1. Prepared by Professor Wei Wang Queen’s University © 2011 McGraw–Hill Ryerson Limited Dividends and Other Payouts Chapter Nineteen

2. 19-1 © 2011 McGraw–Hill Ryerson Limited Chapter Outline 19.1 Different Types of Dividends 19.2 Standard Method of Cash Dividend Payment 19.3 The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy 19.4 Repurchase of Stock 19.5 Personal Taxes, Issuance Costs, and Dividends 19.6 Expected Return, Dividends, and Personal Taxes 19.7 Real-World Factors Favouring a High-Dividend Policy 19.8 The Clientele Effect: A Resolution of Real-World Factors 19.9 What We Know and Do Not Know About Dividend Policy 19.10 Summary and Conclusions

3. 19-2 © 2011 McGraw–Hill Ryerson Limited Different Types of Dividends LO19.1 Many companies pay a regular cash dividend. –Public companies often pay quarterly. –Sometimes firms will throw in an extra cash dividend. –The extreme case would be a liquidating dividend. Often companies will declare stock dividends. –No cash leaves the firm. –The firm increases the number of shares outstanding. Some companies declare a dividend in kind. –Wrigley’s Gum sends around a box of chewing gum. –Dundee Crematorium offers shareholders discounted cremations.

4. 19-3 © 2011 McGraw–Hill Ryerson Limited Standard Method of Cash Dividend Payment LO19.2 Record Date - Person who owns stock on this date received the dividend. Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend. Cash Dividend - Payment of cash by the firm to its shareholders.

5. 19-4 © 2011 McGraw–Hill Ryerson Limited Procedure for Cash Dividend Payment LO19.2 25 Oct.1 Nov.2 Nov.6 Nov.7 Dec. Declaration Date Cum- dividend Date Ex- dividend Date Record Date Payment Date … Declaration Date: The board of directors declares a payment of dividends. Cum-Dividend Date: The last day that the buyer of a stock is entitled to the dividend. Ex-Dividend Date: The first day that the seller of a stock is entitled to the dividend. Record Date: The corporation prepares a list of all individuals believed to be stockholders as of 6 November.

6. 19-5 © 2011 McGraw–Hill Ryerson Limited Price Behaviour around the Ex-Dividend Date LO19.2 In a perfect world, the stock price will fall by the amount of the dividend on the ex- dividend date. $P$P $P - div Ex- dividend Date The price drops by the amount of the cash dividend -t … -2-10+1+2 … Taxes complicate things a bit. Empirically, the price drop is less than the dividend and occurs within the first few minutes of the ex-date.

7. 19-6 © 2011 McGraw–Hill Ryerson Limited The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy LO19.3 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 dividend payouts. 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.

8. 19-7 © 2011 McGraw–Hill Ryerson Limited The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy LO19.3 Example: York Corporation, an all-equity firm At date 0, the managers are able to forecast cash flows perfectly. The firm will receive a cashflow of $10,000 at date 0 and $10,000 at date 1 The firm will dissolve at date 1. The firm has no additional positive NPV projects

9. 19-8 © 2011 McGraw–Hill Ryerson Limited An Illustration of the Irrelevance of Dividend Policy (continued) LO19.3 I ) Current Policy:Dividends set equal to cashflow Dividends (Div.) at each date = $10000 The firm value will be :

10. 19-9 © 2011 McGraw–Hill Ryerson Limited An Illustration of the Irrelevance of Dividend Policy (continued) LO19.3 Assume 1,000 shares are outstanding, then: After the imminent dividend is paid, the stock price will fall to $9.09 (19.09-10)

11. 19-10 © 2011 McGraw–Hill Ryerson Limited An Illustration of the Irrelevance of Dividend Policy (continued) LO19.3 I I) Alternative Policy: Initial dividend > cash flow Pay $11 per share immediately i.e., $11 X 1000 shares = $11,000 as total dividend. The extra $1,000 must be raised by issuing new stock. Date 0Date1 Total dividends to old shareholders $11,000$8,900 Dividends per share $11$8.9 Note: at date1, the new shareholders will get $1,100 of the total cash flow leaving only $8,900 to old shareholders.

12. 19-11 © 2011 McGraw–Hill Ryerson Limited An Illustration of the Irrelevance of Dividend Policy (continued) LO19.3 The PV of dividends per share with the alternative policy: The indifference proposition: -The PV of the stock in both scenarios is the same. -The change in dividend policy did not affect the value of a share.

