1. CORPORATE FINANCIAL THEORY Lecture 6

2. Review Goal: M aximize Value of the Firm Past Topics Investment Decision (spending money) Financing Decision (raising money) Future Topics “Variations on a Theme”

3. Today’s Topics Dividends (today) Define (Capital Budgeting & Investment variation) Dividends & Value of the Firm Capital Structure Define (financing variation) Capital Structure & Value of the Firm

4. Dividends A payment made by a company to the shareholders of the company.

5. Dividend Payments Cash Dividend - Payment of cash by the firm to its shareholders. -Regular -Special Stock Dividend - Distribution of additional shares to a firm’s stockholders. Stock Splits - Issue of additional shares to firm’s stockholders.

6. Dividend Payments Stock Repurchase - Firm buys back stock from its shareholders.  Stock Repurchase (4 methods) 1. Buy shares on the market 2. Tender Offer to Shareholders 3. Dutch Auction 4. Private Negotiation (Green Mail)

7. Dividend Terms  Record Date  Announcement Date  Payment Date  Ex-Dividend

8. Dividend Payments Aug 14 Aug 25 Aug26Sept 1Sept 15 Declaration With- Ex-dividend Record Payment date dividend date date date date Share price falls

9. 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 dividend payouts. In other words, dividend policy will have no impact on the value of the firm.

10. Dividend Policy is Irrelevant Example - Assume Rational Demiconductor has no extra cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend. Record Date Cash1,000 Asset Value9,000 Total Value10,000+ New Proj NPV 2,000 # of Shares 1,000 price/share $12

11. Dividend Policy is Irrelevant Example - Assume Rational Demiconductor has no extra cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend. Record DatePmt Date Cash1,0000 Asset Value9,0009,000 Total Value10,000+9,000 New Proj NPV 2,0002,000 # of Shares 1,0001,000 price/share $12 $11

12. Dividend Policy is Irrelevant Example - Assume Rational Demiconductor has no extra cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend. Record DatePmt DatePost Pmt Cash1,00001,000 (91 sh @ $11 ) Asset Value9,0009,0009,000 Total Value10,000+9,00010,000 New Proj NPV 2,0002,000 2,000 # of Shares 1,0001,0001,091 price/share $12 $11$11 NEW SHARES ARE ISSUED

13. Example - continued - Shareholder Value Record Stock12,000 Cash 0 Total Value12,000 Stock = 1,000 sh @ $12 = 12,000 Dividend Policy is Irrelevant

14. Example - continued - Shareholder Value RecordPmt Stock12,00011,000 Cash 01,000 Total Value12,00012,000 Stock = 1,000sh @ $11 = 11,000

15. Dividend Policy is Irrelevant Example - continued - Shareholder Value RecordPmt Post Stock12,00011,00012,000 Cash 01,000 0 Total Value12,00012,00012,000 Stock = 1,091sh @ $11 = 12,000 Assume stockholders purchase the new issue with the cash dividend proceeds.

16. Payout Policies

17. Dividend & Stock Repurchases $ Billions U.S. Data 1995 - 2013

18. Dividend Theories Leftists (M&M) - Div does not effect value Rightists - Dividends increase value Middle of the roaders - Leftist theory with some reality thrown in. Residual Dividend Policy

19. Dividend Theories MRI = IRR COC12 % r QTY $$$

20. Dividends Increase Value Market Imperfections and Clientele Effect There are natural clients for high-payout stocks, but it does not follow that any particular firm can benefit by increasing its dividends. The high dividend clientele already have plenty of high dividend stock to choose from. These clients increase the price of the stock through their demand for a dividend paying stock.

21. Dividends Increase Value Dividends as Signals Dividend increases send good news about cash flows and earnings. Dividend cuts send bad news. Because a high dividend payout policy will be costly to firms that do not have the cash flow to support it, dividend increases signal a company’s good fortune and its manager’s confidence in future cash flows.

22. Dividends Decrease Value Tax Consequences Companies can convert dividends into capital gains by shifting their dividend policies. If dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move and value the firm more favorably. In such a tax environment, the total cash flow retained by the firm and/or held by shareholders will be higher than if dividends are paid.

23. Taxes and Dividend Policy Companies can convert dividends into capital gains by shifting their dividend policies. If dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move and value the firm more favorably. In such a tax environment, the total cash flow retained by the firm and/or held by shareholders will be higher than if dividends are paid. Since capital gains are taxed at a lower rate than dividend income, companies should pay the lowest dividend possible. Dividend policy should adjust to changes in the tax code.

24. Taxes and Dividend Policy In U.S., shareholders are taxed twice (figures in dollars)

25. Taxes and Dividend Policy Under imputed tax systems, such as that in Australia, Shareholders receive a tax credit for the corporate tax the firm pays (figures in Australian dollars)

26. Capital Structure Read Chapter 17 on your own Overlap with Lecture 3

27. Exam Review