Fundamentals of Corporate Finance Chapter 16 Payout Policy

Fundamentals of Corporate Finance Chapter 16 Payout Policy Fifth Edition Slides by Matthew Will Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 2 Topics Covered ÜHow Companies Pay Cash to Shareholders ÜDividend Payments ÜStock Repurchases ÜHow Do Companies Decide on The Payout? ÜWhy Payout Policy Should Not Matter ÜWhy Dividends May Increase Firm Value ÜWhy Dividends May Reduce Firm Value Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 3 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. Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 4 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. Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 5 Dividend & Stock Repurchases $ Billions U. S. Data 1980 - 2003 Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 6 Dividend Payments Jan 13 Feb 2 Declaration date Withdividend date Feb 3 Ex-dividend date Feb 4 Record date Feb 28 Payment date Share price falls Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 7 Dividend Payments Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 8 Stock Dividend Example - Amoeba Products has 2 million shares currently outstanding at a price of $15 per share. The company declares a 50% stock dividend. How many shares will be outstanding after the dividend is paid? Answer 2 mil x. 50 = 1 mil + 2 mil = 3 mil shares Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 9 Stock Dividend Example - cont - After the stock dividend what is the new price per share and what is the new value of the firm? Answer Ü The value of the firm was 2 mil x $15 per share, or $30 mil. After the dividend the value will remain the same. Ü Price per share = $30 mil / 3 mil sh = $10 per sh. Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 10 Stock Repurchase Example - Cash dividend versus share repurchase Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 11 Stock Repurchase Example - Cash dividend versus share repurchase Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 12 Stock Repurchase Example - Cash dividend versus share repurchase Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 13 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. Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 14 Dividend Policy is Irrelevant ÜSince 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. Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 15 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 Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 16 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 Mc. Graw-Hill/Irwin Pmt Date 0 9, 000 2, 000 1, 000 $11 Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 17 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 Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 18 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 Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 19 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 Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 20 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 Ü Assume stockholders purchase the new issue with the cash dividend proceeds. Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 21 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. Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 22 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. Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 23 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. Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved

16 - 24 Dividends Decrease Value Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved