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Corporate Finance

Week 12 Payout Policy

Part I

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Topics Covered The Choice of Payout Policy: dividends vs.

stock repurchase How Firms Pay Dividends and Repurchase

Stock How Do Companies Decide on the Payout? Information in Dividends and Stock

Repurchases The Payout Controversy

1- 3 Types of Dividends Cash dividends: in the form of cash, from sources of

current or accumulated retained earnings – Regular cash dividends vs. Extra(or special) cash dividends – cf. liquidating dividends (distribution from capital)

Stock dividends: in shares of stock – Cash dividends are taxable, but stock dividends are not taxed

until they are sold – Stock dividends(& stock splits) increase the number of shares

but do not affect the company’s assets, profits, or total value Both reduce value per share

– Commonly expressed as a ratio: e.g. 2 percent stock dividend 1 new share for every 50 currently owned

1- 4 Types of Dividends, cont. Stock dividends: in shares of stock, cont.

– cf. stock split: increases the number of shares outstanding stock price should fall

– A reduction in the par value of each share – e.g. $90 stock w/ a 3:1 stock split price should fall to

about $30 Stock repurchase: use cash to buy back shares of its

stock – The shares are held by the corporation and counted for as

treasury stock

1- 5 Dividend & Stock Repurchases

-800

-600

-400

-200

0

200

400

600

800

1000

1200

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

Dividends Repurchases Remaining earnings

$ B

illio

ns

U.S. Data 1980 - 2009

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Dividend & Stock Repurchases Before 1983 stock repurchases were fairly rare, but

since then they have become increasingly common

What was the reason for the sudden growth in repurchase? – In 1982, the SEC adopted Rule 10b-18. – Before the adoption of this rule firms that repurchased their

own shares ran the risk of being prosecuted for manipulating their share price

– The Rule laid out provisions that would protect firms against prosecution

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Dividend & Stock Repurchases How Do Firms Pay Dividends?

– Dividend is set by the board of directors – The announcement of the dividend states that the payment

will be made to all stockholders who are registered on a particular record date

– Then a week or so later dividend checks are mailed to stockholders

– Stocks are traded ex dividend on and after the second business day before the record date

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Dividend & Stock Repurchases How Do Firms Pay Dividends?

– e.g. An illustration of how dividends are paid – Apr. 15, 2009: Declaration date : ExxonMobil

declares regular quarterly dividend of $.42 per share

– May 11, 2009: Ex-dividend date: Shares start to trade ex dividend

– May 13, 2009 : Record date: Dividend will be paid to shareholders registered on this date

– June 10, 2009: Payment date: Dividend checks are mailed to shareholders

1- 9 Dividend Payments

Exxon Mobil declares regular

quarterly dividend of $.42 per share.

Shares start to

trade ex dividend.

Dividend will be paid to shareholders

registered on this date.

Dividend checks are mailed

to shareholders.

April 15, 2009 May 11, 2009 May 13, 2009 June 10, 2009

Declaration Date

Ex-dividend Date

Record Date

Payment Date

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Dividend & Stock Repurchases How Do Firms Repurchase Stock?

– Firms can use the cash to repurchase stocks. – The reacquired shares may be kept in the company’s

treasury and resold if the company needs money – 4 main ways to repurchase stock

1. Buy shares in the open market 2. Tender offer to shareholders 3. Dutch Auction: the firm states a series of prices Shareholders

submit offers declaring how many shares they wish to sell at each price The company calculates the lowest price

4. Private Negotiation (Green Mail): the target of an attempted takeover buys off the hostile bidder by repurchasing any shares that it has acquired.

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Dividend & Stock Repurchases How Do Companies Decide on the Payout? Three features about firms’ dividend policies

– 1) Managers are reluctant to make dividend changes that may have to be reversed.

– 2) To avoid the risk of a reduction in payout, managers “smooth” dividends dividend changes follow shifts in long-run sustainable earnings

– 3) Managers focus more on dividend changes than on absolute levels

While stock repurchases are like bumper dividends, they do not typically substitute for dividends.

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The Payout Decision

0 10 20 30 40 50 60 70 80 90 100

We try to avoid reducing the dividend

We try to maintain a smooth dividend stream

We look at the current dividend level

We are reluctant to make a change that may have to bereversed

We consider the change in the dividend

Rather than reducing dividends we would raise new fundsto undertake a profitable project

The cost of external capital is lower than the cost of adividend cut

Executives who agree or strongly agree (%)

Dividend Decision Survey (2004)

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Dividend Policy

Lintner’s two observations . – 1) Real-world companies typically set long-

term target ratios of dividends to earnings. – 2) Managers know that only part of any change

in earnings is likely to be permanent. Attitudes concerning dividend targets vary

1

1

EPS ratio targetdividend targetDIV

×==

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Dividend Policy

Dividend Change Dividend changes confirm the following

01

01

DIV-EPS ratiotarget changetarget DIV-DIV

×==

( )0101

DIV-EPS ratio targetrate adjustmentchange targetrate adjustmentDIV-DIV

××=×=

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Dividend Smoothing

Example – CGI has a target payout ratio of .30. Last year’s earnings per

share were $10, and in accordance w/ the target, CGI paid dividends of $3 per share last year.

