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Unformatted text preview: TBS 907 AUTUMN 2005 LECTURE 5 MODULE 3 ( CONTD) DIVIDEND POLICY Dividend Policy Dividend Policy Business decisions investment financing dividend Dividend policy Determining how much of a company's profit is to be paid to shareholders as dividends and how much is to be retained. Types of Dividends
Cash Div Regular Cash Div Special Cash Div Stock Div Stock Repurchase (4 methods)
1. Buy shares on the market 2. Tender Offer to Shareholders 3. Dutch Auction 4. Private Negotiation (Green Mail) What is a Dividend? Cash dividend is payment to shareholders quarterly, annually or on special occasions most often Quarterly Totally Discretionary (for Common Stock) Like liquidating investment in the firm: giving your money back Like a Buy Back of stock, but different taxation (ordinary income vs capital gain) Dividend Vocabulary Dividend Payout Ratio Plowback Ratio Dividend Yield (1 Payout Ratio) Dividend / Stock Price Dividend per Share / EPS Dividend Policy Whether to Pay any? How much to Pay? Per share dollar trend or Payout ratio? If or when to Increase? How will each of these decisions effect the stock price? Is there an Optimal Dividend Is there an Optimal Dividend Policy? In a perfect capital market, dividend policy has no impact on shareholders' wealth and is, therefore, irrelevant. Introducing capital market imperfections, the following views exist: dividend policy does not matter a high dividend policy is best a low dividend policy is best Dividend Theories: Dividends are Irrelevant to Stock Price and Shareholder Wealth Dividends Increase Stock Price and/or Shareholder Wealth Dividends Hurt Shareholder Wealth Pay if you have excess cash on hand Reproportion Capital structure How do Dividends impact Stock Price? Theory 1: Dividends are Irrelevant Investors only care about Total Return Money is simply circulating Investors can sell or purchase stock to mimic Dividend policy How do Dividends impact Stock Price? Theory 2: Dividends Increase Stock Price Cash now bird in hand? Improve public market perception of stock? "Expectations Theory" reassuring "Information Effect" communication How do Dividends impact Stock Price? Theory 3: Dividends Hurt Stock Price Investors want to Defer Tax Payments Dividend tax treatment worse than cap gains (some years) If corporation pays out dividends, needs to raise equity, increasing transaction costs Hurt stock perceptions: No good investment opportunities at company Management ignorance How do Dividends impact Stock Price? Research conclusions:
DIVIDENDS DO NOT IMPACT STOCK PRICE OR RETURN ON INVESTMENT... BUT CHANGES IN DIVIDEND POLICY OR PAYMENTS ARE NOTICED BY THE MARKET! Dividend Policy Conclusions Do not pay Dividends if... Need cash for new investments Ability to pay steady, regular dividends are not extremely stable and predictable Loan or other covenants restrict dividends Dividends taxed at higher rate than Buybacks for recipients... So what about Buybacks? Stock Repurchases & Buybacks Stock Repurchase = Buyback Possible reasons for Buyback: Modify Capital Structure How? Increase EPS to Increase Price is this valid Buy out minority shareholders why? "Our stock is a good investment" rational? Excess cash on hand define excess? Stock "undervalued" what does this really mean? Institutional Features of Institutional Features of Dividends Legal considerations Dividends can only be paid out of profit and are not to be paid out of capital. A dividend cannot be paid if it would make the company insolvent. Dividend restrictions may exist in covenants in trust deeds and loan agreements. Dividend Dates Dividend Dates Declaration date Date board of directors pass a resolution to pay a dividend. Exdividend date Date the seller is entitled to keep the dividend. This is 4 business days before the date of record. 2005 Dividend Dates (cont.) Dividend Dates (cont.) Record (books closing) date Date of payment The date on which holders of record are designated to receive a dividend. Date dividend cheques are mailed. Dividend Policies Dividend Policies Residual dividend policy Pay out as dividends any profit that management does not believe can be invested profitably. Target proportion of annual profits to be paid out as dividend. Aim for dividends to equal the longrun difference between expected profits and expected investment needs. Constant payout policy Smoothed dividend policy 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 longrun, sustainable levels of earnings rather than shortrun 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. Irrelevance Theory Irrelevance Theory Value of firm is determined solely by the earning power of the firm's assets, and the manner in which the earnings stream is split between dividends and retained earnings does not affect shareholders' wealth. Modigliani and Miller (1961) Modigliani and Miller (1961) Given the investment