AFM 371 Winter 2008 Chapter 19 - Dividends And Other Payouts

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1 AFM 371 Winter 2008 Chapter 19 - Dividends And Other Payouts 1 / 29

2 Outline Background Dividend Policy In Perfect Capital Markets Share Repurchases Dividend Policy In Imperfect Markets 2 / 29

3 Introduction Why do corporations pay dividends? Why do investors pay attention to dividends? Perhaps the answers to these questions are obvious. Perhaps dividends represent the return to the investor who put his money at risk in the corporation. Perhaps corporations pay dividends to reward existing shareholders and to encourage others to buy new issues of common stock at high prices. Perhaps investors pay attention to dividends because only through dividends or the prospect of dividends do they receive a return on their investment or the chance to sell their shares at a higher price in the future. Or perhaps the answers are not so obvious. Perhaps a corporation that pays no dividends is demonstrating confidence that it has attractive investment opportunities that might be missed if it paid dividends. If it makes these investments, it may increase the value of its shares by more than the amount of the lost dividends. If that happens, its shareholders may be doubly better off. They end up with capital appreciation greater than the dividends they missed out on, and they find they are taxed at lower effective rates on capital appreciation than on dividends. In fact, I claim that the answers to these questions are not obvious at all. The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just don t fit together. F. Black, The Dividend Puzzle, Journal of Portfolio Management, Winter 1976, pp ackground 3 / 29

4 Different Types of Payouts the two main ways that firms distribute cash to equity investors are dividends and share repurchases different types of dividends: cash dividends are a distribution of cash normally paid on a quarterly basis stock dividends are a distribution of stock no cash leaves the firm there is an increase in the number of shares outstanding e.g. with a 10% stock dividend, investors receive one additional share for each ten shares that they own stock splits are large stock dividends (a stock dividend of greater than 25%) usually expressed as a ratio, e.g. 2:1 means that investors get one new share for each share that they own (so the total number of shares outstanding doubles) a share repurchase (a.k.a. buyback) is a transaction where the firm buys its own stock back from investors can be either an open market repurchase (the firm buys on an exchange like any other investor) or a tender offer (the firm announces to all of its shareholders that it is willing to buy a fixed number of shares at a specified price) ackground 4 / 29

5 Standard Method of Cash Dividend Payment on the declaration date, the board of directors declares a payment of dividends to shareholders of record on the record date dividend cheques are mailed out to shareholders on the payment date as stock trades can take up to three business days to settle, you must have purchased the stock at least three business days before the record date in order to be assured of receiving the dividend the date two days before the record date (i.e. the first trading date on which you are no longer entitled to the dividend) is called the ex-dividend date example: on Feb. 29, 2008 RBC declared a dividend of $0.50 per share payable on May 23, 2008 to common shareholders of record on April 24, 2008 ackground 5 / 29

6 Ex-Dividend Date Stock Price Behaviour in a world without taxes or transaction costs, the stock price will fall by the amount of the dividend on the ex-dividend date (ignoring some slight time value of money considerations) taxes complicate matters: empirically, the price drop is less than the dividend and occurs within the first few minutes of trading on the ex-dividend date notation: original purchase price: P 0 price just before stock goes ex-dividend: P b price just after stock goes ex-dividend: P a dollar amount of dividend per share: D tax rate paid on dividend income: T D tax rate paid on capital gains: T G cash flows from selling just before stock goes ex-dividend: P b (P b P 0 ) T G cash flows from selling just after stock goes ex-dividend: P a (P a P 0 ) T G + D (1 T D ) ackground 6 / 29

7 Ex-Dividend Date Stock Price Behaviour the average investor should be indifferent between selling just before and selling just after, so P b (P b P 0 ) T G = P a (P a P 0 ) T G + D (1 T D ) rearranging the above expression yields P b P a D = 1 T D 1 T G cases: if T D = T G, then P b P a = P = D if T D > T G, then P b P a = P < D if T D < T G, then P b P a = P > D in Canada we have T D > T G, and the ex-dividend date price drop is smaller than the amount of the dividend ackground 7 / 29

