Chapter 17
Assume a firm paid a 50% stock dividend (a 3:2 stock split) A shareholder who owned 100 shares before the dividend had a portfolio worth $4,200: After the split, the shareholder owns ____ shares: The stock price will fall to ____
$42 per share × 100 shares = $4,200 100 shares × $1.50 = 100 shares × = 150 shares $4,200 ÷ 150 shares = $28
How are dividends expressed? (3 ways)
1. dollars per share (dividends per share) 2. percentage of the market price (the dividend yield) 3. percentage of net income or earnings per share (the dividend payout)
What is the current trend with dividends? Trend for aggregate payout Number of companies paying dividends Which firms are paying dividends How does tax play in?
Aggregate payouts are substantial and rising Number of companies that pay dividends has declined; payers are large mature firms Newly listed firms are less likely to pay dividends Tax policies matter, but are not a major deterrent
What is the journal entry made for regular dividends? Does it impact the income statement?
Cash is credited and Retained Earnings is debited, resulting in a reduction in Assets and in Equity There is no impact on the Income Statement; dividends are paid after Net Income is determined
How are CFOs treating dividends? (2)
Corporations actively "smooth" dividends; in a recent survey of corporate CFOs: 90% stated that they attempt to maintain a smooth dividend from year to year 94% try to avoid reducing dividends
5 Dividend policy considerations Flexibility Executive compensation Offsetting dilution Undervaluation Income taxes
Flexibility: Dividends express commitment; repurchases are one-off events Executive compensation: Because dividends decrease stock price and repurchases do not, holders of options would prefer repurchases Offsetting dilution: When options are exercised, the number of shares outstanding increases and stock value is diluted. Repurchases can offset this dilution (but this is a poor reason to repurchase) Undervaluation: Firms might buy back stock if they believe it is under-valued by the market; the market reaction is usually favorable Income taxes: The existence of income taxes favors repurchases over dividends
Assume an investor owns 80 shares of a stock currently priced at $42 per share The company is about to pay a $2 dividend The investor needs cash, so would prefer to receive a $3 dividend How can he achieve this on his own?
He wants a $3 dividend, which is equivalent to 3 * 80 = $240 But instead, he will be receiving $2 * 80 = $160 So, to make up for the $240 - $160 = $80 he is missing, he can sell two shares of stock ex-dividend.
Signaling with repurchases
If investors think management has better information about the firm's future, investors will react favorably to share repurchase announcements In a 2004 survey, 87% of CFOs agreed that companies should repurchase their shares when they think the shares are undervalued
Stock split
If the percentage ≥ 50% in a stock dividend, it is called a stock split In a 2:1 stock split, each shareholder receives a 100% stock dividend—1 new share for each 1 owned
Factors favoring high dividends (4)
Investors (retirees) may desire current income According to behavioral finance: --Investors lack the discipline to optimize their positions --Earning dividends helps investors maintain control: to live off dividends and never "dip into principal" Dividends, which reduce free cash flow, may reduce agency costs by reducing management's ability to spend cash frivolously Tax-exempt and tax-advantaged investors (pension funds, corporations) may prefer to earn current income
The clientele effect What is it? 4 types of clientele and payout preference Under what situation can a firm increase its share price by increasing dividend payout?
Investors of different types will seek out stock with different payout policies: A firm can increase its share price by increasing its dividend policy ONLY if unsatisfied clientele exist
Which repurchase option is most common?
Open market
Types of share repurchses Open market Tender Dutch Targeted
Open market purchases --The most common repurchase method --The firm announces its plan, then buys shares at market prices just like any other investor --The firm can take its time, and need not buy all the shares it said it would --The firm cannot manipulate the price (eg. by buying all the shares on one day) Tender offer --The firm offers to buy shares at a pre-determined price during a short (2-3 week) time period --The price is usually a 10-20% premium over market --If too few owners tender their shares, the offer is canceled Dutch auction --Shareholders state how many shares they will sell at a number of potential prices --The firm pays the lowest price at which it can buy the desired number of shares Targeted repurchase --The firm negotiates the price and purchases shares directly from a major shareholder --May occur if the shareholder wants to sell, but doing so will negatively impact the market price...may sell at a discount --May also occur if the shareholder wants to oust management...may sell only at a premium, called greenmail
When companies generate cash from operations, they can: (4)
Pay off debt Increase cash reserves Fund new investments Give it to the stockholders --By paying a dividend to each shareholder, or --By repurchasing outstanding stock
Different kinds of dividends (4)
Regular cash dividends: Commonly, public companies pay regular cash dividends four times per year. As the name suggests, these are cash payments made directly to shareholders, and they are made in the regular course of business Extra dividends: Sometimes firms will pay a regular cash dividend and an extra cash dividend. By calling part of the payment "extra," management is indicating that the "extra" part may or may not be repeated in the future. Special dividends: A special dividend is similar, but the name usually indicates that this dividend is viewed as a truly unusual or one-time event and won't be repeated. Liquidating dividends: Finally, the payment of a liquidating dividend usually means that some or all of the business has been liquidated—that is, sold off.
