lecture 10: corporate equity, earnings and dividends
TRANSCRIPT
The Corporation
• [1611] A body corporate legally authorized to act as a single individual, an artificial person created by royal charter, prescription, or act of legislature, and having authority to preserve certain rights in perpetual succession. (OED)
• Compare publicani of ancient Rome, essentially corporations (though the most prominent were private collecting agencies for taxes)
For-Profit vs. Non-Profit
• For-profit corporation is owned by shareholders, equal claim after debts paid, subject to corporate profits tax.
• Non-profit is not owned, self-perpetuating directors. Not subject to corporate profits tax.
Common vs. Preferred Stock
• Common stock: dividend is at discretion of firm, subject to legal restrictions
• Preferred stock: Specified dividend does not have to be paid, but firm cannot pay dividend on common stock unless all past preferred stock dividends are paid.
• Corporate bonds: Firm is contractually obligated to pay coupons and there is a maturity date when principal must be paid.
Limited Liability
• Even publicani had some form of limited liability sometimes
• New York State legislature made limited liability standard for all corporations, 1811
• Standard copied by other states, finally California, 1931.
Other Corporate Obligations
• Convertible bonds: bondholder has option to convert the bond to stock
• Employee incentive options
• Tracking stock
• Junk bonds
• Warrants
• Partnership contracts
Voting of Common Shares
• Usually one share one vote, in person or by proxy, for board of directors and some other essential matters
• Shareholders meetings usually annual event, and required by law for big events such as merging corporation
• Shareholder meeting circuses
Berle and Means
• Adolf A. Berle Jr., and Gardiner C. Means, The Modern Corporation and Private Property, 1933
• Separation of ownership and control• “ownership is so widely scattered that working
control can be maintained with but a minority interest.”
• The “quasi-public corporation” is constrained by law to serve other interests.
Payment of Dividends
• Purely discretionary
• Young firms typically pay none
• NASDAQ dividend yield virtually zero
• Corporate culture influences dividends. Microsoft
• Liquidity constraints on dividends
Modigliani-Miller Dividend Irrelevance Theory
• Journal of Business, 1961.• Assume no taxes or transactions costs• Consider purely financial transaction:
selling shares to pay dividends• M&M Conclusion: Dividend policy has no
effect on the value of the firm.• Purely nominal difference between
dividend checks and repurchase checks.
Adding Taxes to M&M World
• Dividends are taxable as personal income, share repurchases are capital gains, lower rate.
• Announcing payment of new dividends should lower value of firm by present value of taxes.
Why Do Firms Pay Dividends?
• Hersch Shefrin and Meir Statman: Self-control theory of dividends. (analogy to Christmas clubs, overwithholding) Rule of thumb spending rule.
• Prospect theory interpretation: framing matters. Dividends framed as income.
• University endowments once required high-yield investments to provide income
Dividend Signalling
• By raising dividends, firm shows it can court bankruptcy.
• Battacharya, Hakansson, Ross
• Problem: alternative signalling methods are cheaper tax-wise
Lintner Model of Dividends
• DIVt-DIVt-1= ( × EPSt-DIVt-1)
=adjustment rate, 0< <1 =target ratio, 0< <1
D IV E P Stk
kt k
( )10
Kahneman & Tversky Framing Example
• “US is preparing for a rare Asian disease which is expected to kill 600 people.”
• “If Program A is adopted, 200 people will be saved. If program B is adopted, there is a 1/3 probability that 600 people will be saved and a 2/3 probability that no people will be saved.” (Majority: A)
K&T Framing Continued
• Other respondents given a different choice:
• If program C is adopted, 400 people will die If Program D is adopted, there is a 1/3 probability that no one will die, and a 2/3 probability tha 600 people will die.” (Majority: D) Scientific American 1981
General Public Utilities Corp
• President Kuhn proposed to substitute stock dividends for cash dividends, and offered to sell the stock dividend for any stockholder for minimal transaction cost. (ca. 1968)
• Direct saving to shareholder: $4 million a year.
• Intense negative shareholder reaction
S&P D/E & D/P 1871-2004
S&P 500 Dividend/Earnings and Dividend/Price, 1871-2004
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
1.8
1860 1880 1900 1920 1940 1960 1980 2000 2020
Year
Dividend/Earning
Dividend/Price
Share Repurchase
• Once rare, now S&P 500 firms repurchase approx. 2% of shares per year. They issue about 1% of shares per year in employee option exercise, so net repurchase is about 1% per year.
• Repurchase now almost as high as dividends paid, but firms still pay dividends. A puzzle.
Reasons for Share Repurchase
• Tax break for investors• Firms’ unwillingness to cut dividends, uncertainty
that current earnings will continue• Price pop after a repurchase. Buybacks taken as a
signal. But price pops are fading.• Now investors sometimes view repurchase as a
sign that firm is “old economy.” NASDAQ firms less likely to repurchase shares, as if they think value is too high.
Employee Options and Share Repurchase
• The “overhang,” percent of stock market promised to employees via options, stood at 6.2% in 144 of largest S&P 500 firms in 1998.
• Option holders have an interest in repurchasing shares rather than paying dividends.
• Lambert Lanen & Larker JFQA 1985: dividend payouts reduced after option plans introduced.