Dividend Policy

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Dividend Policy
Chapter 19 Classes 15 and 17
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Summary

• Cash vs share dividends
• Dividend dates
• Modigliani Miller Irrelevance theorem
• When is dividend policy relevant?
• Dividend policy in practice

• Stock repurchases
• Stock splits
• Stock dividends

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Why Do We Care About Dividends?

• Dividend policy is a decision to give money back
  to shareholders and NOT invest in a new project.
• Affects the firms capital budgeting decision
• Paying dividends means less internal cash
  available for other uses.
• Paying dividends means borrowing money to invest
  in new projects.
• Historically firms pay out dividends in both good
  times and bad times.

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Distributions

• Firms make distributions to their shareholders 2
  ways
• Cash Distributions.
• Cash dividends.
• Stock repurchases.
• Share Distributions.
• Stock dividends.
• Stock splits.

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Cash Dividends Empirical Findings
TSE 300 Composite Index Statistics
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Dividend Differences Across Industry
Average Canadian Dividend Payout Ratios
(1980-1999)Source Standard Poors Computstat
database. September 11,2002
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Dividends and Financing
Relationship between available CF potential uses
Firms should never give up a positive NPV project
to pay dividends!
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Dividend Dates

• Declaration date.
• Ex-dividend date.
• 2 business days prior to the Record date.
• First day the share trades without right to
  receive the declared dividend.
• Share price will fall by the amount of the
  dividend when market opens on the ex-dividend
  date.
• Record date.
• Payment date.

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Dividends announcements
Stock price
May 31
May 15
Feb 15
May 13
Declaration date
Payment date
Ex-dividend date
Record date
Stock price should fall on the ex-div date, by
the amount of the dividend. This is because
market discounts for the value of dividends.
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Dividend Dates Price Behaviour
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Dividends and Stock Price
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To Re-cap

• Shareholders that owned the shares on the close
  of business May 12, receive the dividend May 31.
• Shareholders that acquired their shares on May 13
  or after, are not entitled to get this dividend.
• They would expect to pay less for their shares.
• Shareholders buying on the ex-dividend date or
  after will be willing to pay less since they
  dont get the dividend.

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MM On Dividends

• In the absence of transactions costs and taxes,
  dividend policy is irrelevant and does not affect
  shareholder wealth.
• Investors can create Home Made Dividends by
  selling off a small part of the stock that has
  appreciated in value, or undo dividends by
  reinvesting the cash dividend.
• Show that dividend with offsetting new issue is
  irrelevant.

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Irrelevancy Assumptions

• Once again, perfect market assumptions are
  necessary
• No taxes.
• The firm must hold investment, financing and
  operating policies of the firm fixed. Only
  dividend policy changes.
• Idea firm will issue cash to shareholders as
  dividend, and then recoup this amount by issuing
  new shares.

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Example 1

• PAN AM Airlines earns EBIT of 10M (ignore taxes)
  and has 4M in cash that it wants to pay out as a
  dividend.
• There are 0.6M shares outstanding.
• The current price is 90 and PAN AM wants to pay
  a special dividend of 6.67 per share. PAN AM is
  all equity financed and its WACC is 20.
• 1.)What is the value of the company before the
  dividend?
• 2.)What is the value of the company after the
  dividend?
• 3.)What is the stock price after the dividend?
• 4.)How is shareholder wealth affected by the
  dividend?

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Example 1 Solution

• 1.) 90 x 0.6M 54M 10M/.2 4M
• 2.) 54M - 4M 50M
• Note DPS 4M/0.6M 6.67
• 3.) 90 - 6.67 83.33
• 4.) Dividend policy affects the form of
  stockholder wealth not the amount thereof.
  Consider an investor who owns 1 stock. Before
  dividend, wealth 90 in stock. After the
  dividend, wealth 83.33 in stock 6.67 in
  cash.

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Fundamental Concept
In perfect capital markets, without taxes,
dividend policy is irrelevant
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Taxes and Dividends
In a tax-free world, cash dividends are a wash
between the firm and its shareholders.
Cash stock issue
Firm
Stock Holders
Cash dividends
Taxes
In a world with taxes, the government gets a cut.
Gov.
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Fundamental Concept
Many factors in the real world make dividend
policy relevant
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Real World Relevance - Factors Favoring a Low
Payout.

• Taxes, imposing an immediate tax burden on
  investors.
• Firm has unusually good investment prospects.
• Cost if have to issue new equity in future.
• Why pay dividends incur costs to issue
  securities in the future?

