Dividend Policy. Lakehead University. Types of Dividend. Winter 2005

Transcription

1 Dividend Policy Lakehead University Winter 2005 Types of Dividend Dividends are usually paid in cash, and this four times a year. A company may also pay a stock dividend: A 2% stock dividend, for instance, is such that shareholders receive 1 share for each 50 shares they own. A 2-for-1 stock split is a 100% stock dividend. 2

2 Dividend Payment Procedure Dividends are normally paid quarterly and, if conditions permit, the dividend is increased once a year. Suppose for example that a corporation paid $0.50 per quarter in Its annual dividend is then $2.00. If the corporation decided to increase the annual dividend to $2.08, say, then the quarterly dividend would be $ Dividend Payment Procedure The procedure for paying dividends is as follows: Declaration Date: On January 15, say, corporation XYZ announces that it will pay a dividend on February 16 of the same year. Holder-of-Record Date: At the close of business on the holder-of-record date, January 30, say, XYZ clsoes its stock transfer book and makes a list of shareholders to that date. If XYZ is not notified of the purchase of its stock by an individual before 5 PM on the record date, the individual does not get the dividend. 4

3 Dividend Payment Procedure Ex-Dividend Date: To avoid conflict, the convention is that the right to the dividend remains with the stock until two days before the holder-of-record date. Whoever buys the stock on or after the ex-dividend date does not receive the dividend. In the present example, the ex-dividend date would be January Dividend Payment Procedure Jan 15 Jan 27 Jan 28 Jan 30 Feb 16 Declaration date Dividend goes with the stock Ex-dividend date Holder-of-record date Payment date 6

4 Fall in Stock Price on the Ex-Dividend Date d 0 dividend announced p 0 stock price one day before the ex-dividend date p 0 stock price on ex-dividend date p 0 = t=1 d t (1 + r s ) t p 0 = p 0 + d 0 p 0 p 0 = d 0. Without taxes, the stock price should fall by d 0 on the ex-dividend date. 7 Fall in Stock Price on the Ex-Dividend Date (Taxes) Suppose dividends are taxed at the rate t d, and suppose capital gains are taxed at the rate t cg. The day prior to the ex-dividend date, shareholders expect to receive (1 t d )d 0 and t cg ( p 0 p 0 ) if capital losses are tax deductible. Then p 0 = p 0 + (1 t d )d 0 + t cg ( p 0 p 0 ), and thus p 0 p 0 = 1 t d 1 t cg d 0. 8

5 Dividend Irrelevance Theory XYZ, an all-equity firm has 100 shares outstanding and a cash flow of $10,000 (including liquidation) over the next two years. The firm can then pay a dividend of $100 per shares in each of these two periods, which gives a stock price P 0 = D r s + D 2 (1 + r s ) 2 = (1.10) 2 = $ where r s = 10% is the return required by shareholders (XYZ s cost of capital when an all-equity firm). 9 Dividend Irrelevance Theory Suppose that XYZ wants to change its dividend policy. Instead of paying $100 per year to each shareholder, it will pay $120 per share the first year and whatever remains after liquidation of the firm on the second year. To finance the greater dividend, XYZ has to either raise debt or equity. 10

6 Dividend Irrelevance Theory Equity Is Issued If equity is issued new shares have to be issued in exchange of = $2, 000 after one year. There is no increase in leverage and thus the new shareholders will also require a return of 10%, i.e. a payment of $2,200 at the end of the second year. This means that there will be 10,000 2,200 = $7,800 available to the old shareholders at time Dividend Irrelevance Theory Equity Is Issued The new stock price is then P 0 = (1.10) 2 = (1.10) 2 = (1.10) 2 22 (1.10) 2 = (1.10) 2 (1.10) 2 = (1.10) = (1.10) 2 = $

7 Dividend Irrelevance Theory Debt Is Issued Note that the price did not change when equity was issued to finance the dividend. What happens if, instead, the firm issues debt to pay the extra $20 dividend per share? Suppose the firm borrows $2,000 in year 1 and repay $2,000 (1 + r d ) at the end of year Dividend Irrelevance Theory Debt Is Issued The argument is more complex here but the increase in debt will increase the return required by shareholders, i.e. P 0 = r s (1 + r d) (1 + r s) 2, where r s > 10%. It can be shown that P 0 = P 0. 14

