Chapter 16: Dividend Policy

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Topic Dividends and Dividend Policy
Objectives

• How cash dividends are paid (includes regular
  cash dividend, extra dividends, and liquidating
  dividends)
• Explain dividend policy irrelevance in the MM
  world
• Example showing how shareholder wealth is not
  affected if the fund for cash dividend is raised
  through general cash offer or rights issue
• The effect of personal taxes on dividends and
  capital gains

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In corporate news, Eastman Kodak tumbled nearly
18 percent after the company said it will cut its
dividend by 70 percent Yahoo Finance 09/25/2003
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Microsoft and Dividends
Microsoft Puts Out Clinging to its war chest like
a deadbolted chastity belt, Microsoft (Nasdaq
MSFT) always scoffed at the idea of paying out a
dividend. Until yesterday 17 Jan
03 http//www.fool.com/news/take/2003/take030117.h
tm Other companies are proud of their dividend
payments? Why is there this difference? When
should a firm payout dividends and when should it
use its cashflow in a different way?
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How Dividends Are Paid

• Cash dividends Payment of cash by the firm to
  its shareholders
• The payment of cash by the firm to shareholders,
  is declared by the board of Directors on the
  declaration date
• The dividend is paid on the payment date to all
  shareholders of record as of the record date
  (which is usually 2-3 weeks prior to the payment
  date)
• The record date is the date on which holders of
  record are designated to receive a dividend
• To be a shareholder of record, and thus receive a
  dividend, one must have bought the stock before
  the ex-dividend date. The ex-dividend date is 2
  business days before the record date

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Timeline of Dividend Payments

The stock price drops by about the amount of the
dividend on the ex-dividend date. To be more
precise, the stock price falls by the after-tax
value of the dividend (difficult to measure).
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Ex-dividend price drop (ignoring taxes)
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MM Dividend Policy Irrelevancy Proposition

• Dividend policy should the firm pay out cash to
  its shareholders now, or should it invest that
  money and pay out later? The time pattern of
  dividend payouts.
• Assumptions MM no taxes, no transaction or
  bankruptcy costs
• Proposition dividend policy is irrelevant in MM
  world
• Vdividend-paying firm Vnon dividend-paying
  firm
• Why? If investors can raise cash themselves by
  selling shares, they do not need firms to provide
  them with cash through dividend payments.

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MM Dividend Policy Irrelevancy Example
Unlever Corporation, an all equity firm has 1,000
shares outstanding. The firm will be dissolved in
one year (remaining assets are worth Zero).
Managers know that the firm will receive a
cashflow of 10,000 today, and another 10,000
next year. The firms cost of capital is
10. Current dividend policy D(t)CF(t) Dividen
d per share is 10,000/1,00010 per share each
year Price per share d(0)d(1)/(1r)1010/1.1
19.09 Firm value 10,000
10,000/1.119,090.91
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MM Dividend Policy Irrelevancy Example
Alternative dividend policy Pay a dividend of
11 per share immediately (a total dividend of
11,000). This is 1,000 more than the cashflow
in the current period. Suppose the firm raises
the extra 1,000 by issuing stock. Assuming that
new shareholders require 10 on their investment,
they would demand 1,100 of the last period
cashflow, leaving 8,900 for the old
shareholders. Today Tomorrow Aggregate
dividends to old s/holders 11,000 8,900 Dividen
ds per share 11.00 8.90 Price per share
11 8.90/1.1 19.09 Firm value
19,090.91
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MM Dividend Policy Irrelevancy Homemade dividends
Suppose Ryan Giggs owns one share of Unlever and
he prefers the current dividend policy (10 now
and 10 next year). However Unlever adopts the
alternative dividend policy (11 and
8.90). According to the new policy, Ryan gets
11, keeps 10, and invests the extra dollar at
10 to get 1.1 next year. Next year he gets
8.90 in dividends plus the return in the 1
invested (1.1), a total of 10. Thus, he can
replicate his cashflows under the original
dividend policy. Giggs scores again..he can
undo the new corporate dividend policy
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Example A

