Lecture: 12 Course Code: MBF702 Investment Analysis Lecture: 12 Course Code: MBF702

Outline RECAP Dividend Types of Dividend Dividends a financing decision Dividend payments Stock dividend Dividend versus interest obligations Dividend policy Dividend policy in practice Alternatives to paying a dividend

Definitions A scrip dividend is a dividend payment which takes the form of new share instead of cash, it converts profit reserves into issued share capital. A scrip or bonus issue (also referred to as capitalization issue) involves the issue of new shares to existing shareholders in proportion to their existing holdings.

Types of Dividends Dividends are a permanent distribution of residual earnings/property of the corporation to its owners. Dividends can be in the form of: Cash Additional Shares of Stock (stock dividend) Property If a firm is dissolved, at the end of the process, a final dividend of any residual amount is made to the shareholders – this is known as a liquidating dividend.

Dividends a Financing Decision In the absence of dividends, corporate earnings accrue to the benefit of shareholders as retained earnings and are automatically reinvested in the firm. When a cash dividend is declared, those funds leave the firm permanently and irreversibly. Distribution of earnings as dividends may starve the company of funds required for growth and expansion, and this may cause the firm to seek additional external capital. Corporate Profits After Tax Retained Earnings Dividends

Dividend Payments Mechanics of Cash Dividend Payments Declaration Date this is the date on which the Board of Directors meet and declare the dividend. In their resolution the Board will set the date of record, the date of payment and the amount of the dividend for each share class. when CARRIED, this resolution makes the dividend a current liability for the firm. Date of Record is the date on which the shareholders register is closed after the trading day and all those who are listed will receive the dividend. Ex dividend Date is the date that the value of the firm’s common shares will reflect the dividend payment (ie. fall in value) ‘ex’ means without. At the start of trading on the ex-dividend date, the share price will normally open for trading at the previous days close, less the value of the dividend per share. This reflects the fact that purchasers of the stock on the ex-dividend date and beyond WILL NOT receive the declared dividend. Date of Payment is the date the cheques for the dividend are mailed out to the shareholders.

Dividend Declaration Time Line Declaration Date Date of Record Payment Ex Dividend Date is determined by the Date of Record. The market value of the shares drops by the value of the dividend per share on market opening…compared to the previous day’s close. The Board Meets and passes the motion to create the dividend 2 business days prior to the Date of Record

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%

Dividend Payments Stock Dividends Stock dividends simply amount to distribution of additional shares to existing shareholders They represent nothing more than recapitalization of earnings of the company. (that is, the amount of the stock dividend is transferred from the R/E account to the common share account. Because of the capital impairment rule stock dividends reduce the firm’s ability to pay dividends in the future.

Stock Splits Stock splits – essentially the same as a stock dividend except 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

When should a firm consider splitting its stock? There’s a widespread belief that the optimal price range for stocks is $20 to $80. Stock splits can be used to keep the price in the optimal range. Stock splits generally occur when management is confident, so are interpreted as positive signals.

Dividend Payments Stock Dividends Implications reduction in the R/E account reduced capacity to pay future dividends proportionate share ownership remains unchanged shareholder’s wealth (theoretically) is unaffected Effect on the Company conserves cash serves to lower the market value of firm’s stock modestly promotes wider distribution of shares to the extent that current owners divest themselves of shares...because they have more adjusts the capital accounts dilutes EPS Effect on Shareholders proportion of ownership remains unchanged total value of holdings remains unchanged if former DPS is maintained, this really represents an increased dividend payout

Dividends versus Interest Obligations Interest is a payment to lenders for the use of their funds for a given period of time Timely payment of the required amount of interest is a legal obligation Failure to pay interest (and fulfill other contractual commitments under the bond indenture or loan contract) is an act of bankruptcy and the lender has recourse through the courts to seek remedies Secured lenders (bondholders) have the first claim on the firm’s assets in the case of dissolution or in the case of bankruptcy Dividends A dividend is a discretionary payment made to shareholders The decision to distribute dividends is solely the responsibility of the board of directors Shareholders are residual claimants of the firm (they have the last, and residual claim on assets on dissolution and on profits after all other claims have been fully satisfied)

Dividend Policy Dividends, Shareholders and the Board of Directors There is no legal obligation for firms to pay dividends to common shareholders Shareholders cannot force a Board of Directors to declare a dividend, and courts will not interfere with the BOD’s right to make the dividend decision because: Board members are jointly and severally liable for any damages they may cause Board members are constrained by legal rules affecting dividends including: Not paying dividends out of capital Not paying dividends when that decision could cause the firm to become insolvent Not paying dividends in contravention of contractual commitments (such as debt covenant agreements)

Dividend policy The primary objective of a dividend policy of a company is to maximize shareholder wealth which depends on both the current dividends & capital gain. The major reasons for using retained earnings to finance new investments rather than to pay higher dividends & then borrow or raise more equity to finance the projects are as follows: Using funds from retained earnings means that the project can be undertaken without the involvement of either the shareholders or any outsider. It saves issue cost which would have been incurred if new equity had been issued. it avoids the possibility of change in control of the entity , a risk that usually follows issue of equity.