8 Dividend Irrelevance Theory Note that we have assumed No taxes, no brokerage fees Individuals have homogeneous beliefs Investment policy is not affected by the dividend policy 15 Homemade Dividends Another argument in favour of the dividend irrelevance theory is that an investor not satisfied with the proposed stream of dividends can always create her own personalized stream of income by borrowing or lending. 16

9 Homemade Dividends Suppose that p 0 = d 0 + d r s, but the investor wants to receive all her dividends in period 1, i.e. d 0 = Homemade Dividends If d 0 can be saved at the rate r, this gives If r = r s, then p 0 = p 0. p 0 = 0 + (1 + r)d 0 + d r s. 18

10 Bird-in-the-Hand Theory Myron Gordon and John Lintner have argued that r s decreases as the dividend payout increases because investors are less certain of receiving the capital gains supposed to result from retaining earnings than they are of receiving dividend payments. That is, take r s = D 1 P 0 + g. D 1 /P 0 being more certain than g, r s will decrease as D 1 increases. 19 Bird-in-the-Hand Theory M&M called this theory the bird-in-the-hand fallacy since investors tend to reinvest their dividends in securities that have the same risk characteristics as the stock paying the dividend. 20

11 Taxes Preference Theory Dividends have greater tax consequences than capital gains. Investors in high tax brackets may prefer capital gains, and thus a low payout ratio, to dividends. Also, taxes on capital gains are paid only when the stock is sold, which means that they can be deferred indefinitely. 21 Optimal Dividend Policy On the board. 22

12 Empirical Evidence on Dividend Policy Empirical tests of dividend policy theories have not been too conclusive because of two reasons: For a valid statistical test, things other than dividend policy must be held constant across the firms in the sample, i.e. one must have a sample of firms that differ in their dividend policy only, which is not possible. We must also be able to measure with a high degree of accuracy each firm s cost of equity, another difficulty. 23 Other Dividend Policy Issues Signaling Hypothesis The M&M dividend irrelevance theory assumes that all investors have the same information regarding the firm s future earnings. In reality, however, different investors have different beliefs and some individuals have more information than others. More specifically, the firm managers have better information about future earnings than outside investors. 24

13 Other Dividend Policy Issues Signaling Hypothesis It has been observed that dividend increases are often accompanied by an increase in the stock price and dividend decreases are often accompanied by stock price declines. These facts can be interpreted in two different ways: Investors prefer dividends to capital gains; Unexpected dividend increases can be seen as signals of the quality of future earnings (signaling theory). 25 Other Dividend Policy Issues Clientele Effect Different groups (clienteles) of stockholders prefer different dividend policies. This may be due to the tax treatment of dividends or because some investors are seeking cash income while others want growth. Changing the dividend policy may force some stockholders to sell their shares. 26

14 Other Dividend Policy Issues Clientele Effect This is not a problem if stockholders can switch without costs but there are brokerage costs; the likelihood that the shareholders who sell pay capital gains taxes; a possible shortage of investors who like the firm s newly adopted dividend policy. 27 Dividend Stability Since profits vary over time, dividends should also vary. Many stockholders, however, rely on dividends to meet expenses. Cutting dividends may also send the wrong signal to investors who would then bid the stock price down. Maximizing the stock price requires a firm to balance internal needs of funds with stockholders needs. 28

15 Dividend Stability Public company usually make five- to ten-year financial forecast of earnings. When inflation is not persistent, stable dividend means approximately the same dollar amount each year. With inflation, stable dividend means a dividend that grows in line with inflation. There are two components to dividend stability: The dividend growth rate; How the last dividend can help predict the next one. 29 Dividend Policy in Practice The Residual Dividend Model Under this model, dividends are determined as follows: 1. The firm determines its optimal capital budget; 2. The firm determines the amount of equity needed given the target capital structure; 3. Retained earnings are used to meet equity requirements to the extent possible; 4. Dividends are paid only if more earnings are available than what is needed. 30

