17 Chapter Dividends, Stock Splits, and Share Repurchases Slides Developed by: Terry Fegarty Seneca College

© 2006 by Nelson, a division of Thomson Canada Limited 2 Chapter 17 – Outline (1) Background  Understanding the Dividend Decision  The Dividend Controversy  The Dividend Controversy—Dividend Irrelevance  The Dividend Controversy— Dividend Preference  The Dividend Controversy—Dividend Aversion  The Dividend Controversy—Other Theories and Ideas  The Corporate Life Cycle and Dividend Policy Practical Considerations  Legal and Contractual Restrictions

© 2006 by Nelson, a division of Thomson Canada Limited 3 Chapter 17 – Outline (2)  Dividend Policy—What a Firm Will Pay in Dividends  Alternative Dividend Policies  The Mechanics of Quarterly Dividend Payments  The Dividend Declaration and Payment Process  Dividend Reinvestment Plans  Stock Splits and Dividends Share Repurchases  Motives for Share Repurchases Reverse Stock Splits

© 2006 by Nelson, a division of Thomson Canada Limited 4 Background Dividends as a Basis for Value  Help determine the value of shares From the whole market view The price of a share today is the present value of the infinite stream of dividends Individual investors buy shares expecting return from dividends and the eventual selling price of shares Today’s price represents the present value of those future expected cash flows

© 2006 by Nelson, a division of Thomson Canada Limited 5 Understanding the Dividend Decision The Dividend Decision  Firm’s earnings can be paid out as dividends or retained for reinvestment in the business Board of directors has authority to determine dividend payout, if any Paying dividends gives shareholders an immediate cash payment—current income Retaining earnings for reinvestment offers a potentially higher share price in the future— deferred income

© 2006 by Nelson, a division of Thomson Canada Limited 6 The Dividend Controversy Does the payment of dividends or increasing the dividend payment affect firm’s share price?  Do shareholders prefer current or deferred income? Three major arguments  Dividend irrelevance  Dividend preference  Dividend aversion

© 2006 by Nelson, a division of Thomson Canada Limited 7 The Dividend Controversy— Dividend Irrelevance Arguments concerning dividend policy  Dividend irrelevance—shareholders should be indifferent to the payment of dividends Value of eliminated dividends is offset by growth-created value in future Increased return on retained earnings offsets reduction or elimination of dividends Thus, current share price is independent of changes in early dividends  If a (growing) company doesn’t pay dividends, investors preferring current cash flows can tailor their income stream selling some of their shares

© 2006 by Nelson, a division of Thomson Canada Limited 8 Example 17.1: The DividendControversy— Tailoring the Income Stream Q:The Manns have $100,000 invested in 10,000 shares of Ajax Corporation. Ajax sells for $10 per share and pays an annual dividend of $0.50 per share. This year Ajax eliminated the dividend but began to grow at 5% a year due to the reinvested earnings. How can the Manns maintain their income and their position in Ajax? A:They were generating an annual dividend of 10,000 shares  $0.50 or $5,000 before Ajax eliminated the dividend. After one year of 5% growth, Ajax’s shares should be selling for $ By selling 476 shares ($5,000  $10.50) they can generate $5,000 in cash. Their remaining 9,524 shares would be worth $10.50 each for a total of $100,002. Example

© 2006 by Nelson, a division of Thomson Canada Limited 9 The Dividend Controversy— Dividend Irrelevance Transaction Costs  Can make tailoring an income stream impractical  The more significant the transactions costs, the less valid the irrelevance theory becomes

© 2006 by Nelson, a division of Thomson Canada Limited 10 The Dividend Controversy— Dividend Irrelevance Income Taxes  Capital gains may be taxed at lower rates than dividends  May make deferred income more attractive Flotation Costs  Firms prefer not paying dividend if it avoids selling new shares New share issues incur flotation costs

© 2006 by Nelson, a division of Thomson Canada Limited 11 The Dividend Controversy— Dividend Preference Investors prefer immediate cash to uncertain future benefits  Not a time value of money argument but rather a certainty issue Flaw—if investors are worrying about not receiving the future cash flow, why invest in that firm in the first place?

