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

Transcription

1 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 dividend decisions. Share repurchase as an alternative to dividends.

2 Internally generated New external financing Maintain ongoing operations Cash dividend Available cash flow Distribute to shareholders Repurchase stock Stock split or stock dividend Expansion New capital investments Aquisitions

3 Dividend policy Dividends are Cash payments to stockholders. Decided by the firm s board of directors. Usually paid quarterly. Dividend policy is defined as the choice between financing investments with retained earnings or paying out cash (i.e. dividends) and issuing new shares of stock.

4 Dividend policy irrelevance in a world without taxes Result (Miller and Modigiani) Given the firm s investment decisions, and assuming a perfect capital market, the value of the firm is invariant to its dividend policy because dividend policy merely changes the time patterns of cash flows to the current shareholders but not the present value of the cash flow stream.

5 Example Consider a firm with the following balance sheet (in market values). Cash $1,000 Debt 0 Fixed assets $9,000 Equity 10,000 Tot.assets $10,000 Tot.liabilities $10,000

6 Suppose the firm can invest in a project with a NPV of $2,000, and a cost today of $1,000. This enters the balance sheet as the present value of future growth (PVGO): Cash $1,000 Debt 0 Fixed assets $9,000 Equity 12,000 PVGO 2,000 Tot.assets $12,000 Tot.liabilities $12,000

7 The firm uses the $1,000 of cash to make the investment. (Pay no dividends) New balance sheet: Cash $0 Debt 0 Fixed assets $12,000 Equity 12,000 Tot.assets $12,000 Tot.liabilities $12,000

8 Suppose, however, that the firm decides to use its $1,000 cash to pay a dividend to its current shareholders. To maintain its investment plans, the firm will be required to issue $1,000 of new debt or equity to finance the investment project. Suppose that the firm issues $1,000 of stock. Cash $0 Debt 0 Fixed assets $12,000 Old Equity 11,000 New Equity 1,000 Tot.assets $12,000 Tot.liabilities $12,000 Only difference from previous: The old shareholders now own stock worth only $11,000. This is because they have sold new shares that are worth $1,000. The new shareholders have claim to future dividends that have a present value of $1,000. The old shareholders are neither better off nor worse off. The total value of their wealth is exactly the same whether or not the firm pays a dividend. No dividend $1,000 Dividend

9 Moreover, the shareholders of the firm can undo the effect of any dividend payment. If the shareholders use the $1,000 dividend to purchase the $1,000 of new equity issued by the firm, their position in the firm is exactly the same as if no dividend was paid. Consequently, dividend policy is irrelevant!

10 The effect of taxes. Dividends and capital gains are not taxed the same. To maximise the value of the firm s equity, it should try to minimise the taxes its shareholders pay to the government. As the following example illustrates, this means minimising the dividends paid to shareholders.

11 Example You bought 100 shares of stock one year ago for $10 per share. The current market price is $12 per share. The firm is considering a $1.20 per share distribution. You pay a tax of Tax rates: τ d : dividend tax rate. τ g : captital gains tax rate. How should the distribution be made?

12 There are two methods of distributing the $1.20 per share. 1. Pay the $1.20 as a straight dividend. 2. Repurchase 10% of the equity for a price of $12.00 per share. You would sell 10 shares back to the firm for a total payment of $120, the same amount you would receive as a dividend.

13 Cash flows Dividend Repurchase Before - tax dividend $120 $0 Dividend tax 120τ d 0 After-tax dividend 120(1 τ d ) 0 Before-tax proceeds 0 $120 Capital gains tax 0 ( )τ g After-tax proceeds τ g Value of equity Total wealth τ d τ g

14 The two method provide exactly the same total wealth provided τ d = τ g = 0, or if τ d = τ g or equivalently τ d τ g = 1 6 Note: The ratio τ d τ g that equates the total wealth will depend on the size of the capital gain.

15 The total wealth for different values of τ d and τ g are: Tax rates Total wealth τ d τ g Dividend Repurchase

16 The share repurchase is preferred because the tax is only applied to the difference between the amount distributed ($120) and the investor s basis in the stock ($100). The dividend distribution, on the other hand, is fully taxable.

