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Chapter 16: Payout Policy

Chapter 16: Payout Policy. 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.

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Chapter 16: Payout Policy

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  1. Chapter 16: Payout Policy • 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 Crematoria offers shareholders discounted cremations.

  2. Standard Method of Cash Dividend Payment Cash Dividend - Payment of cash by the firm to its shareholders. 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. Record Date - Person who owns stock on this date received the dividend.

  3. Procedure for Cash Dividend Payment 25 Oct. 1 Nov. 2 Nov. 6 Nov. 7 Dec. … Ex-dividend Date Declaration Date Cum-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 (typical clearing is 3 days).

  4. Price Behavior around the Ex-Dividend Date In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date. -t … -2 -1 0 +1 +2 … $P $P - div The price drops by the amount of the cash dividend Ex-dividend Date 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.

  5. The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy • 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. • Under some important assumption, M&M (1961) proved that dividend policy is irrelevant. The assumptions are • No taxes. • No transaction costs. • Perfect capital market (symmetric information, no agency problems, other)

  6. The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy (example 1) 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.(end its life) • The firm has no additional positive NPV projects

  7. An Illustration of the Irrelevance of Dividend Policy (example 1) I ) Current Policy:Dividends set equal to cashflow Dividends (Div.) at each date =$10000 The firm value will be :

  8. An Illustration of the Irrelevance of Dividend Policy (example 1) Assume 1,000 shares are outstanding, then, price just before dividend is paid is After the imminent dividend is paid, the stock price will fall to $9.09 (19.09-10)

  9. An Illustration of the Irrelevance of Dividend Policy (example 1) I I) Alternative Policy: Initial dividend > cash flow Pay $11 per share immediately i.e., $11 X 1000 shares = $11,000 as dividend. The extra $1,000 must be raised by issuing new stock. Since the investment decision did not change, the required return (cost of capital) is still 10%. So the new shareholders should receive at t=1: Date 0Date1 Total dividends to old shareholders $11,000 $8,900 Dividends per share $11 $8.9

  10. An Illustration of the Irrelevance of Dividend Policy (example 1) The PV of dividends per share (cum-dividend) with the alternative policy: • The indifference proposition: -The value of the firm at t=0 is the same not matter which scenario we consider . -The change in dividend policy did not affect the value of the share (cum-dividend).

  11. An Illustration of the Irrelevance of Dividend Policy (example 1) The mechanics of the policy: At t=0 (Ex-dividend), the price of the share will drop to $8.09 (8.9/1.1). This means that York needs to issue 1000/8.09 = 123.61 shares. There will be a total of 1123.61 shares outstanding. This leads to the following distribution of t=1 cash flow: Number of shares (%) T=1 Dividend old shareholders 1000 (89%) $8,900 new shareholders123.61 (11%)$1,100 Total 1123.61(100%) $9,000

  12. An Illustration of the Irrelevance of Dividend Policy (example 2) Pumpkin Pie Inc. currently has 1,000 shares outstanding with a total market value of $42,000. It expects cash flows from operations to be $10,000 next year. It wants to expand its product lines to include cookies and determines that it is a positive NPV project. The new product line requires a new oven that costs $8,000. Dividend Policy #1 Pay out any cash that is leftover after investing in all positive NPV projects. For next year, Pumpkin Pie Inc. will pay out $2,000 ($10,000 - $8,000) as cash dividend. Dividend Policy #2 Pumpkin Pie is considering a $3,000 cash dividend ($3 per share).

  13. Homemade Dividends • Pumpkin Pie 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

  14. Dividend Policy is Irrelevant • 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:

  15. Irrelevance of Stock Dividends 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

  16. Dividends and Investment Policy • Firms should never forgo positive NPV projects to increase a dividend (or to pay a dividend for the first time). • Note that the dividend-irrelevance argument assumes that “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

  17. Repurchase of Stock • 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.

  18. Share Repurchase Types: • Tender offers - If offer price is set wrong, some stockholders lose. • Auction • Open-market repurchase • Targeted repurchase (Greenmail)

  19. Assets Liabilities & Equity A. Original balance sheet Cash $150,000 Debt 0 Other assets 850,000 Equity 1,000,000 Value of Firm 1,000,000 Value of Firm 1,000,000 Shares outstanding 100,000 = Price per share $1,000,000 /100,000 = $10 = Stock Repurchase versus Dividend Consider a firm that wishes to distribute $100,000 to its shareholders.

