Presentation on theme: "Corporate Taxes Value of the firm and WACC"— Presentation transcript:
0 Dividends and dividend policy Chapter 17Dividends and dividend policy
1 Corporate Taxes Value of the firm and WACC EBIT = $195 million; Tax rate = 35%; Debt = $155 million; Cost of debt = 8%; Unlevered cost of capital = 20%WACC = ?RE = ?
2 Corporate Taxes Value of the firm and WACC EBIT = $195 million; Tax rate = 35%; Debt = $155 million; Cost of debt = 8%; Unlevered cost of capital = 20%VU =975*.65 =633.75VL = *.35 = 688E = = 533WACC=(533/688)* (155/688)(.08)(.65) = = .1842RE = .2 + (.2 – .08)(155/533)(.65) = .2227
3 Value of the firm – Proposition I with Corporate Taxes EBIT = $95 million; Tax rate = 35%; Debt = $55 million; Cost of debt = 11%; Unlevered cost of capital = 22%VU =95*.65/.22=280.68VL = *.35=299.93E = – 55 =RE = (.22 – .11)(55/244.93)(.65)=.2361WACC = (244.93/299.93)* (55/299.93)(.11)(.65) = = .2059
4 Value of the firm – Proposition I with Corporate Taxes EBIT = $95 million; Tax rate = 35%; Debt = $85 million; Cost of debt = 11%; Unlevered cost of capital = 22%VU =95*.65/.22=280.68VL = *.35=310.43E = – 85 =RE = (.22 – .11)(85/225.43)(.65)=.247WACC = (225.43/310.43)* (85/310.43)(.11)(.65) = = .1990
5 Chapter Outline Cash Dividends and Dividend Payment Method of Cash Dividend PaymentDoes Dividend Policy Matter?Real-World Factors Favoring a Low Payout and High PayoutEstablishing a Dividend PolicyStock RepurchaseNot Real Dividends: Stock Dividends and Stock Splits
6 Cash DividendsRegular cash dividend – cash payments made directly to stockholders, usually each quarterExtra cash dividend – indication that the “extra” amount may not be repeated in the futureLiquidating dividend – some or all of the business has been sold
7 Dividend Reinvestment Plans (DRIPs) System that allows shareholders to automatically reinvest their dividends into the purchase of additional company sharesAdvantages for the firm:Retains cashReduces transaction costs of making the paymentsSaves on underwriting fees
8 DRIPs: advantages Advantages for the investor: Shares purchased without transaction costsDiscount – usually 3-5% to the market price
9 Dividend PaymentDeclaration Date – Board declares the dividend and it becomes a liability of the firmEx-dividend DateOccurs two business days before date of recordIf you buy stock on or after this date, you will not receive the dividendStock price generally drops by about the amount of the dividendDate of Record – Holders of record are determined and they will receive the dividend paymentDate of Payment – cheques are mailed
11 What Happens to the Price of a Stock around Ex-dividend Day?
12 Does Dividend Policy Matter? Dividends matter – the value of the stock is based on the present value of expected future dividendsDividend policy may not matterDividend policy is the decision to pay dividends versus retaining funds to reinvest in the firmIn theory, if the firm reinvests capital now, it will grow and can pay higher dividends in the future
13 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
14 Homemade DividendsDividend policy is irrelevant when there are no taxes or other market imperfectionsShareholders can effectively undo the firm’s dividend strategyThe shareholder who receives a dividend that is greater than desired can reinvest the excessThe shareholder who receives a dividend that is smaller than desired can sell extra shares of stock
15 Low Dividend PayoutIndividuals in upper income tax brackets might prefer lower dividend payouts, with the immediate tax consequences, in favor of higher capital gainsFlotation costs – low payouts can decrease the amount of capital that needs to be raised, thereby lowering total flotation costsDividend restrictions – debt contracts might limit the percentage of income that can be paid out as dividends
16 High Dividend Payout Desire for current income Individuals in low tax bracketsUncertainty resolution – no guarantee that the higher future dividends will materializeTaxesDividend exclusion for corporationsTax-exempt investors don’t have to worry about differential treatment between dividends and capital gains
17 Alternatives to Paying a Dividend Select additional capital budgeting projectsRepurchase sharesAcquire other companiesPurchase financial assets
18 Dividends and SignalsChanges in dividends convey informationAsymmetric information – managers have more information about the health of the company than investors
19 Dividend IncreasesManagement believes higher dividend can be sustainedExpectation of higher future dividends, increasing present valueSignal of a healthy, growing firm
20 Dividend DecreasesManagement believes it can no longer sustain the current level of dividendsExpectation of lower dividends indefinitely; decreasing present valueSignal of a firm that is having financial difficulties
21 Clientele EffectSome investors prefer low dividend payouts and will buy stock in those companies that offer low dividend payoutsSome investors prefer high dividend payouts and will buy stock in those companies that offer high dividend payoutsInvestors will self-select into the stocks have their preferred payout policyManagers should focus on capital budgeting decisions and ignore investor preferences
23 Residual Dividend Policy Determine capital budgetDetermine target capital structureFinance investments with a combination of debt and equity in line with the target capital structureIf there are excess earnings, then pay the remainder out in dividends
24 Residual Dividend Policy, example GivenNeed $5 million for new investmentsTarget capital structure: D/E = 2/3Net Income = $4 millionDividend - ?
25 Dividend StabilityCyclical dividend policy – dividend is a fixed fraction of earningsStable dividend policy – all dividend payments are equal
26 Compromise Dividend Policy Goals, ranked in order of importanceAvoid cutting back on positive NPV projects to pay a dividendAvoid dividend cutsAvoid the need to sell equityMaintain a target debt/equity ratioMaintain a target dividend payout ratioCompanies want to accept positive NPV projects, while avoiding negative signals
27 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 stockholdersAnother argument for dividend policy irrelevance in the absence of taxes or other imperfections
28 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 priceRepurchase by direct negotiation – a company negotiates with the major shareholder to buy back its shares
29 Information Content of Stock Repurchases Stock repurchases sends a positive signal that management believes that the current price is lowTender offers send a more positive signal than open market repurchases because the company is stating a specific priceThe stock price often increases when repurchases are announced
30 Stock Dividends Pay additional shares of stock instead of cash Increases the number of outstanding sharesIf you own 100 shares and the company declared a 10% stock dividend, you would receive an additional 10 shares
31 Effect of a 3% stock dividend Before dividendAfter dividendShares outstanding1,000,000Earnings per share$1.00Stock price$20.00P/E20Total market value$20mln.Shares owned by investor X100,000Ownership value
32 Stock SplitsStock splits – essentially the same as a stock dividend except expressed as a ratioFor example, a 2 for 1 stock split is the same as a 100% stock dividendStock price is reduced when the stock splitsCommon explanation for split is to return price to a “more desirable trading range”Reverse stock splits
33 Effect of a six-for-five stock split Before splitAfter splitShares outstanding4mln.Stock price$40.00EPS$1.50Dividends per share$0.50Dividends yield1.25%P/E26.7Market value of a company$160mln.