topic 10 (2012-13)mp dividends

7/29/2019 Topic 10 (2012-13)MP Dividends

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Corporate Financial Policy

Semester A 2012-13City University of Hong Kong

AC4331 Week 11


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1. Financial Management : Core Principles and Applications, 3rd Edition

Ross Westerfield Faffe and Jordan (2011)

2. Financial Management, 3rd Edition Megginson, Smart , Graham (2010)

Topic 10

.


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1-2

Introduction to Financial Management

Free Cash Flow

Financial Planning and Forecasting

Financial Assets and Time Value of Money

Risk and Return Bond and Stock Valuation

Cost of Capital

Cash Flow Estimation and Risk Analysis

Capital Structure and Leverage

Treasury and Valuation

Enterprise Risk Management Dividends and Share Repurchase Merger and Acquisitions


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Extra Ref:Financial Management, Theory and Practice, 12eEugene and

Brigham


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Distributions to shareholders

Chapter 16


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Chapter 16

Investor Preferences onDividends

Signaling Effects Residual Dividend Model Dividend Reinvestment Plans Stock Repurchases Stock Dividends and Stock Splits

16-5


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The decision to pay out earnings versusretaining and reinvesting them.

Dividend policy includes

High or low dividend payout? Stable or irregular dividends?

How frequent to pay dividends?

Announce the policy?

16-6


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Investors are indifferent between dividendsand retention-generated capital gains.

Investors can create their own dividend

policy If they want cash, they can sell stock.

If they dont want cash, they can use dividends tobuy stock.

Proposed by Modigliani and Miller and basedon unrealistic assumptions (no taxes orbrokerage costs), hence may not be true.Need an empirical test.

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May think dividends are less risky thanpotential future capital gains.

If so, investors would value high-payout

firms more highly, i.e., a high payout wouldresult in a high P0.

16-8


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May want to avoid transactions costs Maximum tax rate is the same as on

dividends, but Taxes on dividends are due in the year they are

received, while taxes on capital gains are duewhenever the stock is sold.

If an investor holds a stock until his/her death,beneficiaries can use the date of the death as the

cost basis and escape all previously accrued capitalgains.

16-9


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Investors view dividend increases as signalsof managements view of the future. Since managers hate to cut dividends, they wont

raise dividends unless they think the raise issustainable.

However, a stock price increase at time of adividend increase could reflect higherexpectations for future EPS, not a desire fordividends.

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Different groups of investors, or clienteles,prefer different dividend policies.

Firms past dividend policy determines its

current clientele of investors. Clientele effects impede changing dividend

policy. Taxes and brokerage costs hurtinvestors who have to switch companies.

16-11


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Find the retained earnings needed for thecapital budget.

Pay out any leftover earnings (the residual) as

dividends. This policy minimizes flotation and equity

signaling costs, hence minimizes the WACC.

16-12


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budget

capital

Total

ratio

equity

Target

IncomeNetDividends

16-13

Capital budget $800,000 Target capital structure 40% debt, 60%

equity

Forecasted net income $600,000

How much of the forecasted net incomeshould be paid out as dividends?


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For a given firm, the optimal payout ratio isa function of four factors: Investors preferences for dividends versus

capital gains

The firms investment opportunities Its target capital structure

The availability and cost of external capital

The last three elements are combined inwhat we call the residual dividend model


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Using the Residual Model to Calculate

Dividends Paid

Dividends = .Net

incomeTargetequityratio

Totalcapitalbudget[ ]))((


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Capital budget: $800,000. Given.

Target capital structure: 40% debt, 60%equity. Want to maintain.

Forecasted net income: $600,000.

How much of the $600,000 should wepay out as dividends?


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NI = $400,000: Need $480,000 of

equity, so should retain the whole$400,000. Dividends = 0.

NI = $800,000: Dividends = $800,000- $480,000 = $320,000. Payout =

$320,000/$800,000 = 40%.


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If NI = $400,000

Dividends = $400,000 (0.6)($800,000) =-$80,000.

Since the dividend results in a negative number,the firm must use all of its net income to fund itsbudget, and probably should issue equity tomaintain its target capital structure.

Payout = $0/$400,000 = 0%.

If NI = $800,000

Dividends = $800,000 (0.6)($800,000) =$320,000.

Payout = $320,000/$800,000 = 40%.

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Of the $800,000 capital budget, 0.6($800,000) = $480,000 mustbe equity to keep at target capital structure. [0.4($800,000) =$320,000 will be debt.]

