Untitled Flashcards Set

DIVIDEND PAYOUT POLICY LECTURE 17 Understand dividend types and how they are paid Understand the issues surrounding dividend policy decisions Firm’s Payout Policy • Cash dividends • Special dividends • Stock dividends • Stock splits • Share repurchases Cash Dividend • In the U.S., as in most countries, shareholders have no legal right to receive dividends. • Instead, a firm’s board of directors decides what dividends the firm will pay. • Most U.S. firms that pay dividends do so once every quarter • Percentage of firms paying dividends has declined sharply over the years . • Reason: The increasing number of growth companies that have gone public since 1980s. 3 Average Earnings and Dividends for U.S. Nonfinancial Firms 4 Relevant Dividend Dates • Shareholders of record are entitled to the dividend. • Investors who buy stock on the the dividend payment. record date will miss– Because it takes time to make bookkeeping entries after stocks trade, • To receive the dividend, an investor must own the stock before the ex-dividend date, usually business days prior to the date of record . two • Firms distribute dividends on the payment date which usually comes a few weeks after , the record date. 5 Timeline of Dates in the Dividend Process 7 Other Forms of Dividends • Special Dividends: – Firms sometimes declare one-time special dividends after an unusually profitable year or a large infusion of cash (e.g., from an asset sale). • Stock dividends– Additional shares of stock rather than cash • Increases the number of outstanding shares • Example: if the company has 10000 number of shares outstanding, and does 10% stock dividends, what is the new number of share outstanding: • 10000+ 10%*10000= 11000 7 Stock Splits • Stock splits – essentially the same as a stock dividend except expressed as a ratio ▪ For example, a 2 for 1 stock split is the same as a 100% stock dividend. ▪ We also have reverse split • Stock price is reduced when the stock splits. • Why companies do stocks splits?– Common explanation for split is to return price to a “more desirable trading range.” Dividend Trends: Share Repurchase Programs • Repurchase programs: companies can buy back some of their own shares, usually through open market purchases. • Share repurchases give managers an alternative method to distribute cash to shareholders. • The annual value of share repurchases in the United States sometimes exceeds that of dividends, and investors clearly welcome repurchase announcements. 10 Methods to Repurchase Shares • Open-market share repurchase: Firms buy back their shares in the open market. • Tender offer , or self-tender: Firms offer to buy back a certain number of shares, usually at a premium above the current market price. • Dutch auction repurchase : Firms ask investors to submit prices at which they are willing to sell their shares. 11 Share Repurchase Programs • Repurchase or share buyback– Become increasingly common after the SEC adopted Rule 10b-18 in 1982 • Which protects repurchasing companies from being prosecuted for manipulating their own stock prices.– The most common way to repurchase stock is open market repurchase. • Companies buy stock in the market as investors do. Total Share Repurchases, 1990-2007 13 Dividends, Repurchases, and Taxes • Dividends are normally taxed at an individual’s ordinary income tax rate. • Income from repurchases may be taxed at a lower long term capital gains rate, and then only if the investor chooses to sell shares back to the company. • This encourages firms to shift payout away from dividends and toward repurchases. 19 20 Dividend Initiations by U.S. Public Firms, 2001-2006 Reduction in dividend taxation, May 2003 Stylized facts on payout policy • Dividends– Firms have long-run target dividend payout ratios.– Firms and investors focus more on dividend changes dividend levels. – Dividends changes follow shifts in rather than long-run, sustainable earnings rather than short-run changes in earnings.– Dividends represent firms’ long-term commitment to returning cash to shareholders. Therefore, managers are reluctant to make dividend changes (in particular, dividend increases) that may have to be reversed later. Stylized facts on payout policy • Repurchases– Firms repurchase stock • when they have accumulated a large amount of “unwanted” cash, or • when they wish to change their capital structure by replacing equity with debt.– Stock repurchases are like bumper (one-off) dividends and do not carry any long-term commitment. • They do not typically substitute for dividends; many companies that repurchase stock also pay dividends.