Chapter 17

Reasons the percentage of dividend-paying firms has declined:

(1) Population of firms has changed -Newly listed firms, need cash to fund growth so they do not pay dividends (2) Firms are more likely to make payouts using share repurchases - flexible and less committing than making cash distributions

Pros of Dividends

1. Cash dividends can underscore good results and provide support to the stock price 2. May attract institutional investors who prefer some return in the form of dividends. A mix of institutional and individual investors may allow a firm to raise capital at lower cost because of the ability to the firm to reach a wider market 3. Stock price usually increases with the announcement of a new or increased dividend 4. Dividends absorb excess cash flow and may reduce agency costs that arise from conflicts between management and shareholders

1. Why might some individual investors favor a high dividend payout? 2. Why might some non-individual investors prefer a high dividend payout?

1. Desire for current income. They may be willing to pay a premium to get a higher dividend yield. Also, brokerage fees could be avoided by an investment in high-dividend securities 2. Corporations receive a dividend exclusion when they own stock in another corporation. Also, some investors are tax exempt

An Illustration of the Irrelevance of Dividend Policy

Any increase in a dividend at some point in time is exactly offset by a decrease somewhere else; so the net effect, once we account for time value, is zero

An unexpected increase in the dividend signals good news

Management will raise the dividend only when future earnings, cash flow, and general prospects are expected to rise to such an extent that the dividend will not have to be cut later - Signals to the market that the firm is expected to do well. Thus, the stock price reacts favorably because expectations of future dividends are revised upward, not because the firm has increased its payout

Can a firm boost its share price by having a higher dividend payout ratio?

No. As long as enough high-dividend firms satisfy the dividend-loving investors, a firm won't be able to boost its share price by paying high dividends. An unsatisfied clientele must exist for this to happen.

In May 2003, a reduction in tax rates led to increases in dividends

Tax rates matter, however, they are not a primary determinant of dividend policy -The increase in dividend payers may also be due to maturing firms -Also initiate dividends to attempt to signal investors that they had the cash to make dividend payments now and in the future

2. Ex-Dividend Date

The date two business days before the date of record, establishing those individuals entitled to a dividend. It removes any ambiguity about who is entitled to the dividend Ex: If you buy stock before this date, you are entitled to the dividend (but not on the date, or anytime after). Before this date, the stock is said to trade "with dividend" or "cum dividend." Afterward, the stock trades "ex dividend"

Standard Method of Cash Dividend Payment

The decision to pay a dividend rests in the hands of the BOARD OF DIRECTORS - Once a dividend is declared, it becomes a debt of the firm and cannot be rescinded easily - Sometime after it has been declared, a dividend is distributed to all shareholders as of some specific date

The fact that aggregate dividends grew while the number of payers fell so sharply is because :

Dividend payments are heavily concentrated in a relatively small set of large firms -The decline in dividend payers is almost entirely due to smaller firms, which tend to pay smaller dividends in the first place

Targeted Repurchase

Firm repurchases shares from specific individual shareholders

3. Date of Record

The date by which a holder must be on record to be designated to receive a dividend Ex: Based on its records, the corporation prepares a list on January 30th (record date) of all the individuals believed to be stockholders (holders of record)

1. Declaration Date

The date on which the board of directors passes a resolution to pay a dividend Ex: On January 15th, the board of directors passes a resolution to pay a dividend of $1 per share on February 16th to all holders of record as of January 30th

4. Date of Payment

The date on which the dividend checks are mailed Ex: The dividend checks are mailed on February 16th

More about the Ex-Dividend

The stock is worth about $1 less on Friday morning, so its price will drop by the amount between close of business on Thursday and the Friday opening. In general, we expect that THE VALUE OF A SHARE OF STOCK WILL GO DOWN BY ABOUT THE DIVIDEND AMOUNT WHEN THE STOCK GOES EX-DIVIDEND -"About" because of taxes

Homemade Dividend Policy

The tailored dividend policy created by individual investors who undo corporate dividend policy by reinvesting dividends or selling shares of stock -Many corporations assist their stockholders in creating homemade dividend policies by offering automatic dividend reinvestment plans (ADRs or DRIPs)

In a repurchase, a shareholder pays taxes only if ...

