Finance prelim #3 - Distribution Policy

If the firm is overvalued, are they more likely to issue debt or common stock?

Common Stock. (they are getting a higher price than what its really worth).

Other Distributions

Companies will sometimes send shareholders a sample of their product. -You are not required to receive this dividend.

If the firm is undervalued, are they more likely to issue debt or common stock?

Debt. At least if future prospects and cash flows are likely to enable the firm to service the debt.

Small Stock Dividend

Stock dividends that are less than 20-25%. -Taxed unfavorably for individual investors. -Retained earnings is debited by the fair value of the dividend.

Large Stock Dividend

Stock dividends that are more than 20-25% -Desire for current income and related factors makes this more favorable. -Retained earnings is debited by the market value of the dividend. -Accounted and almost always called stock splits.

Dividend Payout

The Dividend / Earnings Per Share (EPS)

Dividend Yield

The Dividend / Market Price

Dividend Declaration Date

The date on which the board of directors passes a resolution to pay a dividend -When a dividend is announced (sometimes call the announcement date). -It is an act of the board of directors of a corporation. -Once declared, a dividend become an obligation of the issuing corporation.

What is more important, a dividend increase or price per share increase?

dividend increase

Arguments that firm value is unaffected by dividend policy

(M&M theory with not taxes or transaction costs supports it) 1) Miller and Scholes argued that tax consequences of dividends may not be burdensome, because of tax avoidance possibilites. This may explain the existence of generous dividend policies. 2) Miller, Black and Scholes said that enough firms may have switched to low payout policies to satisfy fully the high tax clientele's demand. If so, there is no incentive for additional firms to switch to low payout policies.

Liquidating Dividend

-A distribution of assets in the form of a dividend, from a corporation that is going out of business (or at least some of it is going out of business). -Can come when a firm goes bankrupt or when management decides to sell off a company's assets and pass the proceeds on to shareholders. -Tax may be different than normal dividends.

Extra Dividend

-If a company does not want to give the assurance that it will be able to maintain the payment in the future. -Investors understand that the extra dividend may not be repeated

Special Dividend

-Payments that are unlikely to be repeated -Truly unusual

Reverse Split (or split down)

-When a corporation reduces the number of shares outstanding. -The total number of shares has the same market value, but each share will be worth more.

Why might a firm pay back a stock dividend?

1) To give something to shareholders when no cash is available for a quarterly cash dividend? ...But, it's as "nothing" transaction. 2) "Signal" of future earnings...because stock dividend is accounted for as a transfer from retained earnings to common stock and capital in excess of par accounts. Some debt covenants restrict dividends when retained earnings fall below a minimum so only optimistic firms would risk reducing retained earnings.

U.S. companies payout in 2006

2/3 share repurchase and 1/3 dividends

If a firm has favorable prospects and has cash available (excess cash) after all positive NPV investments, what is likely?

A cash dividend or share repurchase

Ex-Dividend Date

-The date when a stock goes ex-dividend. -2 days before the date of record, establishing those individuals entitled to a dividend (For the NYSE, and most other exchanges). -About 3 weeks before the dividend is paid to shareholders of record. -An investor much purchase the stock before the ex-dividend date, and hold it until at least the ex-dividend, in order to be entitled to the dividend. -Since a stock purchased on the ex-dividend date will be less valuable than a stock purchased before (because they are not entitled to the dividend), the stock price is expected to fall as the stock goes ex-dividend.

How Corporate Leaders View Payouts

1) 87% of 110 Dividend paying companies say they use dividends to signal future earning power. 2) The increase in stock buybacks has NOT come at the expense of dividend increases (Of all the Corporations with buyback programs in place over the past 2 years, 72% also increased the dividend - only 12% chose buyback over increasing dividends. Also, 25% reduced cash flow in ways other than decreasing divided payments, to fund repurchase programs. 3) 93% said that a stock buyback program is more effective than raising dividends to provide downside stock price protection in a falling market. 4) When the going get touch and earnings are under pressure, stock buyback would receive the lowest priority use of corporate cash flow - dividend payments and capital expenditures are managements top priorities (Among companies that pay a dividend, the priority of dividends rank first.... Among stock buyback, capital expenditure programs and dividend payments, only 14% said payouts would get the lowest priority).