8 Dividend Policy In Perfect Capital Markets for the time being, consider a world with perfect capital markets (i.e. no taxes, transactions costs, information asymmetry, etc.) also assume that future investments and cash flows are known with perfect certainty further assume that the investment policy of the firm is fixed, and, for simplicity, consider an all-equity firm consider an all-equity firm in which as of now (t = 0), managers know that the firm will be liquidated after 2 years (t = 2) at t = 0 the manager knows that the firm will generate cash flows of $110,000 at t = 1 and $121,000 at t = 2 the firm has no additional positive NPV projects available return on equity is 10% there are currently 10,000 shares outstanding ividend Policy In Perfect Capital Markets 8 / 29

9 Dividend Policy In Perfect Capital Markets (Cont d) for simplicity assume that the ex-dividend date is the same as the payment date dividend policy #1: set dividends equal to cash flow in this case, the total dividend paid out is $110,000 at t = 1 and $121,000 at t = 2, so the value of the firm is V 0 = $110, $121, = $200,000 since there are 10,000 shares outstanding, the price per share is $20 and the dividends per share are $11 at t = 1 and $12.10 at t = 2 dividend policy #2: pay higher dividend at t = 1, e.g. $14 per share total cash required at t = 1 is $14 10,000 = $140,000, but the firm only has $110,000 available the firm must issue new equity to raise $30,000 at t = 1 ividend Policy In Perfect Capital Markets 9 / 29

10 Dividend Policy In Perfect Capital Markets (Cont d) are the old shareholders better off with policy #2? the time pattern of dividends should not matter as long as the investor is fairly compensated through the return on equity shareholders will not pay more for a firm if the shareholder can either replicate or undo the dividend decision called homemade dividends if this argument reminds you of homemade leverage in the context of capital structure, that is not a coincidence: the proposition that in perfect capital markets the value of a firm value is independent of its dividend policy was first shown by Modigliani and Miller (MM) ividend Policy In Perfect Capital Markets 10 / 29

11 Homemade Dividends since investors do not need dividends to convert shares to cash, they will not pay higher prices for firms with higher dividend payouts in other words, dividend policy has no impact on the value of a firm because investors can create whatever income stream they prefer by using homemade dividends continuing with our example, suppose the firm sticks with policy #1 but an investor who owns 50 shares prefers policy #2: ividend Policy In Perfect Capital Markets 11 / 29

12 Homemade Dividends (Cont d) alternatively, suppose the firm switches to policy #2 and an investor who holds 30 shares prefers the old policy: ividend Policy In Perfect Capital Markets 12 / 29

13 Homemade Dividends (Cont d) problem: The MM Company earns a perpetual operating income of $2.5 million per year which it pays as dividends on its 200,000 outstanding shares. MM is all-equity financed with a required rate of return of 10%. The VP of Finance feels that shareholders would benefit if dividends were increased by $7.50 next year, but only next year. Assume that issuing stock is the only financing alternative. (a) What is the stock price under the current dividend policy? (b) How many new shares must MM issue in order to finance the new policy? (c) Mr. Jones owns 1,000 shares and prefers the current dividend policy? How can he achieve it if the firm switches to the new policy? ividend Policy In Perfect Capital Markets 13 / 29

14 Irrelevance of Stock Splits and Stock Dividends XYZ Inc. is an all-equity firm with 2 million shares outstanding that are trading at $15 per share. The company declares a 50% stock dividend. How many shares will be outstanding after the stock dividend is paid? After the stock dividend what is the new price per share and the new value of the firm? a 50% stock dividend will increase the number of shares by 50% to = 3 million (in fact, this is really a 3:2 split) the value of the firm was 2 $15 = $30 million, which is unchanged after the dividend the price per share is $30,000,000 3,000,000 = $10 note that there is no effect on any investor s wealth: an investor who owned 50 shares had a total value of 50 $15 = $750 before the stock dividend and a total value of 75 $10 = $750 after it Dividend Policy In Perfect Capital Markets 14 / 29

