Week 11 Lecture 11 Ross, Westerfield and Jordan 7e Chapter 18 Dividends and Dividend Policy

Last Week.. Capital Structure Effect of Financial Leverage M&M propositions I and II Case 1 – No Costs Case 2 – With Taxes Case 3 – With Taxes and Bankruptcy Costs Bankruptcy Costs Direct & Indirect Optimal Capital Structure

Chapter 18 Outline Cash Dividends and Dividend Payment Does Dividend Policy Matter? Some Real-World Factors Favoring a Low Payout Some Real-World Factors Favoring a High Payout A Resolution of Real-World Factors Establishing a Dividend Policy Stock Repurchase: An Alternative to Cash Dividends Stock Dividends and Stock Splits

Cash Dividends Regular cash dividend Extra cash dividend – cash payments made directly to stockholders, usually each quarter Extra cash dividend – indication that the “extra” amount may not be repeated in the future Special cash dividend – similar to extra dividend, but definitely won’t be repeated Liquidating dividend – some or all of the business has been sold

Dividend Payment - Chronology Declaration Date Board declares the dividend and it becomes a liability of the firm Ex-dividend Date Two business days before date of record Stock bought on or after this date, will not receive the dividend Stock price generally drops by about the amount of the dividend Date of Record Holders of record are determined Date of Payment Cheques are mailed

Figure 18.2 - Price Behavior around ex date

Example 18.1 Divided 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?

Example 18.1 continued.. Purchase: Tuesday 2nd of May Ex date: Friday 5th of May Saturday 6th do not count Sunday 7th Monday 8th of May Date of record: Tuesday 9th of May Checks mailed: Tuesday 30th of May 2nd 5th 9th 30th Purchase Ex-date Record date Payment

Example 18.1 continued.. Value of stock around ex-dividend date $150 $147.50 -t . . . 0 . . . t $2.50 ex-dividend price drop Investor’s wealth at dividend payment date: $147.50 x 100 shares = $14,750 $2.50 x 100 shares = $250 Total = $15,000

Does Dividends and Dividend Policy Matter? Dividends matter!!!!! the value of the stock is based on the present value of expected future dividends Dividend policy may not matter Pay larger dividends and reinvest less vs Pay smaller dividends and retain funds to reinvest more in the firm In theory, if the firm reinvests capital now, it will grow and can pay higher dividends in the future

Irrelevance Theory Modigliani 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 taxes A fixed capital budgeting program The value of a firm: is determined by the earning power of the firm’s assets is not affected how the income is split between dividends and retained earnings.

Illustration of Irrelevance Palm Inc. is a firm with 2 year life and 100 shares Policy 1: pay out dividends of $100 each year Policy 2: pay $90 dividend year 1, reinvest the other $10 into the firm and then pay $111.20 next year. Investors require a 12% return. Which policy is the best? It doesn’t matter !! Value is the same Market Value with constant dividend = $16,900.51 PV = 10,000 / 1.12 + 10,000 / 1.122 = 16,900.51 Market Value with reinvestment = $16,900.51 PV = 9000 / 1.12 + 11,120 / 1.122 = 16,900.51

Irrelevance of Dividend Policy - Example Operating CF = $10,000; Net Investment = $8,000 Shares Outstanding = 1,000 Shares; Price per share = $42. Firm has a finite life. Bianchi Inc. Policy 1 Policy 2 $2 Div. $3 Div Dividends 2,000 $3,000 Ex-dividend Price per share $40 $39 New Equity Issued $0 $1,000 Shares Outstanding 1,000 1,025.64 Value of the Firm $40,000 $40,000 ($40 x 1000) ($39 x 1025.64)

Homemade 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

Homemade Dividend - Example A company has a choice between 2 dividend policies. Req. rate of return is 10% The company implements Policy 2 – pay $110 now Investor X prefers Policy 1 – he wants $100 each year Homemade 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 1 Policy 2 Year 1 $100 $110 Year 2 $89

Homemade 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-dividend if co. pays $2 Dividend homemade dividends Cash from dividend $160 Cash from selling stock $80 Total Cash Desired $240 Value of Stock Holdings $40 × 78 = $3,120 Total Wealth $3,360 same as if co. paid $3 Dividend $240 $0 $39 × 80 = $3,120 $3,360

Dividend 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 = $3,360 After a $3 dividend, his total wealth is still $3,360: $240 + (80 shares x $39) = $3,360 After 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) = $3,360 19

Contrary 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.

