1. Dividend Policy 03/04/2008 Ch. 10

2. 2 What is a dividend? Return of Cash to the Owners Forms Periodic Cash Dividend - $0.50 per share each quarter (an example) Share repurchase – Company buys back shares any shareholders can sell back a portion of their ownership Liquidating Dividend (Liquidating Event) – Sell all your shares and terminated ownership (can sell ownership to another person or to the company) What is not a dividend Stock split – just exchanging a $20 for two $10s Stock dividend – just a small stock split

3. 3 Chapter 10 Question Are Dividends Good or Bad? Three Answers Dividend Policy is Irrelevant “Cash Dividends” are good “Cash Dividends” are bad We will explore the basis of each answer First, the mechanics of a cash dividend Timing, Amount, Which Owner and so on…

4. 4 Mechanics of a Cash Dividend Board (Management) chooses to return cash to the shareholders Board declares amount per share Date of record (the day that the current shareholder will be determined for the dividend) Payment date (day the cash is “mailed’) There is continuous buying and selling of shares so the price of the stock will reflect who will receive the cash dividend Market determines the ex-date of the stock Buying stock before ex-date means stock trades with the dividend Buying stock after the ex-date the stock trades without the dividend

5. 5 Cash Dividend Example On February 1, 2008 Pepsi Management declares a $0.375 per share to be paid to record holders as of February 15, 2008 to be paid on March 6, 2008 (timeline diagram…page 447) The price of Pepsi is $68.63 on February 1st The ex-date is February 12 th, that is, any shares that trade before Feb. 12 th will be with dividend Anyone who buys the shares on or before 2-12-2008 will have their name on the official records at Pepsi before the close of business on February 15th The date of record is February 15 th Pepsi will “prepare the list” of shareholders as of the close of business on this date Checks will be mailed to the record holders on March 6, 2008. Should you always wait to sell after 2-12-2008?

6. 6 Cash Dividend Example – Cont. When to sell or buy the shares of Pepsi Price at close on February 12 th -- $71.96 Price at close on February 13 th -- $71.63 Price change on ex-date is $0.33 Selling Date is irrelevant (Revenue is always with div) Seller gets Price (which includes dividend) before 2-12 Seller gets Price without dividend but will receive dividend Buying Date is irrelevant (Cost is always w/o div) Buyer never gets the dividend… Pays dividend to seller before 2-12, but gets dividend from Pepsi, after 2-12 just pays for stock

7. 7 Some More Dividend Terms Dividend Yield – Dividend / Price Dividend Payout – Dividends / Net Income Retention Ratio – 1 minus Dividend Payout This is the percent of the Net Income “reinvested” in the company for the owners DRIPS – Dividend Reinvestment Programs Rather than receive a cash dividend, the dividends are “rolled” back to the company and the owner receives additional stock Target Dividend Payout Ratio – anticipated annually distribution percent Sticky Dividends – reluctance to lower dividends

8. 8 Dividend Policy is Irrelevant Note, dividends are not irrelevant but rather the way they are paid is irrelevant Shareholders can undo any dividend policy and make it their own desired policy In a world of no taxes…no transaction costs Old Ms. Hubbard owns 10,000 shares at $10.00 per share Wants dividend for this period of $10,000 Company will pay either $0 or $1 or $2

9. 9 Undoing the Dividend Policy With $0 dividend policy Ms. Hubbard sells 1,000 shares – gets $10,000 for selling and now has 9,000 at $10 for “paper wealth of $90,000 With $1/share dividend policy Ms. Hubbard gets dividend check of $10,000 Price of shares fall by cash dividend to $9 “Paper Wealth” $9 x 10,000 = $90,000 With $2/share dividend policy Ms. Hubbard will receive $20,000 dividend check Ms. Hubbard uses $10,000 to buy additional shares now at $8 per share ($10,000 / $8 = 1,250 shares) “Paper Wealth” is 11,250 x $8 = $90,000 Ms. Hubbard always has $10,000 cash and $90,000 paper

10. 10 Dividends Are Bad Adding Taxes to the mix Dividends are taxed as ordinary income Selling shares – only gain is taxed and this is at the capital gains tax rate Shareholders want to avoid taxes Back to Ms. Hubbard Dividend policy is $0, $1 or $2 Tax rate is 25% ordinary income, 15% capital gains, and original price of stock is $10

11. 11 After-Tax Cash Flow of Dividends At $0 – Sells 1,000 shares and pays no taxes Receives $10,000 after tax At $1 – Receives check of $10,000 but pays tax of $2,500, must sell 250 shares to get to $10,000 cash At $2 – Receives check of $20,000 but pays tax of $5,000 Only has $5,000 for buying stocks, gets only 500 more shares Ms. Hubbard prefers no cash dividends…

12. 12 Dividends are Bad There are many different tax rates Corporations in some countries get tax relief on dividends paid Individuals in some countries get “tax relief” Shareholders get credit for taxes paid by corporation Some countries have lower rates on dividends Individuals can pick timing of receipt with no dividend policy (take dividends when income is lower and thus lower taxes) Some funds pay no taxes Foundations Pension Funds Mutual Funds

13. 13 Dividends are Good Bird in the Hand – give it to shareholders now before the company goes bankrupt Company has more cash than investment opportunities – give excess to shareholders Shareholder like dividends – Widows and Orphans story where they are relying on dividends Disciplines Managers – reduce the amount of cash in the company and managers must validate new borrowing with capital markets

14. 14 Different Policies Policies attract certain types of clienteles High-Yield policies attract shareholders that like dividends Low-Yield policies attract shareholders that like want less distributions in the form of cash dividends Signally Theory Dividends are costly to imitate so they signal optimistic outlook for future dividends

15. 15 Problems to Review All but 3 and 4 Problem #1 – Marginal Tax Rate of Investors (Price B – Price A )/Dividend = (1 – t ORD )/(1 – t CAP ) ($50 - $46.50) / $5 = (1 – t ORD )/(1 – 0.40) -t ORD = ($3.50 / $5) x 0.60 -1 = -0.58 or 58% Problem #2 – Arbitrage all stocks where the stock price falls by less than the cash dividend Proof – NE Gas Buy stock before ex-date, sell after ex-date What is your cash flow, $48 + $4 - $50 = $2