decision of the firm, the dividend payout ratio is a mere detail. It does not affect the wealth of shareholders. Assumptions: no taxes, transaction costs, or other market imperfections a fixed investment or capital budgeting program no personal taxes -- investors are indifferent between receiving dividends or capital gains MM's Conclusion MM's Conclusion Dividend Policy is a tradeoff between retaining profit, paying dividends and making new share issues to replace cash paid out. Paying a dividend and issuing new shares to replace the cash: Does not change the value of the company; and Does not change the wealth of the old shareholders, because the value of their shares falls by an amount equal to the cash paid to them. MM's Conclusion (cont.) MM's Conclusion (cont.) If a company increases its dividends, it must replace the cash by making a share issue. Old shareholders receive a higher current dividend, but a proportion of future dividends must be diverted to the new shareholders. The present value of these forgone future payments is equal to the increase in current dividends. Dividend Policy
Dividend financed by stock issue No dividend, no stock issue New stockholders
Shares Cash New stockholders Firm
Cash Cash Shares Old stockholders Old stockholders Dividend Policy is Irrelevant Example Assume Rational Demiconductor has no extra cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend. Record Date Cash Asset Value Total Value New Proj NPV # of Shares price/share 1,000 9,000 10,000 2,000 1,000 $12 + Dividend Policy is Irrelevant Example Assume Rational Demiconductor has no extra cash, but Record Date Cash Asset Value Total Value New Proj NPV # of Shares price/share Pmt Date 0 9,000 + 9,000 2,000 1,000 $11 declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend. 1,000 9,000 10,000 2,000 1,000 $12 Dividend Policy is Irrelevant Example Assume Rational Demiconductor has no extra cash, but Record Date Cash Asset Value Total Value New Proj NPV # of Shares price/share Pmt Date 0 9,000 +9,000 2,000 1,000 $11 declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend. 1,000 9,000 10,000 2,000 1,000 $12 Post Pmt 1,000 (91 sh @ $11) 9,000 10,000 2,000 1,091 $11 NEW SHARES ARE ISSUED Dividend Policy is Irrelevant Example continued Shareholder Value Stock Cash Total Value Record 12,000 0 12,000 Stock = 1,000 sh @ $12 = 12,000 Dividend Policy is Irrelevant Example continued Shareholder Value Stock Cash Total Value Record 12,000 0 1,000 Pmt 11,000 12,000 12,000 Stock = 1,000sh @ $11 = 11,000 Dividend Policy is Irrelevant Example continued Shareholder Value Record Pmt Post Stock 2,000 11,000 12,000 Cash 0 1,000 0 Total Value 12,000 12,000 12,000 Stock = 1,091sh @ $11 = 12,000 Assume stockholders purchase the new issue with the cash dividend proceeds. MM's Conclusion (cont.) MM's Conclusion (cont.) The MM dividend irrelevance proposition is valid in a perfect capital market with no taxes. Therefore, if dividend policy is important in practice, the reasons for its importance must relate to factors that MM excluded from their analysis. States that dividend payouts can affect shareholders' wealth. Why? `bird in the hand' argument investors prefer high dividend policy because dividends are less risky than the expected future capital gains taxes other market imperfections Relevance Theory of Relevance Theory of Dividends Dividends Increase Value
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. Dividends Decrease Value
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. In such a tax environment, the total cash flow retained by the firm and/or held by shareholders will be higher than if dividends are paid. Taxes and Dividend Policy 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. Dividends and Taxes Dividends and Taxes Differential tax treatment of dividend income versus capital gains arising from retained profits can either favour or penalise payment of dividends. This difference in tax treatment is understood by comparing a classical tax system with an imputation tax system. NonTax Reasons for the NonTax Reasons for the Relevance of Dividend Policy Information effects and signalling to investors Evidence suggests share price changes around the time of the announcement of dividend changes are positively related to the change in the dividend. MM claim that this does not invalidate irrelevance theory. The price change is the result of the information content associated with the dividend announcement. NonTax Reasons for the NonTax Reasons for the Relevance of Dividend Policy (cont.) Three implications of dividend information and signalling hypothesis: Unanticipated dividend changes should be followed by share price changes in the same direction. Empirical support for this implication found by Brown, Finn and Hancock (1977), Easton and Sinclair (1989) and Easton (1991). Dividend and profit information arrive simultaneously and are evaluated together, with