15 Summary: Perfect Capital Markets given the MM assumptions of perfect capital markets, then: dividend policy is irrelevant given the firm s investment decisions, how the firm decides to pay dividends doesn t matter since shareholders can achieve any desired income pattern with homemade dividends dividends are relevant shareholders prefer high dividends to low dividends at any single date if this higher dividend level can be maintained over time (however, this is possible only if net cash flows increase due to a change in the firm s investment policy) main implication: if dividend policy does matter, it is because of market imperfections such as taxes, transactions costs, asymmetric information, etc. another important point: firms should never give up a positive NPV project in order to increase a dividend ividend Policy In Perfect Capital Markets 15 / 29

16 Share Repurchases instead of declaring cash dividends, firms can get rid of excess cash by buying shares of their own stock in the U.S., the amount of cash distributed by a share repurcahse in recent years has been roughly equivalent to the amount paid out as dividends there are potential tax advantages to repurchases: if you choose to sell back your shares, you pay capital gains taxes if you choose to hold on to your shares, your wealth is not affected by taxes alternatively, with dividends you pay taxes on them (at a higher effective rate than you would with capital gains) when tax minimization is important, share repurchases are a potentially useful alternative to dividends hare Repurchases 16 / 29

17 Share Repurchase vs. Dividend consider a firm with the following market value balance sheet that wants to distribute $100,000 to its shareholders: Assets Liabilities & Equity (Original Balance Sheet) Cash $150,000 Debt $0 Other assets $850,000 Equity $1,000,000 Firm value $1,000,000 Firm value $1,000,000 Shares outstanding: 100,000 Price per share: $1,000,000/100,000 = $10 if the $100,000 is distributed as a cash dividend, the balance sheet will look like this: Assets Liabilities & Equity (Balance Sheet After $1 Per Share Dividend) Cash $50,000 Debt $0 Other assets $850,000 Equity $900,000 Firm value $900,000 Firm value $900,000 Shares outstanding: 100,000 Price per share: $900,000/100,000 = $9 hare Repurchases 17 / 29

18 Share Repurchase vs. Dividend (Cont d) if the $100,000 is distributed through a repurchase, the balance sheet will look like this: Assets Liabilities & Equity (Balance Sheet After Share Repurchase) Cash $50,000 Debt $0 Other assets $850,000 Equity $900,000 Firm value $900,000 Firm value $900,000 Shares outstanding: 90,000 Price per share: $900,000/90,000 = $10 with the dividend, the holder of a share receives $1 and retains a share worth $9 with a repurchase, the holder of a share either sells it for $10 or keeps it this shows that, absent imperfections such as taxes, there is no reason to prefer one method of distribution over the other hare Repurchases 18 / 29

19 Real World Factors Affecting The Repurchase Decision besides taxes, what other potential advantages do share repurchases offer? flexibility: an increase in a dividend is often viewed as an ongoing commitment, whereas a repurchase is more of a one-time deal firms which have temporary increases in cash flow are more likely to repurchase, while firms with permanent increases in cash flow are more likely to pay dividends executive compensation: firms with lots of executive stock options are more likely to prefer repurchases (the share price will fall when dividends are paid out, reducing the value of the options) offset to dilution: this is another reason why firms with lots of executive stock options often use repurchases (i.e. to counter the dilution that occurs when the options are exercised) repurchase as investment: managers may believe that their firm s stock price is temporarily undervalued, and so buying back shares represents a good investment (and empirical evidence supports this long term stock price performance of firms after a repurchase tends to be substantially better than the stock price performance of similar firms which do not repurchase) hare Repurchases 19 / 29