13. 19-12 © 2011 McGraw–Hill Ryerson Limited Modigliani and Miller (MM) proposition LO19.3 MM proposition: Investors are indifferent to dividend policy Assumptions: 1)No taxes, brokerage fees, etc. 2)Homogeneous expectations 3)The investment policy of the firm is set ahead of time

14. 19-13 © 2011 McGraw–Hill Ryerson Limited Homemade Dividends LO19.3 ABC Inc. is a $42 stock about to pay a $2 cash dividend. Bob Investor owns 80 shares and prefers $3 cash dividend. Bob’s homemade dividend strategy: –Sell two 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

15. 19-14 © 2011 McGraw–Hill Ryerson Limited Dividend Policy is Irrelevant LO19.3 Since investors do not need dividends to convert shares to cash, dividend policy will have no impact on the value of the firm. In the above example, Bob Investor began with total wealth of $3,360:  After a $3 dividend, his total wealth is still $3,360:  After a $2 dividend, and sale of two ex-dividend shares,his total wealth is still $3,360:

16. 19-15 © 2011 McGraw–Hill Ryerson Limited Irrelevance of Stock Dividends: Example LO19.3 XYZ Inc. has two million shares currently outstanding at $15 per share. The company declares a 50% stock dividend. How many shares will be outstanding after the dividend is paid? A 50% stock dividend will increase the number of shares by 50%: 2 million×1.5 = 3 million shares After the stock dividend what is the new price per share and what is the new value of the firm? The value of the firm was $2m × $15 per share = $30 m. After the dividend, the value will remain the same. Price per share = $30m/ 3m shares = $10 per share

17. 19-16 © 2011 McGraw–Hill Ryerson Limited Dividends and Investment Policy LO19.3 Firms should never forgo positive NPV projects to increase a dividend (or to pay a dividend for the first time). Recall that one of the assumptions underlying the dividend-irrelevance arguments was “The investment policy of the firm is set ahead of time and is not altered by changes in dividend policy.” A final note: -Dividends are relevant -Dividend policy is irrelevant

18. 19-17 © 2011 McGraw–Hill Ryerson Limited Repurchase of Stock LO19.4 Instead of declaring cash dividends, firms can rid itself of excess cash through buying shares of their own stock. Recently share repurchase has become an important way of distributing earnings to shareholders. When tax avoidance is important, share repurchase is a potentially useful adjunct to dividend policy.

19. 19-18 © 2011 McGraw–Hill Ryerson Limited Stock Repurchase versus Dividend LO19.4 $10=/100,000$1,000,000 = Price per share 100,000 = outstanding Shares 1,000,000Value of Firm1,000,000Value of Firm 1,000,000Equity850,000assetsOther 0Debt$150,000Cash sheet balance Original A. Equity &Liabilities Assets Consider a firm that wishes to distribute $100,000 to its shareholders.

20. 19-19 © 2011 McGraw–Hill Ryerson Limited Stock Repurchase versus Dividend LO19.4 $9=00,000$900,000/1 = shareper Price 100,000=goutstandin Shares 900,000Firm of Value900,000Firm of Value 900,000Equity850,000assetsOther 0Debt$50,000Cash dividendcash shareper $1After B. Equity & sLiabilitie Assets If they distribute the $100,000 as cash dividend, the balance sheet will look like this:

21. 19-20 © 2011 McGraw–Hill Ryerson Limited Stock Repurchase versus Dividend LO19.4 Assets Liabilities& Equity C. After stock repurchase Cash$50,000Debt0 Other assets850,000Equity900,000 Value of Firm900,000Value of Firm900,000 Shares outstanding=90,000 Price pershare= $900,000/90,000=$10 If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:

22. 19-21 © 2011 McGraw–Hill Ryerson Limited Share Repurchase (Real-World Considerations) LO19.4 Lower tax Tender offers –If offer price is set wrong, some stockholders lose. Open-market repurchase Targeted repurchase –Greenmail –Gadflies Repurchase as investment –Recent studies have shown that the long-term stock price performance of securities after a buyback is significantly better than the stock price performance of comparable companies that do not repurchase.

23. 19-22 © 2011 McGraw–Hill Ryerson Limited To get the result that dividend policy is irrelevant, we needed three assumptions: –No taxes –No transactions costs –No uncertainty In Canada, individual investors face a lower dividend tax rate due to the dividend tax credit. Capital gains for individuals are taxed at 50% of the marginal tax rate, and the effective tax rate on dividend income is higher than the tax rate on capital gains. Personal Taxes, Issuance Costs, and Dividends LO19.5

24. 19-23 © 2011 McGraw–Hill Ryerson Limited Firms Without Sufficient Cash to Pay a Dividend LO19.5 In a world of personal taxes, firms should not issue stock to pay a dividend. Firm Stock Holders Cash: stock issue Cash: dividends Gov. Taxes Investment Bankers The direct costs of stock issuance will add to this effect.