Low 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 liability Flotation costs – low payouts can decrease the amount of capital that needs to be raised, thereby lowering flotation costs Dividend restrictions – debt contracts might limit the percentage of income that can be paid out as dividends

High Payout Please Why might a high payout be desirable? 1)Desire for current income Individuals that need current income, i.e. retirees Groups that are prohibited from spending principal (trusts and endowments) 2)Uncertainty resolution – no guarantee that the higher future dividends will materialize 3)Taxes Dividend income taxed less for corporation shareholders Tax-exempt investors don’t have to worry about differential treatment between dividends and capital gains

Dividends and Signals Asymmetric information – managers have more information about the health of the company than investors Information Content Effect > Changes in dividends convey information > Cause market reaction Dividend increases Management believes it can be sustained Expectation of higher future dividends, increasing present value Signal of a healthy, growing firm Dividend decreases Management believes it can no longer sustain the current level of dividends Expectation of lower dividends indefinitely; decreasing present value Signal of a firm that is having financial difficulties

Clientele Effect Some investors prefer low dividend payouts and will buy stock in those companies that offer low dividend payouts Some investors prefer high dividend payouts and will buy stock in those companies that offer high dividend payouts If a firms changes the dividend policy from low to high or vice versa, it doesn’t matter!!

Types of Dividend Policies Residual dividend policy Constant growth dividend policy – dividends increased at a constant rate each year Constant payout ratio – pay a constant percent of earnings each year Compromise dividend policy Dividend Reinvestment Plans – DRPs

Residual Dividend Policy Determine capital budget Determine target capital structure Finance investments with a combination of debt and equity in line with the target capital structure Remember that retained earnings are equity If additional equity is needed, issue new shares If there are excess earnings, then pay the remainder out in dividends

Example – Residual Dividend Policy Given Need $5 million for new investments Target capital structure: D/E = 2/3 Net Income = $4 million Finding dividend 40% financed with debt (2 million) 60% financed with equity (3 million) Net Income – equity financing = $1 million, paid out as dividends

Dividend Stability Strict Residual Policy may lead to very unstable dividend payout Depends on profitable investment opportunities When earnings are seasonal, quarterly dividends can vary Eg. Department stores before/after Christmas Stable dividend policy is in the interest of the firm and its shareholders. Decrease uncertainty of future dividends

Compromise Dividend Policy Goals, ranked in order of importance Avoid cutting back on positive NPV projects to pay a dividend Avoid dividend cuts Avoid the need to sell equity Maintain a target debt/equity ratio Maintain a target dividend payout ratio Companies want to accept positive NPV projects, while avoiding negative signals

Dividend Reinvestment Plans - DRPs Cash dividends are used to buy additional newly issued shares in the company Advantages to the Company: cheap and effective means of raising capital and conserving cash promotes good shareholder relations Disadvantages to the company: administration costs promotion of the plan may lead to excessive capital raising

Dividend Reinvestment Plans - DRPs Benefits to Investors taxation benefits flexibility savings program no transaction costs involved sometimes offered at a discount Disadvantages to investors non-participants get diluted when participants get new shares at a discount. comprehensive records to be maintained no control over the reinvestment price

Stock Repurchase Company buys back its own shares of stock Tender offer – company states a purchase price and a desired number of shares Open market – buys stock in the open market Similar to a cash dividend in that it returns cash from the firm to the stockholders Supports the argument for dividend policy irrelevance in the absence of taxes or other imperfections In a world with taxes, repurchases may be more desirable due to the options provided to stockholders

Stock Repurchase vs Dividend Consider a firm that wishes to distribute $100,000 to its shareholders. - Pay dividends or Repurchase Shares??.. $10 = /100,000 $1,000,000 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 Assets 15

Stock Repurchase vs Dividend If they distribute the $100,000 as 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 Assets 16

Stock Repurchase vs Dividend If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this: Assets Li abilities & 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

Stock Dividends Pay additional shares of stock instead of cash Increases the number of outstanding shares Small 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+ %) = 110 New price = old $/(1+ %) = $27.27 Same value as before: $3000

Stock Splits Stock splits – essentially the same as a stock dividend except expressed as a ratio Stock price is reduced when the stock splits If have 100 shares @ $30 each A 2 for 1 stock split is the same as a 100% stock div. New nr of shares = old nr. x (new nr./old nr.) = 200 New price = old $ x (old/ new) = $15 Common explanation for split is to return price to a “more desirable trading range” Reverse split – number of share is reduced If same data and have a 1 for 2 reverse split: New nr of shares = old nr. x (new nr./old nr) = 50 New price = old $ x (old/ new) = $60

Conclusion Dividends 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.

End Chapter 18