A case can be made that dividend policy is irrelevant, why?
Since investors do not need dividends to convert shares to cash, they will not pay higher prices for firms that pay large dividends In other words, dividend policy will have no impact on the value of the firm because investors can create whatever income stream they prefer by using homemade dividends
Consequences of stock dividends and stock splits: How do they affect the firm's equity value? How do they affect the price per share? What is the consequences for the firm or investors?
Stock dividends & splits do not add or destroy value; the total market value of the firm's equity remains unchanged The number of shares outstanding rises, and the price per share falls --The same total equity value is now divided over a larger number of shares Stock dividends are not taxed, so there is no real consequence for the firm or its investors
Dividends vs dividend policy Do dividends matter? Does dividend policy matter?
Sure! Investors would prefer more cash rather than less cash The firm can pay higher dividends by increasing the value of the firm In perfect capital markets, no The value of the firm is not impacted by its dividend payout policy
Journal entry for stock split
The accounting treatment of a stock split is a little different from (and simpler than) that of a stock dividend. Suppose Peterson decides to declare a two-for-one stock split. The number of shares outstanding will double to 20,000, and the par value will be halved to $.50 per share. All three accounts are completely unaffected by the split. The only changes are in the par value per share and the number of shares outstanding. Because the number of shares has doubled, the par value of each is cut in half.
So what is the conclusion on low vs high dividend payouts?
The existence of personal income taxes favors a low dividend payout policy The other factors favor a high payout policy The clientele effect implies that these two influences cancel each other out
M&M and dividend policy indifference In perfect capital markets, holding fixed the investment policy of a firm, what is true?
The firm's choice of dividend policy is irrelevant and does not affect the current value of the firm Investors are indifferent between the firm distributing cash to owners via dividends now vs dividends later By reinvesting dividends or selling shares, investors can replicate either payout method on their own (homemade dividends)
M&M and dividend policy irrelevance (now looking at initial share price and dividends vs repurchases) In perfect capital markets, holding fixed the investment policy of a firm:
The firm's choice of dividend policy is irrelevant and does not affect the initial share price Investors are indifferent between the firm distributing funds via dividends or repurchases By reinvesting dividends or selling shares, investors can replicate either payout method on their own (homemade dividends)
Assume you purchased 100 shares of stock for $60 per share Would you prefer that the firm pay you a $1 per share dividend (for a total of $100) or repurchase one of your shares for $100?
The tax on the dividend income is $15 The tax on the realized capital gain is $6 Tax policy favors repurchases over dividends
Factors favoring low dividends (3)
The tax rate on dividends is greater than the EFFECTIVE rate on capital gains Issuing stock to pay dividends means eventually having to pay additional flotation costs Bond indenture agreements may prohibit paying dividends above some level
Reverse splits What does it do? Why might it be used?
Whereas a stock split increases the number of shares outstanding and reduces the price per share, a reverse split decreases the number of shares outstanding and increases the price per share. In a 1-for-4 reverse split, each investor exchanges 4 old shares for one new share. The par value is increased by a factor of 4 in the process. A firm may use a reverse split to avoid being delisted from the NYSE or NASDAQ, both of which require a $1 per share minimum price
In our imperfect world, which includes taxes, the price drop is....
less than the dividend and occurs within the first few minutes of the ex-dividend date
The rates above are for qualifying dividends. Non-qualifying dividends are taxed at the same rates as
ordinary income.
