• Standard copied by other states, finally California, 1931.

Other Corporate Obligations

• Convertible bonds: bondholder has option to convert the bond to stock

• Employee incentive options• Tracking stock• Junk bonds• Warrants• Partnership contracts

Voting of Common Shares

• Usually one share one vote, in person or by proxy, for board of directors and some other essential matters

• Shareholders meetings usually annual event, and required by law for big events such as merging corporation

• Shareholder meeting circuses

Berle and Means

• Adolf A. Berle Jr., and Gardiner C. Means, The Modern Corporation and Private Property, 1933

• Separation of ownership and control• “ownership is so widely scattered that working

control can be maintained with but a minority interest.”

• The “quasi-public corporation” is constrained by law to serve other interests.

Payment of Dividends

• Purely discretionary• Young firms typically pay none• NASDAQ dividend yield virtually zero• Corporate culture influences dividends.

Microsoft• Liquidity constraints on dividends

Modigliani-Miller Dividend Irrelevance Theory

• Journal of Business, 1961.• Assume no taxes or transactions costs• Consider purely financial transaction:

selling shares to pay dividends• M&M Conclusion: Dividend policy has no

effect on the value of the firm.• Purely nominal difference between

dividend checks and repurchase checks.

Adding Taxes to M&M World

• Dividends are taxable as personal income, share repurchases are capital gains, lower rate.

• Announcing payment of new dividends should lower value of firm by present value of taxes.

Why Do Firms Pay Dividends?

• Hersch Shefrin and Meir Statman: Self-control theory of dividends. (analogy to Christmas clubs, overwithholding) Rule of thumb spending rule.

• Prospect theory interpretation: framing matters. Dividends framed as income.

• University endowments once required high-yield investments to provide income

Dividend Signalling

• By raising dividends, firm shows it can court bankruptcy.

• Battacharya, Hakansson, Ross• Problem: alternative signalling methods are

cheaper tax-wise

Lintner Model of Dividends

• DIVt-DIVt-1= ( × EPSt-DIVt-1) =adjustment rate, 0< <1 =target ratio, 0< <1

D IV E P Stk

kt k

( )10

Kahneman & Tversky Framing Example

• “US is preparing for a rare Asian disease which is expected to kill 600 people.”

• “If Program A is adopted, 200 people will be saved. If program B is adopted, there is a 1/3 probability that 600 people will be saved and a 2/3 probability that no people will be saved.” (Majority: A)

K&T Framing Continued

• Other respondents given a different choice:• If program C is adopted, 400 people will die

If Program D is adopted, there is a 1/3 probability that no one will die, and a 2/3 probability tha 600 people will die.” (Majority: D) Scientific American 1981

General Public Utilities Corp

• President Kuhn proposed to substitute stock dividends for cash dividends, and offered to sell the stock dividend for any stockholder for minimal transaction cost. (ca. 1968)

• Direct saving to shareholder: $4 million a year.

• Intense negative shareholder reaction

S&P D/E & D/P 1871-2004

S&P 500 Dividend/Earnings and Dividend/Price, 1871-2004

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

1860 1880 1900 1920 1940 1960 1980 2000 2020Year

Dividend/EarningDividend/Price

Share Repurchase

• Once rare, now S&P 500 firms repurchase approx. 2% of shares per year. They issue about 1% of shares per year in employee option exercise, so net repurchase is about 1% per year.

• Repurchase now almost as high as dividends paid, but firms still pay dividends. A puzzle.

Reasons for Share Repurchase

• Tax break for investors• Firms’ unwillingness to cut dividends, uncertainty

that current earnings will continue• Price pop after a repurchase. Buybacks taken as a

signal. But price pops are fading.• Now investors sometimes view repurchase as a

sign that firm is “old economy.” NASDAQ firms less likely to repurchase shares, as if they think value is too high.

Employee Options and Share Repurchase

• The “overhang,” percent of stock market promised to employees via options, stood at 6.2% in 144 of largest S&P 500 firms in 1998.

• Option holders have an interest in repurchasing shares rather than paying dividends.

• Lambert Lanen & Larker JFQA 1985: dividend payouts reduced after option plans introduced.

Reasons for Declining Dividend, Earnings Yield in New

Millennium• Perception of great growth opportunities

with new technology• First-mover advantage prized• Dividends, Earnings are for losers• Problem in valuing firms