Lecture 23-24 Chapter 11

Dividend & Share Repurchase: Dividend & Share Repurchase: Theory & Practice Theory & Practice

What is dividend policy?

x

The decision to pay out earnings versus retaining and reinvesting them. Dividend policy includes
x High

or low dividend payout? or irregular dividends? the policy? frequent to pay dividends?

x Stable x How

x Announce

Do investors prefer high or low dividend payouts?

x

Three theories of dividend policy:

x Dividend

irrelevance: Investors dont care about payout. Investors prefer a high payout.

x Bird-in-the-hand: x Tax

preference: Investors prefer a low payout.

Dividend irrelevance theory

x

Investors are indifferent between dividends and retention-generated capital gains. Investors can create their own dividend policy: x If they want cash, they can sell stock. x If they dont want cash, they can use dividends to buy stock. Proposed by Modigliani and Miller and based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true. Need an empirical test. Implication: any payout is OK.

Bird-in-the-hand theory
x

Investors think dividends are less risky than potential future capital gains, hence they like dividends. If so, investors would value highpayout firms more highly, i.e., a high payout would result in a high P0. Implication: set a high payout.

Tax Preference Theory

x

Retained earnings lead to long-term capital gains, which are taxed at lower rates than dividends: 20% vs. up to 38.6%. Capital gains taxes are also deferred. This could cause investors to prefer firms with low payouts, i.e., a high payout results in a low P0. Implication: Set a low payout.

Which theory is most correct?

x Empirical

testing has not been able to determine which theory, if any, is correct. managers use judgment when setting policy. is used, but it must be applied with judgment.

x Thus,

x Analysis

Dividends as a Passive Residual

Can the payment of cash dividends affect shareholder wealth? If so, what dividend-payout ratio will maximize shareholder wealth? (0 or 1)
x x

Pay out only excess cash, Strictly a financing decision The firm uses earnings plus the additional financing that the increased equity can support to finance any expected positive-NPV projects. Any unused earnings are paid out in the form of dividends. This describes a passive dividend policy.

Comments on Residual Dividend Policy

x x

Advantage Minimizes new stock issues and flotation costs. Disadvantages Results in variable dividends, sends conflicting signals, increases risk, and doesnt appeal to any specific clientele. This policy minimizes flotation and equity costs, hence minimizes the WACC. Conclusion Consider residual policy when setting target payout, but dont follow it rigidly.

x x

Whats the clientele effect?

x

Different groups of investors, or clienteles, prefer different dividend policies. Firms past dividend policy determines its current clientele of investors. Clientele effects obstruct changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies.

Problem 11.1

Irrelevance of Dividends
A. Current dividends versus retention of earnings
x

M&M argue that the effect of dividend payments on shareholder wealth is exactly offset by other means of financing. The dividend plus the new stock price after dilution exactly equals the stock price prior to the dividend distribution.

Irrelevance of Dividends
B. Conservation of value
x

M&M and the total-value principle ensures that the sum of market value plus current dividends of two firms identical in all respects other than dividend-payout ratios will be the same. Investors can create any dividend policy they desire by selling shares when the dividend payout is too low or buying shares when the dividend payout is excessive.

Relevance of Dividends
A. Preference for dividends
x

Uncertainty surrounding future company profitability leads certain investors to prefer the certainty of current dividends. Investors prefer large dividends. Investors do not like to manufacture homemade dividends, but prefer the company to distribute them directly.

x x

Relevance of Dividends
B. Taxes on the investor
x

Capital gains are preferred to dividends, everything else equal. Thus, high dividendyielding stocks should sell at a discount to generate a higher before-tax rate of return. Corporations can typically exclude 70% of dividend income from taxation. Thus, corporations generally prefer to receive dividends rather than capital gains.

