University of Science and Technology Beijing Dongling School of Economics and management Chapter 19 Dividends and Other Payouts Jan. 2013 Dr. Xiao Ming USTB 1
Key Concepts and Skills Understand dividend types and how they are paid Understand the issues surrounding dividend policy decisions Understand why share repurchases are an alternative to dividends Understand the difference between cash and stock dividends Dr. Xiao Ming USTB 2
Chapter Outline 19.1 Different Types of Payouts 19.2 Standard Method of Cash Dividend Payment 19.3 The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy 19.4 Repurchase of Stock 19.5 Personal Taxes, Dividends, and Stock Repurchases 19.6 Real-World Factors Favoring a High Dividend Policy 19.7 The Clientele Effect: A Resolution of Real-World Factors? 19.8 What We Know and Do Not Know about Dividend Policy 19.9 Putting It All Together 19.10 Stock Dividends and Stock Splits Dr. Xiao Ming USTB 3
19.1 Different Types of Payouts Many companies pay a regular cash dividend. Public companies often pay quarterly. Sometimes firms will pay an extra cash dividend. The extreme case would be a liquidating dividend. Companies will often declare stock dividends. No cash leaves the firm. The firm increases the number of shares outstanding. Some companies declare a dividend in kind. Wrigley s Gum sends a box of chewing gum. Other companies use stock buybacks. Dr. Xiao Ming USTB 4
19.2 Standard Method of Cash Dividend 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 immediately before this date is entitled to a dividend. Record Date Date on which company determines existing shareholders. Dr. Xiao Ming USTB 5
Procedure for Cash Dividend 25 Oct. 1 Nov. 2 Nov. 5 Nov. 7 Dec. Declaratio n Date Cumdividend Date Exdividend Date Record Date Payment Date Declaration Date: The Board of Directors declares a payment of dividends. Cum-Dividend Date: Buyer of stock still receives the dividend. Ex-Dividend Date: Seller of the stock retains the dividend. Record Date: The corporation prepares a list of all individuals believed to be stockholders as of 5 November. Dr. Xiao Ming USTB 6
Price Behavior In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date. $P -t -2-1 0 +1 +2 The price drops by the amount of the cash dividend. Exdividend Date $P - div Taxes complicate things a bit. Empirically, the price drop is less than the dividend and occurs within the first few minutes of the ex-date. Dr. Xiao Ming USTB 7
19.3 The Irrelevance of Dividend Policy A compelling case can be made that dividend policy is irrelevant. Since investors do not need dividends to convert shares to cash; they will not pay higher prices for firms with higher dividends. In other words, dividend policy will have no impact on the value of the firm because investors can create whatever income stream they prefer by using homemade dividends. Dr. Xiao Ming USTB 8
Homemade Dividends Bianchi Inc. is a $42 stock about to pay a $2 cash dividend. Bob Investor owns 80 shares and prefers a $3 dividend. Bob s homemade dividend strategy: Sell 2 shares ex-dividend homemade dividends Cash from dividend $160 Cash from selling stock $80 Total Cash $240 Value of Stock Holdings $40 78 = $3,120 $3 Dividend $240 $0 $240 $39 80 = $3,120 Dr. Xiao Ming USTB 9
Dividend Policy Is Irrelevant In the above example, Bob Investor began with a total wealth of $3,360: $ 3,360 = 80 shares $42 share After a $3 dividend, his total wealth is still $3,360: $39 $ 3,360 = 80 shares + $240 share After a $2 dividend and sale of 2 ex-dividend shares, his total wealth is still $3,360: $40 $ 3,360 = 78 shares + $160 + $80 share Dr. Xiao Ming USTB 10
Dividends and Investment Policy Firms should never forgo positive NPV projects to increase a dividend (or to pay a dividend for the first time). Recall that one of the assumptions underlying the dividend-irrelevance argument is: The investment policy of the firm is set ahead of time and is not altered by changes in dividend policy. Dr. Xiao Ming USTB 11
19.4 Repurchase of Stock Instead of declaring cash dividends, firms can rid themselves of excess cash through buying shares of their own stock. Recently, share repurchase has become an important way of distributing earnings to shareholders. Dr. Xiao Ming USTB 12
Stock Repurchase versus Dividend Consider a firm that wishes to distribute $100,000 to its shareholders. Assets A.Originalbalance sheet Cash $150,000 Other Assets 850,000 Value of Firm 1,000,000 Shares outstanding = 100,000 Price per share= $1,000,000 /100,000 Liabilities & Equity Debt 0 Equity 1,000,000 Value of Firm 1,000,000 = $10 Dr. Xiao Ming USTB 13
