Foundations of Finance

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Stock Returns

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Stock Returns

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Stock Returns

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Stock Returns

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Dilemma Should the firm use retained earnings
for

• a) Financing profitable capital investments?
• b) Paying dividends to stockholders?

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• If we retain earnings for profitable investments,

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• If we retain earnings for profitable investments,
  dividend yield will be zero,

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• If we retain earnings for profitable investments,
  dividend yield will be zero, but the stock price
  will increase, resulting in a higher capital
  gain.

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• If we pay dividends,

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• If we pay dividends, stockholders receive an
  immediate cash reward for investing,

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• If we pay dividends, stockholders receive an
  immediate cash reward for investing, but the
  capital gain will decrease, since this cash is
  not invested in the firm.

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So, dividend policy really involves 2 decisions

• How much of the firms earnings should be
  distributed to shareholders as dividends, and
  
• How much should be retained for capital
  investment?

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Is Dividend Policy Important?

• Three viewpoints
• 1) Dividends are Irrelevant. If we assume
  perfect markets (no taxes, no transactions costs,
  etc.) dividends do not matter. If we pay a
  dividend, shareholders dividend yield rises, but
  capital gains decrease.

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• With perfect markets, investors are concerned
  only with total returns, and do not care whether
  returns come in the form of capital gains or
  dividend yields.

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• With perfect markets, investors are concerned
  only with total returns, and do not care whether
  returns come in the form of capital gains or
  dividend yields.

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• With perfect markets, investors are concerned
  only with total returns, and do not care whether
  returns come in the form of capital gains or
  dividend yields.
• Therefore, one dividend policy is as good as
  another.

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2) High Dividends are Best

• Some investors may prefer a certain dividend now
  over a risky expected capital gain in the future.

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2) High Dividends are Best

• Some investors may prefer a certain dividend now
  over a risky expected capital gain in the future.

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3) Low Dividends are Best

• Dividends are taxed immediately. Capital gains
  are not taxed until the stock is sold.
  
• Therefore, taxes on capital gains can be deferred
  indefinitely.

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Do Dividends Matter?

• Other Considerations
• 1) Residual Dividend Theory
• The firm pays a dividend only if it has retained
  earnings left after financing all profitable
  investment opportunities.
  
• This would maximize capital gains for
  stockholders and minimize flotation costs of
  issuing new common stock.

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Do Dividends Matter?

• 2) Clientele Effects
• Different investor clienteles prefer different
  dividend payout levels.
  
• Some firms, such as utilities, pay out over 70
  of their earnings as dividends. These attract a
  clientele that prefers high dividends.
  
• Growth-oriented firms which pay low (or no)
  dividends attract a clientele that prefers price
  appreciation to dividends.

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Do Dividends Matter?

• 3) Information Effects
• Unexpected dividend increases usually cause stock
  prices to rise, and unexpected dividend decreases
  cause stock prices to fall.
  
• Dividend changes convey information to the market
  concerning the firms future prospects.

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Do Dividends Matter?

• 4) Agency Costs
• Paying dividends may reduce agency costs between
  managers and shareholders.
  
• Paying dividends reduces retained earnings and
  forces the firm to raise external equity
  financing.
  
• Raising external equity subjects the firm to
  scrutiny of regulators (SEC) and investors and
  therefore helps monitor the performance of
  managers.

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Do Dividends Matter?

• 5) Expectations Theory
• Investors form expectations concerning the amount
  of a firms upcoming dividend.
  
• Expectations are based on past dividends,
  expected earnings, investment and financing
  decisions, the economy, etc.
  
• The stock price will likely react if the actual
  dividend is different from the expected dividend.

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Stock Dividends and Stock Splits

• Stock dividend payment of additional shares of
  stock to common stockholders.
  
• Example Eagle Bancorp of Maryland announces a
  40 stock dividend to all shareholders of record.
  For each 100 shares held, shareholders receive
  another 40 shares.
• Does the shareholders wealth increase?

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Stock Dividends and Stock Splits

• Stock Split the firm increases the number of
  shares outstanding and reduces the price of each
  share.
  
• Example Raven Industries announces a 3-for-2
  stock split. For each 100 shares held,
  shareholders receive another 50 shares.
  
