© Prentice Hall, Chapter 15 Dividend Policy Shapiro and Balbirer: Modern Corporate Finance: A Multidisciplinary Approach to Value Creation Graphics by Peeradej Supmonchai

© Prentice Hall, Learning Objectives è Explain the procedures for cash dividends, and discuss the legal and Internal Revenue Service constraints on dividend payments. è Describe the difference and similarities between stock dividends and stock splits. è Discuss the rationale for share repurchases. è Explain why dividend policy is irrelevant in perfect markets. è Explain how taxes and agency costs make dividend policy relevant. è List the factors that a firm should consider when setting its dividend policy.

© Prentice Hall, Dividend Payment Procedures è Declaration Date è Holder-of-Record Date è Ex-Dividend Date è Payment Date

© Prentice Hall, Dividend Payment Procedures - Time Line Declaration Date Ex-dividend Date Holder-of-Record Date Payment Date

© Prentice Hall, Constraints on Dividend Payments è Restrictive covenants in debt and preferred stock agreements è Net profits rule è Capital impairment rule è Insolvency rule è Penalty taxes on retained earnings

© Prentice Hall, Approaches to Dividend Policy è Pure Residual Policy è Smoothed Residual Policy è Constant Payout Policy

© Prentice Hall, Dividend Policies in Practice è Most US companies tend to follow the smoothed residual approach. è Dividend cuts are infrequent. è After-tax earnings are more volatile than dividends. è Dividend changes lag earnings changes.

© Prentice Hall, Stock Dividends and Stock Splits è Stock Dividends - Payment of additional shares to common stockholders. A 10% stock dividend means that shareholders get 1 additional share for every 10 they own. è Stock Splits - A proportionate increase in the number of common shares. A 2:1 stock split means that stockholders will receive one additional share for every one they own.

© Prentice Hall, Reasons for Stock Dividends and Stock Splits è Stock dividends conserve cash while still maintaining a record of dividends. è Keep share in “popular” trading range in order to appeal to small investors. è Signals management’s confidence in the future. However, increases in stock price will be transitory unless management delivers results.

© Prentice Hall, Stock Repurchase A way for a firm to distribute cash to shareholders by buying back its own stock. The share repurchase is essentially a liquidating dividend for those stockholders who opt to sell their shares.

© Prentice Hall, Methods of Share Repurchase è Tender Offer è Open Market Purchases è Private Transactions - Often associated with greenmail

© Prentice Hall, Reasons for Share Repurchase è Tax Benefits - Dividends are taxed as ordinary income; repurchases are taxed as capital gains. IRS might regard regular share repurchases as a dividend and tax them accordingly. è Signal of Management’s Confidence

© Prentice Hall, MM Dividend Irrelevance Proposition In perfect capital markets, dividend policy is irrelevant in the sense that it cannot effect shareholder value. The effect of any dividend policy can be offset by management adjusting the sale of new stock or by investors adjusting their dividend stream through stock purchases or sales.

© Prentice Hall, Dividend Irrelevance - MicroGeneral Balance Sheet (Market Values) Cash$ 2,000Debt$ 4,000 Fixed Assets$ 5,000 Growth Opportunities*$ 3,000Equity$ 6,000 Total Assets$10,000Value of Firm$10,000 * The value of future opportunities to invest in positive NPV projects

© Prentice Hall, Dividend Irrelevance - MicroGeneral MicroGeneral needs $2,000 in cash to invest in growth opportunities. Each share is worth $60. Suppose management decides to pay a dividend of $10 a share for a total of $1,000. Total assets drop to $9,000 giving the firm a net worth of $5,000. The new price of the stock is $50 a share, a decline of $10 a share.

© Prentice Hall, Dividend Irrelevance - MicroGeneral Holding capital structure constant, MicroGeneral must raise $1,000 in new equity by issuing 20 new shares at $50 a share for a total of $1,000. MicroGeneral’s new balance sheet will look identical to the old except that the equity account will list 120 shares. MicroGeneral’s old stockholders’ wealth position remains the same since the value of their shares ($5,000) plus the dividend of $1,000 equals their original position.

© Prentice Hall, Signaling With Dividends Much of the data we have on a firm is accounting-based. To the extent that this information is incomplete, dividends may have communications value if investors value this information, and the information cannot be communicated by any other means

© Prentice Hall, Bird-in-the-Hand Argument An argument for paying dividends based on the idea that since investors are risk-averse, they prefer a stream of relatively certain dividends over uncertain capital gains. This argument confuses the investment and dividend decision.

© Prentice Hall, Dividends and Taxes In the real world, dividends are taxed at a significantly higher rate than capital gains. This tax treatment favors retentions (and capital gains) over dividends.

© Prentice Hall, Dividends and Taxes - An Example Suppose that tax on dividend income for the highest earning individual is 39.6%, whereas, capital gains are taxed at 20%. What are the differences in valuation for a firm that pays no dividends, and one that pays out all of its earnings in dividends?

© Prentice Hall, Dividends and Taxes - An Example Company A B Dividend Payout Ratio 0%100% Income Available to Shareholder E E Investors’ After Tax Return0.80E0.604E After-Tax Required Return on Equity r r Market Value of the Equity0.80E/r0.604E/r

© Prentice Hall, The Case for Tax Neutrality of Dividends Dividends help those investors who need current income and would incur transaction costs to sell off part of their holdings. Each investor, therefore, trades off the trans- action cost benefits of dividends against the tax disadvantages.

© Prentice Hall, The Case for Tax Neutrality of Dividends Investors sort themselves into three “clienteles”: è those that prefer dividends è those that are indifferent towards dividends è those that are averse to dividends Thus, companies don’t have to worry about their payout policy since clienteles will select the payout policy that serves them best.

© Prentice Hall, Agency Costs and the Case for Dividends è Dividends eliminate some of the in- formation asymmetries underlying the shareholder - manager agency conflict. è Dividend payments reduce management’s control over free cash flow.

© Prentice Hall, Setting Dividend Policy Firms should ask the following questions when establishing dividend policy: è What are our investment opportunities? è What kind of business risk do we face? è Who are our stockholders? è What is our liquidity position? è Is legal listing important to us? è Is control an issue?