Chapter 14 Dividends and Dividend Policy

Key Concepts and Skills Understand dividend types and how they are paid Understand the issues surrounding dividend policy decisions Understand the difference between cash and stock dividends Understand why share repurchases are an alternative to dividends

Chapter Outline Cash Dividends and Dividend Payment Does Dividend Policy Matter? Establishing a Dividend Policy Stock Repurchase: An Alternative to Cash Dividends Stock Dividends and Stock Splits

Dividends and Dividend Policy The heart of the dividend policy question is should the firm: pay out money to its shareholders or take that money and invest it for its shareholders? There are many good reasons to: Pay high dividends as well as Pay low dividends

14.1 Cash Dividends and Dividend Payment

Dividends and Distributions Dividend: Payment made out of a firm’s earnings to its owners, in the form of either cash or stock Usually refers to cash paid out of earnings Distribution: Payment made by a firm to its owners from sources other than current or accumulated retained earnings However, the terms are somewhat interchangeable

The Basic Types of Cash Dividends: Regular cash dividend – cash payment made by a firm to its owners in the normal course of business, usually made four times a year Extra cash dividend – indication that the “extra” amount may not be repeated in the future Special cash dividend – similar to extra dividend, but definitely won’t be repeated Liquidating dividend – some or all of the business has been sold Cash dividends reduce cash and retained earnings (except for liquidating dividends which may reduce paid-in capital)

Cash Dividends The most common type of dividend Made directly to shareholders in cash Made in the regular course of business Nothing unusual about the dividend No reason why it won’t be continued Reduces corporate cash and retained earnings Except in the case of a liquidating dividend (where paid-in capital may be reduced)

Standard Method of Cash Dividend Payment Decision to pay rests in the hands of the board of directors Once “declared” – becomes a liability of the firm and can’t be rescinded easily After declaration – distributed to all shareholders as of some “specific date” Usually expressed in terms of dollars per share (dividends per share) Also expressed as: Percentage of: market price (dividend yield) Percentage of: net income or earnings per share (dividend payout)

Dividend Payment: A Chronology 1. Declaration Date: Date on which the board of directors passes a resolution to pay a dividend

Dividend Payment: A Chronology 2. Ex-dividend Date: two business days prior to the date of record The ex-dividend date removes any ambiguity about who is entitled to the dividend Before this date: the stock is said to trade “with dividend” If you buy the stock “before” this date, you’re entitled to the dividend After this date: the stock trades “ex dividend” If you buy the stock “on” or “after” this date, the previous owner will get the dividend Since the dividend is valuable, the stock price will be affected when the stock goes “ex”

Dividend Payment: A Chronology 3. Date of Record: Date by which holders must be on record to receive a dividend 4. Date of Payment: Date the dividend checks are mailed

More on the Ex-Dividend Date Two business days before the date of record Note: Saturdays, Sundays and holidays are NOT business days! If you buy the stock before the ex-dividend date: the stock trades “with dividend” and the holder will receive the dividend If you buy the stock on or after the ex-dividend date: The stock trades “ex-dividend” and the holder will not receive the dividend When the stock goes “ex dividend”, the value of a share of stock will go down by about the dividend amount

Figure 14.2 The Ex-Day Price Drop -2 -1 +1 +2 t $1 is the ex-dividend price drop Price= $10 Price= $9 The stock price will fall by the amount of the dividend on the ex date (Time 0). If the dividend is $1 per share, the price will be equal to $10 – 1 = $9 on the ex date.

Ex-Dividend Stock Price Example: Not in Book The board of directors of XYZ Inc. declared a dividend of $0.75 per share payable on Monday, January 28 to shareholders of record as of Monday, January 14. You owned 500 shares of XYZ on Wednesday, January 9 when the price was $7.50 per share. Under NYSE rules, if you sell your 500 shares of XYZ on Friday, January 11, what price will you receive, all else the same? Remember: the ex-dividend date is - 2 business days prior to the date of record. Here the ex-dividend date is January 10. When the stock goes ex dividend, the value of a share of stock will go down by about the dividend amount. Friday, January 11th is after the ex-dividend date of January 10th, so the stock trades ex-dividend (without dividend) 500 shares x (7.50 - .75) = $3,375.00

14.2 Does Dividend Policy Matter?

Does Dividend Policy Matter? Should the firm: Pay out cash now or Invest the cash and pay it out later

An Illustration of: The Irrelevance of Dividend Policy A powerful argument can be made that dividend policy does not matter. Assuming that the second dividend is a liquidating dividend and the firm ceases to exist after period 2. PV = 10,000 / 1.12 + 10,000 / 1.122 = 16,900.51 PV = 9000 / 1.12 + 11,120 / 1.122 = 16,900.51

An Illustration of: The Irrelevance of Dividend Policy Wharton Corporation Case: – Bottom of Page 401 Wharton is an all-equity firm that has existed for 10 years. The current financial managers plan to dissolve the firm in two years. The total cash flows the firm will generate, including the proceeds from liquidation, are $10,000 in each of the next two years.