17 Homemade dividends. Dividend irrelevance from the perspective of an individual investor. Current interest rate is 10%. The firm announces dividend payments: Time 1 2 Dividend $10 $10

18 You want to receive: Time 1 2 Dividend $9 $11.10 How to get these cashflows: Investing $1 of the dividend received at time 1: Time 1 2 Dividends Borrowing Cash flow

19 Suppose you want instead to receive: Time 1 2 Dividend $11 $8.90 To achieve these cashflows, borrow $1 at time 1: Time 1 2 Dividends Borrowing Cash flow

20 Possible dividend payments. Date Borrowing 10 Lending Date 2

21 Typical Dividend Policies In practice firms act as though dividend policy is an important decision. The dividend payout policies that firms choose to follow can be classified into one of the following four categories: Stable per share dividend. The policy of paying a stable dollar amount per share is the policy most firms follow in the real world. Under this policy, dividends are increased when and if it appears as though the higher dollar amount per share can be maintained. When the dividend per share has been increase, strenuous efforts are made to maintain the higher level, even if this means the firm must resort to temporary borrowing to pay the dividend. If earnings decline, the existing dividend is generally maintained until it is clear that an earnings recovery will not take place.

22 Constant payout ratio. A small number of firms follow a policy of paying out a constant percentage of earnings. Since earnings fluctuate, following this policy necessarily means that the dollar amount of dividends will fluctuate. For firms that follow this policy, dividends are unlikely to serve as a signal to shareholders. Low regular dividend plus extras. The low regular dividend plus extras policy is a compromise between the first two. It gives the firm some flexibility, but leaves investors uncertain about what their dividend income will be. For firms with volatile earnings, this policy is a popular one.

23 Dividends as a residual. Under the residual policy, cash dividends are paid only as a residual after all profitable investment opportunities are financed with internally generated funds to the extent possible. Since this minimises the need for external financing, flotation cost of new issues are also minimised. However, because earnings and investment opportunities are likely to fluctuate, so too will the firms dividends. It is also much more likely that an increase in dividends will be viewed as bad news by investors under this policy.

24 The information content of dividends. If dividends increase the tax burden of shareholders, then why do prices increase when the firm announces that it will pay higher dividends? To answer this question, we must first understand some stylized facts about how firms determine their dividends 1. Firm have long-run target dividend payout ratios. 2. Managers focus more on dividend changes than on absolute levels. 3. Dividend changes follow shifts in long-run, sustainable earnings. Managers smooth dividends. Transitory earnings changes are unlikely to affect dividend payouts. 4. Managers are reluctant to make dividend changes that might have to be reversed.

25 Given these stylized facts, it is likely that investors will interpret an increase in dividends as a signal that management anticipates permanently higher levels of cash flows in the future. Therefore, it should not be surprising that stock prices increase following the announcement of a higher dividend. The dividend per se does not affect the value of the firm, however. Rather the dividend serves as a signal from management to the capital market that the firms is expected to be more profitable in the future. But because dividends are costly to both investors and the firm, one has to wonder if there are not better ways to signal improved profitability to the capital markets.

26 Factors influencing dividend policy. What factors determine the extent to which a firm will pay out dividends instead of retaining earnings? As a first step in answering this question, we shall consider some of the factors that influence dividend policy in practice. Legal restrictions. Most state laws provide statutory restriction prohibiting the firm from paying cash dividends under certain circumstances. These vary from state to state, but usually include a restriction on the firms dividend-paying ability when 1. The firm s liabilities exceed its assets. 2. The anticipated dividend exceeds the firm s retained earnings 3. The dividend would be paid from the firm s invested capital

27 Factors influencing dividend policy. Contractual Restrictions. Often bond indentures, term loan agreements, and even preferred stock provisions may impose restrictions on the payment of cash dividends. These restrictions usually state 1. Future dividends can be paid out only out of future earnings. 2. Dividends cannot be paid when working capital is below some specified level. 3. No cash dividends can be paid on the common stock until all preferred dividends have been paid.

28 Factors influencing dividend policy. Liquidity position. Profits held as retained earning are generally reinvested in productive assets and not held as cash. Thus, even if a firm has a record of earnings, it may not be able to pay cash dividends because of its liquidity position. Indeed, a growing firm, even a very profitable one, typically has a pressing need for funds, and, therefore, may elect not to pay cash dividends. Cash-rich firms, on the other hand, with substantial cash flow should increase dividends (or repurchase shares) to maximise shareholder wealth. Such firms that do not distribute free cash flow to shareholders, but instead squander it on low-return projects, are prime takeover candidates.

29 Factors influencing dividend policy. Investment Opportunities. The more rapidly a firm is growing, the greater the need for funds to finance asset expansion. The greater the need for future funds, the more likely the firm is to retain earnings rather than to pay them out as dividends. Firm in declining industries, with few profitable investments, are more likely to have excess cash flow and therefore higher dividends.