25. 19-24 © 2011 McGraw–Hill Ryerson Limited Firms With Sufficient Cash to Pay a Dividend LO19.5 The above argument does not necessarily apply to firms with excess cash. Consider a firm that has $1 million in cash after selecting all available positive NPV projects. The firm has several options: –Select additional capital budgeting projects (by assumption, these are negative NPV). –Acquire other companies –Purchase financial assets –Repurchase shares

26. 19-25 © 2011 McGraw–Hill Ryerson Limited In the presence of personal taxes: 1.A firm should not issue stock to pay a dividend. 2.Managers have an incentive to seek alternative uses for funds to reduce dividends. 3.Though personal taxes mitigate against the payment of dividends, these taxes are not sufficient to lead firms to eliminate all dividends. Personal Taxes, Issuance Costs, and Dividends LO19.5

27. 19-26 © 2011 McGraw–Hill Ryerson Limited Expected Return, Dividends, and Personal Taxes LO19.6 What is the relationship between the expected return on the stock and its dividend yield? The expected pretax return on a security with a high dividend yield is greater than the expected pretax return on an otherwise-identical security with a low dividend yield. After tax is a different story; otherwise-identical securities should have the same return.

28. 19-27 © 2011 McGraw–Hill Ryerson Limited Evidence on Dividends and Taxes in Canada LO19.6 Prior to 1972, capital gains were untaxed in Canada In 1985, a life-time exemption on capital gains was introduced. Anticipation of the tax break on capital gains caused investors to bid up prices of low-dividend yield stocks. Firms responded by lowering their dividend payouts. The dividend tax credit works to reduce taxes on dividends received from Canadian firms.

29. 19-28 © 2011 McGraw–Hill Ryerson Limited Real World Factors Favouring a High Dividend Policy LO19.7 Desire for Current Income Behavioral Finance Agency Costs Dividends Signalling

30. 19-29 © 2011 McGraw–Hill Ryerson Limited Desire for Current Income LO19.7 The homemade dividend argument relies on no transactions costs. To put this in perspective, mutual funds can repackage securities for individuals at very low cost: they could buy low-dividend stocks and with a controlled policy of realizing gains, pay their investors at a specified rate.

31. 19-30 © 2011 McGraw–Hill Ryerson Limited Behavioral Finance LO19.7 Investors deal with self-control in investing and consumption. Selling stocks to realize cash for consumption: may sell off too much. Holding high dividend paying stocks: sticking to a firm personal rule of never “dipping into principal.”

32. 19-31 © 2011 McGraw–Hill Ryerson Limited Agency Costs LO19.7 Agency Cost of Debt –Firms in financial distress are reluctant to cut dividends. To protect themselves, bondholders frequently create loan agreements stating dividends can only be paid if the firm has earnings, cash flow, and working capital above pre-specified levels. Agency Costs of Equity –Managers will find it easier to squander funds if they have a low dividend payout.

33. 19-32 © 2011 McGraw–Hill Ryerson Limited Dividends Signalling LO19.7 Stock price rises when a firm stats or resumes dividends, and falls following announcements of dividend omissions. Firms will raise the dividend only when future earnings and cash flows are expected to rise enough so that the dividend is not likely to be reduced later. The rise in the stock price following the dividend signal is called the information content effect of dividend.

34. 19-33 © 2011 McGraw–Hill Ryerson Limited The Clientele Effect: A Resolution of Real-World Factors? LO19.8 Reasons for Low Dividend –Personal Taxes –High Issuing Costs Reasons for High Dividend –Information Asymmetry Dividends as a signal about firm’s future performanc e –Lower Agency Costs capital market as a monitoring device reduce free cash flow, and hence wasteful spending –Bird-in-the-hand: Theory or Fallacy? Uncertainty resolution –Desire for Current Income Clientele Effect

35. 19-34 © 2011 McGraw–Hill Ryerson Limited The Clientele Effect: A Resolution of Real-World Factors? LO19.8 Clienteles for various dividend payout policies are likely to form in the following way: GroupStock High Tax Bracket Individuals Low Tax Bracket Individuals Tax-Free Institutions Corporations Zero to Low payout stocks Low-to-Medium payout Medium Payout Stocks High Payout Stocks Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy.

36. 19-35 © 2011 McGraw–Hill Ryerson Limited What We Know and Do Not Know About Dividend Policy LO19.9 Corporations “Smooth” Dividends. Dividends Provide Information to the Market. 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.

37. 19-36 © 2011 McGraw–Hill Ryerson Limited Summary and Conclusions LO19.10 The optimal payout ratio cannot be determined quantitatively. In a perfect capital market, dividend policy is irrelevant due to the homemade dividend concept. A firm should not reject positive NPV projects to pay a dividend. Personal taxes and issue costs are real-world considerations that favour low dividend payouts. Many firms appear to have a long-run target dividend-payout policy. There appears to be some value to dividend stability and smoothing. There appears to be some information content in dividend payments.

38. 19-37 © 2011 McGraw–Hill Ryerson Limited Quick Quiz What are the different types of dividends, and how is a dividend paid? What is the clientele effect, and how does it affect dividend policy irrelevance? What is the information content of dividend changes? What are stock dividends, and how do they differ from cash dividends? How are share repurchases an alternative to dividends, and why might investors prefer them?