Other Dividend Issues

x Flotation
x Favors

costs the retention of earnings the arbitrage process problems

Transaction costs and divisibility of securities

x Restricts x Divisibility

Institutional restrictions
x Seek

stocks paying reasonable dividends

Financial signaling

Empirical Testing of Dividend Policy

Tax Effect
x

Dividends are taxed more heavily (in PV terms) than capital gains, so before-tax returns should be higher for high-dividend-paying firms. Empirical results are mixed -- recently the evidence is largely consistent with dividend neutrality. Cash dividends speak louder than words Expect that increases (decreases) in dividends lead to positive (negative) excess stock returns. Empirical results are consistent with these expectations.

Financial Signaling
x x

Empirical Testing and Implications for Payout

x

Ex-dividend day tests

x Behavior

of common stock prices

Dividend-yield approach
x Relationship

between dividend yields and stock returns the time of the dividend change find that there is a significant earnings change
18

Financial signaling studies

x At

Implications for Corporate Policy

x

Establish a policy that will maximize shareholder wealth. Distribute excess funds to shareholders and stabilize the absolute amount of dividends if necessary (passive). Payouts greater than excess funds should occur only in an environment that has a net preference for dividends.

Implications for Corporate Policy

x

There is a positive value associated with a modest dividend. Could be due to institutional restrictions or signaling effects. Dividends in excess of the passive policy does not appear to lead to share price improvement because of taxes and flotation costs.

Factors Influencing Dividend Policy

Legal Rules
x

Capital Impairment Rule -- many states prohibit the payment of dividends if these dividends impair (weaken) capital (usually either par value of common stock or par plus additional paid-in capital). Insolvency Rule -- some states prohibit the payment of cash dividends if the company is insolvent under either a fair market valuation or equitable sense. Undue Retention of Earnings Rule -- prohibits the undue retention of earnings in excess of the present and future investment needs of the firm.

Factors Influencing Dividend Policy

Managerial Consideration
x x x x

Funding Needs of the Firm Liquidity Ability to Borrow Restrictions in Debt Contracts (protective covenants)

Dividend Stability
Stability -- maintaining the position of the firms dividend payments in relation to a trend line.
4

Dollars Per Share

50% of earnings paid out as dividends

Earnings per share

3 2 1 Dividends per share

Time

Dividend Stability
Dividends begin at 50% of earnings, but are stable and increase only when supported by growth in earnings.
4

Dollars Per Share

50% dividend-payout rate with stability

Earnings per share

3 2 1 Dividends per share

Time

Valuation of Dividend Stability

x

Information content -- management may be able to affect the expectations of investors through the informational content of dividends. A stable dividend suggests that the company expects stable or growing dividends in the future. Current income desires -- some investors who desire a specific periodic income will prefer a company with stable dividends to one with unstable dividends. Institutional considerations -- a stable dividend may permit certain institutional investors to buy the common stock as they meet the requirements to be placed on the organizations approved list.

Types of Dividends
Regular Dividend
x

The dividend that is normally expected to be paid by the firm.

Extra dividend
x

A non recurring (non frequent) dividend paid to shareholders in addition to the regular dividend. It is brought about by special circumstances.

Problem 11.10

Stock Dividends and Stock Splits

Stock Dividend -- A payment of additional shares of stock to shareholders. Often used in place of or in addition to a cash dividend. Small-percentage stock dividends
x

Typically less than 25% of previously outstanding common stock. Assume a company with 400,000 shares of $5 par common stock outstanding pays a 5% stock dividend. The pre-dividend market value is $40. How does this impact the shareholders equity accounts?

B/S Changes for the Small-% Stock Dividend

Present NS o/s Par value /share MPS Equity CS APiC R/E Total 2,000,000 1,000,000 7,000,000 10,000,000 400000 5 40

Stock Dividend New Shares Market Value Par Value

0.05 20,000 800,000 100,000 subtracted from R/E Added to CS

Small-Percentage Stock Dividends

Before 5% Stock Dividend Common stock ($5 par; 400,000 shares) $ 2,000,000 shares Additional paid-in capital 1,000,000 Retained earnings 7,000,000 Total shareholders equity $10,000,000 After 5% Stock Dividend Common stock ($5 par; 420,000 shares) $ 2,100,000 shares Additional paid-in capital 1,700,000 Retained earnings 6,200,000 Total shareholders equity $10,000,000