– However, earnings have jumped to $20 this year. Because the managers do not believe that this increase is permanent, they do not plan to raise dividends all the way to $6(=.3*$20). Rather their speed of adjustment coefficient is .5 implying that the increase in dividends from last year to this year will be:

– .5*($6-$3)=$1.50 dividends this year will be $4.50. – Now suppose that earnings stay at $20 next year. The increase

in dividends next year will be: – .5*($6-$4.50)=$.75 dividends next year will be $5.25

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Information in Payouts Dividends and stock repurchase decisions contain

information – The information contained in the decisions varies

Asymmetric information may be conveyed – Dividend increases could mean overpriced stock or

increased future profits The signal varies based on prior information about

the company

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The Information in Dividends Paying dividends is one clue for profitability.

– Investors know that a firm that reports good earnings and pays a generous dividend is putting its money where its mouth is

– Of course, firms can cheat in the short run by overstating earnings and scraping up cash to pay a generous dividend. But it’s hard to cheat in the long run

– Most managers don’t increase dividends until they are confident that sufficient cash will flow in to pay them.

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The Information in Dividends Research regarding measuring the information in

dividend changes shows mixed results. – Some have found that dividend changes have little or

no ability to predict future earnings. – However, Healy and Palepu, who focus on

companies that paid a dividend for the first time, find that on average earnings jumped 43% in the year a dividend was paid. managers are confident about prospects, for earnings continued to rise in the following years.

Notice that investors do not get excited about the level of a company’s dividend; they worry about the change (an important indicator of the sustainability of earnings)

1- 20 Dividend Policy

-15

-10

-5

0

5

10

15

Div RiseDiv Cut

Source: Healy & Palepu (1988)

Cha

nge

EPS/

Pric

e at

t =

0 a

s %

Impact of Dividend Changes on EPS

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The Information in Stock Repurchases Unlike dividends, share repurchases are

frequently a one-off event. – Companies repurchase shares when they have

accumulated more cash than they can invest profitably or when they wish to increase their debt levels Neither is good news in itself

– But shareholders are frequently relieved to see companies paying out the excess cash rather than frittering it away on unprofitable investments

– Shareholders also know that firms with large quantities of debt to service are less likely to squander cash

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The Information in Stock Repurchases Unlike dividends, share repurchases are

frequently a one-off event.(continued) – Stock repurchases may also be used to signal a

manager’s confidence in the future mangers believe that their stocks are undervalued

– When companies offer to repurchase their stock at a premium, senior management and directors usually commit to hold on to their stock. a larger rise in the stock price, on average about 11%

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The Payout Policies Example: True or False?

– a) Companies decide each year’s dividend by looking at their capital expenditure requirements and then distributing whatever cash is left out.

– b) Managers and investors seem more concerned with dividend changes than with dividend levels

– c) Managers often increase dividends temporarily when earnings are unexpectedly high for a year of two

– d) Companies undertaking substantial share repurchase usually finance them with an offsetting reduction in cash dividends

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The Payout Controversy Does the payout policy change the value of

the stock, rather than simply providing a signal of its value? Three groups

– Conservative group: an increase in the dividend payment increases firm value

– Radical group: a higher dividend payout reduces firm value b/c of differentials of taxes

– Middle-of-the road party: payout policy makes no difference (MM)

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Dividend Policy is Irrelevant MM case

– Suppose your firm has settled on its investment program.

– You have worked out how much of this program can be financed from borrowing, and you plan to meet the remaining funds requirement from retained earnings. Any surplus is to be paid out as dividends

Now what happens if you want to increase the total payout by upping the dividend w/o also changing the investment and borrowing policy?

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Dividend Policy is Irrelevant – The extra money must come from somewhere. – If the firm fixes its borrowing, the only way it can

finance the extra dividend is to print some more shares and sell them

– The new stockholders are going to part w/ their money only if you can offer them shares that are worth as much as they cost.

– But how can the firm do this when its assets, earnings, investment opportunities, and therefore, market value are all unchanged?

The answer: there must be a transfer of value from the old to the new stockholders!

