16 PAYOUT POLICY McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

16-1 FACTS ABOUT PAYOUT Cash Dividend versus Stock Repurchase Dividends are rarely cut back, managers do not increase dividends unless confident that dividend can be maintained Stock Repurchase Repurchases are more flexible and repurchases are tax-advantaged These are two payout policies—cash dividends and stock repurchases. Stock repurchases also give shareholders cash.

FIGURE 16.1 DIVIDEND AND STOCK REPURCHASES The histogram shows data on dividends and repurchases over the years.

16-1 FACTS ABOUT PAYOUT Dividend Payments Cash Dividend Payment of cash by firm to shareholders Ex-Dividend Date Date that determines when stockholder is entitled to dividend payment Record Date Person who owns stock on this date receives dividend Cash dividend procedure needs to be explained. Shareholders get a check in the mail. The firm’s board of directors declares the dividend. Generally, the stock price falls by the amount of the dividend on the ex-dividend date. The payment will be made to all stockholders who are registered on the record date. Firms are not allowed to pay a dividend out of legal capital, which is generally defined as the par value of outstanding shares. Checks are mailed to the shareholders on the payment date.

16-1 FACTS ABOUT PAYOUT Dividend Payments Stock Dividend Stock Splits Distribution of additional shares to firm’s stockholders Stock Splits Issue of additional shares to firm’s stockholders Stock Repurchase Firm buys back stock from its shareholders Additional terminology associated with dividend payment is provided. A 5% stock dividend means that the firm will send five extra shares to each shareholder for every 100 shares currently owned. For example, a 2-for-1 stock split means that shareholders will receive one new share for every two shares currently owned. A stock split resembles stock dividends, but usually it is much larger.

FIGURE 16.2 EXXON MOBIL'S DIVIDENd January 5, 2012 February 8, 2012 February 10, 2012 March 9, 2012 Exxon Mobil declares quarterly dividend of $.42 per share Shares start to trade ex- dividend Dividend checks mailed to shareholders Dividend will be paid to shareholders registered on this date Declaration date Ex-dividend date Record date Payment date It is sometimes difficult for students to grasp the concept of ex-dividend. It might be beneficial to review this slide along with a handwritten example of how the stock price changes when a stock goes ex-dividend. Show how the removal of cash from a firm reduces its value.

16-1 FACTS ABOUT PAYOUT Types of Dividends Cash Dividend Regular Cash Dividend Special Cash Dividend Stock Dividend Stock Repurchase (4 methods) Buy Shares on Market Tender Offer to Shareholders Dutch Auction Private Negotiation (greenmail) Various types of dividends paid by firms are shown. There are four methods for stock repurchase: Buy shares in the open market, tender offer to shareholders, Dutch auction process, and private negotiation (greenmail). Stock repurchases have increased in recent years.

FIGURE 16.3 DIVIDEND POLICY SURVEY 2004 This is the result of a survey of financial executives.

16-2 INFORMATION CONTENT OF DIVIDEND AND REPURCHASES Payout Decision Managers are reluctant to make dividend changes that may be reversed Managers worry about rescinding dividend increases and raising new funds to maintain payout John Lintner has developed a simple model which is consistent with the above observations and explains dividend payments well. This model suggests that the dividend depends partly on the firm’s current earnings and partly on the dividend for the previous year. Current dividends are related to a weighted average of current earnings and past earnings.

16-2 INFORMATION CONTENT OF DIVIDEND and REPURCHASES Payout Decision To avoid risk of reduction in payout, managers “smooth” dividends Dividend changes follow shifts in long-run sustainable earnings Transitory earnings changes unlikely to affect dividend payouts John Lintner has developed a simple model which is consistent with the above observations and explains dividend payments well. This model suggests that the dividend depends partly on the firm’s current earnings and partly on the dividend for the previous year. Current dividends are related to a weighted average of current earnings and past earnings.

16-2 INFORMATION CONTENT OF DIVIDEND and REPURCHASES Payout Decisions Managers focus on dividend changes over absolute levels Paying a dividend of $2.00 per share is important if last year's dividend was $1.50 Paying a dividend of $2.00 is not important if last year's dividend was $2.00 John Lintner has developed a simple model, which is consistent with the above observations and explains dividend payments well. This model suggests that the dividend depends partly on the firm’s current earnings and partly on the dividend for the previous year. Current dividends are related to a weighted average of current earnings and past earnings.

16-2 INFORMATION CONTENT OF DIVIDEND and REPURCHASES Information Content of Dividends Dividend stock repurchase decisions contain information Information contained in decisions vary Asymmetric information may be conveyed Dividend increases could mean overpriced stock or increased future profits Signal varies based on prior information about company Review some aspects of signaling hypotheses. It would be helpful at this point to provide two opposing examples of how the market reacts differently to the same announcement from different companies. My favorite example is the decline in the price of Microsoft in the aftermath of its first-ever dividend and then the increase in price related to almost any utility making the same announcement.

