Dividends Chapter 14 © 2003 South-Western/Thomson Learning

22 Background Dividends as a Basis for Value Help determine the value of stocks Individual investors buy stocks expecting return from dividends and the eventual selling price of stock Today’s price represents the present value of those future expected cash flows From the whole market view The price of a stock today is the present value of the infinite stream of dividends

33 Understanding the Dividend Decision The Discretionary Nature of Dividends Board of Directors has authority to determine the dividend payout Payout can range from nothing to everything The Dividend Decision A firm’s earnings belong to the stockholders Management makes the dividend decision on behalf of the stockholders Paying dividends gives stockholders an immediate cash payment—current income Retaining earnings for reinvestment offers a potentially higher stock price in the future—deferred income

44 The Dividend Controversy— Irrelevance Does the payment of dividends now or increasing the dividend payment impact the stock price? Do stockholders prefer current or deferred income?

55 The Dividend Controversy— Irrelevance Arguments concerning dividend policy Dividend irrelevance Value of eliminated dividends is offset by growth-created value in the future The increased return on the retained earnings offsets the reduction or elimination of dividends Thus, the current stock price is independent of changes in early dividends Investors can tailor their income stream by selling shares of a growing stock that doesn’t pay dividends or by buying shares of stock of a company that pays more dividends than an investor needs

66 The Dividend Controversy— Irrelevance—Example Example Q:The Winters are retirees with most of their savings invested in 10,000 shares of Ajax Corporation (AJAX). 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 Winters maintain their income and their position in AJAX? A: Their original value of AJAX shares was $10 per share  10,000 shares, or $100,000, which they wish to maintain. But, 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 $ Thus, 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.

77 The Dividend Controversy— Irrelevance Transaction Costs Can make tailoring an income stream impractical The more significant the transactions costs, the less valid the irrelevance theory becomes

88 The Dividend Controversy— Irrelevance Income Taxes Dividends are taxed as ordinary income Appreciation is taxed as a capital gain The View from Within the Company Dividends represent a cash outflow Reduces retained earnings Firms prefer not paying dividends if it avoids selling new stock Retained earnings cost less than new equity

99 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?

10 Dividend Aversion Investors prefer future capital gains to current dividends because of lower tax rates Dividends are taxed at higher ordinary income tax rates This argument hinges on current level of ordinary income vs. capital gain tax rates Capital gains taxes are not paid until stock is sold If stock is passed along to heirs, taxes on capital gains occurring during decedent’s life can be avoided

11 Other Theories and Ideas The Clientele Effect Investors choose stocks for dividend policy— any change in payments is disruptive Retirees may desire stocks with high dividends Young professionals may desire stocks will little or no dividends

12 Other Theories and Ideas The Residual Dividend Theory Dividends are paid from earnings only after all viable projects are funded The Signaling Effect of Dividends Cash dividends signal management’s confidence in the future A continuing payment of dividends when earnings are low can signal management’s confidence about the future A decrease in dividends can signal management’s lack of confidence concerning the future

13 Other Theories and Ideas The Expectations Theory Dividends that fail to fulfill stockholders’ expectations send a negative message even if the payment is good

14 Legal and Contractual Restrictions Dividends can’t be paid by an insolvent firm and must come from current or prior earnings Protects creditors Loan indentures and covenants may limit dividend payments to protect creditors’ interests The cumulative feature of preferred stock limits dividend payments

15 Dividend Policy 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

16 Alternative Dividend Policies Target Payout Ratio Firm selects a long-run target payout ratio Actual payout ratio is set below target allowing for flexibility in earnings Stable Dividends Per Share A 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 the ability to lower dividend (by omitting the extra year-end dividend) without a negative informational effect

17 The Mechanics of Dividend Payments Key Dates Declaration Date: Date on which the board authorizes the dividend Date of Record: You must be an owner by this date to have access to the declared dividend Payment Date: Date the dividend payment will be mailed Ex-Dividend Date: If you buy the stock on or after this day you will not receive the pending dividend

18 Figure 14.1: The Dividend Declaration and Payment Process

19 Dividend Reinvestment Plans Large companies offer automatic dividend reinvestment plans (DRIPs) to stockholders Instead of receiving a cash dividend payment the stockholder receives additional shares of stock Company can either buy the shares on the open market or issue new shares to the stockholder IRS treats reinvested dividends as taxable income

20 Stock Splits and Dividends Stock Split Current stockholder is issued new shares proportionate to his current holdings No change in ownership control occurs Stock Dividend Same as a stock split but called a stock dividend if the number of shares is less than or equal to 20% of original shares outstanding

21 Stock Splits and Dividends A firm with 100,000 shares outstanding executes a 2- for-1 split. Each stockholder will now have twice as many shares as they had before. The firm will now have 200,000 shares outstanding. Each share is worth half as much as before the split. Example

22 Stock Splits and Dividends Accounting Treatment Stock split changes par value and the number of shares Capital accounts are unaffected Stock dividend causes money to be shifted from Retained Earnings to stock account Gives the appearance of a sale at market price

23 Stock Splits and Dividends Rationale for Stock Splits and Stock Dividends Splits keep stock prices in a trading range Between $30 and $80 Stock dividends are an attempt at signaling Sends a positive message

24 Stock Repurchases Alternative to Dividend A firm with cash can either pay a dividend or repurchase some of its own outstanding stock Repurchasing stock reduces number of shares outstanding and increases EPS Remaining shares will rise in value if market uses same P/E ratio after the repurchase

25 Stock Repurchases Johnson Company currently has 2,500,000 outstanding shares of common stock and Net Income of $5 million. The firm’s P/E ratio is 10. Thus, Johnson’s 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 stockholders. If the firm distributes it as a dividend, the firm will pay a dividend of $0.40 per share, or $1,000,000  2,500,000 shares. If the firm instead buys back its own shares, it will be able to retire 50,000 shares, or $1,000,000  $20. There would then be 2,450,000 shares outstanding and EPS would be $5,000,000  2,450,000 or $2.04 per share. If the firm’s P/E ratio remains unchanged, the firm’s stock price should rise to $20.40, or $2.04 x 10. Example

26 Stock Repurchases Method of Repurchasing Shares Buy shares on open market Make a tender offer Negotiated deal with a large investor

27 Other Repurchase Issues Opportunistic Repurchase Repurchases are appropriate when a stock is temporarily undervalued or the firm has excess cash Repurchases to Dispose of Excess Cash Firm may have excess cash which can be distributed as dividend However, firm may suffer from signaling effect A stock repurchase effectively distributes the cash without a signaling effect

28 Other Repurchase Issues Taxes An occasional stock repurchase may benefit stockholders because they pay capital gains taxes rather than ordinary income taxes Repurchases to Restructure Capital By borrowing money and using the cash to repurchase stock, a firm can raise its debt ratio