Observations Regarding Dividend Policy

1) Corporations like to pay dividends because it is a sign of growing up and may increase the market for a firm's stock. 2) Companies tend to give a pay out at a constant percentage of net income. However, if net income fluctuates, then dividends will fluctuate, so managers try to smooth the dividend payments by moving only partway toward the target payout in each year. (Managers don't only look at past earnings performance - they look into the future to set a payment, and investors know that a dividend increase is often a sign of optimism from the firm's management). 3) Companies are reluctant to change dividends quickly - they are not usually adjusted upward until it is clear that the higher the dividend can be maintained. Cuts in dividends are delayed as long as is "reasonable".

Why might a firm split?

1) To give something to shareholders when no cash is available? ...But, it's as "nothing" transaction. 2) To increase the number of shares outstanding with the goal of increasing liquidity? 3) To lower the share price to a normal range and increase the demand for shares.

Why might a firm do a reverse split?

1) To raise the share price to a normal range. 2) To raise the share price since a low share price can have a bad connotation. 3) To raise the share price since a low share price may result in delisting. 4) reduced trading transaction costs. 5) It is a way to force out small shareholders (it is more expensive for firms to have a lot of small investors - they have to you reports that cost them money).

Arguments for high payout ratios

1)The payment of dividends may increase the market for a firm's shares. 2) Desire for current income. (Because of the transaction costs associated with stock sales, low tax braket investors may prefer dividends if they need a regular source of cash). 3) Dividends may signal management's optimism about future earnings. 4) Tax and other benefits. (Corporate investors- a corporate stockholder receiving either common or preferred dividednds is granted a 70% dividend exclusion—does not apply to capital gains) (Some financial institutions are legally restricted from holding stocks that are lacking established dividend records. Trust and endowment funds (tax exempt) may prefer high dividend stocks because dividends are regarded as 'spendable income', while capital gains are 'additions to principle', which cannot be spent).

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. -Paid quarterly, but some companies will pay them monthly, semiannually or annually. -Regular: Indicates the company expects to be able to maintain the payment in the future.

Distribution

A payment made by a firm to its owners from sources other than current or accumulated retained earnings. -It is distribution from capital, and can be referred to as a liquidating dividend

Stock Dividend

A payment made by a firm to its owners in the form of stock, diluting the value of each share outstanding (percentage) -a payment of a corporate dividend in the form of stock rather than cash. -The stock dividend may be additional shares in the company or shares in a subsidiary being spun of to shareholders. -Expressed as a percentage of the shares held by a shareholder (EX: a 5% stock dividend for a shareholder with 100 shares would receive 5 shares). -Corporation point of view - they conserve cash needed to operate the business. -Stockholder point of view - the additional stock is not taxed until sold (unlike a cash dividend, which declarable income in the year it is received. -A stock dividend affects neither the assets nor the liabilities of the firm NO REAL BENEFIT to the stockholder - it essentially means that the corporate pie is cut up into more pieces (shares), and each piece is worth less.

Dividend and Dividend Policy

A payment made out of a firm's earnings to its owners, in the form of either cash or stock. -Can be called a distribution from earnings. Dividend Policy - merely establishes the trade off between dividends at one date and dividends at another date. ( Dividend Policy question - whether the time pattern of dividends (more now versus more later) matters).

Do share repurchases increase or decrease capital?

Decreases. Therefore, bondholders do not like large payouts (dividends or share repurchases) because the bonds or more risky(less cash to pay for interest payments).

Trading Range

The price range between the highest and lowest prices at which a stock is traded.