Does 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 Dividend policy is the decision to pay dividends versus retaining funds to reinvest in the firm In theory, if the firm reinvests capital now, it will grow and can pay higher dividends in the future

Why Dividend Policy Doesn’t Matter? Consider a firm that can either pay out dividends of $10,000 per year for each of the next two years or can pay $9,000 in one year, reinvest the other $1,000 into the firm and then pay $11,120 in two years. Investors require a 12% return. Market Value with constant dividend: Market Value with reinvestment: If the company will earn the required return, then it doesn’t matter when it pays the dividends

Homemade Dividends Dividend policy is irrelevant when there are no taxes or other market imperfections Shareholders can effectively undo the firm’s dividend strategy The shareholder who receives a dividend that is greater than desired can reinvest the excess The shareholder who receives a dividend that is smaller than desired can sell extra shares of stock

Low Dividend Payout Individuals in upper income tax brackets might prefer lower dividend payouts, with the immediate tax consequences, in favor of higher capital gains Flotation costs – low payouts can decrease the amount of capital that needs to be raised, thereby lowering total flotation costs Dividend restrictions – debt contracts might limit the percentage of income that can be paid out as dividends

High Dividend Payout Desire for current income Individuals in low tax brackets Uncertainty resolution – no guarantee that the higher future dividends will materialize Taxes Dividend exclusion for corporations Tax-exempt investors don’t have to worry about differential treatment between dividends and capital gains

Dividends and Signals Signaling Effects: dividends declared by a company serve as a signal to the shareholders of the financial performance & future prospects It is important to maintain a constant stream Asymmetric information – managers have more information about the health of the company than investors Changes in dividends convey information Dividend increases Management believes it can be sustained Expectation of higher future dividends, increasing present value Signal of a healthy, growing firm

Dividends and Signals 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 The company can influence its cliental by way of its dividend policy, it can lead to the following advantages: - Attracts high profile clients - Resist takeovers if there are large corporate entities who have invested for long term strategic purposes rather than for short term profit making

Clientele Effect Cliental Effect: A shareholder makes gain in two ways - Dividend Capital Gain

Implications of the Clientele Effect What do you think will happen if a firm changes its policy from a high payout to a low payout? What do you think will happen if a firm changes its policy from a low payout to a high payout? If this is the case, does dividend POLICY matter? If a firm changes its policy, it will just have different investors. Consequently, dividend policy won’t affect the value of the stock.

Dividend Policy in Practice 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 We will talk about the residual policy and the compromise policy in more detail Given the information content of dividends, will a constant growth policy be good for the stockholders? Given the information content of dividends – will a constant payout ratio be good for stockholders?

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) NI – equity financing = $1 million, paid out as dividends Remind students how to get % debt and % equity given D/E: If D/E = 2/3, then V = 2 + 3 = 5, so D/V = 2/5 = 40% and E/V = 3/5 = 60%

Dividend Stability Cyclical dividend policy – dividend is a fixed fraction of earnings Stable dividend policy – all dividend payments are equal

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

Alternatives to Paying a Dividend Select additional capital budgeting projects Repurchase shares Acquire other companies Purchase financial assets

Stock Repurchase Company buys back its own shares of stock Similar to a cash dividend in that it returns cash from the firm to the stockholders Another argument for dividend policy irrelevance in the absence of taxes or other imperfections

Repurchase methods Buy in the open market Buy back a fixed number of shares at a fixed price – a company will make a tender offer to repurchase a specific number of shares, typically at a premium to the market price Repurchase by direct negotiation – a company negotiates with the major shareholder to buy back its shares

Information Content of Stock Repurchases Stock repurchases sends a positive signal that management believes that the current price is low Tender offers send a more positive signal than open market repurchases because the company is stating a specific price The stock price often increases when repurchases are announced

Advantages of Repurchases Stockholders can tender or not. Helps avoid setting a high dividend that cannot be maintained. Repurchased stock can be used in take-overs or resold to raise cash as needed. Income received is capital gains rather than higher-taxed dividends. Stockholders may take as a positive signal--management thinks stock is undervalued.

Disadvantages of Repurchases May be viewed as a negative signal (firm has poor investment opportunities). Selling stockholders may not be well informed, hence be treated unfairly. Firm may have to bid up price to complete purchase, thus paying too much for its own stock.

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