Dividend Policy Notes

Dividend Policy

What We Have Learned So Far

  • Firms aim to optimize capital structure to maximize firm value or minimize the cost of capital.
  • Optimal capital structure leverage considerations:
    • Greater due to corporate taxes.
    • Lower due to bankruptcy costs.
    • Lower due to risk shifting and debt overhang due to agency problems between shareholders and debtholders.
    • Greater due to debt monitoring, reducing agency problems between managers and shareholders.

Firm Objective

  • Maximize Value
    • Capital Budgeting Decision: Invest in projects that add value to the firm.
    • Financing Decision: Maximize firm value through optimal capital structure.
    • Payout Decision: Return excess cash to investors to maximize shareholder wealth.

Payout Decision

  • Return excess cash to investors to maximize shareholder wealth.
  • Key Questions:
    • How much cash should be returned to shareholders?
    • How should the excess cash be returned to shareholders?

Roadmap

  • Why do firms pay dividends (frequent payments to their shareholders)?
  • Impact of dividends on firm value?
  • Outline:
    • Types of dividends
    • M&M Proposition on Irrelevancy of dividends
    • Stock repurchase
    • Real-world considerations

Dividend Policy

  • Dividend policy is part of the firm’s financing policy.
  • Key aspects:
    • The level of the distribution:
      • How much of its free cash flow should be paid as a dividend?
    • The stability of the distribution:
      • Should a firm maintain a stable, constant payment policy, or should it let the payments vary as conditions change?
    • The form of the distribution:
      • How to distribute to shareholders, dividend, or stock repurchase?

What Firms Tend to Pay Dividends?

StageIntroductionRapid ExpansionMature GrowthDeclineFunding NeedsHigh, but LimitedHighModerateLowCash FlowsNegativeLowIncreasingHighDividend Policy

Dividend Yield

  • Dividend Yield =Annual DividendStock Price= \frac{Annual \, Dividend}{Stock \, Price}
  • The dividend yield is often used to classify stocks as “income” stocks.
  • Common purchasers of income stocks are investors with cash flow needs:
    • Retired individuals
    • Pension plans that currently pay benefits
    • Trust funds
  • Remember: Expected return on stock = Dividend Yield + Price Appreciation

Decreasing Dividend Yields

  • The S&P Yield has generally decreased over time, as shown in the provided graph spanning from 1871 to 2021.

Payout Ratio

  • The dividend payout ratio is the portion of earnings that are paid out to investors in the form of dividends.
    • Dividend Payout Ratio=DividendsEarningsDividend \, Payout \, Ratio = \frac{Dividends}{Earnings}
  • The total payout ratio is the total portion of earnings paid out to equity holders (dividends plus repurchases).
    • Total Payout Ratio=Dividends+RepurchasesEarningsTotal \, Payout \, Ratio = \frac{Dividends + Repurchases}{Earnings}
  • The rest of the firm’s earnings are “plowed back” into the firm to invest in new projects, a.k.a. Retention ratio.
    • Plowback Ratio=1−Total Payout RatioPlowback \, Ratio = 1 - Total \, Payout \, Ratio
  • What kind of companies have a high retention ratio?

Dividend Payout Ratio: January 2022

  • Graphical representation of dividend payout ratios for dividend-paying firms as of January 2022. The data includes the percentage of companies falling into various payout ratio ranges (0-10%, 10-20%, etc.) for both the U.S. and globally.
  • Table of Dividend Payout Ratios by Sub-Region (January 2022):
    • Lists various regions with their respective dividends, net income, and payout ratios.
    • Examples include Africa and the Middle East, Australia & NZ, Canada, China, Eastern Europe & Russia, EU & Environs, India, Japan, Latin America & Caribbean, Small Asia, UK, United States, and Global figures.