Stock Dividends, EPS, and Total Earnings

After a small-percentage stock dividend, what happens to EPS and total earnings of individual investors?
x

Assume that investor SP owns 10,000 shares and the firm earned $2.50 per share. Total earnings = $2.50 x 10,000 = $25,000. After the 5% dividend, investor SP owns 10,500 shares and the same proportionate earnings of $25,000. EPS is then reduced to $2.38 per share because of the stock dividend ($25,000 / 10,500 shares = $2.38 EPS). EPS

x x

Stock Dividends and Stock Splits

Large-percentage stock dividends
x x

Typically 25% or greater of previously outstanding common stock. The material effect on the market price per share causes the transaction to be accounted for differently. Reclassification is limited to the par value of additional shares rather than pre-stock-dividend value of additional shares. Assume a company with 400,000 shares of $5 par common stock outstanding pays a 100% stock dividend. The pre-stock-dividend market value per share is $40. How does this impact the shareholders equity accounts?

B/S Changes for the LargePercentage Stock Dividend

x

$2 million ($5 x 400,000 new shares) transferred (on paper) out of retained earnings. $2 million transferred into common stock account.

Large-Percentage Stock Dividends

Before 100% Stock Dividend Common stock ($5 par; 400,000 shares) $ 2,000,000 shares Additional paid-in capital 1,000,000 Retained earnings 7,000,000 Total shareholders equity $10,000,000 After 100% Stock Dividend Common stock ($5 par; 800,000 shares) $ 4,000,000 shares Additional paid-in capital 1,000,000 Retained earnings 5,000,000 Total shareholders equity $10,000,000

Stock Dividend Example 2

100,000 shares outstanding; $1 par; 5% stock $5 market Before effect of dividend dividend after balance
Common stock par value Shares outstanding Total par value Additional paid-in capital Total paid-in capital Retained earnings Total stockholders' equity $1.00 100,000 $100,000 750,000 850,000 1,000,000 $1,850,000 issue 5,000 sh 5,000 20,000 (25,000) $1.00 105,000 $105,000 770,000 875,000 975,000 $1,850,000

30% stock dividend effect of dividend balance after $1.00 issue 30,000 sh 130,000 30,000 $130,000 750,000 (30,000) 880,000 970,000 $1,850,000

5% MPS Par Extra 5NS 1Par price 4Extra MPS 5000 5000 20000 25000

30% 30000 30000 0 30000

5% stock dividend on 100,000 shares: issue 5,000 additional shares recorded at $5 per share

30% stock dividend on 100,000 shares: issue 30,000 additional shares recorded at $1 per share

Stock Dividends and Stock Splits

Stock Split -- An increase in the number of shares outstanding by reducing the par value of the stock.
x

Similar economic consequences as a 100% stock dividend. Primarily used to move the stock into a more popular trading range and increase share demand. Assume a company with 400,000 shares of $5 par common stock splits 2-for-1. How does this impact the shareholders equity accounts?

Stock Splits
Before 2-for-1 Stock Split Common stock ($5 par; 400,000 shares) $ 2,000,000 shares Additional paid-in capital 1,000,000 Retained earnings 7,000,000 Total shareholders equity $10,000,000 After 2-for-1 Stock Split Common stock ($2.50 par; 800,000 shares) $ 2,000,000 shares Additional paid-in capital 1,000,000 Retained earnings 7,000,000 Total shareholders equity $10,000,000

Stock Dividends and Stock Splits

Reverse Stock Split -- A stock split in which the number of shares outstanding is decreased.
x

Used to move the stock into a more popular trading range and increase share demand. Usually signals negative information to the market upon its announcement (consistent with empirical evidence). Assume a company with 400,000 shares of $5 par common stock splits 1-for-4. How does this impact the shareholders equity accounts?

