FN428 : Investment Banking. Lecture : Dividend Policy

Transcription

1 FN428 : Investment Banking Lecture : Dividend Policy

2 Dividend Policy : The Questions Profitable companies regularly face three important questions: (1) How much of our free cash flow should we pass on to shareholders? (2) Should we provide this cash to stockholders by raising the dividend or by repurchasing stock? (3) Should we maintain a stable, consistent payment policy; or should we let the payments vary as conditions change?

3 The issues that affect dividend policies Mature companies with stable cash flows and limited growth opportunities tend to return a significant amount of their cash to shareholders either by paying dividends or by using the cash to repurchase common stock.

4 The issues that affect dividend policies By contrast, rapidly growing companies with good investment opportunities are prone to invest most of their available cash in new projects rather than paying dividends or repurchasing stock. Microsoft, which has long been regarded as the epitome of a growth company : Its sales grew from $786 million in 1989 to $93.6 billion in 2015

5 Example : Growth Firms This translates to an annual growth rate of nearly 21%. Much of this growth came from large, long-term investments in new products and technology Given the firm s emphasis on growth, it paid no dividends over most of its life.

6 But high growth is not sustainable Microsoft has now pays a significant portion of its cash to shareholders. However, the cash kept pouring in; and by mid 04 Microsoft s cash hoard had grown to more than $60 billion. At that point, the company took some larger steps to return cash to its shareholders.

7 But high growth is not sustainable The dividend was quadrupled to 32 cents a share in just one year. It announced plans to pay a one-time special dividend of $3 a share. Share repurchase up to $30 billion worth of stock in the open market. All told, this meant that $62.62 billion would be provided to its shareholders in Year 2004 alone.

8 But high growth is not sustainable Microsoft continued to generate a great deal of cash. But the company s aggressive use of dividends and share repurchases to return cash to shareholders in recent years represents an important shift in policy.

9 But high growth is not sustainable Could we earn more on the available cash if we kept it in the firm and used it to invest in new projects, or would shareholders earn more if they received the cash and invested it in alternative investments with the same risk?

10 If the decision is made to distribute income to stockholders.. (1) How much should be distributed? (2) Should the distribution be in the form of dividends, or buying back stock? (3) How stable should the distribution be? Should the funds paid out from year to year be stable and dependable, or should they be varied depending on the firms cash flows and investment requirements?

11 Dividend or Capital Gains? target payout ratio defined as the percentage of net income to be paid out as cash dividends Do investors prefer to receive dividends; or would they rather have the firm plow the cash back into the business, which presumably will produce capital gains?

12 Two opposing effect of Dividends If the company increases the payout ratio, this will raise D1, which cause the stock price to rise. However, if D1 is raised, less money will be available for reinvestment, which will cause the expected growth rate to decline.

13 Optimal dividend policy As a result, the optimal dividend policy must strike the balance between current dividends and future growth that maximizes the stock price. Next, we discuss the major theories that have been advanced to explain how investors regard current dividends versus future growth

14 Dividend Irrelevance Theory M.Miller and F.Modigliani (MM) advanced the dividend irrelevance theory, which stated that dividend policy has no effect on either the price of a firm s stock or its cost of capital MM : the value of the firm depends only on the income produced by its assets, not on how that income is split between dividends and retained earnings

15 Dividend Irrelevance Theory MM assumed, among other things, that no taxes are paid on dividends, that stocks can be bought and sold with no transactions costs MM assumption : everyone investors and managers alike has the same information regarding firms future earnings.

16 Dividend Irrelevance Theory MM argued that each shareholder can construct his or her own dividend policy. if a firm does not pay dividends, a shareholder who wants a 5% dividend can create it by selling 5% of stock. Conversely, if a company pays a higher dividend than an investor wants, the investor can use dividends to buy additional shares

17 Dividend Irrelevance Theory In the real world, investors who want additional dividends would have to incur transactions costs to sell shares, and investors who do not want dividends would have to pay taxes on the unwanted dividends and then incur transactions costs to purchase shares Since taxes and transactions costs do exist, dividend policy may well be relevant and investors may prefer policies that help them reduce taxes and transactions costs.