16-2 INFORMATION CONTENT OF DIVIDEND and REPURCHASES Information in Payouts Varying attitudes toward dividend targets DIV1 = target dividend = target ratio × EPS1 Dividend change DIV1 – DIV0 = target change = target ratio × EPS1 – DIV0 Formula for dividend targets and dividend change.

16-2 INFORMATION CONTENT OF DIVIDEND and REPURCHASES Information in Payouts Dividend changes confirm thefollowing DIV1 – DIV0 = adjustment rate × target change = adjustment rate × target ratio × EPS1 – DIV0 Formula for what dividend changes confirm.

16-3 DIVIDENDS OR REPURCHASES? PAYOUT CONTROVERSY Rational Demiconductor balance sheet example.

16-3 DIVIDENDS OR REPURCHASES? PAYOUT CONTROVERSY Rational Demiconductor balance sheet example, continued.

16-3 DIVIDENDS OR REPURCHASES? PAYOUT CONTROVERSY Important Repurchases Calculate Market Capitalization Done by forecasting and discounting free cash flow paid to shareholders To calculate share price, divide market capitalization by number of outstanding shares Calculate Value of Dividends Per Share Account for increased dividend growth rate per share Caused by declining number of shares as shares are repurchased

16-3 DIVIDENDS OR REPURCHASES? PAYOUT CONTROVERSY Rational Demiconductor balance sheet example, ex-dividend in year 0.

16-3 DIVIDENDS OR REPURCHASES? PAYOUT CONTROVERSY Change EPS/price at t = 0 as % The graph shows the effect of dividend changes on EPS. 1 2 3 4 5 6 7 8 9 10 Year

FIGURE 16.4 DIVIDEND POLICY This explains the Modigliani-Miller proposition on dividends. Dividend policy is irrelevant in perfect capital markets. This is proved using homemade dividend argument.

FIGURE 16.5 DIVIDEND POLICY This explains the Modigliani-Miller proposition on dividends.

16-4 THE RIGHTISTS Dividend Policy Is Irrelevant Investors do not need dividends to convert shares to cash They will not pay higher prices for firms with higher dividend payouts Dividend policy will have no impact on value of firm Here Modigliani-Miller proposition is stated.

16-4 THE RIGHTISTS Dividend Theories Leftists Dividends do not affect value Rightists Dividends increase value Middle of Roaders Leftist theory with some reality thrown in Describe the three dividend theories. Note that the residual is not defined. Provide a basic definition, but leave the details until the last slide, where a graph is provided to show how the residual dividend policy works. Simply stated, the residual dividend policy says the firm should pay a dividend of all money left over when all positive NPV projects have been funded.

16-4 THE RIGHTISTS Market Imperfections Clientele Effect Natural clients high-payout stocks Firms can not benefit by increasing dividends High-dividend clientele have several high- dividend stocks to choose from Clients increase price of stock through demand for dividend-paying stock This is called the clientele effect. For example: shareholders in high tax brackets prefer low-dividend paying stocks and shareholders in low tax brackets prefer high-dividend paying stocks.

16-4 THE RIGHTISTS Dividends Increase Value Dividend increases send good news about cash-flow earnings Dividend cuts send bad news High-dividend payout policy will be costly to firms that do not have cash flow to support it Dividend increases signal company’s good fortune Increase in manager’s confidence in future cash flow Dividend payment or nonpayment sends good and bad news, respectively. Similarly dividend initiation implies good news, and dividend stoppage implies bad news. Dividend increase or initiation is good news. Dividend reduction or stoppage is bad news. Dividend payments send information on the manager’s confidence in future cash flows.

16-5 TAXES AND RADICAL LEFT Taxes and Dividend Policy Capital gains taxed at lower rate than dividend income so companies should pay lowest dividend possible Dividend policy should adjust to changes in tax code If tax rates on dividends are higher than capital gains, then low-dividend payments increase the value of the firm. Dividend policy should adjust to changes in the tax code.

TABLE 16.1 TAXES DIVIDEND POLICY Returns to Shareholders Taxed Twice The income tax code given by the IRS. Shareholders in the U.S. face double taxation.

TABLE 16.2 TAXES DIVIDEND POLICY Australian Tax Credit to Shareholders Shareholders in Australia receive a credit on the taxes paid by the firm. A shareholder in the 15% tax bracket gets a tax credit of A$15 and a shareholder in the 47% tax bracket pays only A$17 in taxes. A shareholder in the 30% tax bracket does not pay any taxes.

FIGURE 16.6 DIVIDEND THEORIES Apple's Growth 2002-2012 The residual dividend policy is displayed. The x-axis represents the cumulative dollars invested by a company when it accepts projects in descending order of IRR. MRI is the marginal return on investments (which equates to the IRR) for each of the projects available, in descending order. Be sure to explain that when the firm accepts the next project where the IRR is below the firm COC, the firm is destroying value since the shareholder’s opportunity cost of capital is the COC. As such, they should not take on projects with IRR below the COC and instead pay the remaining funds as a dividend.