FINA351, Chapter 14, NOTES Dividends DIVIDEND PAYMENT CHRONOLOGY

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1 FINA351, Chapter 14, NOTES Dividends DIVIDEND PAYMENT CHRONOLOGY Declaration Date: board meets quarterly and dividend amount is voted Ex-Dividend Date: two business days before date of record; business days exclude official holidays and Sat/Sun; investors buying stock before the ex-dividend date get the dividend. Date of Record: date set by board for determining who gets the dividend; as a practical matter, the ex-dividend date overrides the date of record. Date of Payment: date that checks are mailed, or payment is electronically transferred, or is deposited in a dividend reinvestment program (DRIP) account Go to to see live examples. Big bucks, eh?

2 By how much does the stock price drop on the ex-dividend date? Answer: by approximately the amount of the dividend (less taxes), baring all other factors EXAMPLE: MSFT s enormous $3.08 dividend went ex on 11/15/04 ($32.6 billion). Note how the stock price drops by $2.63, which is approx. the amount of the dividend, less taxes ($3.08 x (1-.15)) = $2.62! DIVIDEND POLICY Basic Issues: How much dividends, if any, should be paid? What is worth more: a dollar in owner's bank account or a dollar in company's bank account? Dividends are irrelevant in a theoretical world for two reasons: (1) the value to investor is the same if dividends are paid or not because Po = PV of future dividends; (2) the homemade dividend theory says that you can create your own desired cash flow despite company dividend policy. If you need cash and the company isn t paying dividends, then sell your stock. If you don't need cash and the company is paying dividends, then re-invest your dividends in stock.

3 Dividends are relevant in real world because of taxes, transactions costs, and the human psyche (dividend is a tangible reminder that you are getting something for your investment, however small). Five different dividend payout approaches: (1) zero approach: pay no dividends now (KeyTech) because high growth requires that money be reinvested in company (2) stable approach: pay a constant increasing dollar amount in dividends (ideal approach; e.g. some Boston and NY banks have been paying steady dividends for more than 200 years) (3) cyclical approach: pay a constant percent of earnings whether they go up or down; results in a constant payout ratio, but not a constant dividend (4) residual approach: pay dividends only when there's cash (5) compromise approach: raise dividends only when the increase can be sustained, never lower a dividend, maintain as constant a payout ratio as possible Firm Lifecycle Theory of Dividend Payout 1. Startup - Initial funds are raised for the start-up and development of the company. These funds are used to purchase property, plant, equipment, raw materials and inventory and to pay staff. The company begins to generate cash flows and these flows are used to pay staff, purchase more raw materials and pay taxes. Little cash, if any, is left over in this stage for dividends. 2. Growth In this stage, sales and expenses are growing rapidly. Any extra cash is re-invested for expansion as raising new capital externally is costly this early on in a firm s life. Therefore, no dividends are paid. This process repeats itself several times until the firm has either maximized its output or saturated the local market. 3. Maturity A firm could remain in this stage for many years. Sales increase slowly, due to intense competition in the market, and products begin to saturate market potential. However, this is a sweet spot for the firm as cash flow is still strong. It could use its cash to launch a new product or expand to a new region, or it could begin paying a dividend. In most firms, shareholders force the company to pay a dividend through their elected representatives (board members who declare the dividend). 4. Decline In this stage, products lose their appeal in existing markets, maybe due to obsolescence. Firms focus on taking their successful product to new regions, funded by raising new capital, while maintaining a progressive dividend. Those who try instead to enter a new product range are less likely to succeed unless there are synergies with the core product. Therefore, the chance of spectacular growth is minimal. Dividends start to taper. 5. Death or rebirth? Who knows? Only time will tell.

