payout policy 1finance - pedro barroso. different types of dividends many companies pay a regular...

Payout Policy

1Finance - Pedro Barroso

Different Types of Dividends• 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


Procedure for Cash Dividend25 Oct. 2 Nov. 5 Nov. 7 Dec.

Declaration Date

Ex-dividend

Date

Record Date

Payment Date

…

Declaration Date: The Board of Directors declares a payment of dividendsEx-Dividend Date: If you purchase the stock on and after ex-dividend date you are not entitled to receive dividendRecord Date: Corporation prepares a list of all individuals believed to be stockholdersPayment Date: Stockholders receive dividend


Price Behavior• In a perfect world, the stock price will fall by the

amount of the dividend on the ex-dividend date

$P

$P - Div

Ex-dividend

Date

The price drops by the amount of the cash dividend

-t … -2 -1 0 +1 +2 …

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


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


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 on ex-dividend date

Homemade dividend $3 Dividend

Cash from dividend $2 x 80 = $160 $3 x 80 = $240

Cash from selling stock $40 x 2 = $80 $0

Total cash $240 $240

Value of stock holdings $40 x 78 = $3,120 $39 x 80 = $3,120


Dividend Policy is Irrelevant

• In the above example, Bob Investor began with a total wealth of $3,360:

42$shares 80360,3$

240$39$shares 80360,3$

80$160$40$shares 78360,3$

After a $3 dividend, his total wealth is still $3,360:

After a $2 dividend and sale of 2 ex-dividend shares, his total wealth is still $3,360:


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”


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


Stock Repurchase versus Dividend

$10=/100,000$1,000,000Price per share100,000outstanding Shares

1,000,000Value of Firm1,000,000Value of Firm1,000,000Equity850,000 AssetsOther

0Debt$150,000Cash

sheet balance Original A.Equity &Liabilities Assets

Consider a firm that wishes to distribute $100,000 to its shareholders



$9=00,000$900,000/1 shareper Price100,000 Shares outstanding

900,000Firm of Value900,000Firm of Value900,000Equity850,000AssetsOther

0Debt$50,000Cash

dividendcash shareper $1After B.Equity & Liabilities Assets

If they distribute the $100,000 as a cash dividend, the balance sheet will look like this:



Assets Liabilities & EquityC. After stock repurchase

Cash $50,000 Debt 0Other Assets 850,000 Equity 900,000Value of Firm 900,000 Value of Firm 900,000

Shares outstanding 90,000Price per share $900,000 / 90,000 = $10

If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:


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– Taxes on capital gains are usually lower than taxes

on dividends


Personal Taxes and Dividends

• 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 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


Firms without Sufficient Cash

In a world of personal taxes, firms should not issue stock to pay a dividend.

Firm Stock Holders

Cash: stock issue

Cash: dividends

Gov.

Taxes

Investment Bankers The direct costs of stock issuance will add to this effect.


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


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


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


The Clientele Effect• Clienteles for various dividend payout policies

are likely to form in the following way:

Group Stock Type

High Tax Bracket IndividualsLow Tax Bracket IndividualsTax-Free InstitutionsCorporations

Zero-to-Low payoutLow-to-Medium payoutMedium payoutHigh payout

Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy


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


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”


payout policy 1finance - pedro barroso. different types of dividends many companies pay a regular...

Documents

dividend cash

dividend record date

exdividend shares

extra cash dividend

cash dividend t

irrelevance of dividend

liquidating dividend

cash dividend bob investor