Dividend Policy

What can a firm with its free cash?

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Buy another plane

Types of Dividends

Regular dividend A direct cash payment from the firm to

shareholders. Generally these occur quarterly Special dividend

This is a one time dividend that is made in addition to the regular dividend.

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Dividend Payment Timeline

Declaration: The board declares a dividend Ex-Dividend: Buy the share before and you are

entitled to the dividend (cum-dividend), buy after and you don’t get the dividend

Record: Dividends are distributed to the shareowner on record as of this date Record is after Ex-Div to allow for record keeping

Payment: Check is mailed out

Record Date Payment DateDec 7thNov 5th

Declaration DateOct 25th

Ex-Dividend DateNov 2nd

Price Reaction

In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date

In the real world, the price drop within the first few minutes of the ex-div date, but it is slightly less than the dividend. WHY?

$P

$P - div

Ex-Dividend

Date

The dividend price drop

-t … -2 -1 0 +1 +2 …

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The Dividend Tradeoff Buy the stock on Friday

Get the dividend, but must pay taxes on it Buy the stock on Monday

Forgo the dividend, get the stock at the lower price The return, after taxes, needs to be the same

for selling before Ex-div as after Ex-Div or else there is an arbitrage opportunity The stock price needs to fall by the after tax

dividend amount

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Ex-Div Date Price Drop

Let pb be the stock price right before Ex-Div Let pa be the stock price right after Ex-Div If you bought at pi (pi < pb ) When do you sell

τcg be tax rate on capital gains

τp be tax rate on dividend income If you sell after the ex-dividend date you still get

dividend

Ex-Div Date Price Drop If you sell before Ex-Div, the after tax gain is:

(1- τcg)(pb – pi) If you sell after Ex-Div, the after tax gain

Cap Gain: (1- τcg)(pa – pi)

Div: (1- τp)*D The two returns must be equal or _________ (1- τcg)(pb – pi) = (1- τcg)(pa – pi) + (1- τp)*D pa = pb - (1- τp) / (1- τcg) * D

Ex-Div Date Price Drop Ex

If τp = 39%,τcg = 28%, and the Div is $5 then the price should drop by:

pa = pb - (1- τp) / (1- τcg) *D

Do Cash Dividends Affect Firm Value

Three view:

1. Cash dividend do not affect firm value

2. Cash dividend increase firm value

3. Cash dividend decrease firm value

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View 1: Cash Dividends Do Not Affect Firm Value

Since investors can exchange shares for cash, and cash for shares they will not pay a higher price for firms with higher, or lower dividend payouts

Dividend policy has no impact on firm value because investors can create whatever income stream they want with homemade dividends

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Dividend Irrelevance Assumptions

There are 4 key assumptions underlying the view1. The firm never forgoes a positive NPV project to

pay or increase dividends Forgoing a positive NPV Project destroys value

2. No taxes

3. No transactions costs

4. No uncertainty

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Homemade Dividends

Bianchi Inc.’s stock is @ $42, and is about to pay a $2 cash div

Investor Bob owns 80 shares but wants a $3 cash dividend.

How can Bob get his $3 dividend?

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Calculations80 shares Ideal World Making it Work

$3 Div $2 Div$ from DivPrice After DivShares to sell$ share saleTotal Cash

Value of Shares

Total Value

Cash Dividends are Irrelevant As we just saw while Bob wants a $3 dividend

he does not need the firm to pay $3 Bob is able to create a $3 dividend by selling

sharesIf this was reversed wanted a $2, but firm did $3

Bob would buy shares Since Bob can create whatever stream he

wants, he will not pay a premium for a firm because of its dividend stream

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Personal Taxes and Dividends

In the US currently dividends and capital gains are taxed at 15%,

But investor decide when to incur capital gains reducing the effective rate on capital gains

This difference in the effective rates implies Firms should not issue stock to pay a dividend Dividends are less valuable to investors than capital gains

While taxes make paying dividends less desirable, taxes are not large enough to eliminate dividends

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Don’t Issue Stock to Pay Dividends

FirmStock

Holders

Cash for Stock

Cash Dividends

Gov.

Taxes, on Dividend

Investment Bankers

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Issuance Costs

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View 2 Dividends Increase Firm Value

There are several ways that this can happen1. Dividends reduce risk

2. Clientele effect

3. Mangers use dividends as a signal

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Story 1: Dividends Reduce Risk

Dividends put money into investors hands If investor already have the money there is less

risk What is wrong with this argument?

