dividends chapter 14 © 2003 south-western/thomson learning
TRANSCRIPT
Dividends
Chapter 14
© 2003 South-Western/Thomson Learning
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Background
Dividends as a Basis for Value Help determine the value of stocks
• Individual investors buy stocks expecting return from dividends and the eventual selling price of stock
• Today’s price represents the present value of those future expected cash flows
• From the whole market view• The price of a stock today is the present value of the
infinite stream of dividends
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Understanding the Dividend Decision The Discretionary Nature of Dividends
Board of Directors has authority to determine the dividend payout
• Payout can range from nothing to everything
The Dividend Decision A firm’s earnings belong to the stockholders
• Management makes the dividend decision on behalf of the stockholders
• Paying dividends gives stockholders an immediate cash payment—current income
• Retaining earnings for reinvestment offers a potentially higher stock price in the future—deferred income
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The Dividend Controversy—Irrelevance
Does the payment of dividends now or increasing the dividend payment impact the stock price? Do stockholders prefer current or deferred
income?
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The Dividend Controversy—Irrelevance Arguments concerning dividend policy
Dividend irrelevance• Value of eliminated dividends is offset by growth-created
value in the future• The increased return on the retained earnings offsets the
reduction or elimination of dividends• Thus, the current stock price is independent of changes
in early dividends
• Investors can tailor their income stream by selling shares of a growing stock that doesn’t pay dividends or by buying shares of stock of a company that pays more dividends than an investor needs
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The Dividend Controversy— Irrelevance—Example
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Q:The Winters are retirees with most of their savings invested in 10,000 shares of Ajax Corporation (AJAX). AJAX sells for $10 per share and pays an annual dividend of $0.50 per share. This year AJAX eliminated the dividend but began to grow at 5% a year due to the reinvested earnings. How can the Winters maintain their income and their position in AJAX?
A: Their original value of AJAX shares was $10 per share 10,000 shares, or $100,000, which they wish to maintain. But, they were generating an annual dividend of 10,000 shares $0.50 or $5,000 before AJAX eliminated the dividend. After one year of 5% growth, AJAX’s shares should be selling for $10.50. Thus, by selling 476 shares ($5,000 $10.50) they can generate $5,000 in cash. Their remaining 9,524 shares would be worth $10.50 each for a total of $100,002.
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The Dividend Controversy—Irrelevance
Transaction Costs Can make tailoring an income stream
impractical The more significant the transactions costs,
the less valid the irrelevance theory becomes
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The Dividend Controversy—Irrelevance Income Taxes
Dividends are taxed as ordinary income Appreciation is taxed as a capital gain
The View from Within the Company Dividends represent a cash outflow
• Reduces retained earnings Firms prefer not paying dividends if it avoids
selling new stock• Retained earnings cost less than new equity
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Dividend Preference
Investors prefer immediate cash to uncertain future benefits Not a time value of money argument but
rather a certainty issue Flaw—if investors are worrying about not
receiving the future cash flow, why invest in that firm in the first place?