• Bond covenants and other restrictions.
• Growth and control issues.
• Short term cash position.
• Inherent firm risk.
• Restrictions on foreign transfers.

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Real World Relevance Factors Favoring a High
Payout

• Desire of current income
• Costs of home made dividends.
• Uncertainty resolution
• Bird-in-the-hand argument.
• Investors prefer cash dividend now to uncertain
  capital gain in future.

• Tax
• Tax exempt owners (pensions, life insurers,
  trusts, endowments, etc.)
• Signaling arguments.
• Free cash flow issues.

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Practical Implementation of a Dividend Policy
Guiding Principles

• Avoid passing on positive NPV projects to pay
  dividends.
• Avoid cutting or reducing dividends.
• Avoid the need to sell equity.
• Maintain the target B/S ratio.
• ?These suggest keeping the payout set low in the
  first place

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Practical Implementation

• Set a low per share constant dollar dividend.
• Set a target payout consistent with long term
  profitability and long term capital needs.
• Increase dividends only when the long term
  profitability supports the new payout level.
• Reduce dividends reluctantly, but do not risk the
  viability of the firm.

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Residual Dividend Policy (Four Steps)

• Establish the optimum capital budget
• Accept all projects with positive net present
  values
• Determine the amount of common equity needed to
  finance the new investments while maintaining the
  firm's capital structure
• Use internally generated funds to supply this
  equity whenever possible
• Pay cash dividends only to the extent that
  internally generated funds remain after taking
  all appropriate capital investment opportunities

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Example 2 Residual Dividend Policy

• Farside Corp follows a strict residual dividend
  policy. Its debt-equity ratio is 3.
• A)If earnings for the year are 150,000, what is
  the maximum amount of capital spending possible
  without new equity?
• B)If planned investment outlays for the coming
  year are 750,000, will Farside pay a dividend?
  How much? What about if the investment outlay was
  500,000?
• C)Does Farside maintain a constant dividend
  payout?

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Example 2 Solution

• B/S 3 implies 3 of B for every 1 of S also
  that B/(BS) .75, S/(BS) .25.
• A) If retain 150 as S, must issue B 450.
  Thus, max investment 450 150 600
• B) I 750 implies newB 562.5 and newS 187.5.
  Retain entire 150 in earnings and issue 37.50 in
  new stock
• C) I 500 implies newB 375 and newS 125.
  Retain 125 in earnings and pay residual 25 as
  dividends

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Share Repurchases

• An alternative way to return value to
  shareholders
• Especially good for firms with clienteles that
  prefer capital gains.
• Repurchased shares are cancelled (no longer
  outstanding).
• 3 kinds
• Open market repurchase (normal course issuer
  bid).
• Buy shares at market price (less than 5).
• Fixed-Price offer (substantial issuer bid).
• Buy target at premium to market price.
• Dutch Auction.
• Target . Shareholders invited to make offers to
  sell to firm inside of prescribed range (min and
  max).

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A Real Life Example

• March 12/2003
• Brewer Molson Inc. is buying back nearly 3.8
  million of its Class A and B shares on the
  Toronto Stock Exchange.
• The buyback affects about three per cent of the
  company's outstanding shares in both classes.
• Molson said it wants to buy back and cancel its
  stock "to counter the dilutive effect of the
  granting of options" to its employees.

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U.S. Repurchases in 1980s
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Repurchase Irrelevance

• Miller Modigliani argue that Dividend Policy is
  irrelevant. The same is true for repurchases
• Shareholder wealth unaffected by repurchase.
• Investors can create Home Made repurchases by
  selling off a small part of the stock that has
  appreciated in value, or
• Undo repurchases by reinvesting proceeds by
  buying more shares.
• Once again, perfect market assumptions are
  necessary.

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More on Share Repurchases

• Advantages
• Can be a 1 time only action.
• Firm can reduce future total dividend payout.
• Immediate effect on firms capital structure.
• Signaling effect.

• Disadvantages
• Empirically, these firms did not have good growth
  opportunities.
• Worry about insider price manipulation.
• Tax effect govt normally treats share
  repurchase as a dividend.

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Example 3 Stock Repurchase Versus Dividend Issue

• Dungeoness Corp is evaluating an extra dividend
  versus a share repurchase. In either case 2500
  would be spent.
• Shares would be repurchased at current market
  prices. Current earnings are 80 per share and
  the stock currently sells for 30 per share.
• There are 150 shares o/s. Ignore taxes and other
  market imperfections.
• a) Evaluate the 2 alternatives in terms of the
  effect on the price per share of the stock and
  shareholder wealth.
• b) What will be the effect on Dungeoness eps and
  p/e ratio under the 2 different scenarios
• c) In the real world, which of these actions
  would you recommend? Why?