Dividends are set equal to the cash flow of $10,000 Wharton Corporation Case: – Bottom of Page 401 Current Policy: Dividends Set Equal to Cash Flow Dividends are set equal to the cash flow of $10,000 100 shares outstanding, so the dividend per share will be $100 $10,000 / 100 shares o/s = $100

Wharton Corporation Case: – Bottom of Page 401 Current Policy: Dividends Set Equal to Cash Flow Remember: The value of the stock is equal to the present value of the future dividends. Assuming a 10 percent required return, the value of a share of stock today, P0, is: P0 = D1 / (1 + R)1 + D2 / (1 +R)2 P0 = $100 / 1.10 + 100 / 1.102 P0 = $173.55 The firm as a whole is thus worth: 100 x $173.55 = $17,355

Pay a dividend of $110 per share on the first date (Date 1) Wharton Corporation Case: – Top of Page 402 Alternative Policy: Initial Dividend Greater Than Cash Flow Pay a dividend of $110 per share on the first date (Date 1) 100 shares x $110 = $11,000 Cash flow = only $10,000 An extra $1,000 must be raised Could issue $1,000 worth of bonds or stock at Date 1 Assume that stock is issued The new stockholders will desire enough cash flow at Date 2 so that they earn the required 10 percent return on their Date 1 investment

What is the value of the firm with this new dividend policy? Wharton Corporation Case: – Top of Page 402 Alternative Policy: Initial Dividend Greater Than Cash Flow What is the value of the firm with this new dividend policy? The new stockholders invest $1,000 at Date 1 They will require a 10% return of the Date 2 cash flow $1,000 x 1.10 = $1,100 This leaves only $8,900 ($10,000 – 1,100) to the old stockholders The dividends to the old stockholders will be:

Wharton Corporation Case: – Top of Page 402 Alternative Policy: Initial Dividend Greater Than Cash Flow Date 1: $11,000 Dividends per share: $11,000 / 100 shares = $110 Date 2: $ 8,900 Dividends per share: $8,900 / 100 shares = $89 The present value of the dividends per share is therefore: P0 = $110 / 1.10 + 89 / 1.102 = $173.55 This is the same value as before The value of the stock is not affected by this switch in dividend policy even though new stock had to be sold to finance the dividend

An Illustration of: The Irrelevance of Dividend Policy Wharton Corporation Case For the Wharton Corporate, dividend policy makes no difference Any increase in a dividend at some point in time is exactly offset by a decrease somewhere else, so the net effect, once we account for time value, is zero.

A Test True or false: Dividends are irrelevant? False: Dividends “are” relevant Investors prefer higher dividends to lower dividends at any single date, if the dividend level is held constant at every other date If the dividend per share at a given date is raised while the dividend per share at every other date is held constant, the stock price will rise The reason: the present value of the future dividends must go up if this occurs Accomplished by improved productivity, increased tax savings, improved product marketing strength, or improved cash flow

A Test True or false: Dividend Policy is irrelevant True: Dividend Policy “is” irrelevant Dividend “Policy” by itself cannot raise the dividend at one date while keeping it the same at all other dates. Dividend “Policy” merely establishes the trade-off between dividends at one date and dividends at another date Once we allow for time value, the PV of the dividend stream is unchanged

A Test In the previous simple-world example, dividend “policy” did not matter Because managers choosing either to raise or to lower the current dividend did not affect the current value of the firm. However, we’ve ignored several real-world factors that might lead us to change our minds: Taxes Flotation Costs

Some Real-World Factors Favoring a Low Payout: Taxes A firm that adopts a low-dividend payout will reinvest the money instead of paying it out This reinvestment increases the value of the firm and of the equity The expected capital gain will be higher in the future For individual shareholders: tax rates on dividend income are higher (taxed as ordinary income) than tax rates on capital gains (lower tax rates deferred until the stock is sold) The fact that capital gains are taxed favorable may lead us to prefer a low dividend payout approach