• All equity firm with 100,000 shares. Total
  market value of assets10 million, so the
  price/share 100.
• Firm wants to pay 10/share dividend.
• It needs to raise 10 x 100,000 1 million cash
• Two alternatives
• General cash offer (issue common stock)
• Rights issue

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General Cash Offer to Fund Dividends

• The firm raises 1M in cash, which are
  automatically paid out to shareholders. So firm
  value is unaffected by the transaction. But to
  raise the 1M the firm has issued shares. How
  many?
• Note on the ex-dividend date, the price/share
  falls to 90/share
• (falls by the amount of the dividend per share)
• new shares issued 1M 11,111 shares
• 90/share
• Firm Value before 10 m 100,000 shares x
  100/share
• Firm Value after 10 m 111,111 shares x
  90/share
• No change in firm value! Shareholders have funded
  their own dividends.

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General Cash Offer to Fund Dividends

• Consider a shareholder with 100 shares
• Wealth before dividend 100 shares x 100/share
  10,000
• Wealth after dividend
• Cash 10 x 100 1,000
• Stock 100 x 90 9,000
• Total 1,000 9,000 10,000
• Conclusion the shareholder has paid for her own
  dividend as the drop in share price exactly
  offsets the dividend

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Rights Issue to Fund Dividends

• Suppose the firm decides on a subscription price
  of 80 per share to raise the 1 million cash
  needed to pay the dividend.
• new shares to be issued 1 million/80
  12,500 shares
• 100,000 rights will be issued (one right per
  existing share).
• Thus, the number of rights required to buy a
  share has to be N1000,000/12,500 8
• Price/share falls to 10M/112,500 88.89 per
  share

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Rights Issue to Fund Dividends

• Alternatively
• Ex-rights price N ? rights-on price
  subscription price / (N1)
• 8x90 80/9 88.89
• Note in this case the rights-on price is 90,
  and not 100, because the new shares are not
  entitled to the 10 dividend

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Rights Issue to Fund Dividends

• Wealth of shareholder with 100 shares
• Before 100 shares x 100/share 10,000
• After (total shares, old new ) x Ex-rights
  price
• cost of new shares dividends
  received
• (100 100/8) x 88.89 -100/8 x 80 100 x 10
  10,000
• Conclusion there is no reason for the firm to
  pay dividends. In fact, as long as the firm can
  invest the cash the same way as (or better than)
  the shareholders can do, the firm should not pay
  any dividends (see section 17.2)

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Example B on NPV vs. Market Value

• All equity firm with 500,000 shares trading at
  36/share. Dividends of 3.60/share have been
  paid for several years. The firm has an
  investment opportunity which will generate
  450,000 every year from the third year on. The
  firm will have to stop paying dividends for 2
  years to fund the project. Should the firm do
  this?
• We need to calculate NPVs. What is the correct
  discount rate?
• R RA RE dividend yield 3.60/36 10
• If the firm does not take the project, share
  price is 36 3.6/.1

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NPV vs. Market Value

• If the firm undertakes the project, the NPV is
• Conclusion the firm should stop dividends for 2
  years and invest in the project.
• The increase in the share price is
  595,041/500,000 1.19
• The share price increase to 37.19

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Dividend Policy and Taxes

• Corporate Taxes
• No effects on dividend policy. Both dividends
  and capital gains are taxed in the same way at
  the corporate level.
• Personal Taxes (Chapter 2)
• Since capital gains are taxed only when they are
  realized, and they are taxed at 50 of the
  marginal tax rate, the effective tax rate on
  dividend income is higher than the tax rate on
  capital gains. This does not imply that firms
  should pay no dividends.

