Presentation on theme: "Last Week.. Capital Structure Effect of Financial Leverage"— Presentation transcript:
0Week 11 Lecture 11 Ross, Westerfield and Jordan 7e Chapter 18 Dividends and Dividend Policy
1Last Week.. Capital Structure Effect of Financial Leverage M&M propositions I and IICase 1 – No CostsCase 2 – With TaxesCase 3 – With Taxes and Bankruptcy CostsBankruptcy CostsDirect & IndirectOptimal Capital Structure
2Chapter 18 Outline Cash Dividends and Dividend Payment Does Dividend Policy Matter?Some Real-World Factors Favoring a Low PayoutSome Real-World Factors Favoring a High PayoutA Resolution of Real-World FactorsEstablishing a Dividend PolicyStock Repurchase: An Alternative to Cash DividendsStock Dividends and Stock Splits
3Cash Dividends Regular cash dividend Extra cash dividend – cash payments made directly to stockholders, usually each quarterExtra cash dividend– indication that the “extra” amount may not be repeated in the futureSpecial cash dividend– similar to extra dividend, but definitely won’t be repeatedLiquidating dividend– some or all of the business has been sold
4Dividend Payment - Chronology Declaration DateBoard declares the dividend and it becomes a liability of the firmEx-dividend DateTwo business days before date of recordStock bought on or after this date, will not receive the dividendStock price generally drops by about the amount of the dividendDate of RecordHolders of record are determinedDate of PaymentCheques are mailed
6Example 18.1Divided Airlines has declared a $2.50 dividend per share payable on Tuesday, May 30, to shareholders of record as of Tuesday, May 9.An investor buys 100 shares of this company on Tuesday May 2 for $150 each.What is the ex date? What are the events happening with respect to the dividend and stock price?
7Example 18.1 continued.. Purchase: Tuesday 2nd of May Ex date: Friday 5th of MaySaturday 6th do not countSunday 7thMonday 8th of MayDate of record: Tuesday 9th of MayChecks mailed: Tuesday 30th of May2nd th th 30thPurchase Ex-date Record date Payment
8Example 18.1 continued.. Value of stock around ex-dividend date $ $147.50-t t$2.50 ex-dividend price dropInvestor’s wealth at dividend payment date:$ x 100 shares = $14,750$2.50 x 100 shares = $250Total = $15,000
9Does Dividends and Dividend Policy Matter? Dividends matter!!!!!the value of the stock is based on the present value of expected future dividendsDividend policy may not matterPay larger dividends and reinvest less vsPay smaller dividends and retain funds to reinvest more in the firmIn theory, if the firm reinvests capital now, it will grow and can pay higher dividends in the future
10Irrelevance TheoryModigliani and Miller’s (1961) irrelevance theory makes use of home-made dividends and relies on a number of assumptions:No company taxes, no transaction costs or market imperfections.No personal taxesA fixed capital budgeting programThe value of a firm:is determined by the earning power of the firm’s assetsis not affected how the income is split between dividends and retained earnings.