Some Real-World Factors Favoring a Low Payout: Flotation Costs Selling new stock (to pay a dividend) can be very expensive If we include the costs of selling stock (“flotation” costs”) in our argument, then we will find that the value of the stock decreases if we sell new stock Flotation Costs may lead us to prefer a low dividend payout approach

Some Real-World Factors Dividend Restrictions Bond indenture covenants can prohibit dividend payments above some level Corporations may be prohibited by state law from paying dividends if the dividend amount exceeds the firm’s retained earnings

Some Real-World Factors Favoring a High Payout: Desire for Current Income Many individuals desire current income and are willing to pay a premium to get a higher dividend yield Retired people Others living on a fixed income

Some Real-World Factors Favoring a High Payout: Desire for Current Income In a simple world with no brokerage fees or transaction costs: An individual preferring high current cash flow but holding low-dividend securities could easily sell off shares to provide the necessary funds An individual desiring a low current cash flow but holding high-dividend securities could just reinvest the dividends However, the real world does have brokerage fees and transactions costs associated with these transactions

Some Real-World Factors Favoring a High Payout: Tax & Legal Benefits from High Dividends The fact that dividends are taxed unfavorably for individual investors is a powerful argument for a low payout

Some Real-World Factors Favoring a High Payout: Corporate Investors A Corporate stockholder receiving either common or preferred dividends is granted a 70% dividend exclusion tax break This 70% exclusion does not apply to capital gains This tax advantage is why high-dividend, low-capital gains stocks may be more appropriate for corporations to hold and is why corporations hold a substantial percentage of the o/s preferred stock in the economy

Some Real-World Factors Favoring a High Payout: Tax-Exempt Investors Tax consequences are irrelevant for those in zero tax brackets: Pension Funds, Endowment Funds, and Trust Funds Institutions such as pension and trust funds often manage money for the benefit of others and have “fiduciary responsibility” to invest money prudently It has been considered imprudent in courts of law to buy stock in companies with no established dividend record University endowment funds and trust funds are frequently prohibited from spending any of the principal and therefore prefer high-dividend yield stocks – current income

Clientele Effects: A Resolution of Real-World Factors? Some groups (wealthy individuals, for example) have an incentive to pursue low-payout (or zero payout) stocks Other groups (corporations, for example) have an incentive to pursue high-payout stocks High-payout companies will attract one group while low-payout companies will attract another These different groups are called clienteles

Clientele Effects: A Resolution of Real-World Factors? Clientele Effect: Argument that stocks attract particular groups based on dividend yield and the resulting tax effects. When a firm chooses a particular dividend policy, the only effect is to attract a particular clientele If a firm changes its dividend policy, then it just attracts a different clientele

Clientele Effects: A Resolution of Real-World Factors? Simple Supply and Demand Argument: If 40% of all investors prefer high dividends, but only 20 percent of the firms pay high dividends, the high-dividend firms will be in short supply; thus their stock prices will rise Consequently, low-dividend firms will find it advantageous to switch policies until 40% of all firms have high payouts At this point, the dividend market is in equilibrium Further changes in dividend policy are pointless because all of the clienteles are satisfied

14.3 Establishing a Dividend Policy

Residual Dividend Approach If a firm wishes to avoid new equity sales, then it will have to rely on internally generated cash flow to finance new, positive NPV projects Dividends can only be paid out of what is left over This leftover is call the residual, and such a dividend policy is called a residual dividend approach

Residual Dividend Approach Residual Dividend Approach: Policy under which a firm pays dividends only after meeting its investment needs (i.e. all profitable investment opportunities are exhausted) while maintaining a desired debt-equity ratio Given this objective we expect: Firms with many investment opportunities to pay a small percentage of their earnings as dividends Young, fast-growing firms commonly employ a low payout ratio Firms with fewer opportunities to pay a high percentage of their earnings as dividends Older, slower-growing firms in more mature industries use a higher ratio

