8Different Types of Dividends Regular Cash DividendAd Hoc Cash DividendLiquidating DividendStock DividendsDividend in Kind
9Procedure for Cash Dividend 25 Oct.1 Nov.2 Nov.5 Nov.7 Dec.…Declaration DateCum-dividend DateEx-dividend DateRecord DatePayment DateDeclaration 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.
10Price BehaviorIn a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date.-t … …$P$P - divThe price drops by the amount of the cash dividend.Ex-dividend DateTaxes complicate things a bit. Empirically, the price drop is less than the dividend and occurs within a few minutes of the ex-date.
11The Irrelevance of Dividend Policy A compelling case can be made that 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 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.
12Dividends 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.”
13Personal Taxes, Issuance Costs, and Dividends To get the result that dividend policy is irrelevant, we needed three assumptions:No taxesNo transactions costsNo uncertaintyIn 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.The dividend and capital gains tax rates are subject to change at the discretion of Congress.
14Taxes, Issuance Costs, 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.
15Empirical Facts What are the empirical facts about dividends? Significant amount of dividends paid out of earnings.Individuals in high tax brackets receive large amounts of dividend income and pay a significant amount of tax on it.Corporations smooth dividendsThe market reacts positively (negatively) to announcements of dividend increases (decreases).
16Real-World Factors Favoring High Dividends Desire for Current IncomeBehavioral FinanceIt forces investors to be disciplined.Tax ArbitrageInvestors can create positions in high dividend yield securities that avoid tax liabilities.Agency CostsHigh dividends reduce free cash flow.
18The Clientele EffectClienteles for various dividend payout policies are likely to form in the following way:GroupStock TypeHigh Tax Bracket IndividualsZero-to-Low payoutLow Tax Bracket IndividualsLow-to-Medium payoutTax-Free InstitutionsMedium payoutCorporationsHigh payoutOnce the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy.
19What We Know and Do Not Know Corporations “smooth” dividends.Dividends provide information to the market.Firms should follow a sensible dividend policy:Don’t 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.
20Stock Dividends Pay additional shares of stock instead of cash Increases the number of outstanding sharesSmall stock dividendLess 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%
21Stock SplitsStock 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.Stock price is reduced when the stock splits.Common explanation for split is to return price to a “more desirable trading range.”www: Click on the web surfer icon to find out about upcoming stock splits and dividends
25Discounted Dividend Model (DDM) MotivationDividends are the cash flows derived from common stock.The price is the present value of cash flows.Thus, the price of a common share should be the present value of its dividendsProblemsDividends (especially far future ones) are not easily estimated.25
26Discounted Dividend Model (DDM) Three Possible Assumptions about Dividends:They are constant (No-Growth Assumption).They are always changing at a constant rate (Constant Growth Assumption).Neither of the above two conditions applies (Non-Constant Assumption).26
27No-Growth AssumptionIf a stock is always expected to produce an unchanging dividend, then it is merely a perpetuity.27
28No-Growth AssumptionIf a stock is always expected to pay an annual dividend of $4.00 and r = 7%, then28
29Constant Growth Assumption If a stock is always expected to produce an dividend that is changing at a constant rate, then it is merely a growing perpetuity.29
30No-Growth AssumptionIf a stock has just paid an annual dividend of $4.00, and the dividend is expected to increase (infinitely) at 2% (r = 7%), then30
31No-Growth AssumptionThe same methodology applies if the dividend is expected to decline.If a stock has just paid an annual dividend of $4.00, and the dividend is expected to decrease (infinitely) at 2% (r = 7%), then31
32Non-Constant Assumption While both of these assumptions are possible, they are not likely to apply to very many firms.Instead, we would expect the firm’s dividend to change at different rates over time.A high growth firm might increase is cash flows at 30% for a few years, but this could not be sustained for any extended period.32
33Non-Constant Assumption But if we were to try to estimate the dividends of a firm year-by-year for an extended period, e.g., ten years, this would become a pure, unfounded guess at values.What will the dividend be for IBM 8 years from now?33
34Non-Constant Assumption To alleviate this problem, we divide the forecast of dividends into two periods:Short Term Prediction/HorizonLong Term Prediction/HorizonShort Term Long Term123td0d1d2d3dt34
35Non-Constant Assumption The Short TermThis is the period over which we can rationally estimate the expected dividends either:As specific dollar amounts, orE.g., $ $ $ $4.90As subject to some growth predictionE.g., $4.00 growing at 10%Dividend ‘Smoothing’35
36Non-Constant Assumption The Long TermBy definition the ‘Long Term’ is the period over which we cannot predict dividends.We cannot ignore the long term, since for many firms the long term provides much of the value of the firm.NOTE: The more a firm’s value is derived from the future the harder it will be to use the DDM as a valuation method.36
37Non-Constant Assumption The Long Term SolutionWe estimate the long term dividends as growing at a reasonable, constant growth rate.That is we estimate long term dividends as a growing perpetuity.Since the growth is assumed to continue infinitely, it cannot be very large.One good estimate for the long term growth rate is the estimated long term growth for the economy as a whole, perhaps 3 or 4%.37
38Non-Constant Assumption Calculations:1) The present value of the short term dividends is the discounted value of the individual dividends.2) The present value of the long term dividends is a delayed growing perpetuity.It is a delayed growing perpetuity because the long term dividends do not begin until after the short term dividends end.3) The price of the stock is the sum of the present values of the short and long term dividends.38
39Non-Constant Assumption EXAMPLEA firm has just paid an annual dividend of $2.00. That dividend is expected to grow at a rate of 30% for one year, 20% for the next two years, then level off to a long term growth rate of 3%. If the discount rate is 12%, what should be the price of the stock?39
45Non-Constant Assumption EXAMPLEData: d0 = 2; g1 = 30%; g2-3 = 20%; g4+ = 3%; r = 12%orShort Term Long Term45
46Capital Asset Pricing Model (CAPM) In a later lecture we shall discuss the Capital Asset Pricing Model (CAPM).This model does not directly estimate the price for common equity.Instead, it is a model for estimating the return on equity, but should be mentioned here given its affinity to issues in stock valuation.46
51‘Implied’ Required Rate of Return The term ‘implied’ sometimes has a semi-technical meaning in finance.As we have seen, we more often than not use a formula of the form:Price = …The goal is to find appropriate input variable to determine the price of an asset.We can then compare the price predicted by the model with the market value of the asset.51
52‘Implied’ Required Rate of Return An alternative use of these formulae would be to use the market price to estimate what the ‘market’ assumes to be one of the input variable, i.e., what is the ‘implied’ variable.We have already used this approach in our yield to maturity calculations for bonds.In that calculation, we ask, given the market price of a bond, what ‘implied’ discount rate, i.e., YTM, must the market be using to discount the cash flows of the bond to arrive at the market price.YTM is the implied required rate of return on a bond.52
53‘Implied’ Required Rate of Return We can use the formulae in this lecture to find the analogous ‘implied’ required rate of return on a stock.If the stock (common or preferred) is modeled as a perpetuity, we can solve the equation for the required rate of return:or53
54‘Implied’ Required Rate of Return ExampleIf a share is selling for $75 and it is paying a constant, annual dividend of $6.00, then54
55‘Implied’ Required Rate of Return If the stock dividends are not constant, then estimating the implied required rate of return requires us to find the internal rate of return (IRR) of the stock.The IRR calculation will be covered in the next lecture, but is essentially identical to finding the YTM of a bond.55