Ch.19 Dividends and Other Payouts Payout policy Ch.19 Dividends and Other Payouts McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

Introduction Corporations can return cash to their shareholders by various payout policies How financial managers decide on the amount and form of payout?

Introduction Corporations can return cash to their shareholders by various payout policies How financial managers decide on the amount and form of payout? Can the wrong dividend policy bankrupt a firm? E.g. of Studebaker Corporation in the US. Automobile industry in 1920’s. The firm’s president believed that dividends alone could increase the value of the stock and increases dividend payout ratio (Div/EPS). However, the sales and earnings decreased. The firm’s financial health was damaged significantly by the generous dividend policy, and it filed for bankruptcy in March, 1933.

A. Different Types of Payouts Dividend: a cash distribution of earnings. Types: Regular cash dividends: in form of cash Stock repurchase Stock dividend Stock split

Dividends in the form of cash Regular cash dividend – normal dividends, usually paid on a quarterly basis Extra cash dividend or Special dividend – paid over and above the regular dividend, may or may not be repeated. Occurs typically When a company has exceptionally strong earnings that it wishes to distribute to shareholders. or when it wishes to make changes to its financial structure (moving to more debt-based).

Standard Method of Cash Dividend 25 Oct. 2 Nov. 5 Nov. 7 Dec. … Declaration Date The stock is trade cum dividend Ex-dividend Date Record Date Payment Date Declaration Date: The Board of Directors declares a payment of dividends. Record Date: The corporation prepares a list of all individuals believed to be stockholders as of 5 November. Record date: all record reaches, but the dividend is not paid. Ex-Dividend Date: occurs 2-3 days prior to the Record day. If purchase the stock on or after, receive no dividend. Payment Date: Checks are mailed.

Price Behavior -t … -2 -1 0 +1 +2 … $P $P - div In a perfect world (no tax, no transaction cost), the stock price will fall by the amount of the dividend on the ex-dividend date. -t … -2 -1 0 +1 +2 … $P $P - div - P1=P0- div (1-t) The price drops by the amount of the cash dividend. Ex-dividend Date

Price behavior The value of the stock is the PV of expected future dividends. If one of those dividends will no longer be received, then the price should drop by that amount. With personal tax, the price should fall by less than the dividend amount to compensate the investor for the taxes on dividend. (no arbitrage opportunity) Microsoft on 15/11/2004: div= $3.08, stock price drop by $2.63 (=$29.97-$27.34) ≈ div (1-15%) Kalay (JoF, 1982): average stock price decline on the ex-div date was 73.4% of div value. (tax rate was about 27%)

The Irrelevance of Dividend Policy A compelling argument can be made that dividend policy is irrelevant. (MM I) Since investors do not need dividends to convert shares to cash; they will not pay higher prices for firms with higher dividends. In other words, dividend policy will have no impact on the value of the firm because investors can create whatever income stream they prefer by using homemade dividends. Homemade dividends: -sell or repurchase some of shares to get the same amount of return

Homemade Dividends Bianchi Inc. is a $42 stock about to pay a $2 cash dividend. Bob Investor owns 80 shares and prefers a $3 dividend. Will Bob be unsatisfied to the Bianchi Inc.’s dividend policy? 80x 3 + (42-3)x 80 = 80x 2 + 40 x 2 + (42-2) x (80-2)

Homemade Dividends Bob’s homemade dividend strategy: selling shares in the appropriate proportion to create an equivalent cash flow to receiving the dividend stream you want. Sell 2 shares on ex-dividend date homemade dividends Cash from dividend $160 Cash from selling stock $80 Total Cash $240 Value of Stock Holdings $40 × 78 = $3,120 $3 Dividend $240 $0 $39 × 80 = $3,120 Total wealth $3,360 $3,360

The Irrelevance of Dividend Policy Note that the value of the stock is the present value of expected future dividends. The dividend growth model: P0 = D1 / (RE – g). In the absence of market imperfections, it can be shown that an increase in the future dividend, D1, will reduce earnings retention and reinvestment. This will reduce the growth rate, g. Therefore, both the numerator and the denominator increase, and the net effect on P0 is canceled out.

True or false Dividends are irrelevant Dividend policy is irrelevant False:  Investors prefer higher dividends to lower at any single date all else equal. If the div at a given date rises while constant for other dates, then the stock price will increase. Dividend policy is irrelevant True : dividend policy cannot raise the div at one date while keeping the div. constant at all other dates. PV of all div. is not affected by the policy

Dividends and Investment Policy Since the payout policy is irrelevant, firms should never forgo positive NPV projects (which increase the firm’s value) to increase a dividend (or to pay a dividend for the first time). From MM, one of the assumptions underlying the dividend-irrelevance argument is: “The investment policy of the firm is set ahead of time and is not altered by changes in dividend policy.” Investment policy is predetermined, so is the value of firm. hence, div policy will not change the value of the firm.

