FIN 360: Corporate Finance Topic 13: Distributions to Shareholders Larry Schrenk, Instructor

Topics Dividends Stock Repurchases Stock Splits

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. Some companies declare a dividend in kind. Wrigley’s Gum sends a box of chewing gum. Dundee Crematoria offers shareholders discounted cremations.

Procedure for Cash Dividend 25 Oct. 1 Nov. 2 Nov. 5 Nov. 7 Dec. … Declaration Date Cum-Dividend Date Ex-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 this date.

Price Behavior In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date. -t … -2 -1 0 +1 +2 … $P $P - div The price drops by the amount of the cash dividend. Ex-Dividend Date

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.

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. Bob’s 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 $39 × 80 = $3,120

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: 19

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.”

Repurchase of Stock 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.

Stock Repurchase versus Dividend Consider a firm that wishes to distribute $100,000 to its shareholders. $10 = /100,000 $1,000,000 Price per share 100,000 outstanding Shares 1,000,000 Value of Firm Equity 850,000 Assets Other Debt $150,000 Cash sheet balance Original A. & Liabilities 15

Stock Repurchase versus Dividend If they distribute the $100,000 as a cash dividend, the balance sheet will look like this: $9 = 00,000 $900,000/1 share per Price 100,000 outstanding Shares 900,000 Firm of Value Equity 850,000 Assets Other Debt $50,000 Cash dividend cash $1 After B. & Liabilities 16

Stock Repurchase versus Dividend If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this: Assets Liabilities & Equity C. After stock repurchase Cash $50,000 Debt Other Assets 850,000 900,000 Value of Firm Shares outstanding = 90,000 Price per share $900,000 / $10 17

Share Repurchase Flexibility for Shareholders Keeps Stock Price Higher Good for insiders who hold stock options As an Investment of the Firm Tax Benefits

Personal Taxes, Issuance Costs, 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. The dividend and capital gains tax rates are subject to change at the discretion of Congress.

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

Taxes, 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.

Real-World Factors Favoring High Dividends Desire for Current Income Behavioral Finance It forces investors to be disciplined. Tax Arbitrage Investors can create positions in high dividend yield securities that avoid tax liabilities. Agency Costs High dividends reduce free cash flow.

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.

What 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.

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%

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.” www: Click on the web surfer icon to find out about upcoming stock splits and dividends