• Does this increase shareholder wealth?
• Are a stock dividend and a stock split the same?

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Stock Dividends and Stock Splits

• Stock Splits and Stock Dividends are economically
  the same the number of shares outstanding
  increases and the price of each share drops. The
  value of the firm does not change.
• Example A 3-for-2 stock split is the same as a
  50 stock dividend. For each 100 shares held,
  shareholders receive another 50 shares.

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Stock Dividends and Stock Splits

• Effects on Shareholder Wealth

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Stock Dividends and Stock Splits

• Effects on Shareholder Wealth these will cut
  the company pie into more pieces but will not
  create wealth. A 100 stock dividend (or a
  2-for-1 stock split) gives shareholders 2
  half-sized pieces for each full-sized piece they
  previously owned.

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Stock Dividends and Stock Splits

• Effects on Shareholder Wealth these will cut
  the company pie into more pieces but will not
  create wealth. A 100 stock dividend (or a
  2-for-1 stock split) gives shareholders 2
  half-sized pieces for each full-sized piece they
  previously owned.
• For example, this would double the number of
  shares, but would cause a 60 stock price to fall
  to 30.

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Stock Dividends and Stock Splits

• Why bother?
• Proponents argue that these are used to reduce
  high stock prices to a more popular trading
  range (generally 15 to 70 per share).
  
• Opponents argue that most stocks are purchased by
  institutional investors who have millions to
  invest and are indifferent to price levels.
  Plus, stock splits and stock dividends are
  expensive!

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Stock Split Example

• Lowes
• has 385 million common shares outstanding, at a
  price of 72 per share.
  
• Market capitalization
• 385 million x 72
• 27.72 billion.

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Stock Split Example

• Lowes announces a 2/1 stock split.
• Shares outstanding
• 385 million x (2/1) 770 million.
• Stock price
• 72 divided by (2/1) 36.
• Market capitalization
• 770 million times 36
• 27.72 billion.

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Stock Dividend Example

• shares outstanding 1,000,000
• net income 6,000,000
• P/E 10
• 25 stock dividend.
• An investor has 120 shares. Does the value of
  the investors shares change?

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• Before the 25 stock dividend
• EPS 6,000,000/1,000,000 6
• P/E P/6 10, so P 60 per share.
• Value 60 x 120 shares 7,200
• After the 25 stock dividend
• shares 1,000,000 x 1.25 1,250,000.
• EPS 6,000,000/1,250,000 4.80
• P/E P/4.80 10, so P 48 per share.
• Investor now has 120 x 1.25 150 shares.
• Value 48 x 150 7,200

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Stock DividendsIn-class Problem

• shares outstanding 250,000
• net income 750,000
• stock price 84
• 50 stock dividend.
• What is the new stock price?

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Hint

• stock price
• P/E net income
• shares

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• Before the 50 stock dividend
• EPS 750,000 / 250,000 3
• P/E 84 / 3 28.
• After the 50 stock dividend
• shares 250,000 x 1.50 375,000.
• EPS 750,000 / 375,000 2
• P/E P / 2 28, so P 56 per share.
• (a 50 stock dividend is equivalent to a
• 3-for-2 stock split)

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Stock Repurchases

• Stock Repurchases may be a good substitute for
  cash dividends.
  
• If the firm has excess cash, why not buy back
  common stock?

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Stock Repurchases

• Stock Repurchases may be a good substitute for
  cash dividends.
  
• If the firm has excess cash, why not buy back
  common stock?

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Stock Repurchases

• Repurchases drive up the stock price, producing
  capital gains for shareholders.
  
• Repurchases increase leverage, and can be used to
  move toward the optimal capital structure.
  
• Repurchases signal positive information to the
  market - which increases stock price.

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Stock Repurchases

• Repurchases may be used to avoid a hostile
  takeover.
  
• Example T. Boone Pickens attempted raids on
  Phillips Petroleum and Unocal in 1985. Both were
  unsuccessful because the target firms undertook
  stock repurchases.

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Stock Repurchases

• Methods
• Buy shares in the open market through a broker.
• Buy a large block by negotiating the purchase
  with a large block holder, usually an institution
  (targeted stock repurchase).
  
• Tender offer offer to pay a specific price to
  all current stockholders.