Principles of Corporate Finance
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1 Principles of Corporate Finance Professor James J. Barkocy The times they are a changin Bob Dylan McGraw-Hill/Irwin Copyright 2015 by The McGraw-Hill Companies, Inc. All rights reserved.
2 Dividend & Stock Repurchases U.S. Data
3 Dividend Payments Share Price Falls 3
4 Ex-Dividend Price Drop 4
5 Stock Dividend Example - Amoeba Products has 2 million shares currently outstanding at a price of $15 per share. The company declares a 50% stock dividend. How many shares will be outstanding after the dividend is paid? Answer 2 mil x.50 = 1 mil + 2 mil = 3 mil shares 5
6 Stock Dividend Example continued - After the stock dividend what is the new price per share and what is the new value of the firm? Answer The value of the firm was 2 mil x $15 per share, or $30 mil. After the dividend the value will remain the same. Price per share = $30 mil / 3 mil sh = $10 per sh. 6
7 Dividend vs. Stock Repurchase Example Prior to any action Assets A. Original balance sheet Liabilities & Equity Cash $150,000 Debt 0 Other assets 850,000 Equity 1,000,000 Value of Firm 1,000,000 Value of Firm 1,000,000 Shares outstanding = 100,000 Price per share = $1,000,00 0 / 100,000 = $10 If you owned 1,000 shares they would be worth $10,000 7
8 Dividend vs. Stock Repurchase Example - Cash dividend Assets B. After cash dividend Liabilities & Equity Cash $50,000 Debt 0 Other assets 850,000 Equity 900,000 Value of F irm 900,000 Value of F irm 900,000 Shares outstanding = 100,000 Price per share = $900,000 / 100,000 = $9 Value of firm drops by $100,000. If you owned 1,000 shares, you would have $9,000 in stock and $1,000 in cash 8
9 Dividend vs. Stock Repurchase Example Stock Repurchase Assets C. After stock repurchase Liabilities & Equity Cash $50,000 Debt 0 Other assets 850,000 Equity 900,000 Value of F irm 900,000 Value of F irm 900,000 Shares outstanding = 90,000 Price per share = $900,000 / 90,000 = $10 Value of the firm declines, but not the stock price. You would get: $9,000 in stock, $1000 in cash, or $10,000 in stock, or $10,000 in cash 9
10 How Dividends Are Determined 1. Firms have longer term target dividend payout ratios. 2. Managers focus more on dividend changes than on absolute levels. 3. Dividends changes follow shifts in long-run, sustainable levels of earnings rather than short-run changes in earnings. 4. Managers are reluctant to make dividend changes that might have to be reversed. 5. Firms repurchase stock when they have accumulated a large amount of unwanted cash. 10
11 How Dividends Are Determined 11
12 Dividend Policy is Irrelevant 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 will have no impact on the value of the firm. 12
13 Firms Without Sufficient Cash to Pay a Dividend Investment Bankers The direct costs of stock issuance will add to this effect. Firm Cash: stock issue Cash: dividends Stock Holders Taxes Gov. In a world of personal taxes, firms should not issue stock to pay a dividend. 13
14 Dividends Increase Value Market Imperfections and Clientele Effect There are natural clients for high-payout stocks, but it does not follow that any particular firm can benefit by increasing its dividends. The high dividend clientele already have plenty of high dividend stock to choose from. These clients increase the price of the stock through their demand for a dividend paying stock. 14
15 Dividends as Signals Dividends Increase Value Dividend increases send good news about cash flows and earnings. Dividend cuts send bad news. Because a high dividend payout policy will be costly to firms that do not have the cash flow to support it, dividend increases signal a company s good fortune and its manager s confidence in future cash flows. 15
16 Dividends Decrease Value Companies can convert dividends into capital gains by shifting their dividend policies. If dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move and value the firm more favorably. Tax Consequences In such a tax environment, the total cash flow retained by the firm and/or held by shareholders will be higher than if dividends are paid. This argument was severely weakened by tax law changes in Now the tax rate for dividends and capital gains are the same, although there are still a few advantages for capital gains. 16
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