Types of Dividends

  • Any payments made by the corporation to its shareholders are considered dividends.
    • Cash dividends are payments in the form of cash.
      • Firm’s cash and retained earnings decrease.
    • Stock dividends are paid out in shares.
      • e.g., With 3% stock dividends, shareholders get 3 extra shares for every 100 they own.
      • Not really dividends because no cash leaves the firm.
      • The number of shares outstanding increases, but the value of each share falls (no change overall).
      • Example: A firm’s shares are currently trading at $30. What would happen to the share price if the firm declares a 3% stock dividend?
    • Stock repurchase

Cash Dividends

  • Ex-dividend date: Only those shareholders who purchased the stock before the ex-dividend date are eligible to receive dividends.
    • The seller receives dividends if the transaction occurs on or after the ex-dividend date.
  • Ex-dividend price vs. cum-dividend price:
    • If the cum-dividend price of a stock is $30, and if the company declared a dividend of $2/share, then what should the ex-dividend price of the stock be?
      • (Ignore taxes & transaction costs)

Important Dividend Dates

  • Board of Directors announces a dividend (dividends become a liability once declared).
  • Owners of the stock on the ex-dividend date will receive the dividend, but any investor that purchases the stock on or after the ex-dividend date will not receive the dividend (two business days before the Date of Record).
  • Shareholders of record (which are the shareholders on the ex-dividend date) will receive the dividend.
  • The dividend is paid to all shareholders of record.
  • When do you expect to see price reaction--if any?

Cash… the Fruit of Microsoft’s Success

  • In 2004, Microsoft set a record for the most cash ever held by a corporation.
  • The company had nearly $40 billion in cash, with another $1 billion in cash inflow per month.
  • What could $40 billion have purchased in 2004?
    • eBay ($14 billion market cap in 2004), Yahoo! ($10 billion), and Amazon ($6.5 billion), with $10 billion to spare.
    • The entire airline industry… twice.
    • 23 space shuttles.
    • Every professional baseball, football, basketball, and hockey team in the US.

Microsoft Special Dividend

  • On July 20, 2004, Microsoft announced a special dividend of $3 per share.
  • The dividend would have a date of record of November 17, 2004, and would be paid on December 2, 2004.
  • With Microsoft’s 10 billion outstanding shares, the total payout was about $32 billion in cash.

The Market’s Reaction

  • Microsoft’s stock closed at $28.32 on July 20.
  • The announcement came after trading hours on July 20.
  • On July 21, Microsoft’s stock opened trading at $29.89, a $1.67, or 5.5%, increase from the previous day’s close.
  • Why did the market react favorably to the dividend announcement?
    • Time value of money of the cash?
    • Investment policy concerns?

The Ex-Dividend Date

  • The date of record was November 17, 2004.
  • The ex-dividend date was two business days before, on November 15, 2004.
  • What happened that day?
  • Anybody that bought the stock on or after November 15 was buying the stock without the dividend (ex-dividend).
  • Microsoft’s stock closed at $29.97 on November 12 and opened at $27.34 on November 15… a decrease in price of $2.63.

Ex Dividend Date Price Behavior

  • In a friction-free world, $3 is the ex-dividend price drop.
  • In Microsoft’s case, the price dropped by $2.63

Microsoft since the Special Dividend

  • What has Microsoft done since the special dividend?
  • The company currently has cash reserves of about $83.03B billion.
  • Dividend policy:
    • “The board will continue to evaluate whether to pay a dividend on a quarterly basis and will base its decisions on the Company’s potential future long-term capital requirements relating to research and development, investments and acquisitions, dilution management, and legal and business risks faced by the company.”
  • Currently, the company pays out a quarterly dividend of $0.28 per share – About $2 billion total paid out for each quarterly dividend.
  • The company heavily uses stock repurchases
    • $40 billion in repurchased stock last fiscal year
    • Outstanding shares: 8.30B billion in that fiscal year

Does dividend policy affect firm value?

  • Investors’ preferences for dividend versus capital gains
    • The dividend irrelevance theory
    • The “bird-in-the-hand” theory
    • The tax preference theory
  • The clientele effect
  • Agency problems

M&M Dividend Irrelevance Theory

  • Modigliani and Miller: In a perfect market, dividend policy is irrelevant to the equity value.
    • The firm’s value depends only on the income produced by its assets, not on how this income is split between dividends and retained earnings.
  • Assumptions to build a perfect market:
    • No taxes or transaction costs
    • No default risk
    • No agency problems
    • No asymmetric information
    • The investment policy of the firm is fixed and is not altered by changes in the dividend policy

