FIN 614: Financial Management Larry Schrenk, Instructor

1.Facts about Dividends 2.Classes of Dividend Theories 3.Clientele Effect 4.Signaling Theory 5.Residual Distribution Policy 6.Final Comments

Corporations ‘smooth’ dividends Dividends provide information to the market Significant amounts are paid out in dividends Firms should follow a sensible dividend policy: Don’t 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.

Dividends are Irrelevant Investors don’t care about payout High Dividends are Preferred Low Dividends are Preferred

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. Theory is based on unrealistic assumptions (no taxes or brokerage costs).

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 ex-dividend 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 $240 $39 × 80 = $3,120

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:

Investors might think dividends (i.e., the-bird- in-the-hand) are less risky than potential future capital gains. High payouts help reduce agency costs Therefore, investors would value high payout firms more highly and would require a lower return to induce them to buy its stock.

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.

Low payouts mean higher capital gains. Capital gains taxes are deferred until they are realized, so they are taxed at a lower effective rate than dividends. Investors to require a higher pre-tax return to induce them to buy a high payout stock, which would result in a lower stock price.

Different groups of investors, or clienteles, prefer different dividend policies Firm’s past dividend policy determines its current clientele of investors Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies due to a change in payout policy.

Some investors prefer low dividend payouts and will buy stock in those companies that offer low dividend payouts Some investors prefer high dividend payouts and will buy stock in those companies that offer high dividend payouts

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.

What do you think will happen if a firm changes its policy from a high payout to a low payout? What do you think will happen if a firm changes its policy from a low payout to a high payout? If this is the case, does dividend POLICY matter?

Dividend changes are signals of management’s view of the future. Managers hate to cut dividends, so won’t raise dividends unless they think raise is sustainable. Therefore, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends.

Asymmetric Information–Managers have more information about the firm than investors Changes in dividends convey information Dividend increases Management believes it can be sustained Expectation of higher future dividends, increasing present value Signal of a healthy, growing firm Dividend decreases Management believes it can no longer sustain the current level of dividends Expectation of lower dividends indefinitely; decreasing present value Signal of a firm that is having financial difficulties

Find the reinvested earnings needed for the capital budget. Pay out any leftover earnings (the residual) as either dividends or stock repurchases. This policy minimizes flotation and equity signaling costs, hence minimizes the WACC.

Determine capital budget Determine target capital structure Finance investments with a combination of debt and equity in line with the target capital structure Remember that retained earnings are equity If additional equity is needed, issue new shares If there are excess earnings, then pay the remainder out in dividends

Fewer good investments would lead to smaller capital budget, hence to a higher dividend payout. More good investments would lead to a lower dividend payout.

Distr. = – Net income Target equity ratio Total capital budget Distr. = – Required equity Net income

Given Need $5 million for new investments Target capital structure: D/E = 2/3 Net Income = $4 million Finding dividend 40% financed with debt (2 million) 60% financed with equity (3 million) NI – equity financing = $1 million, paid out as dividends

Advantages: Minimizes new stock issues and flotation costs. Disadvantages: Results in variable dividends Sends conflicting signals Increases risk Doesn’t appeal to any specific clientele.

Goals, ranked in order of importance 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 Maintain a target dividend payout ratio Companies want to accept positive NPV projects, while avoiding negative signals

Agree or Strongly Agree 93.8% Try to avoid reducing dividends per share 89.6% Try to maintain a smooth dividend from year to year 41.7% pay dividends to attract investors subject to “prudent man” restrictions Important or Very Important 84.1% Maintaining consistency with historic dividend policy 71.9% Stability of future earnings 9.3% Flotation costs to issue new equity

Legal Restrictions: Dividends cannot be paid from permanent capital accounts Liquidity: Retained earnings and cash are not identical Access to other sources of financing Stability of earnings Restrictions in debt contracts

Some research suggests that high payout companies have higher required returns on stock, supporting the tax effect hypothesis. But other research using an international sample shows that in countries with poor investor protection (where agency costs are most severe), high payout companies are valued more highly than low payout companies. Empirical testing has produced mixed results Theories may apply differently to different firms

FIN 614: Financial Management Larry Schrenk, Instructor