Chapter 16 Principles of Corporate Finance Tenth Edition

Chapter 16 Principles of Corporate Finance Tenth Edition Payout Policy Slides by Matthew Will Mc. Graw-Hill/Irwin Copyright © 2011 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

Topics Covered Ø Facts About Payout Ø How Firms Pay Dividends and Repurchase Stock Ø How Do Companies Decide on Payouts? Ø Information in Dividends and Stock Repurchases Ø The Payout Controversy Ø The Rightists Ø Taxes and the Radical Left Ø The Middle of the Roaders 16 -2

Payout Policies 16 -3

Dividend & Stock Repurchases $ Billions U. S. Data 1980 - 2008 16 -4

16 -5 Dividend Payments April 15, 2009 May 11, 2009 Exxon Mobil declares regular quarterly dividend of $. 42 per share. Shares start to trade ex dividend. Declaration Date Ex-dividend Date May 13, 2009 Dividend will be paid to shareholders registered on this date. Record Date June 10, 2009 Dividend checks are mailed to shareholders. Payment Date

Types of Dividends ¤Cash Dividend ¤Regular Cash Dividend ¤Special Cash Dividend ¤Stock Repurchase (4 methods) 1. Buy shares on the market 2. Tender Offer to Shareholders 3. Dutch Auction 4. Private Negotiation (Green Mail) 16 -6

Dividend Payments 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. 16 -7

Dividend Payments Stock Dividend - Distribution of additional shares to a firm’s stockholders. Stock Splits - Issue of additional shares to firm’s stockholders. Stock Repurchase - Firm buys back stock from its shareholders. 16 -8

16 -9 The Payout Decision Dividend Decision Survey (2004) The cost of external capital is lower than the cost of a dividend cut Rather than reducing dividends we would raise new funds to undertake a profitable project We consider the change in the dividend We are reluctant to make a change that may have to be reversed We look at the current dividend level We try to maintain a smooth dividend stream We try to avoid reducing the dividend 0 10 20 30 40 50 60 70 80 Executives who agree or strongly agree (%) 90 100

The Payout Decision 16 -10 Lintner’s “Stylized Facts, ” as updated by Brav, Graham, Harvey, Michaely (2004) 1. 2. 3. Managers are reluctant to make dividend changes that may have to be reversed. They are particularly worried about having to rescind a dividend increase and, if necessary, would choose to raise new funds to maintain the payout. To avoid the risk of a reduction in payout, managers smooth” dividends. Consequently, dividend changes follow shifts in long-run sustainable earnings. Transitory earnings changes are unlikely to affect dividend payouts. Managers focus more on dividend changes than on absolute levels. Thus paying a $2. 00 dividend is an important financial decision if last year’s dividend was $1. 00, but no big deal if last year’s dividend was $2. 00.

Information in Payouts Ø Dividends and stock repurchase decisions contain information Ø The information contained in the decisions varies Ø Asymmetric information may be conveyed Ø Dividend increases could mean overpriced stock or increased future profits Ø The signal varies based on prior information about the company 16 -11

Information in Payouts Ø Attitudes concerning dividend targets vary Ø Dividend Change 16 -12

Information in Payouts Ø Dividend changes confirm the following 16 -13

16 -14 Dividend Policy Change EPS/Price at t = 0 as % Impact of Dividend Changes on EPS Source: Healy & Palepu (1988) Year

Dividend Policy Before Dividend After Dividend New stockholders Total value of firm Each share worth this before … Total number of shares … and worth this after Old stockholders Total number of shares Example of 1/3 rd of worth paid as dividend and raising money via new shares 16 -15

16 -16 Dividend Policy Shares Dividend financed by stock issue No dividend, no stock issue New stockholders Cash Firm Cash Shares Cash Old stockholders

Dividend Policy is Irrelevant Ø Since investors do not need dividends to convert shares to cash they will not pay higher prices for firms with higher dividend payouts. In other words, dividend policy will have no impact on the value of the firm. 16 -17

Dividend Policy is Irrelevant 16 -18 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 the value of the firm is not altered when new shares are issued to pay for the dividend. Record Date Cash 1, 000 Asset Value 9, 000 Total Value 10, 000 + New Proj NPV 2, 000 # of Shares 1, 000 price/share $12

Dividend Policy is Irrelevant 16 -19 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 the value of the firm is not altered when new shares are issued to pay for the dividend. Record Date Cash 1, 000 Asset Value 9, 000 Total Value 10, 000 + New Proj NPV 2, 000 # of Shares 1, 000 price/share $12 Pmt Date 0 9, 000 2, 000 1, 000 $11

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 the value of the firm is not altered when new shares are issued to pay for the dividend. Record Date Cash 1, 000 Asset Value 9, 000 Total Value 10, 000 + New Proj NPV 2, 000 # of Shares 1, 000 price/share $12 Pmt Date 0 9, 000 2, 000 1, 000 $11 Post Pmt 1, 000 (91 sh @ $11) 9, 000 10, 000 2, 000 1, 091 $11 NEW SHARES ARE ISSUED 16 -20

Dividend Policy is Irrelevant Example - continued - Shareholder Value Stock Cash Record 12, 000 0 Total Value 12, 000 Stock = 1, 000 sh @ $12 = 12, 000 16 -21

Dividend Policy is Irrelevant Example - continued - Shareholder Value Stock Cash Record 12, 000 0 Pmt 11, 000 Total Value 12, 000 Stock = 1, 000 sh @ $11 = 11, 000 16 -22

Dividend Policy is Irrelevant Example - continued - Shareholder Value Stock Cash Record 12, 000 0 Pmt 11, 000 Post 12, 000 0 Total Value 12, 000 Stock = 1, 091 sh @ $115 = 12, 000 Ø Assume stockholders purchase the new issue with the cash dividend proceeds. 16 -23

Dividend Theories Leftists (M&M) - Dividend does not effect value Rightists - Dividends increase value Middle of the roaders - Leftist theory with some reality thrown in. Residual Dividend Policy 16 -24

Dividends Increase Value Market Imperfections and Clientele Effect There are natural clients for high-payout stocks, but it does not follow that any particular firm can benefit by increasing its dividends. The high dividend clientele already have plenty of high dividend stock to choose from. These clients increase the price of the stock through their demand for a dividend paying stock. 16 -25

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. 16 -26

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. 16 -27

Taxes and Dividend Policy Ø Since capital gains are taxed at a lower rate than dividend income, companies should pay the lowest dividend possible. Ø Dividend policy should adjust to changes in the tax code. 16 -28

Taxes and Dividend Policy 16 -29

Taxes and Dividend Policy In U. S. , shareholders are taxed twice (figures in dollars) 16 -30

Taxes and Dividend Policy Under imputed tax systems, such as that in Australia, Shareholders receive a tax credit for the corporate tax the firm pays (figures in Australian dollars) 16 -31

16 -32 Dividend Theories Residual Dividend Policy r MRI = IRR 12 % COC QTY $$$

Web Resources Click to access web sites Internet connection required www. earnings. com www. ex-dividend. com www. dripcentral. com 16 -33