Dividend Reinvestment Plan (DRPs or DRIPs)

A plan offered by a corporation that allows investors to reinvest their cash dividends by purchasing additional shares or fractional shares on the dividend payment date. A DRIP is an excellent way to increase the value of your investment. Most DRIPs allow you to buy shares commission free and at a significant discount to the current share price. -The automatic reinvestment of shareholder dividends in more shares of the company's stock (some companies will pay the brokerage fees (which are then taxable income to the investor) and some will discount the stock price (the discount is taxable income). The shares may be newly issued (if new shares are issued, the firm is effectively keeping equity capital while maintaining a dividend. The dividend may keep them on trust "legal lists". With a discounted price, the firm is giving shareholders strong incentive to give the dividend back as equity capital.) or purchased on the open market. -For a corporation, it is a means of raising capital funds without the flotation cost of a new issue. *-The cash dividend is taxable even if it is reinvested via a dividend reinvestment plan.** -If all investors reinvest their dividends, the corporations cash payout is transformed into a taxable stock dividend. No one benefits except the IRS. -If a firm issues new shares at a discount and only some shareholders reinvest, the shareholders who reinvested benefit at the expense of the shareholders who did not reinvest (because of the dilution in the stock price - for this not to be the case, you have to argue that the reinvested cash enhances the value of the firm beyond the raw dollar amount). If the company also pays brokerage costs, the shareholders who did not reinvest are effectively subsidizing the shareholder who do reinvest.

Residual Dividend Approach or Theory

A policy whereby a firm invests in all positive NPV projects and then pays a cash dividend with any remaining cash.

If the firm is undervalued and has cash available for distribution, what is likely?

A share repurchase.

Dividend-received deduction

A tax deduction received by a corporation on the dividends paid to it by companies in which it has an ownership stake. -Corporate Investors get a dividend-received deduction (at the federal level) if the holding period requirement is satisfied.

Stock Split (or split up)

An increase in a corporation's number of outstanding shares of stock without any change in the shareholders' equity (or the aggregate market value at the time of the stock split). -The number of authorized shares increases, while the price per share and dividend per share will decrease proportionally. -When stock splits require an increase in authorized shares and/or a change in par value of the stock, shareholders must approve an amendment of the corporate charter. -Essentially means that the corporate pie is cut into more pieces (shares), and each peace is worth less - NO REAL BENEFIT to the stockholder. -Done when optimistic or at least neutral about future returns.

Direct Stock Purchase Plans (DSP's)

An investment service that allows individuals to purchase a stock directly from a company or through a transfer agent. The greatest benefit of using a DSPP for investors is the ability to avoid commissions by not going through brokers. DSPPs often have minimum deposit requirements that range from $100 to $500. They are perfect for investors who have a long-term trading strategy and are looking for an inexpensive way to begin investing. -You buy shares directly from the company itself -The company ether 1) buys shares on the open market to sell to you, or 2) issues new shares. -These plans DO NOT involve dividends to finance the purchase of shares. -ONLY DO IF FEE IS LESS THAN BROKER FEE

What are income investments?

Bonds and dividend paying stocks.

Price Weighted Average

Dow Jones Industrial Average Higher stock prices have a greater impact on overall indice when stocks increase by the same percentage (It does not matter how big the company is (market cap), it depends on how big the stock price is).

Explain Capital gains taxes

Gains - losses = what can be taxed. -You can carry loses to future periods for tax purposes (can use $3,000 in capital losses each year --- lets say you have 6,000 in losses one year, then you can deduct 3,000 from your gains in that year, and the next year you can deduct the other 3,000 for that givens years gains.

What happens to the common stock price if the firm pays a common stock dividend?

Goes down by amount reflected in the increase in shares.

1987 Tax Law

If a company owns less than 20% of another company, it is able to deduct 70% of the dividends it receives. If the company owns more than 20% but less than 80% of the company paying the dividend, it is able to deduct 80% of the dividend received. If it owns more than 80% of the dividend-paying company, it is allowed to deduct 100% of the dividends it receives. < 20% ownership of the voting stock = 70% of the dividends received are not taxable. 20 to 80% ownership of the voting stock = 80% of the dividends received are not taxable. > 80% ownership of the voting stock = 100% of the dividends received are not taxable.