(1) the shareholder actually chooses to sell (2) the shareholder has a capital gain on the sale

Firms should generally have high dividend payouts because:

1. 'The discounted value of near dividends is higher than the present worth of distant dividends" 2. Between "two companies with the same general earning power and same general position in an industry, the one paying the larger dividend will almost always sell at a higher price" 3. Desire for current income 4. Resolution of uncertainty

Legacy Effect

A long-lasting influence of historical processes on the current ecology of an area - Dividends are murky

Tax and other Benefits from High Dividends (1) Corporate Investors

A significant tax break on dividends occurs when a corporation owns stock in another corporation. They're granted a 70% dividend exclusion. Because the 70% does not apply to capital gains, this group is taxed unfavorably on capital gains. As a result, high-dividend, low-capital gains stocks may be more appropriate for corporations to hold

Dividend

A payment made out of a firm's earnings to its owners, in the form of either cash or stock Come in four forms 1. Regular cash dividends 2. Extra dividends 3. Special dividends 4. Liquidating dividends

Current Policy: Dividends = Cash flow

Alternative Policy: Initial dividend > Cash flow

Desire for Current Income

Widows and orphans are willing to pay a premium to get a higher dividend yield - The sale of low-dividend stocks would involve brokerage fees and other transaction costs. These direct cash expenses could be avoided by an investment in high-dividend securities

The life cycle theory claims that

firms trade off the agency costs of excess cash retention against the potential future costs of external equity financing

Corporations have an incentive to ...

... pursue high-payout stocks

The value of stock equals the ____________ _________ of future dividends

Present value

The amount of the cash dividend expressed is usually in terms of ...

... dollars per share (dividends per share) - But can be expressed as percentage of market price ( dividend yield) or as a percentage of net income or earnings per share (dividend payout)

The fact that dividend changes convey information about the firm to the market ...

... makes it difficult to interpret the effect of the dividend policy on the firm

Wealthy individuals have an incentive to ...

... pursue low-payout stocks

If there are no imperfections, a cash dividend and a share repurchase are essentially ...

... the same thing

1. Why might a stock repurchase make more sense than an extra cash dividend? 2. What is the effect of a stock repurchase on a firm's EPS? Its PE?

1. A repurchase has a significant tax advantage over cash dividends. A dividend is taxed, and the shareholder has no choice whether to receive the dividend. In a repurchase, a shareholder only pays taxes if the shareholder actually chooses to sell or the shareholder has a capital gain on the sale 2. It causes earnings per share to increase because it reduces the number of outstanding shares, but has no effect on total earnings. AS A RESULT, EPS RISES, BUT THE PE STAYS THE SAME

Putting it all Together

1. Aggregate dividend and stock repurchases are massive, and they have increased steadily in nominal and real terms over the years 2. Dividends are heavily concentrated among a relatively small number of large, mature firms 3. Managers are very reluctant to cut dividends, normally doing so only due to firm-specific problems 4. Managers smooth dividends, raising them slowly and incrementally as earnings grow 5. Stock prices react to unanticipated changes in dividends

1. How can an investor create a homemade dividend? 2. Are dividends irrelevant?

1. An investor can create a homemade dividend by reinvesting dividends (reinvests excess $10 in year 2 to increase $89 to $100) or selling shares of stock (sells $10 worth of stock to boost cash to $110 x .10 = 11 -> 100-11 = desired $89) 2. No. However, dividend policy does not matter because managers choosing either to raise or lower the current dividend do not affect the current value of the firm

Con of Dividends

1. Dividends are taxed to recipients 2. Dividends can reduce internal sources of financing. Dividends may force the firm to forgo positive NPV projects or to rely on costly external equity financing 3. Once established, dividend cuts are hard to make without adversely affecting a firm's stock price

1. What are the tax benefits of low dividends? 2. Why do flotation costs favor a low payout?

1. Individuals in upper income tax brackets might prefer lower dividend payouts, given the immediate tax liability, in favor of higher capital gains with the deferred tax liability 2. Low payouts can decrease the amount of capital that needs to be raised thereby lowering flotation costs

Share repurchases are typically accomplished in one of three ways:

1. Purchase their own stock 2. Firm could institute a tender offer 3. Repurchase shares from specific individual stockholders (targeted repurchase)

Real-World Factors Favoring a Low Dividend Payout

1. Taxes - Higher on dividends 2. Flotation Costs 3. Dividend Restrictions

1. What are the different types of cash dividends? 2. What are the mechanics of the cash dividend payment? 3. How should the price of a stock change when it goes ex-dividend?

1. The different types of cash dividends are (1) regular cash dividends, (2) extra dividends, (3) special dividends, (4) Liquidating dividends 2. Declaration date, ex-dividend date, date of record, and date of payment 3. The value of the stock drops by about the price of the dividend

1. How does the market react to unexpected dividend changes? What does this tell us about dividends? About dividend policy? 2. What is a dividend clientele? All things considered, would you expect a risky firm with significant but highly uncertain prospects to have a low or high dividend payout?