Dividend Irrelevance Example

  • Genron Corporation has $20M in excess cash and no debt. The firm expects to generate additional free cash flows of $48m per year in subsequent years. If Genron’s unlevered cost of capital is 12%, then the enterprise value of its ongoing operations is:
    • Enterprise Value = PV (Future FCF) = \frac{48}{0.12} = $400M
    • Including the cash, Genron’s total asset value is $420M.
  • Genron’s board is meeting to decide how to pay out its $20M excess cash to shareholders and is evaluating the following options:
    1. Using the $20M to pay a $2 cash dividend to its 10M shareholders.
    2. Repurchasing shares instead of paying a dividend.
    3. Pay a larger dividend today, in anticipation of high future FCFs.

Dividend Irrelevance Example -Solution

  • Alternative 1:
    • PcumP_{cum} = Current Div + PV(Future Dividends) = 2 + 4.80.12\frac{4.8}{0.12} = $42
    • PexP_{ex} = PV(Future Dividends) = 4.80.12\frac{4.8}{0.12} = $40
    • In a perfect capital market, when a dividend is paid, the share price drops by the amount of the dividend when the stock begins to trade ex-dividend.
  • Alternative 2:
    • Genron can repurchase \frac{$20M}{$42} per share = 0.476M shares, leaving 10 - 0.476 = 9.524M shares.
    • Genron expects to have $48M in free cash flow, which can be used to pay a dividend of \frac{$48M}{9.524M} shares = $5.04 per share each year. Thus Genron’s share price today is
    • P_{rep} = \frac{5.04}{0.12} = $42
    • In a perfect capital market, an open market purchase has no effect on the stock price, and the stock price is the same as the cum-dividend price if a dividend were paid instead.

Dividend Irrelevance Example -Solution

  • Alternative 3:
    • Suppose Genron starts to pay $48M in dividends starting this year. It has only $20M in cash today, so needs an additional $28M to pay the larger dividend now. Suppose it raises money by going for an equity issue. Given a share price of $42, Genron could raise $28M by selling \frac{$28M}{$42} per share = 0.67M shares. The amount of dividend per share each year will be
    • \frac{48M}{10.67M} = $4.5
    • Under this new policy, Genron’s cum-dividend share price is
    • P_{cum} = 4.5 + \frac{4.5}{0.12} = 4.5 + 37.5 = $42

Dividend Irrelevance

  • Suppose our firm wants to increase its dividend.
  • Where does the cash come from? All of the other cash is being used for investments.
  • Answer: issuing new shares of stock.
  • But, the total value of the company didn’t change, we just transferred some ownership from the old shareholders to the new shareholders.
  • The capital loss on the stock for the old shareholders exactly offsets the dividend they receive.

Dividend Irrelevance ----MM Continued

  • So, the old shareholders have the same total value after the dividend as before
    • Some of the value is in cash from the dividend
    • The rest of the value is in stock
  • Alternatively, shareholders could go into the market and sell some stock for cash, producing the exact same results as the dividend (Homemade Dividends).
  • Investors won’t pay more for the firm to do something they can do cheaply on their own… the firm value is the same with or without dividends.
  • End result: dividends are unnecessary and irrelevant.

M&M Argument Illustrated

  • Illustration of dividend irrelevance showing the flow of value between old stockholders, new stockholders, and the firm before and after a dividend payment and new stock issuance.
  • Example of 1/3rd of worth paid as dividend and raising money via new shares

Dividend Policy with “Imperfections”

  • We have seen that in a perfect MM world, dividend policy is irrelevant.
  • However, we know that, in real life, dividend policy is indeed relevant…
    • Firms that pay dividends seem to do so consistently, and do not like to cut dividends.
    • A cut or hike in dividends seems to impact price.
  • So, what market “imperfections” make dividends relevant, and why?

Does payout policy matter when the market is not perfect?

  • Uncertainty of cash flows
    • Bird-in-the-hand theory
  • Taxes
    • Tax preference theory: taxes on dividends versus capital gains
    • Clientele effect: taxes on individuals with different tax brackets
    • What should a firm do?
  • Agency problems
  • Asymmetric information
    • Stability of distribution

Bird-in-the-hand theory: Dividends are “good”

  • Investors are less certain of receiving capital gains than they are of receiving dividend payments.
  • They value a dollar of expected dividends more highly than a dollar of expected capital gains because dividends are less risky.
  • Therefore cost of equity decreases as the dividend payout ratio increases.