Story 2: Clientele Effect Argues the existence of investor clienteles with a

preference for various dividend streams, that they are willing to pay a premium for

What is wrong with this logic

Clientele 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

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Story 3: Signals Managers know more about the firm than

investors, and use dividend to signal their inside informationA high dividend policy is costly for firms with low

cash flows → only firms with strong prospects can increase dividends, manager signals that he is confident in the firms future

Increases signal good newsCuts send bad news.

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View 3:Dividends Reduce Firm Value

Intuition: Since capital gains are taxed at a lower rate than dividend income, companies should pay the lowest dividend possible.As more money flows to Uncle Sam, less money

into our pockets Firms should only repurchase share to give

cash back to shareholders

Repurchase of Stock

Instead of paying a dividend, the firm buys its own shares back

Share repurchase have become an important way of distributing cash to shareholdersWhat role do you think stock options play in this?

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Declining Dividends

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Value of repurchases

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Types of Repurchases Open-market: Firm buy share just like any other

investor on the open market Tender: Firm offers to buy a specific numbers of

share at a premiumThis is either open to all investors or some subset

Ex. Investors with less than 500 shares

Private Negotiation: Firms buy from a block holderGenerally this is a way to make a hostile bidder go

away (Green Mail) 26

Stock Repurchase versus Dividend

$10=/100,000$1,000,000=Price per share100,000=outstanding Shares

1,000,000Value of Firm1,000,000Value of Firm1,000,000Equity850,000 AssetsOther

0Debt$150,000Cash

Equity &Liabilities Assets

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

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Cash Dividend

$9=00,000$900,000/1 = shareper Price

Shares Outstanding = 100,000

900,000Firm of Value900,000Firm of Value

900,000Equity850,000AssetsOther

0Debt$50,000Cash

If they distribute the $100,000 as a cash dividend ($1 per share), the situation changes too:

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Assets Liabilities & Equity

Stock Repurchase

Assets Liabilities & Equity

Cash $50,000 Debt 0

Other Assets 850,000 Equity 900,000

Value of Firm 900,000 Value of Firm 900,000

Shares outstanding= 90,000

Price per share = $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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Stock Repurchase versus Dividend

In the simple world there really isn’t much of a difference

In the real world with taxes, transactions cost, etc, repurchases are generally a better option

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Advantages of Repurchases

Flexibility for shareholders Keeps stock price higher

Good for insiders who hold stock options Signal that they feel the firm is undervalued Tax benefits

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What We Know About Dividends

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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Lintner’s “Stylized Dividend Facts”

1. Firms have a long term target payout ratio2. Managers focus more on dividend changes than

on levels3. Dividend changes follow shifts in long-run

earnings4. Managers are reluctant to make changes that

might have to be reversed Especially decreasing dividends

Div/Repurchase CFO Survey

CFOs indicate that:• They pay dividends because they don’t want

to cut.• 40% target $ amount• 28% target payout ratio• 4% target dividend yield.• They view shares as cheap when they

repurchase shares

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Non-Cash Dividends Stock dividends

The firm distributes shares to its current shareholdersNo Money Involved5% stock div → shareholders receives 5% more

shares Dividend in kind

The firm gives shareholders a non-cash assetNo Money InvolvedWrigley’s sends a box of chewing gum.Dundee Crematoria offers discounted cremations.

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Irrelevance of Stock Dividends Shimano USA has 2 million shares outstanding at $15

per share. The company declares a 50% stock dividend. How many shares will the company have?

What is the value of the new firm?

What is the new share price?

Shimano Investment You owned 50,000 share of Shimano, how is

your portfolio affected Value of your portfolio: before, after?

Percent of firm own: before, after?

Has anything really changed?

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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. Like with a stock dividend, the stock price

falls, but nothing really changes

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Why Pay a Stock Div or Split?

Companies generally claim to do this so that the stock price is in a “more desirable trading range”

Also a lot of people are like my motherThey think they are getting something from the

company, and it makes them feel good so they buy more shares

This artificial increase in demand increases share price

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Quick Quiz What are the different types of dividends, and

how is a dividend paid? What is the clientele effect, and how does it

affect dividend policy irrelevance? What is the information content of dividend

changes? What are stock dividends, and how do they

differ from cash dividends? How are share repurchases an alternative to

dividends, and why might investors prefer them?

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Why we care?

Example of potential financial smoke and mirrors

Better understanding of investing

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