16 Dividend Policy in Practice The Residual Dividend Model Under the residual dividend model, dividends are determined as follows: Dividends = Net Income Target Equity Ratio Capital Needed 31 Dividend Policy in Practice The Residual Dividend Model Suppose a firm has a target equity ratio of 60% and needs to spend $50m on new projects. The firm needs.6 50 = $30m in equity. If its net income is $100m, its dividend will be = $70m. If capital requirements were $200m, the firm would not pay any dividend. 32

17 Dividend Policy in Practice The Residual Dividend Model Under the residual dividend model, the better the firm s investment opportunities, the lower the dividend paid. Following the residual dividend policy rigidly would lead to fluctuating dividends, something investors don t like. 33 Dividend Policy in Practice The Residual Dividend Model To satisfy shareholders taste for stable dividends, firms should 1. Estimate earnings and investment opportunities, on average over the next five to ten years; 2. Use this information to find out the average residual payout ratio; 3. Set a target payout ratio. 34

18 Dividend Policy in Practice Note that one way to maintain a regular dividend payment is to set a payment sufficiently low to never exceed the expected payment given by the target payout ratio. There are other factors influencing the dividend policy: Bond indentures Preferred stock restrictions Availability of cash 35 Dividend Policy and Growth Rate Let b denote the firm s retention ratio, and let r denote the rate of return the firm will earn, on average, on new investments. Let I t denote investment at time t and let E t denote earnings at time t. Note that r can be approximated by the return on equity (ROE). 36

19 Dividend Policy and Growth Rate Then E t = E t 1 + ri t 1 = E t 1 + rbe t 1 = (1 + rb)e t Dividend Policy and Growth Rate The growth in dividends is then g = D t D t 1 D t 1 = (1 b)e t (1 b)e t 1 (1 b)e t 1 = E t E t 1 E t 1 = rb. That is, the expected growth rate in dividends can be approximated by Return on Equity (ROE) Retention Ratio. 38

20 Repurchases of Shares Advantages of Stock Repurchases Repurchase announcements are viewed as positive signals by investors. Stockholders have a choice when a firm repurchases stocks: They can sell or not sell. Dividends are sticky in the short-run because reducing them may negatively affect the stock price. Extra cash may then be distributed through stock repurchases. The target payout ratio may be achieved with the help of repurchases. 39 Repurchases of Shares Disadvantages of Stock Repurchases Stockholders may not be indifferent between dividends and capital gains. The selling stockholders may not be fully aware of all the implications of a repurchase. The corporation may pay too much for the repurchased stocks. 40

21 Repurchases of Shares (vs Dividend Payment) The day before a dividend payment, the price of a stock is p 0 = d 0 + t=1 d t (1 + r s ) t = d 0 + t=1 CF t /n 0 (1 + r s ) t where CF t is the cash flow net of debt payments at time t and n 0 is the initial number of shares. Suppose that instead of paying d 0, the firm decides to repurchase n shares. 41 Repurchases of Shares (vs Dividend Payment) Anybody left with a share will receive CF t /(n 0 n ) t=1 (1 + r s ) t = p 0 The firm uses dividend money to repurchase the shares, and thus n is such that n p 0 = n 0 d 0 42

22 Repurchases of Shares (vs Dividend Payment) This gives us p 0 = = = = CF t /(n 0 n ) t=1 (1 + r s ) t n 0 n 0 n t=1 n 0 n 0 n 0 d 0 / p d 0 / p 0 CF t /n 0 (1 + r s ) t t=1 t=1 CF t /n 0 (1 + r s ) t CF t /n 0 (1 + r s ) t 43 Repurchases of Shares (vs Dividend Payment) p 0 p 0 d 0 p 0 p 0 = = 1 1 d 0 / p 0 t=1 p 0 = d 0 + CF t /n 0 (1 + r s ) t t=1 t=1 CF t /n 0 (1 + r s ) t CF t /n 0 (1 + r s ) t = p 0. 44

23 Stock Splits A stock split takes place when a firm declares that each outstanding share now becomes more than one share. A two-for-one split, for example, means that each outstanding shares now becomes two separate shares. In efficient markets, the two-for-one split of a $80 stock would create two $40 stocks. 45