  20. Assets Liabilitie s & Equity B. After $1 per share cash dividend Cash $50,000 Debt 0 Other assets 850,000 Equity 900,000 Value of Firm 900,000 Value of Firm 900,000 Shares outstandin g = 100,000 Price per share = $900,000/1 00,000 = $9 Stock Repurchase versus Dividend If they distribute the $100,000 as cash dividend, the balance sheet will look like this:

  21. Assets Li abilities & 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 900,000 Shares outstanding = 90,000 Price per share = $900,000 / 90,000 = $10 Stock Repurchase versus Dividend If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:

  22. Violation of M&M Assumptions(1) Taxes • In Canada, individual investors face a lower dividend tax rate due to the dividend tax credit. • However, capital gains for individuals are taxed at 50% of the marginal tax rate so the effective tax rate on dividend income is higher than the tax rate on capital gains. If dividends are taxed more heavily than capital gains, investors should pay more for stocks with low dividends (i.e., investors would be happy with a lower pretax rate of return from firms offering capital gains rather than dividends).

  23. Example (Table 16.1) Firm A Firm B Next year’s price $112.50 $102.50 Dividend $0 $10 Total pretax payoff $112.50 $112.50 Today’s stock price $100 $97.78 A is preferred to B because it does not pay highly taxed dividends Dividend tax (40%) 0 10×0.4= $4.00 Capital gain tax (20%) 12.5×0.2=$2.5 4.72×0.2=$0.94 After tax income 12.5-2.5=$10 14.72-4.94=$9.78 After tax return 10/100=10% 9.78/97.78=10% Before tax return 12.5/100=12.5% 14.72/97.78=15.05% A and B provide same return after tax, B provides higher return pretax

  24. Dividends Decrease Value (if one considers only the issue of taxes) Tax Consequences • Companies can convert dividends into capital gains by shifting their dividend policies. If dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move and value the firm more favorably. • Since capital gains are taxed at a lower rate than dividend income, companies should pay the lowest dividend possible. • Dividend policy should adjust to changes in the tax code.

  25. Evidence on Dividends and Taxes in Canada • 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.

  26. Violation of M&M Assumptions(2) Transaction costs • Also, in the real world there are transaction costs. This may suggest that • Shareholders may pay high transaction costs for selling shares instead of receiving dividends. • Issuing shares to raise equity my involve high fees to investment bankers.

  27. Violation of M&M Assumptions(3) Agency Costs • Consider a firm 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 (empire building) • Purchase financial assets • Repurchase shares

  28. Violation of M&M Assumptions(4) Information Asymmetry Dividends as Signals Dividend increases send good news about cash flows and earnings. Dividend cuts send bad news. Because a high dividend payout policy will be costly to firms that do not have the cash flow to support it, dividend increases signal a company’s good fortune and its manager’s confidence in future cash flows.

  29. Desire for Current Income(5) Market Imperfection Dividends and Income Trusts and endowment funds may be prohibited to invest in non-dividend paying firms. Since they manage funds by themselves, they may not be willing to spend the fees required in other intermediaries to pass this requirement.

  30. Summary of all Effects • Reasons for Low Dividend • Personal Taxes • High Issuing Costs • Reasons for High Dividend • Information Asymmetry • Dividends as a signal about firm’s future performance • Lower Agency Costs • capital market as a monitoring device • reduce free cash flow, and hence wasteful spending • Desire for Current Income

  31. The Clientele Effect: A Resolution of Real-World Factors? (cont.) Clienteles for various dividend payout policies are likely to form in the following way: Group Stock High Tax Bracket Individuals Zero to Low payout stocks Low Tax Bracket Individuals Low-to-Medium payout Tax-Free Institutions Medium Payout Stocks Corporations High Payout Stocks Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy.

  32. The Clientele Effect Example • 40% of investors prefer high dividends • 60% of investors prefer low dividends • 20% of firms pay high dividends • 80% of firms pay low dividend High dividend firms in short supply (price ↑), Low dividends firm in high supply (price ↓). Some firms will change policy and increase dividends, till 40% of firm pay high dividends, and 60% of firms will pay low dividends. Once payouts of corporations conform to the desires of shareholders, no single firm can affect its market value by switching from one dividend strategy to another.

  33. The Dividend Decision Lintner’s “Stylized Facts” (How Dividends are Determined) 1. Firms have longer term target dividend payout ratios. 2. Managers focus more on dividend changes than on absolute levels. 3. Dividends changes follow shifts in long-run, sustainable levels of earnings rather than short-run changes in earnings. 4. Managers are reluctant to make dividend changes that might have to be reversed. 5. Firms repurchase stock when they have accumulated a large amount of unwanted cash or wish to change their capital structure by replacing equity with debt.

  34. Summary and Conclusions • 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 favor 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. Agency consideration may also lead to high dividends.

  35. Practice question 1: Time Line On April 5, the board of directors of Capital City Golf Club declared a dividend of $0.75 per share payable on Tuesday, May 4, to shareholders of record as of Tuesday April 20. Suppose you bought 350 shares of Capital City stock on April 6 for $8.65 a share. Assume there are no taxes, no transaction costs, and no news between your purchase and sale of the stock. If you were to sell your stock on April 16, for how much would you be able to sell your stock? What if you were to sell the stock on April 21?