With $600,000 of net income, the residual is $600,000 -

$480,000 = $120,000 = dividends paid.Payout ratio = $120,000/$600,000

= 0.20 = 20%.


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Calculate portion of capital budget to befunded by equity. Of the $800,000 capital budget, 0.6($800,000) =

$480,000 will be funded with equity.

Calculate excess or need for equity capital. There will be $600,000 $480,000 = $120,000

left over to pay as dividends.

Calculate dividend payout ratio. $120,000/$600,000 = 0.20 = 20%.

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Fewer good investments would lead tosmaller capital budget, hence to a higherdividend payout.

More good investments would lead to alower dividend payout.

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Advantage Minimizes new stock issues and flotation costs.

Disadvantages

Results in variable dividends Sends conflicting signals

Increases risk

Doesnt appeal to any specific clientele.

Conclusion Consider residual policy whensetting long-term target payout, but dontfollow it rigidly from year to year.

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Shareholders can automatically reinvest theirdividends in shares of the companyscommon stock. Get more stock than cash.

There are two types of plans: Open market

New stock

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Dollars to be reinvested are turned over totrustee, who buys shares on the openmarket.

Brokerage costs are reduced by volumepurchases.

Convenient, easy way to invest, thus usefulfor investors.

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Firm issues new stock to DRIP enrollees(usually at a discount from the market price),keeps money and uses it to buy assets.

Firms that need new equity capital use newstock plans.

Firms with no need for new equity capital useopen market purchase plans.

Most NYSE listed companies have a DRIP.Useful for investors.

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Forecast capital needs over a planninghorizon, often 5 years.

Set a target capital structure.

Estimate annual equity needs. Set target payout based on the residual

model.

Generally, some dividend growth rate

emerges. Maintain target growth rate ifpossible, varying capital structure somewhatif necessary.

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Buying own stock back from stockholders Reasons for repurchases:

As an alternative to distributing cash as dividends. To dispose of one-time cash from an asset sale. To make a large capital structure change.

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Stockholders can tender or not.

Helps avoid setting a high dividend thatcannot be maintained.

Repurchased stock can be used in takeoversor resold to raise cash as needed.

Income received is capital gains rather thanhigher-taxed dividends.

Stockholders may take as a positivesignalmanagement thinks stock isundervalued.

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May be viewed as a negative signal (firm haspoor investment opportunities).

IRS could impose penalties if repurchases

were primarily to avoid taxes on dividends. Selling stockholders may not be well

informed, hence be treated unfairly.

Firm may have to bid up price to complete

purchase, thus paying too much for its ownstock.

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Stock dividend: Firm issues new shares inlieu of paying a cash dividend. If 10%, get 10shares for each 100 shares owned.

Stock split: Firm increases the number ofshares outstanding, say 2:1. Sendsshareholders more shares.

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Both stock dividends and stock splitsincrease the number of shares outstanding,so the pie is divided into smaller pieces.

Unless the stock dividend or split conveysinformation, or is accompanied by anotherevent like higher dividends, the stock pricefalls so as to keep each investors wealth

unchanged. But splits/stock dividends may get us to an

optimal price range.

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Theres a widespread belief that the optimalprice range for stocks is $20 to $80. Stocksplits can be used to keep the price in thisoptimal range.

Stock splits generally occur whenmanagement is confident, so are interpretedas positive signals.

On average, stocks tend to outperform themarket in the year following a split.

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Eugene textbook

Questions:16-1, 16-3, 16-5, 16-6

Problems: 16-1, 16-2,16-3,16-6, 16-9

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Dividends and Other Payouts

Supplementary Notes

for Advanced Learners

Ref: Ross Westerfield Jaffe Jordan

Core Principles and Applications

of Corporate Finance

Chapter 16


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Differentiate and explain various dividendtypes and how they are paid

Grasp and apply the issues surroundingdividend policy decisions

Comprehend and explain why sharerepurchases are an alternative to dividends

Distinguish the difference between cash and

stock dividends

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16.1 Different Types of Dividends

16.2 Standard Method of Cash Dividend Payment

16.3 The Benchmark Case: An Illustration of theIrrelevance of Dividend Policy

16.4 Repurchase of Stock

16.5 Personal Taxes, Issuance Costs, and Dividends16.6 Real World Factors Favoring a High-Dividend

Policy

16.7 The Clientele Effect: A Resolution of Real WorldFactors?

16.8 What We Know and Do Not Know About DividendPolicy

16.9 Stock Dividends and Stock Splits

Appendix: Supplementary Materials

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Many companies pay a regular cash dividend. Public companies often pay quarterly.

Sometimes firms will pay an extra cash dividend.