Reverse Stock Splits

Before 1-for-4 Stock Split Common stock ($5 par; 400,000 shares) $ 2,000,000 shares Additional paid-in capital 1,000,000 Retained earnings 7,000,000 Total shareholders equity $10,000,000 After 1-for-4 Stock Split Common stock ($20 par; 100,000 shares) $ 2,000,000 shares Additional paid-in capital 1,000,000 Retained earnings 7,000,000 Total shareholders equity $10,000,000

Problem 11.8

Stock Repurchase
Stock Repurchase -- The repurchase (buyback) of stock by the issuing firm, either in the open (secondary) market or by self-tender offer.
Reasons for stock repurchase:
x x x x

Substitute for cash dividends Available for management stock-option plans Means to compensate employees Employees with existing stock options prefer share repurchase Available for the acquisition of other companies Go private by repurchasing all shares from outside stockholders. To permanently retire the shares

x x

Methods of Repurchase
x

Fixed-price self-tender offer -- Formal offer to stockholders to purchase so many shares at a set price Dutch auction self-tender offer -- A buyer (seller) seeks bids within a specified price range, usually for a large block of stock or bonds. After evaluating the range of bid prices received, the buyer (seller) accepts the lowest price that will allow it to acquire (dispose of) the entire block. Open-market purchase -- A company repurchases its stock through a brokerage house on the secondary market. SEC rules, Disclose intentions

Repurchasing as Part of a Dividend Decision

x

Fewer shares remaining outstanding

x EPS

rise per share rise price per share should rise

x Dividends x Market x x

Personal tax effect Signaling effect

Repurchasing as Part of Dividend Policy

Assume:
x x

Earnings after taxes Number of common shares outstanding Earnings per share Current market price per share Expected dividend per share Expected total dividends to be paid out

$ 800,000 400,000 $ $ $ 2 31 1

x x

x x

$ 400,000

Repurchasing as Part of Dividend Policy

If dividend is paid, shareholders receive: x Expected dividend per share $ x Market price per share $ x Total value $ If shares repurchased, shareholders receive:
x x x

1 30 31 0 31 31
= 12,903 = 15 = $2.07 = $31

Dividend per share Market price per share* Total value

$ $ $

* Shares repurchased Original P/E ratio New EPS New market price

= $400,000 / $31 = $30/$2 $30 = $800,000 / 387,097 = $2.07 x 15

Summary of Repurchasing as Part of Dividend Policy

x The

capital gain arising from the repurchase (stock rising from $30 to $31) exactly equals the dividend ($1) that would have otherwise been paid. result holds in the absence of taxes and transaction costs. the taxable investor, capital gains (repurchases) are favored to dividend income as the tax on the capital gain is postponed until the actual sale of the common shares.

x This x To

Administrative Considerations: Procedural Aspects

May 8 May 29 May 31 June 15

Record Date -- The date, set by the board of directors when a dividend is declared, on which an investor must be a shareholder of record to be entitled to the upcoming dividend. The board of directors met on May 8th to declare a dividend payable to shareholders on June 15th to the shareholders of record on May 31st.

Administrative Considerations: Procedural Aspects

May 8 May 29 May 31 June 15

Ex-dividend Date -- The first date on which a stock purchaser is no longer entitled to the recently declared dividend.
The buyer and seller of the shares have several days to settle (pay for the shares or deliver the shares). The brokerage industry has a rule that new shareholders are entitled to dividends only if they purchase the stock at least two business days prior to the record date.

Administrative Considerations: Procedural Aspects

May 8 May 29 May 31 June 15

Declaration Date -- The date that the board of directors announces the amount and date of the next dividend. Payment Date -- The date when the corporation actually pays the declared dividend.

Problem 11.9

Some Final Observations

x

Dividend in excess of residual implies a favorable effect on shareholder wealth Lack of clear empirical evidence Many companies believe dividend payout affects share price Repurchase of stock
x When

x x

sizable amount of excess funds more important

exists
x Increasingly

Setting Dividend Policy

x x x x x

Forecast capital needs over a planning horizon, 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 if possible, varying capital structure somewhat if necessary.