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Chapter 16Principles of
Corporate FinanceTenth Edition
Payout Policy
Slides by
Matthew Will
McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
16-2
Topics Covered
Facts About Payout How Firms Pay Dividends and Repurchase Stock How Do Companies Decide on Payouts? Information in Dividends and Stock Repurchases The Payout Controversy The Rightists Taxes and the Radical Left The Middle of the Roaders
16-3
Payout Policies
16-4
Dividend & Stock Repurchases
-800
-600
-400
-200
0
200
400
600
800
1000
120019
8019
8219
8419
8619
8819
9019
9219
9419
9619
9820
0020
0220
0420
0620
08
Dividends Repurchases Remaining earnings
$ B
illi
ons
U.S. Data 1980 - 2008
16-5
Dividend Payments
Exxon Mobildeclares regular
quarterly dividendof $.42 per share.
Shares start totrade ex dividend.
Dividend will be paidto shareholders
registeredon this date.
Dividend checksare mailed
to shareholders.
April 15, 2009 May 11, 2009 May 13, 2009 June 10, 2009
Declaration Date
Ex-dividend Date
RecordDate
PaymentDate
16-6
Types of Dividends
Cash Dividend Regular Cash Dividend Special Cash Dividend Stock Dividend Stock Repurchase (4 methods)
1. Buy shares on the market2. Tender Offer to Shareholders3. Dutch Auction4. Private Negotiation (Green Mail)
16-7
Dividend Payments
Record Date - Person who owns stock on this date received the dividend.
Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend.
Cash Dividend - Payment of cash by the firm to its shareholders.
16-8
Dividend Payments
Stock Repurchase - Firm buys back stock from its shareholders.
Stock Dividend - Distribution of additional shares to a firm’s stockholders.
Stock Splits - Issue of additional shares to firm’s stockholders.
16-9
The Payout Decision
Executives who agree or strongly agree (%)
Dividend Decision Survey (2004)
16-10
The Payout Decision
1. Managers are reluctant to make dividend changes that may have to be reversed. They are particularly worried about having to rescind a dividend increase and, if necessary, would choose to raise new funds to maintain the payout.
2. To avoid the risk of a reduction in payout, managers smooth” dividends. Consequently, dividend changes follow shifts in long-run sustainable earnings. Transitory earnings changes are unlikely to affect dividend payouts.
3. Managers focus more on dividend changes than on absolute levels. Thus paying a $2.00 dividend is an important financial decision if last year’s dividend was $1.00, but no big deal if last year’s dividend was $2.00.
Lintner’s “Stylized Facts,” as updated by Brav, Graham, Harvey, Michaely (2004)
16-11
Information in Payouts
Dividends and stock repurchase decisions contain information
The information contained in the decisions varies Asymmetric information may be conveyed Dividend increases could mean overpriced stock
or increased future profits The signal varies based on prior information about
the company
16-12
Information in Payouts
Attitudes concerning dividend targets vary
Dividend Change1
1
EPS ratiotarget
dividendtarget DIV
1
1
EPS ratiotarget
dividendtarget DIV
01
01
DIV-EPS ratiotarget
changetarget DIV-DIV
01
01
DIV-EPS ratiotarget
changetarget DIV-DIV
16-13
Information in Payouts
Dividend changes confirm the following
01
01
DIV-EPS ratiotarget rate adjustment
changetarget rate adjustmentDIV-DIV
01
01
DIV-EPS ratiotarget rate adjustment
changetarget rate adjustmentDIV-DIV
16-14
Dividend Policy
-15
-10
-5
0
5
10
15
Div Rise
Div Cut
Source: Healy & Palepu (1988)
Ch
ange
EP
S/P
rice
at
t =
0 a
s %
Year
Impact of Dividend Changes on EPS
16-15
Dividend Policy
Before Dividend
After Dividend
New stockholders
Each share worth this before …
Old stockholders
… and worth
this after
Tot
al v
alue
of
firm
Total number of shares
Total number of shares
Example of 1/3rd of worth paid as dividend and raising money via new shares
16-16
Dividend Policy
Firm
Old stockholders
New stockholders New stockholders
Old stockholders
SharesCash
Cash
Cash Shares
Dividend financed by stock issue
No dividend, no stock issue
16-17
Dividend Policy is Irrelevant
Since investors do not need dividends to convert shares to cash they will not pay higher prices for firms with higher dividend payouts. In other words, dividend policy will have no impact on the value of the firm.
16-18
Dividend Policy is IrrelevantExample - Assume Rational Demiconductor has no extra cash, but declares a
$1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.