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Example Dividends and Taxes

• In 1998, Wordsoft Ltd. Adopted a policy of buying
  back its own outstanding
• common stock instead of paying cash dividends.
  Earnings after taxes for the
• 4 years 1998-2001 stayed at a constant 8,000,000
  and were used exclusively
• for the repurchase program.
• Assuming there were 32,000,000 shares outstanding
  at the beginning of 1998, and that shares have
  traded at a stable price-earnings ratio of 16
  since then, calculate earnings per share, the
  market price per share, and the number of shares
  repurchased for 4 years 1998 through 2001.
• Determine the preference of a shareholder who
  owns 2,100 shares of Wordsoft Ltd., from 1998 to
  the end of 2001, for either cash dividends or
  share repurchases. The shareholders provincial
  marginal tax rate is 30 percent and federal
  marginal tax rate is 26 percent. The shareholder
  has exhausted any tax-free amounts that may be
  available on dividend or capital gains income, so
  that investment income received is taxable.
  Ignore the time value of money and assume that
  earnings are fully paid out in dividends or used
  for share repurchases.

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• Solutions
• 1998 1999 2000 2001
  2002
• (1) AT Earnings 8,000,000 8,000,000
  8,000,000 8,000,000 8,000,000
• (2) Shares Outstanding 32,000,000
  30,000,000 28,125,000 28,367,188
  24,719,239
• at beg. of year
• (3) EPS (1) ? (2) .25
  .266 .284 .3034
  .3236
• (4) P/E Ratio 16
  16 16
  16 16
• (5) Share Price at beg.
• of year (3) ? (4) 4
  4.26 4.5511 4.8545
  5.1782
• (6) Shares Repurchased
• (1) ? (5) 2,000,000
  1,875,000 1,757,812 1,647,949
• (7) Total Market Value
• (5) ? (2) 128M
  128M 128M 128M

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Cash dividends Dividend 8M/32M shares .25
per share Total dividends during 1998-20014 x
.25 1 per share Dividend received by a
shareholder with 2,100 shares 2,100 After-tax
dividends 2,100 - 432.25 1,667.75 Capital
gains under share repurchase CG P in 2001 P
in 1998 5.1782 -4 1.1782 per share Total
capital gain 2,100 x 1.1782
2,474.22 After-tax capital gain 2,474.22 -
418.14 2,056.08
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Assigned Reading and Questions
Questions 1, 4, 6, pp594 Ch 17.
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Topic Dividends and Dividend Policy
Objectives

• Real-world factors affecting company payout
• Resolutions of real world factors
• Establishing a dividend policy
• Distinguish between cash dividends, stock
  dividends, stock splits, and stock repurchases

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Real-world Factors for Low Payout

• Taxes When the marginal tax rate for individuals
  exceeds that for firms, investors may prefer that
  earnings be retained rather than paid out as
  dividends
• Flotation costs Firms that pay high dividends
  and simultaneously sell stock to fund growth will
  incur higher flotation costs than comparable low
  payout firms
• Dividend restrictions Most bond indentures and
  some federal and provincial laws limit the
  dividends a firm can pay

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Real-world Factors for High Payout

• Desire for current income (widows and orphans)
  the firm paying a larger dividend will sell at a
  higher price. But not all investors desire high
  current income and they may self-select into
  different clienteles
• Uncertainty resolution distant dividends are
  more uncertain than near dividends, so firms with
  near dividends should sell at a higher price. The
  uncertainty over future income is not changed by
  a firms dividend policy
• Taxes and legal benefits from high dividends
  Dividend income to Canadian firms are tax-exempt,
  as well as to pension and trust funds which are
  usually not allowed to spend their principal.

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A Resolution of Real-World Factors?

• Information content of dividends In markets
  where there is little information, dividend
  policy becomes an important form of communication
  about firms future prospects
• Note stock prices rise/fall when D is
  unexpectedly increased/decreased
• - Firm value is not affected by changes in
  dividends. Rather, firm value increases if
  managements increase in dividends signals the
  presence of high NPV opportunities. Stock prices
  fall after dividend cuts, which signal bad future
  prospects.
• The clientele effect Different groups of
  investors desire different levels of dividends.
  If clienteles are satisfied with current
  dividends, dividend policy changes are pointless

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Establishing a Dividend Policy

• Residual dividend approach Policy where a firm
  pays dividends only after meeting its investment
  needs while maintaining a desired debt-to-equity
  ratio (selling stock to pay a dividend is
  expensive)
• problem dividends can be very unsatable
• Dividend stability A stable dividend policy is
  in the interest of the firm and its shareholders
  as dividend stability reduces uncertainty

