Lecture Note 2 Dividend Policy

1
Lecture Note 2Dividend Policy
2
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

3
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

4
Types of dividends
5
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.

6
Standard Method of Cash Dividend
Cash Dividend - Payment of cash by the firm to
its 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.
Record Date Date on which company determines
existing shareholders.
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Procedure for Cash Dividend
25 Oct.
1 Nov.
2 Nov.
5 Nov.
7 Dec.

Ex-dividend Date
Declaration Date
Cum-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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Stock price
St
D Cash dividend
S0
S0
S0- De-rt
time
t Ex-dividend date
9
Stock price
St
D(1-dividend tax)
S0
S0
S0- (D (1-dividend tax)) e-rt
time
t Ex-dividend date
10
The stock price will decrease proportionally with
the amount of cash dividends.
11
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

12
Forms of Dividends
13
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.

15
Stock Repurchase versus Dividend
Consider a firm that wishes to distribute
100,000 to its shareholders.
Equity


Liabilities





Assets


Original

A.
sheet
balance
0
Debt
150,000
Cash
1,000,000
Equity
850,000
Assets
Other
1,000,000
Value of Firm
1,000,000
Value of Firm
100,000
outstanding

Shares

10

/100,000
1,000,000
Price per share


16
Stock Repurchase versus Dividend
If they distribute the 100,000 as a cash
dividend, the balance sheet will look like this
Equity



s
Liabilitie





Assets
dividend
cash

share
per

1
After

B.
0
Debt
50,000
Cash
900,000
Equity
850,000
Assets
Other
900,000
Firm

of

Value
900,000
Firm

of

Value
100,000

g
outstandin

Shares
9

00,000
900,000/1



share
per

Price
17
Stock Repurchase versus Dividend
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 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

19
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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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 isP/E 40/1.0857 36.84

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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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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 surplus 180,000
Retained earnings 586,500

Total owner's equity 776,500
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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 surplus 240,000
Retained earnings 524,000

Total owner's equity 776,500
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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.

25
????????

• 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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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

• 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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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 Theory
• Tax Preference Theory
• Dividends Preference Theory
• The 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.

37
Tax Preference Theory
38
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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Firms without Sufficient Cash
Investment Bankers
The direct costs of stock issuance will add to
this effect.
Cash stock issue
Firm
Stock Holders
Cash dividends
Taxes

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

Gov.
40
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

41
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
43
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?,???????,????????????,???????????,?????????????,?
????????????
44

• ??????????? ?????? ????????
• ?? 2317(TW) ?(2)??????,?????? ??,????????????,????
  ???? ??,????????????????????? ??,??????????,??????
  ,??? ????4.5??????????,???????

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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.

46
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
Tax preference
Set low payout
Dividends preference
Set high payout
But which, if any, is correct???
48
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
50
The Clientele Effect

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

Group
Stock Type
High Tax Bracket Individuals
Zero-to-Low payout
Low Tax Bracket Individuals
Low-to-Medium payout
Tax-Free Institutions
Medium payout
Corporations
High payout
Once the clienteles have been satisfied, a
corporation is unlikely to create value by
changing its dividend policy.
51
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.

52
The Dividend Decision
53
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.

54
The Dividend Decision Lintners Stylized Facts
(How Dividends are Determined)

• 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.

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The Dividend Decision

• Attitudes concerning dividend targets vary
• Dividend Change

56
The Dividend Decision

• 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?