– Repurchases are much more volatile than dividends. • They rise during booms and decline during recessions. Payout policy and life cycle of firm • No payout by young growth firms– They have plenty of profitable investment opportunities and are often cash flow negative, and therefore, it is efficient to retain and reinvest all operating cash flow. • As firms begin to mature, they initiate payout– Positive-NPV projects become more scarce relative to cash flows ➔ Maturing firms begin to accumulate cash ➔ Investors begin to worry about inefficient investment or managerial waste ➔ They start pressuring management to pay out cash. • As firms continue to age, more and more payout is called for. The payout may come as higher dividends or large repurchases. Information content of dividends • Dividend policy can be a good indicator of firm quality when reported earnings can not be completely trusted– Companies with truly superior performance can commit to a generous dividend policy to signal their quality. • Can companies with fake earnings copy this strategy? • Evidence on the information content of dividends– Stock prices rise upon announcements of dividend increases and drop upon dividend cuts.– Dividend initiations and omissions can predict future earnings. Information content of repurchases • Different from dividends– Stock repurchases are often a one-time thing, and do not represent a long-term commitment to distribute more cash.– Can not serve as a signal for true performance. • Possible information conveyed by repurchase– Lack of profitable investment opportunities– Stock being undervalued • Key for this signal to be credible: managers don’t sell their shares during stock repurchases.– Net effect: positive stock price reaction The payout controversy • Does a firm’s payout policy change its value, rather than simply signal its value?– Three schools of thoughts • Dividend-irrelevance theorem by Merton Miller and Franco Modigliani (M&M) • Dividends increase value. • Dividends decrease value. Does Dividend Policy Matter? • Dividends matter – the value of the stock is based on the present value of expected future dividends. • Dividend policy may not matter ▪ Dividend policy is the decision to pay dividends versus retaining funds to reinvest in the firm. ▪ In theory, if the firm reinvests capital now, it will grow and can pay higher dividends in the future. Dividend Irrelevance in a World With Perfect Capital Markets • Miller and Modigliani demonstrated that in a world of frictionless capital markets (no taxes, bankruptcy, agency costs) , payout policy cannot affect a firm’s value. • As long as the firm accepts all positive-NPV investment projects and has costless access to capital markets any level of dividends it desires. , it can pay • If payout policy does affect firm value, it must be because markets are imperfect. 33 Higher dividends can increase Shareholder value • Clientele effect– There are natural clients for high-payout stocks • Some financial institutions are legally required to hold stocks with established track records.– They push up the stock price through their demand for dividend paying stocks. • Agency costs of free cash flow– Regular dividend payouts can take the money out of the hands of self-serving, empire building managers. Higher dividends can decrease Shareholder value • Tax disadvantage of dividends relative to capital gains– Historically, dividends were taxed at a higher rate than capital gains (but not since the 2003 tax cuts).– Even if capital gains and dividends are taxed at the same rate, capital gain taxes can be deferred until capital gains are realized, while dividend taxes have to be paid immediately. • Everything else being equal, low-dividend-paying stocks are more attractive to taxpaying investors than high-dividend-paying stocks, and therefore should be valued higher. Payout Policy: Key Lessons • Aggregate payouts are massive and have increased over time. • Firms take a conservative approach to dividends: Managers are reluctant to cut dividends. • Managers smooth dividends. • Dividends are concentrated among a small number of large, mature firms.– The key factor driving dividend payments is the stability of long-run cash flows. • Managers view share repurchases as more flexible. • Stock prices react to unanticipated changes in dividends. 37 Price Behavior around the Ex-Dividend Date Question 1 • A company’s stock is priced at $50 per share, and it plans to pay a $2 cash dividend. ▪ Assuming perfect capital markets, what will the per share price be after the dividend payment? ▪ If the average tax rate on dividends is 25%, what will the new share price be? Question 1 • A company’s stock is priced at $50 per share, and it plans to pay a $2 cash dividend. ▪ Assuming perfect capital markets, what will the per share price be after the dividend payment? ▪ If the average tax rate on dividends is 25%, what will the new share price be? In perfect market, new price = 50- 2=$48. The stock price should drop by the after tax dividend amount, or: In imperfect market, new price = 50- (2*(1-.25))= $48.50 Question 2 Chowdury, Incorporated, announced on May 1st that it will pay a dividend of $1.20 per share on June 15th to all holders of record as of May 31st. The firm’s stock price closed today at $42 per share. Assume all investors are in the 22 percent tax bracket.