Holding Period

If before July 18, 1984 - 16 day holding period If after July 18 1984 - 46 day holding period (Code Sec. 246(c)) If after March 1, 1986 - 46 day holding period (Tax Reform Act of 1986...before the tax reform act, dividends did not receive deduction only if the holding period required was not met and the stock was disposed of by the corporation).

Arguments for low payout ratios

If the tax rate on dividends is higher than on capital gains, the investor might prefer a share share repurchase. However some might prefer dividends or be indifferent. 1) Note that intercorporate dividend received deductions may imply that dividends received by a corporate investor maybe taxed at a lower rate than capital gains. 2) Many investors are non taxable: pension funds, endowments, and bank trusts for example. 3) the 2003 Tax Act implies that many taxable individuals pay taxes at the same rate on both dividends and capital gains. Even if dividends and capital gains are taxed at the same rate, dividends are taxed in the year that they are received, while capital gains are taxed in the year that they are realized -- capital gains potentially has a deferral advantage over dividend policies.

What happens to a common stock price if there is a reverse split?

It increases.

Value Weighted Average

NASDAO and S&P Indice is affected more by companies with large market cap stock than small ones.

When there are no taxes, transaction cost, etc... does dividend policy matter?

NO. A dividend policy cannot enhance the firm value since if the firm makes the wrong choice from the investors point of view, the investor can manufacture (homemade policy) a policy consistent with their preferences. DOES NOT APPLY THAT THAT DIVIDENDS ARE NOT IMPORTANT, JUST THAT THE TIMING OF THOSE DIVIDEND PAYMENTS IS IRRELEVANT IN A WORLD WITHOUT TAXES, TRANSACTION COSTS, ETC.

Does a share repurchase represent an investment by the firm in itself?

No - An investment is when the left side of the balance sheet increases. A share repurchase decrease assets and SE (shrinkage).

What happens to a common stock price if there is a split?

The price goes down. If you expect a stock to go down, probably will not do a stock split!!

P(s,x) and P(s,c)

P(s,c) - The stock price at the market close on the last cum dividend day (business day before ex dividend date) P(s,x) - The stock price at the market open on the ex dividend day Note that: Auner Kalay found that the actual average stock price decline on the ex dividend date was about 73.4% of the value of the dividend.

If a manager holds executive stock options (warrants), which payout form is most advantageous to him/her personally... a cash dividend or share repurchase?

Share Repurchase because the stock price does not decrease.

Record Date (or Date of Record)

The date by which a holder must be on record to be designated to receive a dividend -The date when a shareholder must officially own shares in order to be entitled to a dividend (To officially own shares by the record date, those shares must have been purchased before the ex-dividend date and held until the ex-dividend date). - 2 days after the ex-dividend date.

Dividend Payment Day (or Date of Payment)

The date on which the dividend checks are mailed -Day that the dividend is actually paid

What may not be taxed and under what circumstances?

The following are not taxed if 90% or more of profits are paid in dividends each year: Master Limited Partnership (MLP) Business Development Corporation (BDC) Real Estate Investment Trust (REIT)

Information content effect

The markets reaction to a change in corporate dividend payout

The clientele effect

The observable fact that stocks attract particular groups based on dividend yield and the resulting tax effects. -The different groups are called "clienteles". - A firm who changes their dividend policy, is just attracting a different clientele. - If 40% of investors want a high dividend payout, then the market will adjust until 40% of companies are giving the high dividend payout - dividend market is in equilibrium (further changes are pointless, because all clienteles are satisfied - changing dividend payout ratio will not increase share price if clienteles exist).

Stock repurchase

The purchase by a corporation of its own shares of stock, also known as a buyback. -Significant tax advantage over a cash dividend (which is taxed, no choice but to receive) -Number of companies that pay dividends has declined- populaion of firms has changed; make payouts using share repurchases which are flexible

Homemade dividend policy

The tailored dividend policy created by individual investors who undo corporate dividend policy by reinvesting dividends or selling shares of stock.