Journal entries for stock dividend
par value * number of new shares issued is added to common stock account market price in excess of par value * number of new issues is added to capital surplus the increase in common stock + increase in capital surplus is subtracted from the RE
Regular dividends, if they are paid at all, are typically paid
quarterly
Tax policy favors dividends or repurchases?
repurchases
Liquidating (return of capital) dividends may arise if.... What journal entry is made? Is there an impact on the income statement? How is the dividend treated for the recipient?
the firm liquidates all or part of itself Cash is credited and Paid-in Capital is debited (NOT RE!), resulting in a reduction in Assets and in Equity There is no impact on the Income Statement; liquidating dividends are unrelated to Net Income Treated as capital gains rather than ordinary income for recipients
If a payment is made from sources other than current or accumulated retained earnings, the term ______ is used. It is acceptable to refer to a distribution from earnings as a dividend and a ___________ as a liquidating dividend.
distribution distribution from capital
In a perfect world, the stock price will fall on the ex-dividend date by....
exactly the amount of the dividend
What is a key assumption of the dividend policy is irrelevant argument?
A key assumption underlying the dividend-irrelevance argument is that the investment policy of the firm is set ahead of time and is not altered by changes in dividend policy In other words, firms should never forgo positive NPV projects to increase a dividend (or to pay a dividend for the first time)
Stock dividends
A stock dividend provides each shareholder with one new share for each X shares already owned --In a 20% stock dividend, each shareholder receives 1 new share for each 5 shares owned --In a 50% stock dividend, each shareholder receives 1 new share for each 2 shares owned
A firm's board is meeting to decide how to pay out $20 million in excess cash to shareholders The firm has no debt; its equity cost of capital equals its unlevered cost of capital of 12% There are 10 million shares outstanding; the current market price is $42 per share Assume perfect capital markets exist (no taxes) What are their options? How do they each affect share price?
Alternative 1: Pay dividends With 10 million shares outstanding, the dividend will be $2.00 per share $20 million ÷ 10 million shares = $2 per share In perfect capital markets, the price will drop by the amount of the dividend on the ex-dividend date, to $40 per share After the dividend, the owners have $2 in cash, and $40 in stock, for a total value of $42 Alternative 2: Share repurchase Suppose that instead of paying a dividend, the firm uses the $20 million to repurchase its shares on the open market With an initial share price of $42, the firm will repurchase 476,000 shares $20 million ÷ $42 per share = 0.476 million shares This will leave 9.524 million shares outstanding 10 million − 0.476 million = 9.524 million shares Prior to the repurchase, the market cap was $420 million: $42 per share × 10 million shares = $420 million The repurchase will reduce market cap to $400: $420 million − $20 million = $400 million After the repurchase, the price is still $42: $400 million ÷ 9.524 million shares = $42 per share
How does the ex-dividend date work?
An investor who purchases the stock before the ex-dividend date will receive the current dividend. An investor who purchases the stock on or after the ex-dividend date will not receive the current dividend.
Dividend Chronology
Declaration date: The date on which the Board authorizes the dividend Legally obligates the Board to pay the dividend Ex-Dividend: The date two BUSINESS days prior to record date Purchasers on or after this date will not receive dividend Date of Record: The date on which dividend recipients are logged Stockholders of record are BELIEVED to be stockholders (If you buy the stock just before this date, the corporation's records may not reflect that fact because of mailing or other delays. Without some modification, some of the dividend checks will get mailed to the wrong people. This is the reason for the ex-dividend date convention). Payment (or Distribution) Date: The date on which the dividends are actually paid Also called the distribution date
Signaling with dividends hypothesis increasing dividends signal Deceasing dividends signal
Dividend signaling hypothesis: If a firm smooths dividends, the firm's dividend choices will contain information regarding management's expectations of future earnings Increasing dividends sends a positive signal: --Increases occur only when sustainable --Stock prices rise after announcement of an increase Decreasing dividends sends a negative signal: --The firm need to conserve cash --Stock prices fall after announcements of reductions
Other ways to pay dividends besides cash (3)
Dividends can also be paid in shares of stock: Stock dividends Stock splits Spin-offs
Are dividends taxable for recipients? Tax-deductible The issuer?
YES! Regular dividends represent taxable income for most recipients NO! The issuer
Greenmail
a payment by a firm to a hostile party for the firm's stock at a premium