Tax preference theory: Dividends are “Bad”

  • Before 2003, individual investors paid ordinary income taxes on dividends but lower rates on long-term capital gains.
  • The Jobs and Growth Act of 2003 changed this to the same.
  • Investors may still prefer capital gains instead of dividends
    • Time value effects: capital gains are never taxed sooner than dividends
    • Holding effects: If a stock is held by someone until he or she dies, no capital gains tax is due at all to the beneficiaries
  • Because of tax advantages, investors may be willing to pay more for low-payout companies everything else the same.

Long-Term Capital Gains Versus Dividend Tax Rates in the United States, 1971–

  • Investors may still prefer capital gains. Time value effects: Capital gains are never taxed sooner than dividends. Holding effects: If a stock is held by someone until he or she dies, no capital gains tax is due at all to the beneficiaries.
  • Tax advantages drive investors willing to pay more for low-payout companies, everything else being the same.
  • Under “Tax Preference” theory, capital gains are preferred (not dividends).
  • The Jobs and Growth Act

The Worst Cases of Dividend Payments

  • The worst possible case for dividends occurs if a company has to issue new stock to fund the dividend
  • Then, not only is value destroyed because of the taxes on the dividend, but there are the costs of issuing new equity
    • Underwriter spread
    • Administrative costs
  • These firms should cut their dividends rather than incur these costs.

Does that actually happen?

  • Never raise money to pay dividends. Issuing cost (transaction costs).
  • Instead of a dividend, should look for other ways to return value to investors.

Payout Preferences

  • Graphical representation of how stock price and cost of equity are affected by payout under MM Irrelevance, Bird-in-the-Hand, and Tax Preference theories.

Clientele effect

  • Different groups, or clienteles, of stockholders prefer different dividend payout policies.
  • Some prefer cash income so they prefer dividend-paying firms
    • Pension funds pay no taxes
    • Corporate investors can exclude 70% of their dividend income from taxes, while all capital gains are taxed
    • Individual investors in low tax brackets
  • Individuals with high tax brackets are likely to prefer companies with either no or low dividend payouts

Agency Problem

  • Reduction in agency costs
    • By reducing excess FCFs, dividends mitigate the agency problem between managers and shareholders

Asymmetric Information

  • Signaling of financial strength
    • Assume that managers know more about the quality of the firm’s future earnings than outside investors (“asymmetric information”)
      • i.e., investors cannot distinguish between “good” and “bad” firms
    • Managers of a “good” firm can signal their quality to investors by committing to pay high dividends
      • “Bad” quality firms don’t have the financial muscle to mimic this strategy
    • Information-content effect of dividends:
      • Stock price rises when dividends are increased
      • Stock price drops when dividends are cut

Dividend payment now…

  • 7 Stocks Increasing Dividends In March 2012
    • List of companies such as JPMorgan Chase (JPM), U.S. Bancorp (USB), State Street (STT), Air Products & Chemicals (APD), Cliffs Natural Resources (CLF), Xilinx (XLNX), and Realty Income (O) that increased dividends in March 2012.

Dividend payment now…

  • On April 13, 2012, P&G declared a 7% dividend increase (52.5 cents to 56.2 cents).
  • P&G, which is in the process of cutting 5,700 jobs as it aims to trim $10 billion in costs, has now raised its dividend for 56 consecutive years.

"Sticky" Dividends

  • Graphical representation of dividend changes at US companies, showing the percentage of companies that increased, decreased, or made no change to their dividends.

In 2020, a crisis year

  • Of the S&P 500 companies, 287 companies increased their dividends and 11 companies initiated dividends.
  • Of the S&P 500 companies, 27 decreased dividends and 42 suspended dividends.
    • While the 42 dividend suspensions were the most in the last 20 years, the number of companies that increased dividends (298) vastly exceeded the number that cut or suspended dividends(69).
    • In perhaps the most revealing statistic of all, 133 of the 500 largest market cap companies did not pay dividends leading into 2020 or in 2020.