4 Signaling theory or information content of dividends: a dividend increase signals good prospects; a dividend cut signals problems (e.g. letter from Delta Airlines CEO to shareholders trying to soften the blow of the first ever dividend cut) Reasons for low dividend payout (1) investors may prefer capital gains because of tax-free compounding, but dividends are taxed immediately. (Before Bush s dividend tax cut in 2003, dividends were usually taxed at higher rates than capital gains; Obama has said he ll reverse Bush s cut.) (2) if dividend payout is kept low, then investor expectations aren t raised, which might not be met later because of poor cash flow (3) it doesn t make any sense to obtain expensive financing (borrow or issue stock) in order to pay a dividend. (4) bondholders often restrict the amount of dividends that can be paid in order to insure sufficient cash flow to make bond interest/principal payments first (5) most states prohibit corporations from paying dividends if there is insufficient retained earnings Reasons for high dividend payout (1) bird-in-hand theory or uncertainty resolution says that dividends are a more certain, current source of return than waiting for the stock price to increase, which may or may not happen (2) desire for current income (e.g. retired people who may be house rich but cash hungry; WWU scholarship endowment which may rely on dividend income to pay scholarships) (3) 70%-100% of dividend income earned by corporate investors is not subject to income tax (otherwise, this would result in triple taxation or worse) (4) dividends may support the price of the stock in boring regulated industries (e.g. utilities) Differences among industries: Dividend payout ratios differ from industry to industry. For example, why does the high tech sector not pay dividends but utilities pay high dividends? High tech firms usually have stock prices with growth sufficient to satisfy investors without having to pay dividends. Growing firms need to reinvest cash in the business. Whereas, a utility company has gov t-regulated profits and must pay a dividend to attract investors to what otherwise might be a boring stock. Differences among countries: Why do British and Japanese companies typically pay higher dividends than American companies? Some have speculated that these countries tend to be more conservative and less likely to take long-term risks. A risk-tolerant investor would prefer that cash not be paid out in dividends now but allowed to reinvest in the business, with the gamble that this will results in increased capital gains down the road. The effect of taxes: President Bush proposed to tax dividends at the same 15% maximum rate as longterm capital gains. His proposal was passed by Congress in 2003, effective 1/1/03. Obama hated this tax cut and pledged to reverse it. In a compromise agreement with Republicans, Obama got part of his wish on 1/1/13 to raise the maximum dividend rate to 20%, plus another 3.8% for wealthy Americans. Notice how dividend payouts spiked as soon as President Bush cut dividends tax rate. Corporations smartly decided that it would be a good time to distribute cash to investors in the most tax-efficient manner.

5 Notice the downward trend in the proportion of firms paying dividends; also, notice the proportion has increased since the 2003 Bush tax cut.

6 Investors prefer dividends to be in the form of cash (dividends paid in non-cash assets are called property dividends). If non-cash dividends are paid, investors wonder whether the company is doing well, as illustrated here: Dear Shareholder: In an effort to reduce an overstocked inventory, you will be receiving under separate cover a number of the company s household cleaning supplies of equal or greater value than your regular quarterly cash dividend. Does this investor look happy? STOCK SPLITS Reasons for splits: (1) Popular trading range. It is assumed that investors like shares to be priced no more than say $100 per share because stocks are usually traded in round lots of 100 shares at a time in order to reduce brokerage fees. However, recent evidence that shows investors don t care about how high the stock prices goes (e.g. GOOG or AAPL). The general consensus is that individual investors care about splits but institutional investors are more interested in signals that are backed with cash, like share buybacks or dividend increases. Since the level of individual stock ownership has declined, the views of institutional investors are more important to companies these days. (2) Sends a positive signal about company prospects, often causing a small bump in price when announced. Splits do not change any components of stockholders' equity except the number of shares, the par value, and the market value splits simply divide the pie into more pieces but the pie stays the same size in total. Thus, there are no real economic consequences from a split. However, splits are usually viewed as a positive signal. Studies indicate that stocks that split have returns outperforming those that don t. Obviously, stocks would only split when their value has been rising significantly. Going against the grain: Some companies avoid splits. Consider Warren Buffet and his Berkshire- Hathaway stock (BRKA), which has never split. REVERSE STOCK SPLITS Reverse splits result in fewer shares each worth more. Reasons for reverse stock splits: (1) avoid penny stock labels when stock prices get too low (2) increase marketability of stock when price is within popular trading range (3) force out small shareholders to gain control (e.g. in 1-for-3000 reverse split, anyone owning less than 3000 shares will end up with a partial share and their investment will be liquidated. Then the company can undergo a 1-for-3000 stock split to restore the stock to its original price). (4) reduce the costs of processing/mailing small dividend checks to small shareholders (5) meet minimum stock prices required on some exchanges (Nasdaq de-lists stocks with prices less than $1 for 30 days). E.g. on 7/1/10, NYSE delisted BlockBuster after shareholders failed to pass a reverse stock split aimed at raising the stock price above $1. Some exchanges have rules that preclude reverse stock splits for this purpose. (6) reduce trading costs to investors