© 2006 by Nelson, a division of Thomson Canada Limited 12 The Dividend Controversy— Dividend Aversion Investors prefer future capital gains to current dividends because of lower tax rates  Dividends taxed at higher income tax rates  Taxes on capital gains not paid until shares sold  High-income shareholders may prefer low current dividends

© 2006 by Nelson, a division of Thomson Canada Limited 13 The Dividend Controversy—Other Theories and Ideas The Clientele Effect  Investors choose shares for dividend policy— any change in payments is disruptive Retirees may desire high dividends Young professionals may desire small or no dividends

© 2006 by Nelson, a division of Thomson Canada Limited 14 The Dividend Controversy—Other Theories and Ideas The Residual Dividend Theory  Dividends paid only after all viable projects are funded from retained earnings  Not realistic The Signalling Effect of Dividends  Cash dividends signal management’s confidence in the future Continuing payment of dividends when earnings are low can signal management’s confidence about future Decrease in dividends can signal management’s lack of confidence concerning future

© 2006 by Nelson, a division of Thomson Canada Limited 15 The Dividend Controversy—Other Theories and Ideas The Expectations Theory  Dividends that fail to fulfill shareholders’ expectations send a negative message even if the payment is steady or increasing Conclusion re Dividend Controversy  We don’t know whether dividend payments affect share prices  Many large corporations do pay dividends

© 2006 by Nelson, a division of Thomson Canada Limited 16 The Corporate Life Cycle and Dividend Policy Firm’s dividend policy often influenced by its stage of corporate development  Small firm may pay no dividends Needs all of its retained earnings for reinvestment  As growth continues, may want to raise additional capital externally rather than to pay dividends  As firm matures, may pay out significant cash dividends More cash flows from its operations Less need for expansion funds Pressure for dividends from shareholders and financial markets

© 2006 by Nelson, a division of Thomson Canada Limited 17 Legal and Contractual Restrictions Dividends can’t be paid by insolvent firm and must come from retained earnings  Protects creditors Loan indentures and covenants may limit dividend payments to protect creditors’ interests The cumulative feature of preferred shares limits payment of common dividend

© 2006 by Nelson, a division of Thomson Canada Limited 18 Dividend Policy—What a Firm Will Pay in Dividends Payout ratio  States dividends as a fraction of earnings: dividend per share  EPS Stability  A stable dividend is one that is non- decreasing  A dividend with a stable growth rate is one that increases at a more or less constant growth rate

© 2006 by Nelson, a division of Thomson Canada Limited 19 Alternative Dividend Policies Target Payout Ratio  Firm selects long-run target payout ratio Actual payout ratio is set below target allowing for flexibility in earnings Stable Dividends Per Share  Constant dividend is paid regardless of earnings Dividend may change if firm consistently does well or poorly Small Regular Dividend with a Year-End Extra if Earnings Permit  Gives firm ability to lower dividend (by omitting the extra year-end dividend) without a negative informational effect

© 2006 by Nelson, a division of Thomson Canada Limited 20 The Mechanics of Quarterly Dividend Payments Key Dates  Declaration Date: Date on which board authorizes the dividend  Date of Record: You must be an owner by this date to have access to declared dividend  Payment Date: Date the dividend payment will be mailed  Ex-Dividend Date: If you buy the shares on or after this day you will not receive declared dividend

© 2006 by Nelson, a division of Thomson Canada Limited 21 The Dividend Declaration and Payment Process Declaration Date Ex-Dividend Date Record Date Payment Date Two Days Usually Four Weeks