Story so far…

  • In a perfect MM world without taxes and transaction costs, dividend policy is irrelevant.
  • In a world with taxes:
    • A firm (that does not have sufficient cash) should not issue stock/bonds to pay dividends.
    • Firms that have excess cash have a choice between paying dividends and alternative uses.
      • Whether the firm should pay dividends or not depends on: returns from alternative uses, personal and corporate tax rates.

Stock Dividends: Example

  • Imagine a corporation currently has 10 million shares outstanding selling at $60 per share and declares a three-for-two stock split. After the split, what will be the new share price?
  • After the split, how many shares will be outstanding?

More Types of Dividends

  • Spin-Offs
    • Companies sometimes spin off subsidiaries or divisions.
      • A new company is created, and its shares begin trading.
    • The parent company gives shares in the new company to the investors as a dividend.
      • Then investors in the parent company own two different companies.
    • Examples: 3Com and Palm, Kraft and Altria Group, Travelers, and Citigroup.
  • DRIPs (Dividend Reinvestment Plans) have become more popular in recent times in US.
    • Companies allow shareholders to purchase new stock with their dividend proceeds with no commission, sometimes even get to purchase stock at a discount.
    • Programs are helpful for small investors who don’t need cash income.
    • Getting $30 in dividends in a quarter doesn’t help much, especially if you have to pay an $8 commission to reinvest the money or go through the hassle of withdrawing it from your brokerage account.

Repurchase of Stock

  • Stock repurchase is an alternative method of paying out surplus cash to shareholders.
  • Instead of paying dividends to shareholders, a firm uses surplus cash to buy back shares.
  • Balance-sheet Impact: After a share repurchase, both cash and the book value of equity decrease.
  • In a perfect MM world, stock repurchase is as good as cash dividends.
    • Even though EPS increases post-repurchase, total value to shareholders is the same (see example on next slide).

Example: Dividends vs. Repurchase

  • (Assume a perfect MM world) A firm has 100,000 shares outstanding. It has excess cash of $300,000 that it can use to either pay dividends or to repurchase shares. The firm’s net income is $450,000, and the (ex-dividend) PE-ratio applicable to the firm is 6.
  • Suppose the firm pays dividends. Compute the EPS, ex-dividend stock price, and the cum-dividend stock price?
  • Suppose the firm repurchases shares at $30/share. Compute the EPS and stock price?

Answer Key to Example

  • Under the dividend option:
    • Dividend per share = \frac{$300,000}{100,000} = $3
    • EPS = \frac{$450,000}{100,000} = $4.50
    • Ex-dividend share price = $4.50*PE ratio = $27
    • So cum-dividend share price = $27 + $3 = $30
  • Under the repurchase option:
    • No. of shares repurchased = \frac{$300,000}{$30} = 10,000
    • Shares outstanding after repurchase = 90,000
    • EPS = \frac{$450,000}{90,000} = $5
    • So stock price = $5*PE ratio = $30

Dividends and Stock Repurchases in the US

  • Graphical representation of dividends and buybacks on the S&P 500 from 1988-2021, showing the magnitude of buybacks compared to dividends over time. It also includes the proportion of total payout from buybacks.

Advantages of Share Repurchase

  • No long-term commitment involved
    • Regular dividends imply a commitment to continue payments in the future (negative consequences to cutting dividends)
  • Tax advantage
    • When capital gains are taxed at a lower rate than dividends
    • Moreover, shareholders have the option of not selling shares (i.e., they can avoid realizing capital gains)
  • Maintaining control (with “targeted” repurchases)
    • Provides a way for insiders to increase control and thwart hostile takeover attempts
  • Less costly mechanism to alter debt-equity ratio
    • Firms pay significant transaction costs when they issue stock/debt

Summary: A sensible dividend policy

  • We have seen that:
    • Firms should avoid having to cut back on positive NPV projects to pay dividends
    • Firms should avoid issuing stock to pay dividends in a world with personal taxes
    • Repurchases should be considered when there is a surplus of unneeded cash
  • Overall:
    • Firms with many positive NPV projects relative to available cash should have a low dividend payout
    • Firms with few positive NPV projects relative to available cash should have a high dividend payout