  36. Practice question 2: M&M Theorem The net income of Novis Corporation, which has 10,000 outstanding shares and a 100% payout policy is $32,000. The expected value of the firm one year hence is $1,545,600. The appropriate discount rate for Novis is 13%. • What is the current value of the firm? • What is the ex-dividend price of Novis’s stock if the board follows its current policy? • At the dividend declaration meeting, several board members claimed that the dividend is too small and is probably depressing Novis’ price. They proposed that Novis sell enough new shares to finance a $4.25 dividend. (a) comment on the claim that the low dividend is depressing the stock price. Support your argument with calculations. (b) If the proposal is adopted, at what price will the new shares sell and how many will be sold?

  37. Practice question 3: Dealing with Taxes National Business Machine Co. (NBM) has $2 million of extra cash. NBM has two choices to make use of this cash. One alternative is to invest the cash in financial assets. The resulting investment income will be paid out as a special dividend at the end of three years. In this case, the firm can invest in TB yielding 7%, or an 11% preferred stock. Only 30% of the dividends from investing in preferred stock would be subject to corporate taxes. Another alternative is to pay out the cash as dividends and let the shareholders invest on their own in treasury bills with the same yield. The corporate tax rate is 35%, and the individual tax rate is 31%. Should the cash be paid today or in three years? Which of the two options generates the highest after-tax income for the shareholders?

  38. Practice question 4: Real World Factors? In the May 4, 1981, issue of Fortune, an article entitled “Fresh Evidence That Dividends Don’t Matter” stated, “All told, 115 companies of the S&P 500 firms raised their payout every year during the period 1970-1989. Investors in this group would have fared somewhat better than investors in the 500 as a whole with a median return of 10.7% versus 9.4% for the S&P 500.” Is the evidence that investors prefer dividends to capital gains? Why or why not?

  39. Chapter 17Does Debt Policy Matter? • The Effect of Capital Structure in a Competitive Tax Free Environment • Financial Risk and Expected Returns • The Weighted Average Cost of Capital • A Final Word on After Tax WACC

  40. M&M (What is it all about?) • What is the capital structure question? • Why maximizing equity value and firm value is the same (under what assumptions)?

  41. M&M (Debt Policy Doesn’t Matter) Modigliani & Miller It makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure. Major Assumptions (not all): (1) Individuals and firms borrow/lend at same rate. (2) No Bankruptcy costs (3) No transaction costs (4) No taxes

  42. The Idea.. Can We Create Value By Splitting a Pie? The derivation is straightforward: The present value of this stream of cash flows is VL The present value of this stream of cash flows is VU

  43. M&M (Debt Policy Doesn’t Matter)

  44. M&M (Debt Policy Doesn’t Matter)

  45. Example 1 Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.) Current Assets $20,000 Debt $0 Equity $20,000 Debt/Equity ratio 0.00 Interest rate n/a Shares outstanding 400 Share price $50 Proposed $20,000 $8,000 $12,000 2/3 8% 240 $50

  46. EPS and ROE Under Current Capital Structure Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 Net income $1,000 $2,000 $3,000 EPS $2.50 $5.00 $7.50 EBIT/A 5% 10% 15% ROE 5% 10% 15% Current Shares Outstanding = 400 shares

  47. EPS and ROE Under Proposed Capital Structure Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 640 640 640 Net income $360 $1,360 $2,360 EPS $1.50 $5.67 $9.83 EBIT/A 5% 10% 15% ROE 3% 11% 20% Proposed Shares Outstanding = 240 shares

  48. EPS and ROE Under Both Capital Structures All-Equity Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 Net income $1,000 $2,000 $3,000 EPS $2.50 $5.00 $7.50 EBIT/A 5% 10% 15% ROE 5% 10% 15% Current Shares Outstanding = 400 shares LeveredRecession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 640 640 640 Net income $360 $1,360 $2,360 EPS $1.50 $5.67 $9.83 EBIT/A 5% 10% 15% ROE 3% 11% 20% Proposed Shares Outstanding = 240 shares

  49. Financial Leverage and EPS 12.00 Debt 10.00 8.00 No Debt Advantage to debt 6.00 Break-even point EPS 4.00 2.00 0.00 1,000 2,000 3,000 Disadvantage to debt (2.00) EBIT EBI in dollars, no taxes

  50. Homemade Leverage Recession Expected Expansion EPS of Unlevered Firm $2.50 $5.00 $7.50 Earnings for 40 shares $100 $200 $300 Less interest on $800 (8%) $64 $64 $64 Net Profits $36 $136 $236 ROE (Net Profits / $1,200) 3% 11% 20% We are buying 40 shares of a $50 stock on margin. We get the same ROE as if we bought into a levered firm. Our personal debt equity ratio is:

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