17-1 dividends and payout policy chapter 17 copyright © 2013 by the mcgraw-hill companies, inc. all...

17-1

Dividends and Payout Policy

Chapter 17

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

17-2

Chapter Outline

•Dividend Payments

•Dividend Theory

•Does Dividend Policy Matter?

•Factors Favoring a Low Dividend Payout

•Factors Favoring a High Dividend Payout

•Experience with Dividend Policies

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Chapter Outline


•Dividend Theory





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Dividends and Retained Earnings

Net Income

Dividends Retained Earnings

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Net Income

Dividends Retained Earnings

The decision as to how many dividend dollars to allocate from the net income is the firm’s Dividend Policy.

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Cash Dividends

•Regular cash dividend – cash payments made directly to stockholders, usually each quarter

•Extra cash dividend – indication that the “extra” amount may not be repeated in the future

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Cash Dividends

•Special cash dividend – similar to extra dividend, but definitely will not be repeated

•Liquidating dividend – some or all of the business has been sold

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Vocabulary for Dividend Payments

1.Declaration Date – Board declares the dividend, and it becomes a liability of the firm

2. Ex-dividend Date• Occurs two business days before

date of record• If you buy stock on or after this

date, you will not receive the dividend

• Stock price generally drops by about the amount of the dividend

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Vocabulary for Dividend Payments

3. Date of Record – Holders of record are determined, and they will receive the dividend payment

4. Date of Payment – checks are mailed

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Timing of Dividend Payments

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Bonus Dividends

Bonus Dividend –

The payment of additional dollars to each shareholder (above the “regular” dividend payment). This is another name for extra cash dividends.

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Stock Dividends

•Pay additional shares of stock instead of cash

•Increases the number of outstanding shares

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Stock Dividends• Small stock dividendLess 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• Stock splits – essentially the same as a stock dividend except expressed as a ratio:

For example, a 2 for 1 stock split is the same as a 100% stock dividend

•The stock price is reduced when the stock splits

•The common explanation for split is to return price to a “more desirable trading range”

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Work the Web

Find out about current Stock Splits

http://www.stocksplits.net/

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Stock Repurchase

A company buys back its own shares of stock

•Tender offer – company states a purchase price and a desired number of shares

•Open market – buys its own common stock in the open market

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Stock Repurchase A company buys back its own shares of stock

•Similar to a cash dividend in that it returns cash from the firm to the stockholders

•This is another argument for dividend policy irrelevance in the absence of taxes or other imperfections

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Real-World Considerations

• Stock repurchase allows investors to decide if they want the current cash flow and associated tax consequences.

•Given our tax structure, repurchases may be more desirable due to the options provided stockholders.

The IRS recognizes this and will not allow a stock repurchase for the sole purpose of allowing investors to avoid taxes.

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Information Content of

Stock Repurchases

•Stock repurchases send a positive signal that management believes the current price is low

•Tender offers send a more positive signal than open market repurchases because the company is stating a specific price

•The stock price often increases when repurchases are announced

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An Actual Example: Repurchase

Announcement “America West Airlines announced that its Board of Directors has authorized the purchase of up to 2.5 million shares of its Class B common stock on the open market as circumstances warrant over the next two years …

Following the approval of the stock repurchase program by the company’s Board of Directors earlier today. W. A. Franke, chairman and chief officer said ‘The stock repurchase program reflects our belief that America West stock may be an attractive investment opportunity for the Company, and it underscores our commitment to enhancing long-term shareholder value.’

The shares will be repurchased with cash on hand, but only if and to the extent the Company holds unrestricted cash in excess of $200 million to ensure that an adequate level of cash and cash equivalents is maintained.”

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Chapter Outline


•Dividend Theory





17-22

Dividend Policy Theory

The “Residual Theory of Dividends” Given three pieces of information, we can construct the theoretical optimal dividend payout for a firm:

1.The estimated (forecasted) profits,

2.The firm’s Optimal Capital Structure,

3.The total cash needed to purchase next year’s projects (the firm’s shopping list for projects)

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Residual Theory of DividendsAn example will explain this better:

1.The estimated (forecasted) profits:$3,000,000

2. The Optimal Capital Structure:D/E = .65/.35

3. The total cash needed for future projects:

$2,150,000

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Residual Theory of DividendsEstimate the equity needed for

purchasing:

$2,150,000 ( .35) = $752,500Now construct the division of estimated profits to retained earning and dividends:

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Estimated Net Income$3,000,000

Dividends$2,247,500

Retained Earnings$752,500

The residual is paid out as dividends:

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Chapter Outline


•Dividend Theory





17-27

Does Dividend Policy Matter?

We know that many firms do NOT follow the “Residual Theory of Dividends”. What is going on? It appears that there are other factors at play when it comes to a firm’s dividend policy.

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M & M’s “Information Content of Dividends”

Modigliani and Miller (M & M) postulate that the payment of dividends, the non- payment of dividends, or the change of pattern to the past payment of dividends all signal important information to the shareholders.

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Dividends and Signals

Asymmetric information –

Managers have more information about the health of the company than investors

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Changes in dividends convey information:

Dividend increases:

•Management believes it can be sustained

•Expectation of higher future dividends, increasing present value

•Signal of a healthy, growing firm

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Changes in dividends convey information:

Dividend decreases:•Management believes it can no longer sustain the current level of dividends

•Expectation of lower dividends indefinitely; decreasing present value

•Signal of a firm that is having financial difficulties

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Dividends may matter – the value of the stock is based on the present value of expected future dividends

Maybe “YES”

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Dividend policy may not matter:

Dividend policy is the decision to pay dividends versus retaining funds to reinvest in the firm

In theory, if the firm reinvests capital now, it will grow and can pay higher dividends in the future

Maybe “No”

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Illustration of Irrelevance

Consider a firm that can either pay out dividends of $10,000 per year for each of the next two years

or can pay $9,000 this year, reinvest the other $1,000 into the firm and then pay $11,120 next year.