30 Factors influencing dividend policy. Access to the Capital Markets. A large, well-established firm with a record of profitability has easier access to the capital markets and other forms of external financing than a small, new, or relatively unknown firm with a shorter history. If the firm s ability to raise external financing is restricted, it must retain more of its earnings to finance operations. A well established firm is thus likely to have a higher dividend payout rate than a new or small firm.

31 Factors influencing dividend policy. Control. For many smaller and medium-sized firms, ownership control is an important issue. They may be reluctant to sell more common stock and will prefer to retain more internally generated funds to provide the equity capital needed for growth. By using internally generated funds plus any borrowing required, they may be able to maintain control and meet the firm s capital needs.

32 Factors influencing dividend policy. Information content (signal). In a world with incomplete information, the firm s cash dividend may communicate (that is, signal) information about the firms future earnings potential above and beyond any existing information. For example, an increase in the payout ratio may be viewed as a signal that the firm s future earnings potential has improved. The firm s stock price may thus increase simply as a result of the increased dividend, because the stock market believes that the firm s insiders know that they can sustain the higher dividend.

33 Factors influencing dividend policy. Taxes and clienteles. The tax position of a corporation s owners greatly influences the desire for dividends. For example, a corporation closely held by a few taxpayers in high income tax brackets is likely to pay a relatively low dividend. The owners will likely prefer capital gains to dividend income. Stockholders of a large, widely held corporation might instead prefer a high dividend payout. Some investors (mostly institutions) are restricted from buying stocks that pay no dividends.

34 Factors influencing dividend policy. Earnings stability. Another factor that is often considered in practice is the stability of the firms earnings. Other things equal, more stable firms are often in a better position to pay large cash dividends than less stable firms. This is because they can plan for the future with more certainty than highly cyclical firms.

35 Share repurchase as an alternative to dividends. Alternative cash dividends: Firm can distribute cash through the repurchase of its own shares. Companies have been repurchasing their stock in record amounts in recent years.

36 Advantages to repurchase 1. Repurchases may be viewed as a stronger positive signal by investors than an increase in dividends. 2. Repurchases allow shareholders to choose for themselves whether or not to sell their shares in exchange for cash. Dividend payments do not permit this kind of flexibility. 3. Shareholders are taxed less heavily on share repurchases than on dividend payments. 4. Share repurchases allow the firm to distribute cash to its shareholders without raising the dividend rate. This provides a good alternative when the firm has a temporary cash surplus.

37 1. Repurchased stock can be used for acquisitions or released when stock options are exercised, when convertibles are converted, or when warrants are exercised. Repurchased stock can also be resold by the firm when it its in need of additional new financing. 2. Repurchases can be used to effect an immediate and often large-scale change in the firms capital structure. For example, the sale of long-term debt with the proceeds used to repurchase stock is an effective way to increase the firm s debt-equity ratio.

38 Disadvantages 1. Firms that repurchase substantial amounts of stock generally have poorer growth and investment opportunities than firms that do not. Announcing a repurchase program may thus signal to investors that good investment opportunities may not exist. 2. From a legal standpoint, the SEC may raise some questions if it appears the firm is using the repurchases to manipulate stock price. 3. If repurchases are regular, the IRS may view them as actually dividends and fine the firm under the improper accumulation of earnings provision of the Tax Code. 4. The firm might overpay for its shares, to the detriment of the non-selling shareholders. (A good example of this is the case of greenmail).

39 Exercise Suppose that a company has the following position : Net Profit $50 million Number of shares before repurchase 10 million Earnings per share $5 Price-Earnings ratio 20 The company plans to repurchase 2 million shares of stock at the going market price. Ignore taxes. 1. What effect does the repurchase have on the value of the firm? 2. What effect will the repurchase have on the price per share, earnings per share, and price-earnings ratio? 3. How would the value of the firm, price per share, earnings per share, and price-earnings ratio be affected if the firm used the cash for the repurchase to pay a dividend instead? 4. Which of the two methods of distributing cash is preferred by the shareholders? Would your answer change if the shareholders were subject to personal taxation?

40 Summary. The Dividend question. What determines a firm s dividend policy? Key result (M&M): If we fix the investment policy of a firm, the timing of the firms dividend payments do not affect the firm s value. With taxes, dividends are costly to shareholders, prefer capital gains. (depend on tax regime) Academic investigations indicate dividends are penalized. Share repurchase an important alternative to dividends.