18 Dividend Irrelevance Theory The principal conclusions of MM s dividend irrelevance theory are investors are indifferent between dividends and capital gains dividend policy does not affect either stock prices or the required rate of return on equity, k s.

19 Argument 1 : Bird-in-hand fallacy Why dividend is preferred? M.Gordon and J.Lintner : investors preferred a sure dividend today to an uncertain future capital gain. In particular, k s declines as the dividend payout is increased because investors are less certain of receiving the capital gains that should result from retaining earnings than they are of receiving dividend payments

20 Unrealistic Assumptions of MM most investors face transactions costs when they sell stock; so investors who are looking for a steady stream of income would logically prefer that companies pay regular dividends. For example, retirees who have accumulated wealth over time and now want annual income from their investments probably prefer dividend-paying stocks.

21 Why some investors prefer capital gain? income tax rate are generally higher than capital gain tax Since 2003, the maximum tax rate on dividends and long term capital gains has been set at 15%. This change lowered the tax disadvantage, but capital gains still have two tax advantages over dividends.

22 Why some investors prefer capital gain? Personal income taxes must be paid on dividends the year they are received, whereas taxes on capital gains are not paid until the stock is sold (time value of money) if a stock is held by someone until he or she dies, there is no capital gains tax

23 Information Content, or Signaling, Hypothesis An increase in the dividend is often accompanied by an increase in the stock price, while a dividend cut generally leads to a stock price decline. This refute MM MM argue that dividend announcements have information content, or signaling, about future earnings. (dividend increase only if management expect higher future CF to support it and vice versa)

24 Information Content (Signaling Hypothesis) it is difficult to tell whether the stock price changes that follow dividend increases or decreases reflect only signaling effects (as MM argue) or both signaling and dividend preference. For example, if a firm has good long-term prospects but also need cash to fund current investments, it might be tempted to cut dividend to increase funds available for investment. However, this action might cause the stock price to decline because the dividend reduction can be taken as a signal of bad future earnings, when just the reverse is actually true

25 Clientele Effect Clientele Effect - The tendency of a firm to attract a set of investors that like its dividend policy For example, retired individuals, pension funds generally prefer cash income. They might invest in electric utilities, which had an average payout of 60% in 2008, while investors favoring growth could invest in the software industry, which paid out only 18%

26 Clientele Effect different groups, or clienteles, of stockholders prefer different dividend payout policies. A change in dividend policy might upset the majority clientele and have a negative effect on the stock s price. This suggests that a company should follow a stable, dependable dividend policy so as to avoid upsetting its clientele.

27 Clientele Effect different groups, or clienteles, of stockholders prefer different dividend payout policies. A change in dividend policy might upset the majority clientele and have a negative effect on the stock s price. This suggests that a company should follow a stable, dependable dividend policy so as to avoid upsetting its clientele.

28 Other factors that affect dividend policy May be group to the following (1) Constraints on dividend payments (2) investment opportunities, (3) availability and cost of alternative sources of capital

29 Constraints Bond Indenture : limit dividend Availability of Cash Impairment of Capital Rule : Law state dividend can not exceed retain earnings. Investment Opportunities Number of profitable investments Ability to accelerate or delay investment : to achieve stable dividend policy

30 availability and cost of alternative sources of capital Cost of selling new stock (flotation cost) If cost of new stock are high, firms are better off to set low payout ratio to increase RE for future investment Management Control Managers are reluctant to issue new equity if they were to retain control over the firm

31 Stock split vs. Stock dividends Although no research support, management believe there exist optimal price per share range of $20-$80. Stock split use to manage sharp price rise Generally interpreted as good news (signaling) Stock dividends use to keep price per share in check every year (ex 5% new share every year)

32 Summary managers should retain earnings if and only if they can invest the money within the firm and earn more than stockholders can earn outside the firm. Consequently, high-growth companies with many good projects tend to retain a high percentage of earnings, whereas mature companies with a great deal of cash but limited investment opportunities tend to have generous cash distribution policies.