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Dividend Policy is Irrelevant A transfer of value from the old to the new

– The new ones get the newly printed shares, each one worth less than before the dividend change was announced

– The old ones suffer a capital loss on their shares – The capital loss borne by the old shareholders just

offsets the extra cash dividend they receive B/C investors do not need dividends to convert

shares to cash, they will not pay higher prices for firms with higher dividend payouts. dividend policy has no impact on the value of the firm

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Dividend Policy is Irrelevant Before

Dividend After

Dividend

New stockholders

Each share worth this before …

Old stockholders

… and worth

this after

Tota

l val

ue o

f firm

Total number of shares

Total number of shares

Example of 1/3rd of worth paid as dividend and raising money via new shares

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Dividend Policy is Irrelevant

Firm

Old stockholders

New stockholders New stockholders

Old stockholders

Shares Cash

Cash

Cash Shares

Dividend financed by stock issue

No dividend, no stock issue

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Dividend Policy is Irrelevant Example: Assume Rational Demiconductor has no extra cash,

but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.

Record Date Cash 1,000 Fixed assets 9,000 Total Value 10,000 + New Proj NPV 2,000 # of Shares 1,000 price/share $12

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Dividend Policy is Irrelevant Example - Assume Rational Semiconductor has no extra cash, but declares a

$1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.

Record Date Pmt Date Cash 1,000 0 Fixed assets 9,000 9,000 Total Value 10,000 + 9,000+ New Proj NPV 2,000 2,000 # of Shares 1,000 1,000 price/share $12 $11

After paying dividends, this old

stock is worth 9,000+NPV

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Dividend Policy is Irrelevant Example - Assume Rational Demiconductor has no extra cash, but declares a

$1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.

Record Date Pmt Date Post Pmt Cash 1,000 0 1,000 (91 sh @ $11) Fixed assets 9,000 9,000 9,000 Total Value 10,000 + 9,000+ 10,000 New Proj NPV 2,000 2,000 2,000 # of Shares 1,000 1,000 1,091 price/share $12 $11 $11

NEW SHARES ARE ISSUED!

New stocks must be sold at the same price $1,000/$11=91

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Dividend Policy is Irrelevant Example : (continued) Shareholder Value Record Stock 12,000 Cash 0 Total Value 12,000 Stock = 1,000 sh @ $12 = 12,000

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Dividend Policy is Irrelevant Example : (continued) Shareholder Value Record Pmt Stock 12,000 11,000 Cash 0 1,000 Total Value 12,000 12,000 Stock = 1,000sh @ $11 = 11,000

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Dividend Policy is Irrelevant Example : (continued) Shareholder Value Record Pmt Post Stock 12,000 11,000 12,000 Cash 0 1,000 0 Total Value 12,000 12,000 12,000 Stock = 1,091sh @ $11 = 12,000

Assume stockholders purchase the new issue with the cash dividend proceeds.

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Dividend Policy is Irrelevant Example: Suppose that a technical discovery reveals that

RD’s new project is not a positive-NPV. Management announces that the project is to be discarded and that the $1,000 earmarked for it will be paid out as an extra dividend of $1 per share. After the dividend payout, the balance sheet is

Since there are 1,000 shares outstanding, the stock price is $10,000/1,000=$10 before the dividend payment and $9,000/1,000=$9 after the payment

Rational Demiconductor’s Balance Sheet (Market Values) Cash $ 0 $ 0 Debt Existing 9,000 9,000 Equity fixed assets New project 0 Tot. asset value $9,000 $9,000 Tot. firm value

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Dividend Policy is Irrelevant Example: (continued) What if RD uses the $1,000 to repurchase stock

instead? As long as the company pays a fair price for the stock,

the $1,000 buys $1,000/$10=100 shares. 900 shares worth 900*$10=$9,000

Switching from cash dividends to share repurchase has no effect on shareholders’ wealth: they forgo a $1 cash dividend but end up holding shares worth $10 instead of $9.

Corporate FinanceTopics CoveredTypes of DividendsTypes of Dividends, cont.Dividend & Stock RepurchasesDividend & Stock RepurchasesDividend & Stock RepurchasesDividend & Stock RepurchasesDividend PaymentsDividend & Stock RepurchasesDividend & Stock RepurchasesThe Payout DecisionDividend PolicyDividend PolicyDividend SmoothingInformation in PayoutsThe Information in DividendsThe Information in DividendsDividend PolicyThe Information in Stock RepurchasesThe Information in Stock RepurchasesThe Payout PoliciesThe Payout ControversyDividend Policy is IrrelevantDividend Policy is IrrelevantDividend Policy is IrrelevantDividend Policy is IrrelevantDividend Policy is IrrelevantDividend Policy is IrrelevantDividend Policy is IrrelevantDividend Policy is IrrelevantDividend Policy is IrrelevantDividend Policy is IrrelevantDividend Policy is IrrelevantDividend Policy is IrrelevantDividend Policy is Irrelevant