Stock repurchase The firm may use cash to buy back shares of its stock. The number of shares outstanding is reduced. The shares are held by the company and accounted for as treasury stock.

Stock Repurchase Three ways to repurchase stock: Open market purchases: the firm simply purchases its own stock at the market price. The trading volume is regulated by the SEC. Tender offer: buy a fixed number of shares at a specific price (usually higher than the market price). Often for repurchase of large proportion of shares. Usually at a higher than market price (10%-20% premium) . Dutch auction may be used to tender the shares. Targeted repurchase: repurchase shares from a major shareholder (at a negotiated price ). Open market: don’t know the purchaser. Often regulated by SEC to avoid speculation or price manipulation. The firm is not allowed to purchase >25% of the average daily trading volume in a single day. Most common method of repurchase (95% of all repurchase transaction). Tender offer: sometimes the price is not determined. Instead, it is conducted by Dutch auction, asking the sellers (shareholders) to indicate how many shares they are willing to sell at each price. The price is the lowest price at which it can buyback its desired number of shares. Targeted repurchase: price may be higher or lower than the market price. If a shareholder (often in need of money) wants to sell a large number of shares, but the market is not sufficiently liquid to absorb all the share without severely depressing the price, the shareholder may be willing to sell the shares back to the firm at a discount (lower than the market) price. If a major shareholder threats to take over the firm and remove the management, the firm may buying out the shareholder –often at a large premium over the market price. This type of repurchase is called Greenmail.

3. Stock Repurchase versus Dividend If we assume no market imperfections (no taxes, transaction costs, information asymmetry), then stockholder wealth is unaffected by the choice between share repurchases and cash dividends. Recently, share repurchase has become an important way of distributing earnings to shareholders.

Stock Repurchase versus Dividend $10 = /100,000 $1,000,000 Price per share 100,000 outstanding Shares 1,000,000 Value of Firm Equity 850,000 Assets Other Debt $150,000 Cash sheet balance Original A. & Liabilities The firm wishes to distribute $100,000 of cash to its shareholders. What will be the price of stock and the shareholders’ wealth If the cash is distributed as dividend? If the cash is used to repurchase stock? 15

Stock Repurchase versus Dividend If they distribute the $100,000 as a cash dividend, the balance sheet will look like this: $9 = 00,000 $900,000/1 share per Price 100,000 g outstandin Shares 900,000 Firm of Value Equity 850,000 Assets Other Debt $50,000 Cash dividend cash $1 After B. & s Liabilitie 16

Stock Repurchase versus Dividend If they distribute the $100,000 through a stock repurchase at the market price (open market purchase), the balance sheet will look like this: Assets Li abilities & Equity C. After stock repurchase Cash $50,000 Debt Other Assets 850,000 900,000 Value of Firm Shares outstanding = 90,000 Price per share $900,000 / $10 In an ideal world, the firm is indifferent from stock repurchase and dividend. Stock price is higher after a repurchase than after a dividend. However share holders are indifferent of the two policies. =>MM dividend irrelevance. 17

Dividend & Stock Repurchases U.S. Data 1980 - 2008 $ Billions

3.1. Taking into account Personal Taxes To get the result that dividend policy is irrelevant, we needed three assumptions: No taxes, No transactions costs, No other frictions In the United States, both dividends and capital gains from stock repurchase are (currently) taxed at a maximum rate of 15 percent. Taxes are treated differently for div. vs. capital gains If the firm repurchases stock, SHs receive cash only when they sell their stocks. Taxes on capital gain can be deferred. If the firm pays dividends, taxes must be paid immediately by SHs. The dividend and capital gains tax rates are subject to change at the discretion of Congress.

Summary of personal taxes In the presence of personal taxes: A firm should not issue stock to pay a dividend. Managers have an incentive to seek alternative uses for funds to reduce dividends. Since capital gains can be deferred, the tax rate on dividends is greater than the effective rate on capital gains.