Stock Repurchase versus Dividend If they distribute the $100,000 as a cash dividend, the balance sheet will look like this: Assets Liabilities B. After $1per share cash dividend & Equity Cash $50,000 Debt 0 Other Assets 850,000 Equity 900,000 Value of Firm 900,000 Value of Firm 900,000 Shares outstanding = 100,000 Price per share = $900,000/100,000 = $9 Dr. Xiao Ming USTB 14
Stock Repurchase versus Dividend If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this: Assets C. After stock repurchase Liabilities & Equity Cash $50,000 Debt 0 Other Assets 850,000 Equity 900,000 Value of Firm 900,000 Value of Firm 900,000 Shares outstanding= 90,000 Price per share = $900,000 / 90,000 = $10 Dr. Xiao Ming USTB 15
Share Repurchase Flexibility for shareholders Keeps stock price higher Good for insiders who hold stock options As an investment of the firm (undervaluation) Tax benefits Dr. Xiao Ming USTB 16
19.5 Personal Taxes, Dividends, and Stock Repurchases To get the result that dividend policy is irrelevant, we needed three assumptions: No taxes No transactions costs No uncertainty In the United States, both cash dividends and capital gains are (currently) taxed at a maximum rate of 15 percent. Since capital gains can be deferred, the tax rate on dividends is greater than the effective rate on capital gains. Dr. Xiao Ming USTB 17
Firms without Sufficient Cash Firm Investment Bankers Cash: stock issue Cash: dividends The direct costs of stock issuance will add to this effect. Stock Holders Taxes Gov. In a world of personal taxes, firms should not issue stock to pay a dividend. Dr. Xiao Ming USTB 18
Firms with Sufficient Cash The above argument does not necessarily apply to firms with excess cash. Consider a firm that has $1 million in cash after selecting all available positive NPV projects. Select additional capital budgeting projects (by assumption, these are negative NPV). Acquire other companies Purchase financial assets Repurchase shares Dr. Xiao Ming USTB 19
Taxes and Dividends In the presence of personal taxes: 1. A firm should not issue stock to pay a dividend. 2. Managers have an incentive to seek alternative uses for funds to reduce dividends. 3. Though personal taxes mitigate against the payment of dividends, these taxes are not sufficient to lead firms to eliminate all dividends. Dr. Xiao Ming USTB 20
19.6 Real-World Factors Favoring High Dividends Desire for Current Income Behavioral Finance It forces investors to be disciplined. Tax Arbitrage Investors can create positions in high dividend yield securities that avoid tax liabilities. Agency Costs High dividends reduce free cash flow. Dr. Xiao Ming USTB 21
19.7 The Clientele Effect Clienteles for various dividend payout policies are likely to form in the following way: Group High Tax Bracket Individuals Low Tax Bracket Individuals Tax-Free Institutions Corporations Stock Type Zero-to-Low payout Low-to-Medium payout Medium payout High payout Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy. Dr. Xiao Ming USTB 22
19.8 What We Know and Do Not Know Corporations smooth dividends. Fewer companies are paying dividends. Dividends provide information to the market. Firms should follow a sensible policy: Do not forgo positive NPV projects just to pay a dividend. Avoid issuing stock to pay dividends. Consider share repurchase when there are few better uses for the cash. Dr. Xiao Ming USTB 23
19.9 Putting It All Together Aggregate payouts are massive and have increased over time. Dividends are concentrated among a small number of large, mature firms. Managers are reluctant to cut dividends. Managers smooth dividends. Stock prices react to unanticipated changes in dividends. Dr. Xiao Ming USTB 24
19.10 Stock Dividends Pay additional shares of stock instead of cash Increases the number of outstanding shares Small stock dividend Less than 20 to 25% If you own 100 shares and the company declared a 10% stock dividend, you would receive an additional 10 shares. Large stock dividend more than 20 to 25% Dr. Xiao Ming USTB 25
Stock Splits Stock splits essentially the same as a stock dividend except it is expressed as a ratio For example, a 2 for 1 stock split is the same as a 100% stock dividend. Stock price is reduced when the stock splits. Common explanation for split is to return price to a more desirable trading range. Dr. Xiao Ming USTB 26
Quick Quiz What are the different types of dividends, and how is a dividend paid? What is the clientele effect, and how does it affect dividend policy irrelevance? What is the information content of dividend changes? What are stock dividends, and how do they differ from cash dividends? How are share repurchases an alternative to dividends, and why might investors prefer them? Dr. Xiao Ming USTB 27
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