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Corporate Finance Lecture Note 21 Lecture Note 2 Dividend Policy

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Corporate Finance Lecture Note 22 What is in This Note? Overview of Types of Dividends Overview of Forms of Dividends Overview of Dividend Policies Overview of Real World Dividend Decisions Reference: Chapter 18 of RWJJ, Chapter 16 of BMA Overview of Types of Dividends Overview of Forms of Dividends Overview of Dividend Policies Overview of Real World Dividend Decisions Reference: Chapter 18 of RWJJ, Chapter 16 of BMA

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Corporate Finance Lecture Note 23 Roadmap Understand dividend types and how they are paid Understand why share repurchases are an alternative to dividends Understand dividend polices Understand real world dividend decisions

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Corporate Finance Lecture Note 24 Types of dividends

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Corporate Finance Lecture Note 25 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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Corporate Finance Lecture Note 26 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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Corporate Finance Lecture Note 27 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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Corporate Finance Lecture Note 28 t: Ex-dividend date time Stock price D: Cash dividend S0S0 StSt S 0 - De -rt S0S0

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Corporate Finance Lecture Note 29 t: Ex-dividend date time Stock price D*(1-dividend tax) S0S0 StSt S 0 - (D *(1-dividend tax)) e -rt S0S0

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Corporate Finance Lecture Note 210 The stock price will decrease proportionally with the amount of cash dividends.

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Corporate Finance Lecture Note 211 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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Corporate Finance Lecture Note 212 Forms of Dividends

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Corporate Finance Lecture Note 213 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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Corporate Finance Lecture Note 214 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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Corporate Finance Lecture Note 215 Stock Repurchase versus Dividend $10=/100,000$1,000,000 = Price per share 100,000 = outstanding Shares 1,000,000Value of Firm1,000,000Value of Firm 1,000,000Equity850,000 AssetsOther 0Debt$150,000Cash sheet balance Original A. Equity &Liabilities Assets Consider a firm that wishes to distribute $100,000 to its shareholders.

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Corporate Finance Lecture Note 216 Stock Repurchase versus Dividend $9=00,000$900,000/1 = shareper Price 100,000=goutstandin Shares 900,000Firm of Value900,000Firm of Value 900,000Equity850,000AssetsOther 0Debt$50,000Cash dividendcash shareper $1After B. Equity & sLiabilitie Assets If they distribute the $100,000 as a cash dividend, the balance sheet will look like this:

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Corporate Finance Lecture Note 217 Stock Repurchase versus Dividend Assets Liabilities&Equity C. After stock repurchase Cash$50,000Debt0 Other Assets850,000Equity900,000 Value of Firm900,000Value of Firm900,000 Shares outstanding= 90,000 Price pershare= $900,000/90,000=$10 If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:

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Corporate Finance Lecture Note 218 Share Repurchase ( or ) Flexibility for shareholders Keeps stock price higher Good for insiders who hold stock options As an investment of the firm (undervaluation of the stock price) Tax benefits , (3260), 3035 , etc

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Corporate Finance Lecture Note 219 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 taxes 1. Evaluate the two alternatives on shareholder wealth 2. What will be the effect on Lee Anns EPS and PE ratio under these two different alternatives?

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Corporate Finance Lecture Note 220 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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Corporate Finance Lecture Note 221 Stock Dividends Pay additional shares of stock instead of cash Increases the number of outstanding shares Small stock dividend Less 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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Corporate Finance Lecture Note 222 In-Class Exercise Ross, Westerfield, and Jaffe Question 2 (pp. 543) 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)10,000 Capital surplus180,000 Retained earnings586,500 Total owner's equity776,500

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Corporate Finance Lecture Note 223 In-Class Exercise Common stock ($ 1 par value) 11,000 Capital surplus 204,000 Retained earnings 561,500 Total owner's equity 776,500 Common stock ($ 1 par value)12,500 Capital surplus240,000 Retained earnings524,000 Total owner's equity 776,500

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Corporate Finance Lecture Note 224 Stock Splits Stock splits essentially the same as a stock dividend except it is expressed as a ratio For 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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Corporate Finance Lecture Note 225 91XX TDR 10 TDR): TDR 16 DR . TDR: 9103 : 96 6 11 4 for 1 stock split 9105 : 94 4 7 10 for 1 stock split

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Corporate Finance Lecture Note 226 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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Corporate Finance Lecture Note 227 In-Class Exercise Ross, Westerfield, and Jaffe Question 3 (pp. 543) 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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Corporate Finance Lecture Note 228 Dividend Policy

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Corporate Finance Lecture Note 229 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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Corporate Finance Lecture Note 230 Roadmap Dividend Irrelevance Theory Tax Preference Theory Dividends Preference Theory The Clientele Effect

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Corporate Finance Lecture Note 231 Dividend Irrelevance Theory

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Corporate Finance Lecture Note 232 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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Corporate Finance Lecture Note 233 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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Corporate Finance Lecture Note 234 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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Corporate Finance Lecture Note 235 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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Corporate Finance Lecture Note 236 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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Corporate Finance Lecture Note 237 Tax Preference Theory

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Corporate Finance Lecture Note 238 Personal Taxes and Dividends To get the result that dividend policy is irrelevant, we needed three assumptions: No taxes No transactions costs No uncertainty In 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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Corporate Finance Lecture Note 239 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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Corporate Finance Lecture Note 240 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 companies Purchase financial assets Repurchase shares

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Corporate Finance Lecture Note 241 Taxes and Dividends In the presence of personal taxes: 1.A firm should not issue stock to pay a dividend. 2.Managers have an incentive to seek alternative uses for funds to reduce dividends. 3.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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Corporate Finance Lecture Note 242 Dividends Preference Theory

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Corporate Finance Lecture Note 243

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2317(TW) (2) 4.5 Corporate Finance Lecture Note 244

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Corporate Finance Lecture Note 245 Real-World Factors Favoring High Dividends Desire for Current Income: Retired investors Behavioral Finance It forces investors to be disciplined. Agency Costs High dividends reduce free cash flow.

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Corporate Finance Lecture Note 246 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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Corporate Finance Lecture Note 247 Implications of 3 Theories for Managers TheoryImplication IrrelevanceAny payout OK Dividends preferenceSet high payout Tax preferenceSet low payout But which, if any, is correct???

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Corporate Finance Lecture Note 248 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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Corporate Finance Lecture Note 249 The Clientele Effect

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Corporate Finance Lecture Note 250 The Clientele Effect Clienteles for various dividend payout policies are likely to form in the following way: GroupStock 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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Corporate Finance Lecture Note 251 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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Corporate Finance Lecture Note 252 The Dividend Decision

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Corporate Finance Lecture Note 253 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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Corporate Finance Lecture Note 254 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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Corporate Finance Lecture Note 255 The Dividend Decision Attitudes concerning dividend targets vary Dividend Change

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Corporate Finance Lecture Note 256 The Dividend Decision Dividend changes confirm the following

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Corporate Finance Lecture Note 257 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?