Taxes on capital gains and dividends 1971-2012

Trends in the Use of Dividends and Repurchases

3.2 clientele based explanation Basis: Investors may form clienteles based upon their tax brackets. Investors in high tax brackets may invest in stocks which do not pay dividends those in low tax brackets may invest in dividend paying stocks. Evidence: A study of 914 investors' portfolios was carried out to see if their portfolio positions were affected by their tax brackets. The study found that Older investors were more likely to hold high dividend stocks Poorer investors tended to hold high dividend stocks

Results from Regression: Clientele Effect

3.3 Signaling effect Increases in dividend are often viewed as an indication of an increase in future earnings. Information content effect: Changes in dividends may be important signals if the market anticipates that the change will be maintained through time. If div. increases, the market infers a rise in earnings and cash flow, leading to a higher stock price. E.g. 1967-1993: raising div by 10%, stock price rise by 1.34% after announcement,; cutting div by 10%, price drop – 3.71%. However, paying(cutting) div may also be a signal of lack (need) of investment opportunities=> price rising (drop)

The Payout Decision Lintner’s “Stylized Facts,” as updated by Brav, Graham, Harvey, Michaely (2004) 1. Managers are reluctant to make dividend changes that may have to be reversed. They are particularly worried about having to rescind a dividend increase and, if necessary, would choose to raise new funds to maintain the payout. 2. To avoid the risk of a reduction in payout, managers smooth” dividends. Consequently, dividend changes follow shifts in long-run sustainable earnings. Transitory earnings changes are unlikely to affect dividend payouts. 3. Managers focus more on dividend changes than on absolute levels. Thus paying a $2.00 dividend is an important financial decision if last year’s dividend was $1.00, but no big deal if last year’s dividend was $2.00. 18

Signaling and stock repurchase Stock repurchase—a less strong signal Managers are much less committed to repurchase than div payout Firms do not smooth their repurchase activity. It conveys a signal that the stock is undervalued. +3% price increases for open market share repurchase 12% for fixed-price tender offers. 8% for Dutch auction share repurchases.

4. Payout vs Retention of cash A firm with extra cash after selecting all available positive NPV projects. In perfect capital market: MM irrelevance of payout. Firms should never forgo positive NPV projects to increase a dividend. With corporate taxes: retaining cash is costly as it may be taxed twice. Future uncertainty: retaining cash allows a firm to avoid the issuance cost (7% spread for equity issue) to avoid financial distress and its associated costs. Agency costs—free cash flow hypothesis—managers may take wasteful or risky projects with too much cash. In a perfect captial market. Buying and selling securities is a zero-NPV transaction, not affecting firms’ value. Corporate taxes: eg. Microsoft paying dividend at $3 per share ($32billion) in 2004, tax saving for shareholders = $3*35%=$1.05 per share or $32b* 35% =$11.2b

Empirical observations Aggregate payouts (div & repurchase) are massive and have increased over time. Dividends are concentrated among a small number of large, mature firms. Managers are reluctant to cut dividends. Managers smooth dividends, raising slowly and incrementally as cash grow. Stock prices react to unanticipated changes in dividends.

Explaination 1-2: life cycle theory 3-5: signaling theory Young firms with less available cash should pay little div: need cash to fund positive NPV project When firms becomes mature, they generate free cash flow. Too much cash leads to agency cost=> pay dividends 3-5: signaling theory Paying div. signals that firms are profitable and have enough cash to pay the div. Less cash flow signals that firms incur less agency cost.

Determinants of Dividend Policy Investment Opportunities: More investment opportunities - > Lower dividends Stability in earnings: More stable earnings -> Higher Dividends Alternative sources of capital: More alternative sources -> Higher Dividends Constraints: More constraints imposed by bondholders and lenders -> Lower Dividends Signaling Incentives: More options to supply information to financial markets - Lower need to pay dividends as signal Stockholder characteristics: Older, poorer stockholders -> Higher dividends

5. Other types Stock dividend No cash leaves the firm. The firm increases the number of shares outstanding. Expressed as a percentage: 25% stock dividend means you receive 1 share for every 4 that you own. Stock split (higher proportion of stock div (>50%)) The firm’s existing shares are divided into multiple shares Expressed as a ratio, e.g., a 2-for-1 split means you will receive 2 shares for every one that you own. Value of each share decreased 2% of stock dividend: buy 1 new share with 50 old shares owned. stock split: similar to SD but with larger scale of expension.

Homework To be submitted no later than 1:55 Thursday, 24 November. In book of Ross, Westerfield and Jaffe, “Corporate Finance”, 9th edition. Chapter 19—Questions and Problems: 11, 13 Chapter 20—Questions and Problems: 4, 7(please note that the flotation cost is in % of net funds), 14, 16, 17 To be submitted no later than 1:55 Thursday, 24 November.