20 Personal Taxes, Issuance Costs, and Dividends as noted above, the effective tax rate on capital gains is lower than the effective tax rate on dividends for individual investors suppose a firm does not have sufficient cash to pay a dividend: if it issues shares worth, say $1 million, in order to pay a dividend, then in aggregate investors contribute $1 million but they get back less because of taxes on dividends as a result, in general firms should not issue stock in order to pay a dividend flotation costs to issue the new shares add to this effect if instead that a firm does have enough cash to pay a dividend: if the firm already has no further positive NPV projects to invest in, then any additional capital expenditures will be in negative NPV projects (which could be worse than subjecting investors to taxes on dividends) the firm could acquire other companies (but this is often very costly and the general tendency is that acquiring firms is an unprofitable strategy) it might go with a share repurchase instead of a dividend ividend Policy In Imperfect Markets 20 / 29

21 Personal Taxes, Issuance Costs, and Dividends (Cont d) another possibility for a firm with enough cash to pay a dividend is to purchase financial assets instead example: a firm has $10,000 of extra cash. It can retain the cash and invest it in Treasury bills yielding 4% or it can pay the cash out to shareholders as a dividend. Shareholders can also invest in Treasury bills with the same yield. Assume that Treasury bills pay interest annually. Both the firm and the shareholders reinvest the interest income received from the Treasury bills. The corporate tax rate is 40% and the individual tax rate for dividend income is 30% and for interest income is 40%. What amount of cash will shareholders have after 5 years if (i) the firm pays out the $10,000 today as a dividend; and (ii) the firm invests the $10,000 in Treasury bills and distributes the cash as a dividend after 5 years? ividend Policy In Imperfect Markets 21 / 29

22 Personal Taxes, Issuance Costs, and Dividends (Cont d) does anything change if we reduce the dividend tax rate to 20%? how about changing the personal tax rate on interest income to (i) 25%, and (ii) 45%? other things equal, if T i is the tax rate on investment income for investors (either interest or capital gains), and T C is the corporate tax rate, then the firm has an incentive to pay out dividends now if T i < T C and an incentive to retain the cash if T i > T C in other words, higher personal tax rates (compared to corporate tax rates) give firms an incentive to reduce payouts other points: also recall that firms pay no tax on dividend income received however, some investors are tax exempt (e.g. pension funds), giving an incentive to increase payouts ividend Policy In Imperfect Markets 22 / 29

23 Expected Returns, Dividend Yields, and Personal Taxes consider two firms, A and B, which are equally risky firm A does not pay any dividends, whereas firm B does assume effective capital gains taxes are zero (or that investors are going to hold onto their shares) since the firms are equally risky, they will offer the same after-tax expected return: E(P A 1 ) PA 0 P A 0 = E(PB 1 ) + E(d B 1 )(1 T d) P B 0 P B 0 (where T d is the tax rate on dividend income) therefore, on a pre-tax basis: E(P A 1 ) PA 0 P A 0 < E(PB 1 ) + E(d B 1 ) PB 0 P B 0 in other words, expected returns (pre-tax) will be higher for firms paying higher dividends this implies that tax-exempt institutional investors (e.g. pension funds) should hold stocks which pay high dividends ividend Policy In Imperfect Markets 23 / 29

24 Real World Factors in Favour of High Dividends from a tax perspective, the higher effective tax rate on dividends compared to capital gains suggests that dividends should be reduced other considerations, however, indicate that dividends should be increased: desire for current income: the homemade dividend argument in perfect markets ignores transaction costs, so investors who want income now may prefer to receive it directly rather than incurring costs of selling securities agency costs of equity: recall the free cash flow argument from Ch. 17, i.e. that managers will tend to waste the firm s resources on themselves rather than trying to benefit the shareholders paying out dividends reduces the ability of managers to do this but repurchases would also accomplish this tax arbitrage: some people argue that investors may be able to avoid taxes on dividends (e.g. if you borrow money to invest, interest payments are tax deductible against investment income received; moreover, if you don t like the extra risk due to borrowing, you can invest in safe bonds in a tax-deferred savings plan such as an RRSP to offset the leverage) ividend Policy In Imperfect Markets 24 / 29

