Dividend Policy and Stock Repurchases

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1 Dividend Policy and Stock Repurchases Class Notes 1 Outline of the lecture Types of dividends On the irrelevance of the dividend policy Homemade dividends Taxes Repurchases of shares 2 Types of Dividends Cash dividend, usually paid four times a year. Stock dividend: For example, a 2% stock dividend is such that shareholders receive 1 share for each 50 shares they own. A 2-for-1 stock split is a 100% stock dividend. 3 Method of Cash Dividend Payment Figure 1 shows the timing of a dividend payment. Anybody purchasing the stock on or after the ex-dividend date won t receive the dividend. 1

2 Jan 15 Jan 28 Jan 30 Feb 16 Declaration date Ex-dividend date Record date Payment date Figure 1: Timing of a dividend payment. 4 Fall in Stock Price on the Ex-Dividend Date d 0 divideno be paid p 0 stock price the day before the ex-dividend date p 0 stock price on the ex-dividend date p 0 p 0 p 0 + d 0 p 0 p 0 d 0. Without taxes, the stock price should fall by an amount d 0 on the ex-dividend date. Suppose dividends are taxed at the rate t d, and suppose capital gains are taxed at the rate t cg. The day prior to the ex-dividend date, shareholders expect to receive (1 t d )d 0 and t cg ( p 0 p 0 ), i.e. the capital loss is tax deductible. Then p 0 p 0 + (1 t d )d 0 + t cg ( p 0 p 0 ), anhus p 0 p 0 1 t d 1 t cg d 0. 5 On the Irrelevance of the Dividend Policy An entrepreneur has a profitable one-period capital investment project that requires an initial investment I 0 at time 0. The project s expected return is r, which is greater than the firm s 2

3 discount rate r. The present value of the project s payoff is anhe net present value of the project is P V (1 + r )I r NP V I 0 + (1 + r )I r (r r)i r > 0. The entrepreneur finances the project with debt (B 0 ) and equity (S 0 ) and may use some of the proceeds to pay himself a dividend (d 0 ), such that I 0 + d 0 B 0 + S 0. The value of the entrepreneur s equity, E 0 is E 0 P V B 0 S 0 d 0 NP V d 0. Note that the entrepreneur s wealth is the same for any d 0 0. As long as B 0 + S 0 P V and d 0 NP V, the dividend policy does not affect the value of the firm. Dividend irrelevance proposition: In an ideal capital market, dividend policy is irrelevant as long as the firm s capital investments and debt policy are fixed. Dividend payments are simply financed over time by a combination on excess retained earnings and, as necessary, new equity financing. 6 Another Example (Borrowing to Pay a Dividend) p 0 d 0 + Suppose insteahat the dividend at time 0 is d 0 d 0 + x, where x is borrowed at the rate 1 + r b and will be repaid in period 1, i.e. d 1 d 1 (1 + r b )x. For all t 2, d t. Assume risk neutrality, i.e. r b r s. 3

4 p 0 d 0 + d t d 0 + x + d 1 (1 + r b )x 1 + r s + d 0 + d 0 + p 0. t2 + x (1 + r b)x 1 + r s + x x 7 Another Example (Issue Shares to Pay a Dividend) CF t firm s cash flow at time t. number of shares initially. n number of shares issueo pay a dividend. CF t, d t d 0 + x for t 0, The number of new shares issued, n must be such that x n CF t for all t 1. +n CF t /( + n ), 4

5 p 0 d 0 + d 0 + x + d 0 + n d t CF t /( + n ) (1 + r s ) t CF t /( + n ) + d n d 0 + CF t /( + n ) CF t / p 0 CF t /( + n ) Note that we have assumed No taxes, no brokerage fees Individuals have homogeneous beliefs Investment policy is not affected by the dividend policy 8 Homemade Dividends An investor not satisfied with the proposed stream of dividends can always create her own personalized stream of income by borrowing or lending. Suppose that p 0 d 0 + d r s, but the investor wants to receive all her dividends in period 1, i.e. d 0 0. If d 0 can be saved at the rate r, this gives If r r s, then p 0 p 0. Homemade dividends can be offered by p (1 + r)d 0 + d r s. 5

6 corporations, through automatic dividend reinvestment plans; investment dealers selling stripped common shares. 9 Taxes In the presence of personal taxes, issuing shares to pay dividends won t benefit shareholders since it decreases the firm s value. Nevertheless, management may be tempteo issue stocks to maintain a constant stream of dividends when it does not have sufficient cash to pay a promised dividend. Why? Because investors prefer regular dividend payments. Firms with sufficient cash may avoid a dividend payment because of the tax disavantage. These firms may instead use the cash to Finance additional project (agency cost of equity) Acquire other companies Purchase financial assets, depending on corporate taxes. 10 Repurchases of Shares (vs Dividend Payment) p 0 d 0 + d 0 + CF t / where CF t is cash flow at time t and is the initial number of shares. Suppose that instead of paying d 0, the firm decides to repurchase n shares. Anybody left with a share will receive CF t /( n ) p 0 The firm uses dividend money to repurchases the shares, anhus n is such that n p 0 d 0 6

7 This gives us p 0 11 Some Observations Dividend yields are declining CF t /( n ) n CF t / (1 + r s ) t CF t / d 0 / p 0 (1 + r s ) t 1 CF t / 1 d 0 / p 0 (1 + r s ) t p 0 p 0 d 0 CF t / p 0 (1 + r s ) t p 0 d 0 + CF t / p 0. Ratio repurchases over market value of equity is rising Dividend smoothing Signaling effect of dividends and/or repurchases 7

Dividend irrelevance in a world without taxes. The effect of taxes. The information contents of dividends. Dividend policy in practice.

Dividends - lecture Dividend irrelevance in a world without taxes. The effect of taxes. Tax disadvantage of dividends. The information contents of dividends. Dividend policy in practice. Factors influencing