The extreme case would be a liquidating dividend.

Companies will often declare stock dividends. No cash leaves the firm.

The firm increases the number of shares outstanding.

Some companies declare a dividend in kind. Wrigleys Gum sends a box of chewing gum. Dundee Crematoria offers shareholders discounted

cremations.

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Record DateDate on which company

determines existing shareholders.

Ex-Dividend Date - Date that determines

whether a stockholder is entitled to a dividend

payment; anyone holding stock immediately

before this date is entitled to a dividend.

Cash Dividend - Payment of cash by the firm

to its shareholders.


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25 Oct. 1 Nov. 2 Nov. 5 Nov. 7 Dec.

DeclarationDate Cum-dividend

Date

Ex-dividend

Date

RecordDate PaymentDate

Declaration Date: The Board of Directors declares a payment

of dividends.

Cum-Dividend Date: Buyer of stock still receives the dividend.

Ex-Dividend Date: Seller of the stock retains the dividend.

Record Date: The corporation prepares a list of all individuals

believed to be stockholders as of 5 November.


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In a perfect world, the stock price will fall by theamount of the dividend on the ex-dividend date.

40

$P

$P - div

Ex-

dividend

Date

The price drops

by the amount ofthe cash

dividend.

-t -2 -1 0 +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.


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A compelling case can be made that dividendpolicyis irrelevant.

Since investors do not need dividends toconvert 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 becauseinvestors can create whatever income streamthey prefer by using homemade dividends.

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Bianchi Inc. is a $42 stock about to pay a $2 cashdividend.

Bob Investor owns 80 shares and prefers a $3dividend.

Bobs homemade dividend strategy: Sell 2 shares ex-dividend

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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


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True or False: Dividends are irrelevant

True or False: Dividend policy is irrelevant

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In the above example, Bob Investor beganwith a total wealth of $3,360:

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share

42$

shares80360,3$

240$

share

39$shares80360,3$

80$160$

share

40$shares78360,3$

After a $3 dividend, his total wealth is still $3,360:

After a $2 dividend and sale of 2 ex-dividend shares, histotal wealth is still $3,360:


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Firms should never forgo positive NPVprojects to increase a dividend (or to pay adividend for the first time).

Recall that one of the assumptions underlying

the dividend-irrelevance argument is: Theinvestment policy of the firm is set ahead oftime and is not altered by changes individend policy.

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Instead of declaring cash dividends, firmscan rid themselves of excess cash throughbuying shares of their own stock.

Recently, share repurchase has become animportant way of distributing earnings toshareholders.

During the financial crisis of 2007 and 2008

share repurchases and dividends exceededreported earnings

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$10=/100,000$1,000,000=Price per share

100,000=outstandingShares

1,000,000Value of Firm1,000,000Value of Firm

1,000,000Equity850,000AssetsOther

0Debt$150,000Cash

sheetbalanceOriginalA.

Equity&LiabilitiesAssets

Consider a firm that wishes to distribute $100,000 to its

shareholders.


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$9=00,000$900,000/1=shareperPrice

100,000=goutstandinShares

900,000FirmofValue900,000FirmofValue

900,000Equity850,000AssetsOther

0Debt$50,000Cash

dividendcashshareper$1AfterB.

Equity&sLiabilitieAssets

If they distribute the $100,000 as a cash dividend, the balance

sheet will look like this:


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Assets Liabilities &Equity

C. After stock repurchase

Cash $50,000 Debt 0

Other Assets 850,000 Equity 900,000

Value of Firm 900,000 Value of Firm 900,000Shares 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:


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Flexibility for shareholders Keeps stock price higher

Good for insiders who hold stock options

As an investment of the firm

Tax benefits

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To get the result that dividend policy isirrelevant, we needed three assumptions: No taxes No transactions costs

No uncertainty In the United States, both cash dividends

and capital gains are taxed at a maximumrate of 15 percent (at least through 2010).

Since capital gains can be deferred, the taxrate on dividends is greater than theeffectiverate on capital gains.

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In a world of personaltaxes, firms should notissue stock to pay a

dividend. 52

FirmStock

Holders

Cash: stock issue

Cash: dividends

Gov.

Taxes

Investment Bankers The direct costs ofstock issuance willadd to this effect.


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The above argument does not necessarilyapply to firms with excess cash.

Consider a firm that has $1 million in cashafter selecting all available positive NPV

projects. Select additional capital budgeting projects (by

assumption, these are negative NPV).

Acquire other companies

Purchase financial assets Repurchase shares

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In the presence of personal taxes:1. A firm should not issue stock to pay a dividend.

