1. Prof. Roy Sembel, Ph.D LECTURE NOTE Prof. Roy Sembel, PhD Smart_WISDOM@yahoogroups.com

2. Prof. Roy Sembel, Ph.D Return = Capital Gain Dividend Yield Recall: Stock Returns P 1 - Po + D 1 P 1 - Po + D 1 Po Po P 1 - Po D 1 P 1 - Po D 1 Po Po Po Po +=

3. Prof. Roy Sembel, Ph.D Dilemma: Should the firm use retained earnings for: a) Financing profitable capital investments? b) Paying dividends to stockholders?

4. Prof. Roy Sembel, Ph.D Dividend Policy: Why Does It Matter? WHY PUBLICLY LISTED COMPANIES PAY DIVIDEND ?

5. Prof. Roy Sembel, Ph.D Dividend Policy in The Real World n Reasons for Low Dividend –Personal Taxes –High Issuing Costs n Reasons for High Dividend –Information Asymmetry »Dividends as a signal about firm’s future performance –Lower Agency Costs »capital market as a monitoring device »reduce free cash flow, and hence wasteful spending –Bird-in-the-hand: Theory or Fallacy? »Uncertainty resolution –Desire for Current Income n Clientele Effect

6. Prof. Roy Sembel, Ph.D n If we retain earnings for profitable investments, dividend yield will be zero, but the stock price will increase, resulting in a higher capital gain. P 1 - Po D 1 P 1 - Po D 1 Po Po Po Po + Return =

7. Prof. Roy Sembel, Ph.D n If we pay dividends, stockholders receive an immediate cash reward for investing, but the capital gain will decrease, since this cash is not invested in the firm. P 1 - Po D 1 P 1 - Po D 1 Po Po Po Po + Return =

8. Prof. Roy Sembel, Ph.D So, dividend policy really involves 2 decisions: n How much of the firm’s earnings should be distributed to shareholders as dividends, and n How much should be retained for capital investment.

9. Prof. Roy Sembel, Ph.D Is Dividend Policy Important? Three viewpoints: 1) Dividends are Irrelevant. If we assume perfect markets (no taxes, no transactions costs, etc.) dividends do not matter. If we pay a dividend, shareholders’ dividend yield rises, but capital gains decrease.

10. Prof. Roy Sembel, Ph.D n Dividend irrelevance: In perfect markets, an increase in dividends means less money will be invested, so the growth rate declines. n The increase in D 1 is offset by the decrease in g. n Consequently, dividend policy does not affect stock price. Po = D 1 kc - g

11. Prof. Roy Sembel, Ph.D n Dividend irrelevance: In perfect markets, investors do not care if returns come in the form of dividend yields or capital gains. P 1 - Po D 1 P 1 - Po D 1 Po Po Po Po + Return =

12. Prof. Roy Sembel, Ph.D n Dividend irrelevance: In perfect markets, investors do not care if returns come in the form of dividend yields or capital gains. P 1 - Po D 1 P 1 - Po D 1 Po Po Po Po + Return =

13. Prof. Roy Sembel, Ph.D n Dividend irrelevance: In perfect markets, investors do not care if returns come in the form of dividend yields or capital gains. P 1 - Po D 1 P 1 - Po D 1 Po Po Po Po + Return =

14. Prof. Roy Sembel, Ph.D 2) High Dividends are Best n Some investors may prefer a certain dividend now over a risky expected capital gain in the future. P 1 - Po D 1 P 1 - Po D 1 Po Po Po Po + Return =

15. Prof. Roy Sembel, Ph.D 3) Low Dividends are Best n Dividends are taxed immediately. Capital gains are not taxed until the stock is sold. n Therefore, taxes on capital gains can be deferred indefinitely.

16. Prof. Roy Sembel, Ph.D Do Dividends Matter? Other Considerations: 1) Residual Dividend Theory: n The firm pays a dividend only if it has retained earnings left after financing all profitable investment opportunities. n This would maximize capital gains for stockholders and minimize flotation costs of issuing new common stock.

17. Prof. Roy Sembel, Ph.D Do Dividends Matter? 2) Clientele Effects: n Different investor clienteles prefer different dividend payout levels. n Some firms, such as utilities, pay out over 70% of their earnings as dividends. These attract a clientele that prefers high dividends. n Growth-oriented firms which pay low (or no) dividends attract a clientele that prefers price appreciation to dividends.

18. Prof. Roy Sembel, Ph.D Do Dividends Matter? 3) Information Effects: n Raising a firm’s dividend usually causes the stock price to rise and decreasing the dividend causes the stock price to fall. n Dividend changes convey information to the market concerning the firm’s future prospects.

19. Prof. Roy Sembel, Ph.D Do Dividends Matter? 4) Agency Costs: n Paying dividends may reduce agency costs between managers and shareholders. n Paying dividends reduces retained earnings and forces the firm to raise external equity financing. n Raising external equity subjects the firm to scrutiny of regulators (SEC) and investors and therefore helps monitor the performance of managers.

20. Prof. Roy Sembel, Ph.D Do Dividends Matter? 5) Expectations Theory: n Investors form expectations concerning the amount of a firm’s upcoming dividend. n Expectations are based on past dividends, expected earnings, investment and financing decisions, the economy, etc. n The stock price will likely react if the actual dividend is different from the expected dividend.

21. Prof. Roy Sembel, Ph.D Dividend Policies 1) Constant Payout Ratio Policy: if directors declare a constant payout ratio of, for example, 30%, then for every dollar of earnings available to stockholders, 30 cents would be paid out as dividends. the ratio remains constant over time, but the dollar value of dividends changes as earnings change.