Residual Dividend Policy Example: Problem 15 (b) – Page 417 Wildcat, Inc., predicts that earnings in the coming year will be $30 million. There are 8 million shares, and Wildcat maintains a debt-equity ratio of 1.5. (b) Suppose the firm uses a residual dividend policy. Planned capital expenditures total $40 million. Based on this information, what will the dividend per share be? What dividend will be paid? $30M + 1.5($30M) = $75M $30M Equity + $45M Debt = $75M Equity %: $30M / $75M = 40% (1.5 x .40 = 60% debt) Equity to retain for cap ex: $40M x .40 = $16M Dividend Paid: $30M - $16M = $14M Dividend per Share: $14M / 8M shares = $1.75

Residual Dividend Policy Example: Not in Book Smith, Inc. has a target debt/equity ratio of .75. Aftertax earnings for 2001 were $850,000 and the firm needs $1,150,000 for new investments. If the company follows a residual dividend policy, what dividend will be paid? $850,000 + .75($850,000) = $1,487,500 $850,000 + $637,500 = $1,487,500 Equity %: $850,000 / $1,487,500 = 57% (leave in calculator) (.75 x .57 = 43%) Equity to retain for new investments: $1,150,000 x .57 = $657,142.86 Dividend Paid: = $850,000 - $657,142.86 = $192,857

Dividend Stability If investment opportunities in one period are quite high, dividends will be low or zero Dividends might be high in the next period if investment opportunities are considered less promising

Dividend Stability If a firm’s earnings are forecast to be equal from year to year but quarterly earnings change through the year, the firm can choose between at least two types of dividend policies: A cyclical dividend policy Each quarter’s dividend are a fixed percentage of that quarter’s earnings Dividends payments will vary throughout the year A stable dividend policy Each quarter’s dividend is a fixed percentage of forcasted yearly earnings All dividend payments will be equal

Dividend Stability Most financial managers agree that a stable dividend policy is in the best interest of the firm and its stockholders Most companies try to maintain a steady dividend through time Increasing the dividend only when management is confident the new dividend can be sustained indefinitely Dividend cuts are viewed as highly undesirable Often interpreted as a sign of financial distress

A Compromise Dividend Policy Many firms follow a compromise dividend policy based on 5 main goals: Avoid cutting back on positive NPV projects to pay a dividend Avoid dividend cuts Avoid the need to sell equity Maintain a target debt-equity ratio (long range) May be allowed to vary in the short run to avoid a dividend cut or the need to sell new equity Maintain a target dividend payout ratio

A Compromise Dividend Policy Financial Managers tend to think investors are entitled to a “fair” share of corporate income This share is the long-run target payout ratio: The fraction of the earnings the firm expects to pay as dividends under ordinary circumstances A firm’s long-term desired dividend-earnings ratio

A Compromise Dividend Policy Dividend instability can be minimized by creating two types of dividends: Regular Dividends: most likely a small fraction of permanent earnings, so that it could be sustained easily Extra Dividends: granted when an increase in earnings is expected to be temporary Investors view as a bonus with little disappointment when not repeated Few companies use in practice A share repurchase does much the same thing with some extra advantages

14.4 Stock Repurchase: An Alternative to Cash Dividends

Cash Dividends versus Repurchase When there are no taxes or other imperfections, a cash dividend and a share repurchase are essentially the same thing.

Cash Dividends versus Repurchase Payout of cash dividends to the shareholder reduces the value of the company by the amount of dividend payment After the dividend payment The shareholder has the same number of shares (reduced in value by the amount of the cash payout per share) Plus the dividend payment per share The two equal the original value of the firm Therefore, the shareholder’s wealth is unaffected

Cash Dividends versus Repurchase Share Repurchase: Company buys back its own shares of stock Tender offer – company states a purchase price and a desired number of shares Open market – buys stock in the open market Similar to a cash dividend in that it returns cash from the firm to the stockholders This is another argument for dividend policy irrelevance in the absence of taxes or other imperfections

Cash Dividends versus Repurchase Share Repurchases are : Usually initiated when firms have an excess amount of cash on hand Rather than increase the quarterly dividend payout to a level they might not be able to sustain in the future, they turn to the next best alternative, a stock repurchase When a firm repurchases shares of stock, it reduces the amount of equity outstanding which increases earnings and cash flow per share and is viewed by many investors as a positive signal regarding the firm’s future prospects.