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Example 3 Share Repurchase Option

• 2,500/3083.33 shares repurchased number of
  outstanding shares after repurchase150
  83.3366.66 total earnings 0.8x150120
• EPSbefore0.80 EPSafter 120/66.661.80
• Vbefore30x1504,500 Vafter4,500-2,5002,000
• Pbefore30 Pafter2,000/66.6630
• (P/E)before30/.837.5 (P/E)after30/1.8016.66
• EPS rises, P/E drops, P does not change.

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Example 3 Dividend Option

• Vbefore4,500 Vafter2,000
• EPSbeforeEPSafter.80
• Pbefore30 DPS2,500/15016.66 Pafter30-16.66
  or 2000/150 13.33
• (P/E)before 30/.837.5 (P/E)after
  13.3/.816.6
• EPS does not change P/E drops P drops.

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Example 4 Premium Price Stock Repurchase
(targeted share repurchase or greenmail)

• Baron Realty has 100,000 shares of common stock
  o/s with a market price of 50 per share.
• The firm normally distributes 60 of its earnings
  as cash dividends.
• However this year, the firm wishes to use
  540,000, i.e., 60 of 900,000 (firms earnings)
  to repurchase 10,000 shares at 54 per share from
  a dissident shareholder.
• Are existing shareholders better or worse off
  after the repurchase?

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Example 4 Solution

• The dissident shareholder is being bought out at
  a high price of 54 per share rather than the
  existing market price of 50 per shares.
• The dissident shareholder gains and the other
  shareholders lose.
• The wealth transfer from the other shareholders
  to the dissident is 10,000x4 40,000.

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Stock Dividends and Splits

• Essentially the same thing distributing shares
  instead of cash.
• 10 stock dividend 1110 split.
• 21 split 100 stock dividend.
• There is an accounting difference.
• Stock Dividend Retained Earnings drops Capital
  Stock rises by same amount.
• Stock Split no change in either account.

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Stock Dividends and Splits
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Stock Dividends

• Instead of paying a cash dividend paying out a
  stock dividend.
• Reasons
• Maintaining payout record when cash is low.
• Some clienteles differentiate income principal.

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Example 5 Stock Dividends

• The market value balance sheet for Ace
  Manufacturing is shown below. Ace has declared a
  15 stock dividend.
• The stock goes ex dividend tomorrow (the
  chronology for a stock dividend is similar to
  that for a cash dividend).
• There are 10,000 shares o/s. What will be the ex
  dividend price?

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Example 5 Solution

• The number of shares outstanding rises from 10K
  to 10K(1.05) 11.5K
• Cum dividend P 350K/10K 35
• Ex dividend P 35/1.15 30.43

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Reverse Splits

• When share price gets extremely low firms
  sometimes propose a Reverse Split or
  Consolidation.
• Simply because the share price is now in a more
  respectable range, doesnt mean it is a better
  investment.

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Example 6

• National Profit Company had the following
  shareholders equity section before declaring a
  5 stock dividend
• Shareholders equity Authorized 500,000 shares
  without par value
• Issued 200,000 common shares 2 million
• Retained earnings 0.6 million
• 2.6 million
• A) Show the change in shareholders equity
  section after the 5 stock dividend given that
  the firms shares are currently trading at 15
  per share. In accordance with accounting rules,
  the firm records the book value of new stock at
  15 per share
• B) If an investor holds 100 shares of National
  Profit Company, what should the total value of
  those holdings be before and after the stock
  dividend.
• C) If the company continues to pay its earlier 2
  dividend after the stock dividend, what is the
  incremental cash dividend received by an investor
  under B)?

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Example 6 Solution

• A) 5x200K 10K is the increase in the number of
  outstanding shares. The decrease in the Retained
  Earnings account is 10Kx15 or 150K. Thus, the
  amount in Retained Earnings from 600K to 450K
  while the Common Stock account rises from 2,000K
  to 2,150K
• B) Market value of 100 shares. Before 100x15
  1,500 After 100(1.05) x (15/1.05) 1,500
• C) The investor will own 5 new shares. Thus, the
  investor will receive 10 additional dividends.

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Summary and Recap

• Cash versus share dividends.
• Dividend dates.
• MM again!
• When are dividends relevant?
• Dividend policy in practice.
• Stock repurchases, splits (reverse splits) and
  dividends.