11Illustration of Irrelevance Palm Inc. is a firm with 2 year life and 100 sharesPolicy 1: pay out dividends of $100 each yearPolicy 2: pay $90 dividend year 1, reinvest the other $10 into the firm and then pay $ next year. Investors require a 12% return.Which policy is the best?It doesn’t matter !! Value is the sameMarket Value with constant dividend = $16,900.51PV = 10,000 / ,000 / = 16,900.51Market Value with reinvestment = $16,900.51PV = 9000 / ,120 / = 16,900.51
12Irrelevance of Dividend Policy - Example Operating CF = $10,000; Net Investment = $8,000Shares Outstanding = 1,000 Shares;Price per share = $42. Firm has a finite life.Bianchi Inc. Policy 1 Policy 2$2 Div. $3 DivDividends 2,000 $3,000Ex-dividend Price per share $40 $39New Equity Issued $0 $1,000Shares Outstanding 1,000 1,025.64Value of the Firm $40,000 $40,000($40 x 1000) ($39 x )
13Homemade Dividend Policy Investors 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 because investors can create whatever income stream they prefer by using homemade dividends.Homemade Dividend Policy = Tailored dividend policy created by individual investors to undo corporate dividend policy
14Homemade Dividend - Example A company has a choice between 2 dividend policies. Req. rate of return is 10%The company implements Policy 2 – pay $110 nowInvestor X prefers Policy 1 – he wants $100 each yearHomemade Dividend:X can retain only $100 and reinvest the extra $10.At 10% it will grow to $11.In year 2, X receives 89+11= 100, the desired amount.Policy 1Policy 2Year 1$100$110Year 2$89
15Homemade Dividends - Example Bianchi Inc. (slide 12) is a $42 stock about to pay a $2 dividend.Bob Investor owns 80 shares and prefers $3 dividend.Bob’s homemade dividend strategy:Sell 2 shares ex-dividendif co. pays $2 Dividendhomemade dividendsCash from dividend $160Cash from selling stock $80Total Cash Desired $240Value of Stock Holdings $40 × 78 =$3,120Total Wealth $3,360same as if co. paid$3 Dividend$240$0$39 × 80 =$3,120$3,360
16Dividend Policy is Irrelevant Since investors do not need dividends to convert shares to cash, dividend policy will have no impact on the value of the firm.In the above example, Bob Investor began with total wealth of $3,360:80 shares x $42 = $3,360After a $3 dividend, his total wealth is still $3,360:$240 + (80 shares x $39) = $3,360After a $2 dividend, and sale of 2 ex-dividend shares, his total wealth is still $3,360:$160 + (2 shares x $40) + (78 shares x $40) = $3,36019
17Contrary Views Others believe dividend policy is relevant. They argue that:investors prefer high dividend policy because dividends are cash, and so are less risky than capital gains that depend on future market sentiment.Differential tax treatment for dividends and capital gains can either favour or penalise a dividend policy.
18Low Payout Please Why might a low payout be desirable? Individuals in upper income tax brackets might prefer lower dividend payouts, given the immediate tax liability, in favor of higher capital gains with the deferred tax liabilityFlotation costs – low payouts can decrease the amount of capital that needs to be raised, thereby lowering flotation costsDividend restrictions – debt contracts might limit the percentage of income that can be paid out as dividends
19High Payout Please Why might a high payout be desirable? 1)Desire for current incomeIndividuals that need current income, i.e. retireesGroups that are prohibited from spending principal (trusts and endowments)2)Uncertainty resolution – no guarantee that the higher future dividends will materialize3)TaxesDividend income taxed less for corporation shareholdersTax-exempt investors don’t have to worry about differential treatment between dividends and capital gains
20Dividends and SignalsAsymmetric information – managers have more information about the health of the company than investorsInformation Content Effect > Changes in dividends convey information > Cause market reactionDividend increasesManagement believes it can be sustainedExpectation of higher future dividends, increasing present valueSignal of a healthy, growing firmDividend decreasesManagement believes it can no longer sustain the current level of dividendsExpectation of lower dividends indefinitely; decreasing present valueSignal of a firm that is having financial difficulties
21Clientele EffectSome investors prefer low dividend payouts and will buy stock in those companies that offer low dividend payoutsSome investors prefer high dividend payouts and will buy stock in those companies that offer high dividend payoutsIf a firms changes the dividend policy from low to high or vice versa, it doesn’t matter!!