Record Date
Cash 1,000
Asset Value 9,000
Total Value 10,000 +
New Proj NPV 2,000
# of Shares 1,000
price/share $12
16-19
Dividend Policy is Irrelevant
Example - Assume Rational Demiconductor has no extra cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.
Record Date Pmt Date
Cash 1,000 0
Asset Value 9,000 9,000
Total Value 10,000 + 9,000
New Proj NPV 2,000 2,000
# of Shares 1,000 1,000
price/share $12 $11
16-20
Dividend Policy is IrrelevantExample - Assume Rational Demiconductor has no extra cash, but declares a
$1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.
Record Date Pmt Date Post Pmt
Cash 1,000 0 1,000 (91 sh @ $11)
Asset Value 9,000 9,000 9,000
Total Value 10,000 + 9,000 10,000
New Proj NPV 2,000 2,000 2,000
# of Shares 1,000 1,000 1,091
price/share $12 $11 $11
NEW SHARES ARE ISSUED
16-21
Dividend Policy is Irrelevant
Example - continued - Shareholder Value
Record
Stock 12,000
Cash 0
Total Value 12,000
Stock = 1,000 sh @ $12 = 12,000
16-22
Dividend Policy is Irrelevant
Example - continued - Shareholder Value
Record Pmt
Stock 12,000 11,000
Cash 0 1,000
Total Value 12,000 12,000
Stock = 1,000sh @ $11 = 11,000
16-23
Dividend Policy is Irrelevant
Example - continued - Shareholder Value
Record Pmt Post
Stock 12,000 11,000 12,000
Cash 0 1,000 0
Total Value 12,000 12,000 12,000
Stock = 1,091sh @ $115 = 12,000
Assume stockholders purchase the new issue with the cash dividend proceeds.
16-24
Dividend Theories
Leftists (M&M) - Dividend does not effect value
Rightists - Dividends increase value
Middle of the roaders - Leftist theory with some reality thrown in.
Residual Dividend Policy
16-25
Dividends Increase Value
Market Imperfections and Clientele Effect
There are natural clients for high-payout stocks, but it does not follow that any particular firm can benefit by increasing its dividends. The high dividend clientele already have plenty of high dividend stock to choose from.
These clients increase the price of the stock through their demand for a dividend paying stock.
16-26
Dividends Increase Value
Dividends as Signals
Dividend increases send good news about cash flows and earnings. Dividend cuts send bad news.
Because a high dividend payout policy will be costly to firms that do not have the cash flow to support it, dividend increases signal a company’s good fortune and its manager’s confidence in future cash flows.
16-27
Dividends Decrease Value
Tax ConsequencesCompanies can convert dividends into capital gains by shifting their dividend policies. If dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move and value the firm more favorably.
In such a tax environment, the total cash flow retained by the firm and/or held by shareholders will be higher than if dividends are paid.
16-28
Taxes and Dividend Policy
Since capital gains are taxed at a lower rate than dividend income, companies should pay the lowest dividend possible.
Dividend policy should adjust to changes in the tax code.
16-29
Taxes and Dividend Policy
0.101000.10100(%)return of rateAfter tax
78.9)94.04()72.410(1050.2)50.120(taxes)-gain cap(div
incomeTax After Total94.072.4.202.5012.50.2020% @Gain Capon Tax
4.0010.40050% @ divon Tax
05.151005.12100(%)return of ratePretax
4.7212.50gain Capital
97.78100pricestock sToday'
112.50112.50payoffpretax Total
100Dividend
102.50112.50price syear'Next dividend)(high
B Firm
dividend) (no
A Firm
97.789.78
10010
97.7814.72
10012.5
16-30
Taxes and Dividend Policy
Cash Flow
Operating Income 100.00Corporate tax at 35% 35.00After Tax income (paid as div) 65.00Income tax paid by investors at 15.0% 9.75Cash to Shareholder 55.25
In U.S., shareholders are taxed twice (figures in dollars)
16-31
Taxes and Dividend Policy
Rate of Income tax
15% 30% 47%Operating Income 100 100 100Corporate tax (Tc=.30) 30 30 30After Tax income 70 70 70
Grossed up Dividend 100 100 100Income tax 15 30 47Tax credit for Corp Pmt -30 -30 -30Tax due from shareholder -15 0 17Cash to Shareholder 85 70 53
Under imputed tax systems, such as that in Australia, Shareholders receive a tax credit for the corporate tax the firm pays (figures in Australian dollars)
16-32
Dividend Theories
MRI = IRR
COC12 %
r
QTY $$$
Residual Dividend Policy
16-33
Web Resources
Click to access web sitesClick to access web sites
Internet connection requiredInternet connection required
www.earnings.com
www.ex-dividend.com
www.dripcentral.com