© 2006 by Nelson, a division of Thomson Canada Limited 22 Dividend Reinvestment Plans Large companies offer automatic dividend reinvestment plans (DRIPs) to shareholders  Instead of receiving cash dividend, shareholder receives additional shares Company can either buy shares on open market or issue new shares CRA treats reinvested dividends as taxable income  More than 100 corporations on TSX offer DRIPs

© 2006 by Nelson, a division of Thomson Canada Limited 23 Stock Splits and Dividends Stock Split  Current shareholder is issued new shares proportionate to his current holdings  No change in ownership control Stock Dividend  Same as stock split but called stock dividend when fewer new shares issued

© 2006 by Nelson, a division of Thomson Canada Limited 24 Stock Splits and Dividends Accounting Treatments  Stock split increases only number of shares outstanding Book value per share and earnings per share reduced Capital accounts are unaffected  Stock dividend causes money to be shifted from Retained Earnings to Common Shares account Gives appearance of a sale of shares at market price Increases number of shares outstanding

© 2006 by Nelson, a division of Thomson Canada Limited 25 Table 17.1: Eagle Inc. Shareholders’ Equity Example

© 2006 by Nelson, a division of Thomson Canada Limited 26 Table 17.2: Eagle Inc. Shareholders’ Equity After a Two-for-One Stock Split Example

© 2006 by Nelson, a division of Thomson Canada Limited 27 Table 17.3: Eagle Inc. Shareholders’ Equity After a 10% Stock Dividend Example

© 2006 by Nelson, a division of Thomson Canada Limited 28 Stock Splits and Dividends Rationale for Stock Splits and Stock Dividends  Stock splits keep share prices in a trading range Between $10 and $50  Stock dividends are attempt at signaling To send positive message

© 2006 by Nelson, a division of Thomson Canada Limited 29 Share Repurchases Company buys up own shares Method of Repurchasing Shares  Buy shares on open market  Make tender offer  Negotiated deal with large investor

© 2006 by Nelson, a division of Thomson Canada Limited 30 Motives for Share Repurchases Alternative to dividend  A firm with cash can either pay dividend or repurchase some of outstanding shares Repurchasing shares reduces number of shares outstanding and increases EPS Remaining shares will rise in value if market uses same P/E ratio after repurchase May benefit shareholders because they pay tax on capital gain rather than on dividend

© 2006 by Nelson, a division of Thomson Canada Limited 31 Motives for Share Repurchases To dispose of one-time excess cash  Without raising expectations of future distributions When shares are temporarily undervalued on stock market To restructure (replace) shares with debt To offset exercise of stock options To increase control of major shareholders and senior managers

© 2006 by Nelson, a division of Thomson Canada Limited 32 Share Repurchases—Example Johnson Company currently has after-tax earnings of $5 million and 2,500,000 common shares outstanding. The firm’s P/E ratio is 10. Then EPS is $5,000,000  2,500,000 or $2.00 per share; and the firm’s market price is $2.00 x 10 or $20. Johnson has $1 million in cash available for distribution to shareholders. If the firm distributes it as a dividend, the firm will pay a dividend of ($1,000,000  2,500,000 =) $0.40 per share. If the firm instead buys back its own shares, it will be able to retire ($1,000,000  $20 =) 50,000 shares. There would then be 2,450,000 shares outstanding and EPS would be $5,000,000  2,450,000 or $ per share. If the firm’s P/E ratio remains unchanged, the firm’s share price should rise to ($ x 10 =) $ The market value of the firm increases by (2,450,000 x $0.408 =) $1,000,000 (rounded). Value increase equals dividend not paid. Example

© 2006 by Nelson, a division of Thomson Canada Limited 33 Reverse Stock Split Company issues one new share for a certain number of old shares outstanding Inexpensive method to increase share price by reducing number of shares outstanding. No cash expenditure by company Usually due to significant decline in share price To avoid perception that business is failing Eligibility requirements that company’s share price be above certain level  For inclusion in stock market indices,  For purchase by pension and mutual funds.  To maintain listing on stock exchange.