22. Prof. Roy Sembel, Ph.D Dividend Policies 2) Stable Dollar Dividend Policy: the firm tries to pay a fixed dollar dividend each quarter. n firms and stockholders prefer stable dividends. Decreasing the dividend sends a negative signal!

23. Prof. Roy Sembel, Ph.D Dividend Policies 3) Small Regular Dividend plus Year-End Extras n the firm pays a stable quarterly dividend and includes an extra year-end dividend in prosperous years. n By identifying the year-end dividend as “extra,” directors hope to avoid signaling that this is a permanent dividend.

24. Prof. Roy Sembel, Ph.D Dividend Payments 1) Declaration Date: the board of directors declares the dividend, determines the amount of the dividend, and decides on the payment date. Jan.4 Jan.28 Feb.1 Mar. 11 Declare Ex-div. Record Payment dividend date date date

25. Prof. Roy Sembel, Ph.D Dividend Payments 2) Ex-Dividend Date: To receive the dividend, you have to buy the stock before the ex-dividend date. On this date, the stock begins trading “ex- dividend” and the stock price falls approximately by the amount of the dividend. Jan.4 Jan.28 Feb.1 Mar. 11 Declare Ex-div. Record Payment dividend date date date

26. Prof. Roy Sembel, Ph.D Dividend Payments 3) Date of Record: 4 days after the ex- dividend date, the firm receives the list of stockholders eligible for the dividend. n often, a bank trust department acts as registrar and maintains this list for the firm. Jan.4 Jan.28 Feb.1 Mar. 11 Declare Ex-div. Record Payment dividend date date date

27. Prof. Roy Sembel, Ph.D Dividend Payments 4) Payment Date: date on which the firm mails the dividend checks to the shareholders of record. Jan.4 Jan.28 Feb.1 Mar. 11 Declare Ex-div. Record Payment dividend date date date

28. Prof. Roy Sembel, Ph.D Stock Dividends and Stock Splits n Stock dividend: payment of additional shares of stock to common stockholders. n Example: Citizens Bancorporation of Maryland announced a 5% stock dividend to all shareholders of record on March 27, 1987. For each 100 shares held, shareholders received another 5 shares. n Did the shareholders’ wealth increase?

29. Prof. Roy Sembel, Ph.D Stock Dividends and Stock Splits n Stock Split: the firm increases the number of shares outstanding and reduces the price of each share. n Example: Joule, Inc. announced a 3-for-2 stock split. For each 100 shares held, shareholders received another 50 shares. n Does this increase shareholder wealth? n Are a stock dividend and a stock split the same?

30. Prof. Roy Sembel, Ph.D Stock Dividends and Stock Splits n Stock Splits and Stock Dividends are economically the same: the number of shares outstanding increases and the price of each share drops. The value of the firm does not change. n Example: A 3-for-2 stock split is the same as a 50% stock dividend. For each 100 shares held, shareholders receive another 50 shares.

31. Prof. Roy Sembel, Ph.D Stock Dividends and Stock Splits n Effects on Shareholder Wealth: these will cut the company “pie” into more pieces but will not create wealth. A 100% stock dividend (or a 2-for-1 stock split) gives shareholders 2 half-sized pieces for each full-sized piece they previously owned. n For example, this would double the number of shares, but would cause a $60 stock price to fall to $30.

32. Prof. Roy Sembel, Ph.D Stock Dividends and Stock Splits n Why bother? n Proponents argue that these are used to reduce high stock prices to a “more popular” trading range (generally $15 to $70 per share). n Opponents argue that most stocks are purchased by institutional investors who have $millions to invest and are indifferent to price levels. Plus, stock splits and stock dividends are expensive!

33. Prof. Roy Sembel, Ph.D Stock Dividend Example n shares outstanding: 1,000,000 n net income = $6,000,000; P/E = 10 n 25% stock dividend. n An investor has 120 shares. Does the value of the investor’s shares change?

34. Prof. Roy Sembel, Ph.D Before the 25% stock dividend: n EPS = 6,000,000/1,000,000 = $6 n P/E = P/6 = 10, so P = $60 per share. n Value = $60 x 120 shares = $7,200 After the 25% stock dividend: n # shares = 1,000,000 x 1.25 = 1,250,000. n EPS = 6,000,000/1,250,000 = $4.80 n P/E = P/4.80 = 10, so P = $48 per share. n Investor now has 120 x 1.25 = 150 shares. n Value = $48 x 150 = $7,200

35. Prof. Roy Sembel, Ph.D Stock Repurchases n Stock Repurchases may be a good substitute for cash dividends. n If the firm has excess cash, why not buy back common stock?

36. Prof. Roy Sembel, Ph.D Stock Repurchases n Repurchases drive up the stock price, producing capital gains for shareholders. n Repurchases increase leverage, and can be used to move toward the optimal capital structure. n Repurchases signal positive information to the market - which increases stock price.

37. Prof. Roy Sembel, Ph.D Stock Repurchases n Repurchases may be used to avoid a hostile takeover. Example: T. Boone Pickens attempted raids on Phillips Petroleum and Unocal in 1985. Both were unsuccessful because the target firms undertook stock repurchases.

38. Prof. Roy Sembel, Ph.D Stock Repurchases Methods: n Buy shares in the open market through a broker. n Buy a large block by negotiating the purchase with a large block holder, usually an institution. (targeted stock repurchase) n Tender offer: offer to pay a specific price to all current stockholders.