7 STOCK DIVIDENDS Stock dividends are misunderstood by general public who often thinks they have value. Corporations prey on public ignorance by "issuing stock dividends in lieu of cash dividends. What they are really saying is that they have no or low cash. In reality, stock dividends provide the same result to investors as a stock split (zero value) and are thus often called "a stock split effected in the form of a stock dividend." The one difference is that a stock dividend re-arranges the components of stockholders' equity to "capitalize retained earnings," even though total stockholder equity doesn't change. STOCK REPURCHASES (OR BUYBACKS OR TREASURY STOCK) Stock repurchases distribute money to owners and have economic effects similar to cash dividends. In both cases, investor s receive a distribution of corporate cash. But from an investor s perspective, stock repurchases have advantages over dividends: (1) in a buyback, the investor can choose to liquidate the investment; but there s no choice for the investor in receiving a dividend (2) the resulting capital gain in a buyback may receive preferential tax treatment (currently not the case for most people under Bush s 2003 dividend tax cut) (3) even if tax rates on dividends and capital gains were the same, buybacks would still allow tax-free compounding, whereas one must pay tax on dividends every year From a corporation s perspective, stock repurchases have the following advantages: (1) have shares to distribute to employees in stock option plans (ESOPs) without having to deal with issue costs and regulations (2) distributes cash to owners without raising dividend expectations (3) support the stock price by creating demand (e.g. buybacks during 1987 market crash) (4) increases earnings per share (5) provides shares for potential corporate takeovers where stock is exchanged (6) avoids a hostile takeover (7) raises capital cheaper by buying low and selling high, without issue costs and regulation (8) reduces number of shares which may decrease trading costs

8 Notice how more stock has been repurchased than issued in recent years, especially for non-financial firms.

9 Notice how share repurchases (stock buybacks or treasury stock) have become more popular during bull markets and less popular during bear markets. Corporate cocaine Companies are spending record amounts on buying back their own shares. Investors should be worried Sep 13th 2014 From the print edition FINANCIAL excess is more commonly associated with banks than with blue-chip companies. While the rich world s finance industry supposedly the brain of the economy went berserk in the run-up to the crash, other big firms behaved sensibly, avoiding too much debt, keeping their costs under control and their eyes on long-term opportunities in emerging markets. But in the era of weak growth and low interest rates that has characterized the aftermath of that crash, there is growing evidence that the blue chips are engaged in their own kind of financial excess: a dangerous addiction to share buy-backs. Over the past 12 months American firms have bought more than $500 billion of their own shares, close to a record amount. From Apple to Walmart, the most profitable and prominent companies have big buy-back schemes (see article). IBM spends twice as much on share repurchases as on research and development. Exxon has spent over $200 billion buying back its shares, enough to buy its arch-rival BP. The phenomenon is less extreme in other countries, but is becoming popular

10 even in conservative corporate cultures. Led by firms such as Toyota and Mitsubishi, Japanese companies are buying back record amounts of their own shares. Buy-backs are not necessarily a bad idea. When firms buy their own stock in the open market they return surplus cash to their shareholders, in much the same way as if they were paying out dividends. And if firms can t find opportunities for profitable investment, handing cash back to investors is the right thing to do. In many ways the surge in buy-backs is a symptom of the rich world s feeble growth prospects. But it could also be a source of trouble, for two main reasons. First, both short-term investors and managers have incentives that could lead them to overdo buy-backs and neglect long-term investment projects. The announcement of a buy-back scheme can prompt a sudden spike in share prices and a quick buck for the short-term investor. By reducing the number of shares outstanding, buy-back schemes can also artificially boost a firm s earnings per share. This helps explain why managers whose pay depends on reaching specific earnings-per-share targets like to buy back shares. Second, some firms may be borrowing too much to pay for their buy-back habit. American companies, if one includes their global operations as a whole, are only moderately indebted; record buy-backs are being paid out of record profits. But the overall figures are skewed by a few cash-rich giants, such as Google. In 2013, 38% of firms paid more in buy-backs than their cash flows could support, an unsustainable position. Some American multinationals with apparently healthy global balance sheets are, in fact, dangerously lopsided. They are borrowing heavily at home to pay for buy-backs while keeping cash abroad to avoid America s high corporate tax rate. Drawing a line If firms are overdoing buy-backs and starving themselves of investment, artificially propped-up share prices will eventually tumble. That is why investors need to pay close attention. In the long term they need to ensure that bosses pay schemes are designed in a way that does not create a perverse incentive to repurchase stock. In the short term, they must give willing firms a license to invest. There are some signs that this is beginning to happen. According to a poll by Bank of America Merrill Lynch, a record majority of fund managers now think firms are investing too little; only a minority want higher cash returns. That is welcome: shareholder capitalism is about growth and creation, not just dividing the spoils