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Dividend Aversion
Investors prefer future capital gains to current dividends because of lower tax rates Dividends are taxed at higher ordinary income tax
rates This argument hinges on current level of ordinary
income vs. capital gain tax rates Capital gains taxes are not paid until stock is sold If stock is passed along to heirs, taxes on capital
gains occurring during decedent’s life can be avoided
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Other Theories and Ideas
The Clientele Effect Investors choose stocks for dividend policy—
any change in payments is disruptive• Retirees may desire stocks with high dividends• Young professionals may desire stocks will little
or no dividends
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Other Theories and Ideas
The Residual Dividend Theory Dividends are paid from earnings only after all viable
projects are funded
The Signaling Effect of Dividends Cash dividends signal management’s confidence in
the future• A continuing payment of dividends when earnings are low
can signal management’s confidence about the future• A decrease in dividends can signal management’s lack of
confidence concerning the future
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Other Theories and Ideas
The Expectations Theory Dividends that fail to fulfill stockholders’
expectations send a negative message even if the payment is good
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Legal and Contractual Restrictions Dividends can’t be paid by an insolvent firm
and must come from current or prior earnings Protects creditors
Loan indentures and covenants may limit dividend payments to protect creditors’ interests
The cumulative feature of preferred stock limits dividend payments
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Dividend Policy
Payout ratio States dividends as a fraction of earnings:
dividend per share EPS Stability
A stable dividend is one that is non-decreasing
A dividend with a stable growth rate is one that increases at a more or less constant growth rate
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Alternative Dividend Policies
Target Payout Ratio Firm selects a long-run target payout ratio
• Actual payout ratio is set below target allowing for flexibility in earnings
Stable Dividends Per Share A constant dividend is paid regardless of earnings
• Dividend may change if firm consistently does well or poorly
Small Regular Dividend with a Year-End Extra if Earnings Permit Gives firm the ability to lower dividend (by omitting the
extra year-end dividend) without a negative informational effect
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The Mechanics of Dividend Payments Key Dates
Declaration Date: Date on which the board authorizes the dividend
Date of Record: You must be an owner by this date to have access to the declared dividend
Payment Date: Date the dividend payment will be mailed
Ex-Dividend Date: If you buy the stock on or after this day you will not receive the pending dividend
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Figure 14.1: The Dividend Declaration and Payment Process
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Dividend Reinvestment Plans
Large companies offer automatic dividend reinvestment plans (DRIPs) to stockholders Instead of receiving a cash dividend
payment the stockholder receives additional shares of stock
• Company can either buy the shares on the open market or issue new shares to the stockholder
• IRS treats reinvested dividends as taxable income
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Stock Splits and Dividends
Stock Split Current stockholder is issued new shares
proportionate to his current holdings No change in ownership control occurs
Stock Dividend Same as a stock split but called a stock dividend if the
number of shares is less than or equal to 20% of original shares outstanding
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Stock Splits and Dividends
A firm with 100,000 shares outstanding executes a 2-for-1 split. Each stockholder will now have twice as many shares as they had before. The firm will now have 200,000 shares outstanding. Each share is worth half as much as before the split.E
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Stock Splits and Dividends
Accounting Treatment Stock split changes par value and the
number of shares• Capital accounts are unaffected
Stock dividend causes money to be shifted from Retained Earnings to stock account
• Gives the appearance of a sale at market price
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Stock Splits and Dividends
Rationale for Stock Splits and Stock Dividends Splits keep stock prices in a trading range
• Between $30 and $80 Stock dividends are an attempt at signaling
• Sends a positive message
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Stock Repurchases
Alternative to Dividend A firm with cash can either pay a dividend or
repurchase some of its own outstanding stock
• Repurchasing stock reduces number of shares outstanding and increases EPS
• Remaining shares will rise in value if market uses same P/E ratio after the repurchase
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Stock Repurchases
Johnson Company currently has 2,500,000 outstanding shares of common stock and Net Income of $5 million. The firm’s P/E ratio is 10. Thus, Johnson’s EPS is $5,000,000 2,500,000 or $2.00 per share; and the firm’s market price is $2.00 x 10 or $20. Johnson has $1 million in cash available for distribution to stockholders. If the firm distributes it as a dividend, the firm will pay a
dividend of $0.40 per share, or $1,000,000 2,500,000 shares.
If the firm instead buys back its own shares, it will be able to retire 50,000 shares, or $1,000,000 $20. There would then be 2,450,000 shares outstanding and EPS would be $5,000,000 2,450,000 or $2.04 per share. If the firm’s P/E ratio remains unchanged, the firm’s stock price should rise to $20.40, or $2.04 x 10.
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Stock Repurchases
Method of Repurchasing Shares Buy shares on open market Make a tender offer Negotiated deal with a large investor
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Other Repurchase Issues
Opportunistic Repurchase Repurchases are appropriate when a stock is
temporarily undervalued or the firm has excess cash
Repurchases to Dispose of Excess Cash Firm may have excess cash which can be
distributed as dividend• However, firm may suffer from signaling effect
A stock repurchase effectively distributes the cash without a signaling effect
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Other Repurchase Issues
Taxes An occasional stock repurchase may benefit
stockholders because they pay capital gains taxes rather than ordinary income taxes
Repurchases to Restructure Capital By borrowing money and using the cash to
repurchase stock, a firm can raise its debt ratio