Cash Dividends versus Repurchase Thus a firm’s stock price often jumps when a share repurchase is announced as interest in the stock increases

Real-World Considerations in a Repurchase In the real world a repurchase has a significant tax advantage over a cash dividend A cash dividend is fully taxed as ordinary income The shareholder has no choice about whether or not to receive the dividend In a share repurchase, a shareholder pays taxes only if: The shareholder actually chooses to sell and The shareholder has a capital gain

Real-World Considerations in a Repurchase Note: the IRS does not allow a repurchase solely for the purpose of avoiding taxes There must be a business-related reason for doing it The stock is undervalued, etc. A “buyback” is another term for a share repurchase Share “buybacks” are very big business and seem to be getting bigger and more common all the time

Share Repurchase and EPS A Share Repurchase: Reduces the number of outstanding shares Has no effect on total earnings EPS rises Same earnings divided by a reduced number of shares outstanding The EPS increase is simply an adjustment that reflects the change in the number of shares outstanding The increase in the EPS is exactly tracked by the increase in the market price per share

14.5 Stock Dividends and Stock Splits

Stock Dividend Stock Dividend: payment made by a firm to its owners in the form of stock, diluting the value of each share outstanding. Increases the number of shares each owner holds With more shares outstanding, each is worth less Commonly expressed as a percentage A 20% stock dividend means that a shareholder receives 1 new share for every 5 currently owned (1 / 5 = a 20% increase) Since every shareholder owns 20% more stock, the total number of shares o/s rises by 20% Each share of stock is worth about 20% less

Stock Dividend Price Adjustment Example: Problem 6 (b) – Page 415-16 Bermuda Triangle Corporation (BTC) currently has 300,000 shares of stock outstanding that sell for $80 per share. Assuming no market imperfections or tax effects exist, what will the share price be after: (b) BTC has a 15 percent stock dividend? 300,000 s/o x $80 = $24,000,000 Market Value of Equity 300,000 s/o x 1.15 = 345,000 s/o after 15% stock dividend $24,000,000 / 345,000 s/o = $69.57 or $80(1/1.15) = $69.57

Stock Dividend Small Stock dividend Large stock dividend stock dividends less than 20 to 25% Large stock dividend stock dividends greater than 20 to 25%

Stock Split Stock Split: An increase in a firm’s shares outstanding without any change in owners’ equity Each share is split up to create additional shares In a 3 for 1 stock split, each old share is split into 3 new shares

Stock Split Price Adjustment Example: Problem 6 (a) – Page 415-16 Bermuda Triangle Corporation (BTC) currently has 300,000 shares of stock outstanding that sell for $80 per share. Assuming no market imperfections or tax effects exist, what will the share price be after: (a) BTC has a five-for-three stock split? 300,000 s/o x $80 = $24,000,000 Market Value of Equity (300,000 s/o / 3) x 5 = 500,000 $24,000,000 / 500,000 s/o = $48.00 or $80 (3/5) = $48.00

Value of Stock Splits and Stock Dividends Stock splits and stock dividends can: (1) leave the value of the firm unaffected (2) increase its value or (3) decrease its value Unfortunately, the issues are complex enough that one cannot easily determine which of the three relationships holds.

Value of Stock Splits and Stock Dividends The Benchmark Case A strong case can be made that stock dividends and splits do not change either the wealth of any shareholder or the wealth of the firm as a whole. The number of shares outstanding is simply adjusted However, there may be some benefits to these actions. Stock split or stock dividend decisions are not treated lightly in practice.

Popular Trading Range Proponents of stock dividends and stock splits frequently argue that a security has a “proper” Trading Range: price range between highest and lowest prices at which a stock is traded. Above this level many investors do not have the funds to buy the common trading unit of 100 shares called a round lot. Commissions are greater for securities traded in odd-lot form (fewer than 100 shares)

Reverse Splits Reverse Split: Stock split under which a firm’s number of shares outstanding is reduced i.e. in a one-for-three reverse split, each investor exchanges three old shares for one new share. A case can be made that a reverse split changes nothing substantial about the company, however: Transaction costs may be less after the reverse split The liquidity and marketability of a company’s stock might be improved when its price is raised to the popular trading range Stocks selling below a certain level are not considered respectable and some argue that a reverse split can achieve instant respectability Stock exchanges have a minimum price per share requirements

Suggested Homework and Test Review Know chapter theories, concepts and definitions Know how to calculate: Stock Dividend Price Adjustment Problem 6 (b)(c) – page 415-16 Stock Split Price Adjustment Problem 6 (a) – page 415-16 Ex-Dividend Stock Price Problem 1 – page 415 Residual Dividend Problem 15 (b) – page 417 and Example in this presentation (Slide 42)