22Types of Dividend Policies Residual dividend policyConstant growth dividend policy – dividends increased at a constant rate each yearConstant payout ratio – pay a constant percent of earnings each yearCompromise dividend policyDividend Reinvestment Plans – DRPs
23Residual Dividend Policy Determine capital budgetDetermine target capital structureFinance investments with a combination of debt and equity in line with the target capital structureRemember that retained earnings are equityIf additional equity is needed, issue new sharesIf there are excess earnings, then pay the remainder out in dividends
24Example – Residual Dividend Policy GivenNeed $5 million for new investmentsTarget capital structure: D/E = 2/3Net Income = $4 millionFinding dividend40% financed with debt (2 million)60% financed with equity (3 million)Net Income – equity financing = $1 million, paid out as dividends
25Dividend StabilityStrict Residual Policy may lead to very unstable dividend payoutDepends on profitable investment opportunitiesWhen earnings are seasonal, quarterly dividends can varyEg. Department stores before/after ChristmasStable dividend policy is in the interest of the firm and its shareholders.Decrease uncertainty of future dividends
26Compromise Dividend Policy Goals, ranked in order of importanceAvoid cutting back on positive NPV projects to pay a dividendAvoid dividend cutsAvoid the need to sell equityMaintain a target debt/equity ratioMaintain a target dividend payout ratioCompanies want to accept positive NPV projects, while avoiding negative signals
27Dividend Reinvestment Plans - DRPs Cash dividends are used to buy additional newly issued shares in the companyAdvantages to the Company:cheap and effective means of raising capital and conserving cashpromotes good shareholder relationsDisadvantages to the company:administration costspromotion of the planmay lead to excessive capital raising
28Dividend Reinvestment Plans - DRPs Benefits to Investorstaxation benefitsflexibilitysavings programno transaction costs involvedsometimes offered at a discountDisadvantages to investorsnon-participants get diluted when participants get new shares at a discount.comprehensive records to be maintainedno control over the reinvestment price
29Stock Repurchase Company buys back its own shares of stock Tender offer – company states a purchase price and a desired number of sharesOpen market – buys stock in the open marketSimilar to a cash dividend in that it returns cash from the firm to the stockholdersSupports the argument for dividend policy irrelevance in the absence of taxes or other imperfectionsIn a world with taxes, repurchases may be more desirable due to the options provided to stockholders
30Stock Repurchase vs Dividend Consider a firm that wishes to distribute $100,000 to its shareholders.- Pay dividends or Repurchase Shares??..$10=/100,000$1,000,000Price per share100,000outstandingShares1,000,000Value of FirmEquity850,000assetsOtherDebt$150,000CashsheetbalanceOriginalA.&LiabilitiesAssets15
31Stock Repurchase vs Dividend If they distribute the $100,000 as cash dividend, the balance sheet will look like this:$9=00,000$900,000/1shareperPrice100,000outstandingShares900,000FirmofValueEquity850,000assetsOtherDebt$50,000Cashdividendcash$1AfterB.&LiabilitiesAssets16
32Stock Repurchase vs Dividend If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:AssetsLiabilities&EquityC.After stock repurchaseCash$50,000DebtOther assets850,000900,000Value of FirmShares outstanding=90,000Price pershare$900,000/$1017
33Stock DividendsPay additional shares of stock instead of cashIncreases the number of outstanding sharesSmall stock dividend – less than 20 to 25%Large stock dividend – more than 20 to 25%If you own 100 shares, at $30 each, and the company declared a 10% stock dividend:New total shares = old shares x (1+ %) = 110New price = old $/(1+ %) = $27.27Same value as before: $3000
34Stock SplitsStock splits – essentially the same as a stock dividend except expressed as a ratioStock price is reduced when the stock splitsIf have 100 $30 eachA 2 for 1 stock split is the same as a 100% stock div.New nr of shares = old nr. x (new nr./old nr.) = 200New price = old $ x (old/ new) = $15Common explanation for split is to return price to a “more desirable trading range”Reverse split – number of share is reducedIf same data and have a 1 for 2 reverse split:New nr of shares = old nr. x (new nr./old nr) = 50New price = old $ x (old/ new) = $60
35ConclusionDividends are important because the value of a share is determined by expectations about future dividends.There is no ideal dividend policy. Boards must determine the dividend policy that best suits the type of business they are in, and the economic conditions they face.