(Investors require a 12% return.)

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Illustration of Irrelevance

Consider a firm that can either pay out dividends of $10,000 per year for each of the next two years

or can pay $9,000 this year, reinvest the other $1,000 into the firm and then pay $11,120 next year.

Thus, it makes no difference!

$10,000/ (1.12) + $10,000/ (1.12)2

= $ 8,928.57 + $7,971.94 = $16,900.51

$ 9,000/ (1.12) + $11,120/ (1.12)2

= $ 8,035.71 + $8,864.80 = $16,900.51

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Chapter Outline


•Dividend Theory





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Low Payout, Please

Why might a low payout be desirable?

1. Individuals in upper income tax brackets might prefer lower dividend payouts, given the immediate tax liability, in favor of higher capital gains with the deferred tax liability

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Taxes for the Wealthy

Net Income

DividendsRetained Earnings

Taxed at ordinary income

tax level (high taxes)

Taxed at a fixed tax rate for capital gains

when the stock is sold(lower tax rate)

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Low Payout, Please

Why might a low payout be desirable?

2. Flotation costs – low payouts can decrease the amount of capital that needs to be raised, thereby lowering flotation costs

3. Dividend restrictions – debt contracts might limit the percentage of income that can be paid out as dividends

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Chapter Outline


•Dividend Theory





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High Payout, Please

Why might a high payout be desirable?

1. Desire for current income

• Individuals that need current income(for example, retirees needing fixed incomes)

• Groups that are legally prohibited from spending principal (for example, managers of trusts and endowments)

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High Payout, Please

Why might a high payout be desirable?

2. Uncertainty resolution – no guarantee that the higher future dividends will materialize

3. Taxes• Dividend exclusion for

corporations

• Tax-exempt investors don’t have to worry about differential treatment between dividends and capital gains

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Clientele Effect (It’s all about the

investors!)Some investors prefer low dividend payouts and will buy stock in those companies that offer low dividend payouts

Some investors prefer high dividend payouts and will buy stock in those companies that offer high dividend payouts

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Implications of the Clientele Effect

•What do you think will happen if a firm changes its policy from a high payout to a low payout?

•What do you think will happen if a firm changes its policy from a low payout to a high payout?

•If this is the case, does dividend policy matter?

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Chapter Outline


•Dividend Theory





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What We Know (and Do Not Know)

• Corporations “smooth” dividends

• Dividends provide valuable information to the market

• Corporations rarely change their dividend policy

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What We Know (and Do Not Know)

• Firms should follow a sensible dividend policy:

1. Don’t forgo positive NPV projects just to pay a dividend

2. Avoid issuing stock to pay dividends

3. Consider share repurchase when there are few better uses for the cash

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Putting the Pieces Together

• Aggregate payouts are massive and have increased 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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Management View of Dividend Policy: Survey Results

Agree or Strongly Agree:

•93.8% Try to avoid reducing dividends per share

•89.6% Try to maintain a smooth dividend from year to year

•41.7% Pay dividends to attract investors subject to “prudent man” restrictions

17-50

Management View of Dividend Policy: Survey Results

Important or Very Important

•84.1% Maintaining consistency with historic dividend policy

•71.9% Stability of future earnings

•9.3% Flotation costs to issue new equity

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Ethics Issues

Should a company initiate a dividend policy exclusively to reduce the taxes paid by some of their shareholders?

Should the management of a company announce the increase payment of dividends when they have knowledge of significant cash flow problems?

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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 relevance?

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?

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Comprehensive Problem

A company’s stock is priced at $50 per share, and it plans to pay a $2 cash dividend.

Assuming perfect capital markets, what will the per share price be after the dividend payment?

If the average tax rate on dividends is 25%, what will the new share price be?

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Comprehensive Problem

A company’s stock is priced at $50 per share, and it plans to pay a $2 cash dividend.

Assuming perfect capital markets, what will the per share price be after the dividend payment?

If the average tax rate on dividends is 25%, what will the new share price be?

In a perfect market, new price = $50-$2 = $48.00

In an imperfect market, new price = 48 + 2*.25= $48.50

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Terminology

•Dividend Policy•Cash Dividend•Stock Dividend•Bonus Dividend•Stock Split•Stock Repurchase•Signaling Effect•Clientele Effect

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Terminology

•Declaration Date•Ex-dividend Date•Date of Record•Date of Payment

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Key Concepts and Skills

•Define the types of dividends•Describe how and when dividends are paid•Why are dividends paid (or not paid, for that matter)?•Explain how cash and stock dividends differ•How can stock repurchases be used as an alternative to dividend payments?

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1. Dividend Policy is the decision by management to pay dividends versus keeping retained earnings.

2. Dividends are typically paid quarterly in the form of cash.

3. Alternatives to cash dividends are stock dividends and repurchasing.

What are the most important topics of this chapter?

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4. Firms have reasons for high or low dividend payouts often involving “information”.

5. Investors have separate reasons for high or low dividend payouts often involving taxes or cash needs.

What are the most important topics of this chapter?

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Questions?

17-1 dividends and payout policy chapter 17 copyright © 2013 by the mcgraw-hill companies, inc. all...

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