2. Managers have an incentive to seek alternativeuses for funds to reduce dividends.

3. Though personal taxes mitigate against thepayment of dividends, these taxes are notsufficient to lead firms to eliminate all dividends.

4. Under current tax law, shareholders generallyprefer a repurchase to a dividend.

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Desire for Current Income Behavioral Finance

It forces investors to be disciplined.

Do investors have sufficient discipline to optimize

their position?

Agency Costs High dividends reduce free cash flow.

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Empirically, stock prices increase afterdividend increase announcements

Dividend increases are a signal that the firmis expected to do well

It is the expectation of good times, orinformation content effect, that raises theprice of the stock on dividend increases, notthe increase in the dividend itself

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Clienteles for various dividend payout policiesare likely to form in the following way:

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Group Stock 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 bychanging its dividend policy.

Stated differently, a firm can boost its stock price by paying

higher dividends only if an unsatisfied clientele exists


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Stability of dividends is important.Reducing dividends to make funds availablefor capital investment could send incorrectsignals to investors, who might push down

the stock price.

Dividend stability has 2 components: How dependable is the growth rate Can we count on at least receiving the current

dividend in the future


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Dividends are large in the aggregate Number of companies that pays has declined Many newly listed firms; less likely to pay dividends Tax policies matter; not a major deterrent

Corporations smooth dividends. Dividends provide information to the market. Firms should follow a sensible dividend policy:

Dont 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.

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Aggregate payouts are massive and haveincreased over time. Dividends are concentrated among a small

number of large, mature firms.

Managers are reluctant to cut dividends. Managers smooth dividends. Stock prices react to unanticipated changes in

dividends.

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Pay additional shares of stock instead ofcash

Increases the number of outstandingshares

Small stock dividend Less than 20 to 25% If you own 100 shares and the company declared a

10% stock dividend, you would receive an

additional 10 shares. Large stock dividend more than 20 to

25%

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Stock splits essentially the same as a stockdividend except it is expressed as a ratio For example, a 2 for 1 stock split is the same as a

100% stock dividend.

Stock price is reduced when the stock splits. Common explanation for split is to return

price to a more desirable trading range.

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http://www.stocksplits.net/


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1. What is Dividend Policy? 2. Do investors prefer High or Low payout?

Three theories

3. What is information content or signaling

hypothesis?

4. What is a Residual Dividend Model?

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Its the decision to pay out earnings versusretaining and reinvesting them. Includesthese elements:1. High or low payout?

2. Stable or irregular dividends?

3. How frequent?

4. Do we announce the policy?


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Dividends are irrelevant: Investors dontcare about payout.

Bird-in-the-hand: Investors prefer a highpayout.

Tax preference: Investors prefer a low

payout, hence growth.


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Firms value is determined only by its basicearning power and its business risk.

Investors are indifferent between dividendsand retention-generated capital gains. Ifthey want cash, they can sell stock. If theydont want cash, they can use dividends tobuy stock.

Modigliani-Miller support irrelevance.

Theory is based on unrealistic assumptions(no taxes or brokerage costs), hence maynot be true. Need empirical test.


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Investors think dividends are less riskythan potential future capital gains, hencethey like dividends.

If so, investors would value high payoutfirms more highly, i.e., a high payoutwould result in a high P0.


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Retained earnings lead to capital gains,which are taxed at lower rates thandividends: 28% maximum vs. up to

39.6%. Capital gains taxes are alsodeferred.

This could cause investors to prefer

firms with low payouts, i.e., a highpayout results in a low P0.


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Theory Implication

Irrelevance Any payout OK

Bird-in-the-hand Set high payout

Tax preference Set low payout

But which, if any, is correct???


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Stock Price ($)

Payout50% 100%

40

30

20

10

Bird-in-Hand

Indifference

Tax preference

0


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Cost of equity (%)

Payout50% 100%

15

20

10

Tax Preference

Indifference

Bird-in-Hand

0


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Empirical testing has not been able todetermine which theory, if any, is correct.

Thus, managers use judgment whensetting policy. Analysis is used, but it must be applied

with judgment.


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Managers hate to cut dividends, so wontraise dividends unless they think raise issustainable. So, investors view dividend

increases as signalsof managements viewof the future.

Therefore, a stock price increase at time of adividend increase could reflect higherexpectations for future EPS, not a desire fordividends.


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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 ofdividend changes? What are stock dividends, and how do

they differ from cash dividends?

How are share repurchases an alternativeto dividends, and why might investorsprefer them?

topic 10 (2012-13)mp dividends

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