The Dividend Controversy Principles of Corporate Finance Seventh Edition Richard A. Brealey Stewart C. Myers Slides by Matthew Will Chapter 16 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

16- 2 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Topics Covered  How Dividends Are Paid  How Do Companies Decide on Dividend Payments?  Information in Dividends and Stock Repurchases  The Dividend Controversy  The Rightists  Taxes and the Radical Left  The Middle of the Roaders

16- 3 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Types of Dividends  Cash Div  Regular Cash Div  Special Cash Div  Stock Div  Stock Repurchase (3 methods) 1. Buy shares on the market 2. Tender Offer to Shareholders 3. Private Negotiation (Green Mail)

16- 4 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Dividend Payments Cash Dividend - Payment of cash by the firm to its shareholders.

16- 5 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Dividend Payments Cash Dividend - Payment of cash by the firm to its shareholders. 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.

16- 6 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Dividend Payments Cash Dividend - Payment of cash by the firm to its shareholders. 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. Record Date - Person who owns stock on this date received the dividend.

16- 7 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Dividend Payments Stock Dividend - Distribution of additional shares to a firm’s stockholders.

16- 8 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Dividend Payments Stock Dividend - Distribution of additional shares to a firm’s stockholders. Stock Splits - Issue of additional shares to firm’s stockholders.

16- 9 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Dividend Payments Stock Dividend - Distribution of additional shares to a firm’s stockholders. Stock Repurchase - Firm buys back stock from its shareholders. Stock Splits - Issue of additional shares to firm’s stockholders.

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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. Lintner’s “Stylized Facts” (How Dividends are Determined)

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved The Dividend Decision  Attitudes concerning dividend targets vary  Dividend Change

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved The Dividend Decision  Dividend changes confirm the following

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Dividend Policy Source: Healy & Palepu (1988) Change EPS/Price at t = 0 as % Year Impact of Dividend Changes on EPS

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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.

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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 $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

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Dividend Policy is Irrelevant Example - continued - Shareholder Value Record Stock12,000 Cash 0 Total Value12,000 Stock = 1,000 $12 = 12,000

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Dividend Policy is Irrelevant Example - continued - Shareholder Value RecordPmt Stock12,00011,000 Cash 01,000 Total Value12,00012,000 Stock = $11 = 11,000

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Dividend Policy is Irrelevant Example - continued - Shareholder Value RecordPmt Post Stock12,00011,00012,000 Cash 01,000 0 Total Value12,00012,00012,000 Stock = $115 = 12,000  Assume stockholders purchase the new issue with the cash dividend proceeds.

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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.

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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.

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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. In such a tax environment, the total cash flow retained by the firm and/or held by shareholders will be higher than if dividends are paid.

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Taxes and Dividend Policy  Since capital gains are taxed at a lower rate than dividend income, companies should pay the lowest dividend possible.  Dividend policy should adjust to changes in the tax code.

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Taxes and Dividend Policy

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Taxes and Dividend Policy 2000 Marginal Income Tax Brackets

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Taxes and Dividend Policy In U.S., shareholders are taxed twice (figures in dollars)

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Taxes and Dividend Policy Under imputed tax systems, such as that in Australia, Shareholders receive a tax credit for the corporate tax the firm pays (figures in Australian dollars)