Payout Policy 1Finance - Pedro Barroso

Different Types of Dividends Many companies pay a regular cash dividend – Public companies often pay quarterly – Sometimes firms will pay an extra cash dividend – The extreme case would be a liquidating dividend Companies will often declare stock dividends – No cash leaves the firm – The firm increases the number of shares outstanding Some companies declare a dividend in kind – Wrigley’s Gum sends a box of chewing gum 2Finance - Pedro Barroso

Procedure for Cash Dividend 25 Oct.2 Nov.5 Nov.7 Dec. Declaration Date Ex- dividend Date Record Date Payment Date … Declaration Date: The Board of Directors declares a payment of dividends Ex-Dividend Date: If you purchase the stock on and after ex- dividend date you are not entitled to receive dividend Record Date: Corporation prepares a list of all individuals believed to be stockholders Payment Date: Stockholders receive dividend 3Finance - Pedro Barroso

Price Behavior In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date $P$P $P - Div Ex- dividend Date The price drops by the amount of the cash dividend -t … … Taxes complicate things a bit. Empirically, the price drop is less than the dividend and occurs within the first few minutes of the ex-date 4Finance - Pedro Barroso

Irrelevance of Dividend Policy A compelling case can be made that dividend policy is irrelevant 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 5Finance - Pedro Barroso

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 Bob’s homemade dividend strategy: – Sell 2 shares on ex-dividend date Homemade dividend$3 Dividend Cash from dividend$2 x 80 = $160$3 x 80 = $240 Cash from selling stock$40 x 2 = $80$0 Total cash$240 Value of stock holdings$40 x 78 = $3,120$39 x 80 = $3,120 6Finance - Pedro Barroso

Dividend Policy is Irrelevant In the above example, Bob Investor began with a total wealth of $3,360:  After a $3 dividend, his total wealth is still $3,360:  After a $2 dividend and sale of 2 ex-dividend shares, his total wealth is still $3,360: 7Finance - Pedro Barroso

Dividends and Investment Policy Firms should never forgo positive NPV projects to increase a dividend (or to pay a dividend for the first time) Recall that 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” 8Finance - Pedro Barroso

Repurchase of Stock Instead of declaring cash dividends, firms can rid themselves of excess cash through buying shares of their own stock Recently, share repurchase has become an important way of distributing earnings to shareholders 9Finance - Pedro Barroso

Stock Repurchase versus Dividend $10=/100,000$1,000,000Price per share 100,000outstanding Shares 1,000,000Value of Firm1,000,000Value of Firm 1,000,000Equity850,000 AssetsOther 0Debt$150,000Cash sheet balance Original A. Equity &Liabilities Assets Consider a firm that wishes to distribute $100,000 to its shareholders 10Finance - Pedro Barroso

Stock Repurchase versus Dividend $9=00,000$900,000/1 shareper Price 100,000 Shares outstanding 900,000Firm of Value900,000Firm of Value 900,000Equity850,000AssetsOther 0Debt$50,000Cash dividendcash shareper $1After B. Equity & Liabilities Assets If they distribute the $100,000 as a cash dividend, the balance sheet will look like this: 11Finance - Pedro Barroso

Stock Repurchase versus Dividend Assets Liabilities&Equity C. After stock repurchase Cash$50,000Debt0 Other Assets850,000Equity900,000 Value of Firm900,000Value of Firm900,000 Shares outstanding90,000 Price pershare $900,000/90,000=$10 If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this: 12Finance - Pedro Barroso

Share Repurchase Flexibility for shareholders Keeps stock price higher – Good for insiders who hold stock options As an investment of the firm (undervaluation) Tax benefits – Taxes on capital gains are usually lower than taxes on dividends 13Finance - Pedro Barroso

Personal Taxes and Dividends To get the result that dividend policy is irrelevant, we needed three assumptions: – No taxes – No transactions costs – No uncertainty In the United States, both cash dividends and capital gains are taxed at a maximum rate of 15 percent Since capital gains can be deferred, the tax rate on dividends is greater than the effective rate on capital gains 14Finance - Pedro Barroso

Firms without Sufficient Cash In a world of personal taxes, firms should not issue stock to pay a dividend. Firm Stock Holders Cash: stock issue Cash: dividends Gov. Taxes Investment Bankers The direct costs of stock issuance will add to this effect. 15Finance - Pedro Barroso

Firms with Sufficient Cash The above argument does not necessarily apply to firms with excess cash Consider a firm that has $1 million in cash after selecting all available positive NPV projects – Select additional capital budgeting projects (by assumption, these are negative NPV). – Acquire other companies – Purchase financial assets – Repurchase shares 16Finance - Pedro Barroso

Taxes and Dividends In the presence of personal taxes: 1.A firm should not issue stock to pay a dividend 2.Managers have an incentive to seek alternative uses for funds to reduce dividends 17Finance - Pedro Barroso

Factors Favoring High Dividends Desire for Current Income Behavioral Finance – It forces investors to be disciplined Tax Arbitrage – Investors can create positions in high dividend yield securities that avoid tax liabilities Agency Costs – High dividends reduce free cash flow 18Finance - Pedro Barroso

The Clientele Effect Clienteles for various dividend payout policies are likely to form in the following way: GroupStock Type High Tax Bracket Individuals Low Tax Bracket Individuals Tax-Free Institutions Corporations Zero-to-Low payout Low-to-Medium payout Medium payout High payout Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy 19Finance - Pedro Barroso

What We Know and Do Not Know Corporations “smooth” dividends Fewer companies are paying dividends Dividends provide information to the market Firms should follow a sensible policy: – Do not forgo positive NPV projects just to pay a dividend – Avoid issuing stock to pay dividends – Consider share repurchase when there are few better uses for the cash 20Finance - Pedro Barroso

Stock Splits Stock splits – essentially the same as a stock dividend except it is expressed as a ratio – For example, a 2 for 1 stock split is the same as a 100% stock dividend. Stock price is reduced when the stock splits Common explanation for split is to return price to a “more desirable trading range” 21Finance - Pedro Barroso