1. Dividend Policy “I tell you Wellington is a bad general, the English are bad soldiers: We will settle the matter by lunch time” –Napolean Bonaparte Waterloo, June 18, 1815

2. Dividend Policy - Outline  What are dividends?  Managers and Dividend Decisions  Dividends as Signals  Dividend irrelevance (M&M)  Taxes and dividends

3. Related Ideas Stock Repurchase - Firm buys back stock from its shareholders. Stock Dividend - Distribution of additional shares to a firm’s stockholders. Stock Splits - Issue of additional shares to firm’s stockholders.

4. Dividend Payments Record Date - Person who owns stock on this date received the dividend. Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend. Cash Dividend - Payment of cash by the firm to its shareholders.

5. Managers and Dividend Decisions 1. Firms have long-run target payout ratios. 2. Managers focus more on dividend changes than on levels. Thus, paying a $2 dividend is a major decision if last year's dividend was $1 but no big deal if it was $2. 3. Dividend changes follow shifts in sustainable earnings. Managers smooth dividends. Transitory earnings changes are unlikely to affect payouts. 4. Managers are reluctant to make changes that may have to be reversed. They are particularly worried about having to rescind an increase.

6. Dividend Decisions Executives who agree or strongly agree (%) Dividend Decision Survey (2004)

7. Dividends as signals The way companies set dividends makes dividends an important signal of management's view of future profits Typically, therefore, companies which make cuts are poor performers, and vice versa Focus is more on changes than levels

8. Dividends Can Increase Value Dividends as Signals Dividend increases can send good news about cash flows and earnings. Dividend cuts can send bad news. Because a high dividend payout policy will be costly to firms that do not have the cash flow to support it, dividend increases can signal a company’s good fortune and its manager’s confidence in future cash flows.

9. Stock price rises when firms start paying dividends Source: Asquith & Mullins (1983) Abnormal performance %

10. The Dividend Question If investment policy and capital structure are held constant, how does a change in dividend policy affect the value of the firm?

11. Dividend tradeoff Suppose firm announces extra dividend. Where does the cash come from? 1. Capital investment tradeoff 2. Capital structure tradeoff 3. Dividend policy tradeoff Invest less in cash in real assets Borrow more Issue shares or repurchase fewer (1) (2) (3)

12. The Modigliani and Miller (M&M) Dividend Irrelevance Argument Every firm is subject to a cash flow ‘sources and uses’ constraint: SourcesUses EarningsEInvestmentI External financeXDividendsD TotalE + XTotalI + D Given existing E and debt usage, if a firm increases D and holds I constant, then it must find the cash by issuing new equity. Then the firm is simply recycling cash.

13. Share Valuation and Dividend Irrelevance The sources and uses constraint implies that, if investment is unchanged, any dividend increase must be matched by an increase in external finance Some part of the future dividend stream is diverted to the newly issued shares If the new shares are sold at a fair price, the present value of the diverted dividends will be equal to the amount of money raised (which in turn equal the amount of the dividend increase) The old shareholders gain by the increased dividend and lose through their reduced share of subsequent dividends Since investors do not need dividends to convert shares to cash they 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

14. Dividend Policy Before Dividend After Dividend New stockhol ders Each share worth this before … Old stockhol ders … and worth this after Total value of firm Total number of shares Example of 1/3 rd of worth paid as dividend and raising money via new shares

15. Dividend policy is irrelevant in perfect markets 1. STARTING BALANCE SHEET Cash 1000 Equity 10,000 Fixed assets 9000 Note: Equity value = no. of shares x share price 10,000 = 1000 x 10 2. FIND PROJECT Investment = 1000 NPV = 2000 Cash 1000 Equity 12,000 Fixed assets 9000 NPV 2000 SHARE PRICE INCREASES TO $12

16. Dividend Policy Example - Continued An alternative strategy 3. PAY DIVIDEND OF $1 PER SHARE Fixed assets 9000 Equity 11,000 = NPV 2000 1000 x 11 AND 4. RAISE NEW SHARES AND INVEST Fixed assets 10,000 Equity 12,000 = NPV 2000 1091 x 11 WHICH WOULD YOU PREFER? One share for $12 OR One share for $11 plus a dividend of $1?

17. Share valuation and dividend irrelevance 1 2 3 Dividends 10 10 10 PV = 10/.1 = 100 Company pays extra 10 dividend in Year 1 and issues new stock worth 10 1 2 3 Total dividends 20 10 10 Divs diverted 1 1 to new shares Divs on initial 20 9 9 shares PV = 20 + 9 + 9 +... 1.1 1.1 2 1.1 3 = 100

18. Implications If MM idea held, firms would not worry if one year’s bad earnings meant that they had to cut dividends - there would be no need to maintain liquidity to ensure a dividend in any year - there would be no need to set dividends at a ‘conservative’ level to be sure they can be maintained. But firms in practice worry a great deal about changing dividends and in particular about cutting them.

19. Objections to dividend irrelevance? n Dividends are like birds in the hand. Capital gains are birds in the bush. n There is a clientele of investors that want high dividends (eg retirees, endowments) -Low yield stock will attract high-tax-payers (though they may hold some high yield stocks to improve diversification). - Low-tax-payers will be least unhappy to hold high yield stocks.

20. Why do shareholders seem to like high dividends? Dividends may be signals... AND WHY DO THEY PRESSURE MANAGERS FOR HIGH DIVIDENDS? Is it that they don’t trust managers to spend the money wisely?

21. Why dividends may matter: Taxes Idea: if dividends are taxed more heavily than capital gains, the firm would lower the tax burden on its owners by lowering the payout ratio (and reducing share issues or increasing share repurchase). Implications: - The cost of equity increases with the dividend yield (to equalize after-tax returns to shareholders) - This raises the question of why pay dividends at all and why are managers so reluctant to cut dividends.

22. Dividend & Stock Repurchases $ Billions U.S. Data 1980 - 2005

23. Taxes and Dividend Policy If capital gains are taxed at a lower rate than dividend income, companies should pay the lowest dividend possible. Historically, there have been times when US tax law has favored capital gains over dividends. Currently, qualified dividends are taxed at a top rate of 15% like capital gains. But, capital gains are taxed only when realized. Dividend policy should adjust to changes in the tax code. Next change could come in early 2013!