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A Compromise Dividend Policy

• In practice, many firms appear to follow what
  amounts to a compromise dividend policy. Such
  policy is based on the following goals
• Avoid cutting back on positive NPV projects to
  pay a dividend
• Avoid dividend cuts
• Avoid the need to sell equity
• Maintain a target debt-to-equity ratio
• Maintain a target dividend (relative to earnings)
  payout ratio

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Stock Dividends and Stock Splits

• Stock Dividend Distribution of additional shares
  to a firms shareholders, diluting the value of
  each share outstanding. The cash is kept in the
  firm for investment shareholders receive
  additional shares. A 10 stock dividend would
  issue one share per ten shares outstanding.
• Stock Split Issuance of additional shares to a
  firms shareholders, without changing owners
  equity. No cash is exchanged, only a change in
  the number of shares issued and a change in the
  value of a share occurs.
• A stock dividend is a mini stock split. No cash
  is involved and the book value of equity does not
  change. With more shares outstanding, market
  value per share drops, but total market value of
  the firm stays the same

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Share Repurchases

• Share Repurchase a firm buys back stock from its
  shareholders
• A share repurchase has the same effect as a cash
  dividend the cash account in the firm is reduced
  and the shareholders as a group have more cash.
  The book value of the equity is reduced in both
  cases

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Example A

• The stock of Payout Corp. will go ex dividend
  tomorrow. The dividend will be 1.00 per share,
  and there are 20,000 shares of stock outstanding.
  Todays market value balance sheet for Payout is
  shown below
• Assets Liabilities and Equity
• Cash 100,000 Equity 1,000,000
• Fixed assets 900,000 Debt 0
• a. What price is Payout stock selling for today?
• b. What price will it sell for tomorrow? Ignore
  taxes.

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Example A ( Solution)

• todays price 1,000,000/20,000 50 per share
• for reference, a shareholder A with 100 shares
  has 5,000
• tomorrows price 50 - 1 49
• After the dividend payment, the market value
  balance sheet is
• Assets Liabilities and Equity
• Cash 80,000 Equity 980,000
• Fixed assets 900,000 Debt 0
• Shareholder A has 1,000 100 in cash
  100x49 in shares

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Example B

• Now suppose that Payout from Example A announces
  its intention to repurchase 20,000 worth of
  stock instead of paying out the dividend. What
  effect will the repurchase have on shareholder A,
  who currently holds 100 shares and sells 2 of
  those shares back to the company in the
  repurchase?
• After the repurchase, the market value balance
  sheet is
• Assets Liabilities and Equity
• Cash 80,000 Equity 980,000
• Fixed assets 900,000 Debt 0
• Since 20,000/50 400 shares were repurchased,
  the price per share after the repurchase is
  980,000/20,000 - 400 50
• As wealth will be 5,000 98 x 50 (in shares)
  2x50 (in cash)

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Compare Example A and Example B

• Comparing the effects of the repurchase to the
  effects of the cash dividend, we reach the
  following conclusion
• If there are no imperfections, and taxes are
  ignored, then a cash dividend and a share
  repurchase are essentially the same thing.

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Example C

• Now suppose that Payout again changes its mind
  and decides to issue a 2 percent stock dividend
  instead of either issuing the cash dividend or
  repurchasing 2 percent of the outstanding stock.
  How should this action affect a shareholder who
  owns 100 stock? Compare with your answers to
  Examples A and B

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With a 2 stock dividend, each shareholder
receives 2 new shares every 100 previously held.
So our shareholders wealth after the stock
dividend will be 102 shares x price per share
after stock dividend What is the share price
after the stock dividend is paid? of shares
after stock dividend 1.02 x 20,000
20,400 Since the combined market value of equity
does not change, the price per share will be
1,000,000 / 20,400 49.02 So our
shareholders wealth after the tax would be 102
x 49.019608 5,000

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In summary,
Without taxes, there is no change in shareholder
wealth under all three cases.