1. The market reacts to unexpected dividend changes. You find with some consistency that stock prices rise when the current dividend is unexpected increased, and they generally fall when the dividend is unexpected decreased. This illustrates the fact that dividends are important. But, many authors have pointed out that this observation does not really tell us much about dividend policy 2. Dividend clientele is a group of shareholders with a preference regarding how much a company will pay out in dividends, often for tax reasons. Dividend clientele usually make decisions regarding distributions based on which is most advantageous to them. Normally the desired factors for high dividend payout are: (1) Desire for current income (2) Resolution of uncertainty (3) Brokerage and other transaction cost (4) Fear of consumption out of principal. Therefore, a risky firm with significantly but highly uncertain growth prospects would have a low dividend payout

Regular Cash Dividend

A cash payment made by a firm to its owners in the normal course of business, usually paid four times a year

Dividend Restrictions on Low Dividend Payout

A covenant might prohibit dividend payments above some level - A corporation may be prohibited by state law from paying dividends if the dividend amount exceeds the firm's retained earnings

Dividend policy is irrelevant

Dividend policy by itself cannot raise the dividend at one date while keeping it the same at all other dates. Rather, dividend policy merely establishes the trade-off between present value of the dividends and dividends at another date -Dividend policy does not matter because managers choosing either to raise or lower the current dividend do not affect the current value of the firm

Extra Cash Dividend

Management is indicating that the "extra" part may not be repeated in the future

Taxes on Low Dividend Payout

For individual shareholders, effective tax rates on dividend income are higher than the tax rates on capital gains -Historically, dividends received have been taxed as ordinary income and capital gains were taxed at somewhat lower rates, and the tax on a capital gain is deferred until the stock is sold -Changed in 2003. Tax rates on dividends and capital gains were lowered from 35-39% to 15%/ later changed to 0%, 15% or 20% based on individual's marginal tax rate LOWERED TAX RATE ON DIVIDENDS

Flotation Costs on Low Dividend Payout

If we include flotation costs, we find that the value of stock decreases if we sell new stock FLOTATION COSTS ARE EXPENSIVE ON LARGE DIVIDENDS - Imagine two firms identical in every way except that one pays out a greater percentage of its cash flow in the form of dividends. Because the other firm plows back more cash, its equity grows faster. If these two firms are to remain identical, then the one with the higher payout will have to periodically sell some stock to catch up. Because this is expensive, a firm might be inclined to have a low payout

Overall, individual investors may have a desire for current income and may thus be willing to pay the dividend tax

In addition, some very large investors such as corporations and tax-free institutions may have a very strong preference for high dividend payouts

Purchase their own stock:

In these open market purchases, the firm does not reveal itself as the buyer. Thus, the seller does not know whether the share were sold back to the firm or just to another investor

A dividend cut is usually not a voluntary, planned change in divident policy

Instead, it signals that management does not think that the current dividend policy can be maintained. As a result, expectations of future dividends should generally be revised downward. The present value of expected future dividends falls, and so does the stock price

Dividends are relevant

Investors prefer higher dividends to lower dividends at any single date if the dividend level is held constant at every other date because the stock price will rise - The reason is that the present value of the future dividends must go up if this occurs

Why should firms ever choose a cash dividend?

It sends a two-part signal" (1) The firm anticipates to be profitable (2) Firm wont be hoarding cash

Share Repurchase and EPS

Share repurchases cause earnings per share to INCREASE -The reason is simply that a share repurchase reduces the number of outstanding shares, but it has no effect on total earnings - resulting with EPS rising

Tender Offer

The firm announces to all of its stockholders that it is willing to buy a fixed number of shares at a specific price

Information Content Effect

The market's reaction to a change in corporate dividend payout

Real-World Considerations in a Repurchase

The most important difference is tax treatment -Taxes are paid only on the PROFIT from a sale

Clientele Effect

The observable fact that stocks attract particular groups based on dividend yield and the resulting tax effects -When a firm chooses a particular dividend policy, the only effect is to attract a particular clientele. If a firm changes its dividend policy, then it just attracts a different clientele

Stock Repurchase

The purchase, by a corporation, of its own shares of stock; also known as a buyback -Becoming more popular

Dividend Policy

The time pattern of dividend payout -Should the firm pay out a large percentage of its earnings now or a small (or even zero) percentage?

Tax and other Benefits from High Dividends (2) Tax-Exempt Investors

Those in zero tax brackets Ex: Pension funds, endowment funds, and trust funds

As a firm matures, its begins to generate free cash flow which could lead to agency problems if not distributed (ex: spend in a way not favored by shareholders)

Thus, firms come under pressure to make distributions rather than horde cash - A firm should begin making distributions when it generates sufficient internal cash flow to fund its investment needs now and into the forseaable future

Why don't firms just commit to a policy instead of setting aside whatever money would be used to pay dividends and use it instead to buy back shares?

Two drawbacks (1) Verifiability - Firm could announce a repurchase and simply not do it (2) Forces management to make negative NPV investments

Special Dividend

Usually indicates that this dividend is viewed as a truly unusual or one-time event and won't be repeated

Liquidating Dividend

Usually means that some or all of the business has been liquidated/sold off

No matter what pattern of dividend payout a firm chooses, the ___________ of _________ will always be the same

Value of stock