25 Information Content and Signalling empirical evidence shows that stock prices increase when firms announce an increase in their dividends and decrease when firms announce cuts in dividends or suspensions of dividend payments is this because a higher dividend is a good financial decision, or because it conveys favourable information to the market? some (e.g. Lintner) have argued that a firm s earnings should be viewed as containing both permanent and temporary components, and that firms have long run dividend payout ratio targets that depend on the permanent component management will use a dividend increase to signal its expectation of high future (permanent) earnings changes in dividends will be smoother than changes in earnings ividend Policy In Imperfect Markets 25 / 29

26 Information Content and Signalling (Cont d) let t be the target dividend payout ratio and let s denote the speed of adjustment of dividends to target, so that d t+1 = d t + s [t EPS t+1 d t ] special cases: s = 1 implies that there is an immediate and full adjustment to target s = 0 implies that there is no change at all in dividends there is a good deal of empirical support for this; in addition to the stock price reactions described above: changes in dividends lag changes in retained earnings (firms are reluctant to cut dividends during temporarily bad times; firms do not increase dividends as fast as retained earnings during economic expansions) special dividends (firms sometimes announce an extra dividend payment but state that it is only temporary): basically a signal that the firm has been doing very well, but that this is not necessarily expected to continue Dividend Policy In Imperfect Markets 26 / 29

27 The Clientele Effect investors may form clienteles based upon their tax brackets clienteles for various dividend payout policies are likely to form in the following way: Group Stocks High tax bracket individuals Zero-to-low payout stocks Low tax bracket individuals Low-to-medium payout stocks Tax-exempt institutions Medium-to-high payout stocks Corporations High payout stocks once the clienteles have been satisfied (e.g. if there are already enough firms paying high dividends to meet demand), a firm is unlikely to be able to create value by changing its dividend policy ividend Policy In Imperfect Markets 27 / 29

28 Summary and Other Considerations in perfect capital markets, dividend policy is irrelevant firms should not cut back on positive NPV projects to pay a dividend and should generally avoid issuing stock in order to pay a dividend repurchases should be considered when there are few positive NPV investments available and there is a surplus of cash flotation costs: firms should keep dividends low to avoid costs of issuing new securities (this will be more important to firms with lots of investment opportunities) transactions costs and indivisibility of shares: the purchase or sale of shares to create homemade dividends incurs transactions costs. This factor could favour either high or low dividends, depending on investor preferences for dividends vs. capital gains. Indivisibility implies that investors may not be able to create exactly the dividend policy they want. DRIPS and stripped common shares are evidence that these factors do matter. corporate control: issuing new shares may mean giving up some control to new shareholders; this can be limited by reducing dividend payments ividend Policy In Imperfect Markets 28 / 29

29 Summary and Other Considerations (Cont d) agency costs: management will tend to waste excess cash on perks and bad investments, so dividends should be kept high legal factors, including: institutional holdings: some institutional investors are legally prohibited from investing in firms which have not paid dividends impairment of capital: some institutional investors are not allowed to spend principal debt covenants: these provisions may include restrictions on the amount that can be paid out as a dividend signalling: dividends can be used to convey information about management s expectations about the firm s future prospects clientele effects: for various reasons (e.g. taxes, desire for current income, etc.), different groups of investors are attracted to firms with high or low dividends. When a firm changes its dividend policy, it just attracts a different clientele ( keep policy stable to avoid transactions costs). Unless there is an unsatisfied clientele (e.g. not enough firms paying low dividends relative to market demand), there is no reason to change the firm s dividend policy. ividend Policy In Imperfect Markets 29 / 29

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