1. 1 Today Financing decisions Financing patterns and stock market reaction Payout policy Reading Brealey and Myers, Chapter 16, 17

2. 2 Financing decisions What is the goal? How can financing decisions create value?

3. 3 Stock Market Reaction Stock issues are bad news, but debt issues are either neutral or good news Interpretation Dilution? Signaling: what types of firms issue equity vs. debt? Firms that are overvalued Firms with relatively poor prospects Convertibles as ‘backdoor equity’

4. 4 Financing Decision Empirical summary Pecking order Firms prefer internal to external financing, and external debt to external equity Target capital structure Firms seem to have target debt ratios. Different industries view the trade-off between debt and equity differently. Investor reaction Stock offerings are bad news, debt offerings are neutral, and bank loans are good news. Prices react positively to leverage- increasing transactions.

5. 5 Payout policy Questions How do firms payout cash? What are the advantages and disadvantages of each method? How much cash should a firm hold?

6. 6 Payout methods Dividends Regular dividend Special dividend Share repurchases Open market repurchase Fixed price tender offer Dutch auction tender offer Payout policy

7. 7 Payout Policy The Choice of Payout Policy Dividend Payments and Stock Repurchases How Do Companies Decide on The Payout? Information in Dividends and Stock Repurchases The Payout Controversy The Rightists Taxes and the Radical Left The Middle of the Roaders

8. 8 Payout Policies

9. 9 Dividend & Stock Repurchases $ Billions U.S. Data 1980 - 2002

10. 10 Dividend & Stock Repurchases  Cash Div  Regular Cash Div  Special Cash Div  Stock Div  Stock Repurchase (4 methods) 1. Buy shares on the market 2. Tender Offer to Shareholders 3. Dutch Auction 4. Private Negotiation (Green Mail)

11. 11 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.

12. 12 Dividend Payments 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.

13. 13 Stock Dividend vs. Stock Split Number of shares? Assets? Total Value? Profit? Stock Price? Accounting?

14. 14 The Dividend Decision 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. Lintner’s “Stylized Facts” Survey (How Dividends are Determined)

15. 15 Dividend Policy Firm Old stockholders New stockholders Old stockholders Shares Cash Shares Dividend financed by stock issue No dividend, no stock issue

16. 16 Dividend Policy Before Dividend After Dividend New stockholders Each share worth this before … Old stockholders … 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

17. 17 How does dividend policy affect firm value?

18. 18 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 dividend payouts. In other words, dividend policy will have no impact on the value of the firm.

19. 19 Dividend Policy is Irrelevant Example - Assume Rational Demiconductor has no extra cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend. Record Date Cash1,000 Asset Value9,000 Total Value10,000+ New Proj NPV 2,000 # of Shares 1,000 price/share $12

20. 20 Dividend Policy is Irrelevant Example - Assume Rational Demiconductor has no extra cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend. Record DatePmt Date Cash1,0000 Asset Value9,0009,000 Total Value10,000+9,000 New Proj NPV 2,0002,000 # of Shares 1,0001,000 price/share $12 $11

21. 21 Dividend Policy is Irrelevant Example - Assume Rational Demiconductor has no extra cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend. Record DatePmt DatePost Pmt Cash1,00001,000 (91 sh @ $11 ) Asset Value9,0009,0009,000 Total Value10,000+9,00010,000 New Proj NPV 2,0002,000 2,000 # of Shares 1,0001,0001,091 price/share $12 $11$11 NEW SHARES ARE ISSUED

22. 22 Dividend Policy is Irrelevant Example - continued - Shareholder Value RecordPmt Post Stock12,00011,00012,000 Cash 01,000 0 Total Value12,00012,00012,000 Stock = 1,091sh @ $11 = 12,000 Assume stockholders purchase the new issue with the cash dividend proceeds.

23. 23 Dividends Increase Value Market Imperfections and Clientele Effect There are natural clients for high-payout stocks, but it does not follow that any particular firm can benefit by increasing its dividends. The high dividend clientele already have plenty of high dividend stock to choose from. These clients increase the price of the stock through their demand for a dividend paying stock.

24. 24 Dividends Increase Value Dividends as Signals Dividend increases send good news about cash flows and earnings. Dividend cuts 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 signal a company ’ s good fortune and its manager ’ s confidence in future cash flows.

25. 25 Dividends Increase Value Dividends mitigate agency problem Dividend payment solves agency problems of free cash flow. Dividend payment decrease the probability of cash manipulation by managers.

26. 26 Dividends Decrease Value Tax Consequences Companies can convert dividends into capital gains by shifting their dividend policies. If dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move and value the firm more favorably. Since capital gains are taxed at a lower rate than dividend income, companies should pay the lowest dividend possible.

27. 27 Taxes and Dividend Policy If dividends are taxed more heavily than capital gains, investors should pay more for stocks with low dividend yield

28. 28 Taxes and Dividend Policy

29. 29 Repurchases Fixed price tender offer Offer specifies a number of shares, a purchase price, and an expiration date Avg 20% premium over market price If oversubscribed, shares are purchased pro rata Management typically does not participate Example Your firm has $5 million in excess cash and the stock is trading at $50. The firm announces that it will buy, directly from shareholders, up to 80,000 shares at $60 / share. You have 30 days to tender your shares.

30. 30 Repurchases How should the price react? How should shareholders behave? Should you tender?

31. 31 Fixed price tender offers, 1962 – 1979

32. 32 Repurchases Dutch auction tender offer Offer specifies a number of shares, a price range, and an expiration date Avg range is 2% – 16% above market price Shareholders submit bids, specifying the number of shares and minimum price at which they’ll sell Repurchase price is the minimum necessary to complete the tender offer Management may or may not participate Participates 60% of the time

33. 33 Repurchases

34. 34 Stock Price Reaction

35. 35 Fraction of firms paying dividends

36. 36 Payout policy