stronger effects if the two are consistent. NonTax Reasons for the NonTax Reasons for the Relevance of Dividend Policy (cont.) Three implications of dividend information and signalling hypothesis: Unanticipated dividend changes should be followed by market revision of expectations of future earnings in the same direction. Empirical evidence also supports this implication, for example Ofer and Seigel (1989). Analysts revisions of earnings forecasts are positively related to dividend changes. NonTax Reasons for the NonTax Reasons for the Relevance of Dividend Policy (cont.) Three implications of dividend information and signalling hypothesis: Changes in dividends should be followed by changes in earnings in the same direction. Evidence on this implication is mixed and does not strongly support it. Watts (1973), Penman (1983) find little support for implication. Healy and Palepu (1988) find support when focusing on companies that initiate and omit dividends. Benartzi, Michael and Thaler (1997) find link between increased dividends and recent earnings but no link between increased dividends and future increases in earnings. NonTax Reasons for the NonTax Reasons for the Relevance of Dividend Policy (cont.) Agency costs agency costs can be reduced by paying higher dividends increased capitalraising required accountability to market increases provision of information increases monitoring of managers managers more likely to act in interests of shareholders Agency costs (cont.) NonTax Reasons for the NonTax Reasons for the Relevance of Dividend Policy (cont.) Empirical evidence shows that in countries where investors' interests are relatively well protected, dividends are less likely to be a mechanism to reduce agency costs. Wellprotected investors are willing to forgo dividends now in return for growth. Highgrowth companies pay lower dividends in economies where investors are relatively wellprotected legally. Shareholders' preference for current income NonTax Reasons for the NonTax Reasons for the Relevance of Dividend Policy (cont.) need for shares to yield current income MM support irrelevance stance, given shareholders can create `homemade dividends' Issue and transaction costs company can avoid incurring costs associated with share issue by reducing dividends this means that more financing requirements can be met internally, out of retained profits NonTax Reasons for the NonTax Reasons for the Relevance of Dividend Policy (cont.) Dividend clienteles Groups of investors who choose to invest in companies that have dividend policies which meet their particular requirements. If equilibrium exists in terms of the supply and demand for particular dividend policies, the price of a company's shares will be independent of its dividend policy. This is because there are always other companies with the same (or a similar) dividend policy that can act as a substitute. Share Buybacks Share Buybacks A share buyback is when a company purchases its own shares on the stock market and then proceeds to either cancel them (Aust.) or retain them as treasury stock (US). There are legal requirements associated with buybacks, but generally companies can repurchase up to 10 per cent of their ordinary shares in a 12month period. Why Repurchase Shares? Why Repurchase Shares? Dividend substitution If capital gains are taxed more favourably than dividends. Some supporting evidence from the US, where dividend payout ratios have been falling in the 80s and 90s. Improved performance measures EPS may rise, but if cash is returned rather than used to retire debt, financial risk is increased and PE ratio along with share price may fall. Return of funds that cannot be profitably used will raise share price. Why Repurchase Shares? (cont.) Signalling and Undervaluation Managers buying back company stock indicates that they believe the stock is undervalued by the market. Alternatively, a buyback announcement could be accompanied by some new information, e.g. sale of unprofitable asset/division. Resource Allocation Share repurchase returns capital to shareholders, who can reallocate funds into profitable activities through the capital market. Financial Flexibility Why Repurchase Shares? Why Repurchase Shares? (cont.) Payment of dividends is a longterm commitment and sudden major changes (especially decreases) in dividend policy are unappreciated by market. Buybacks offer an alternative way to make distributions that may not be permanent. Employee Share Options Unlike paying dividends, share repurchases do not lead to the exdividend price dropoff. Option holders (typically management) prefer a share repurchase to a dividend payout as a means of distributing profits to shareholders. ...
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This note was uploaded on 07/10/2009 for the course FIN FIN taught by Professor Dr. during the Spring '09 term at Baptist College of Health Sciences.
- Spring '09