Session

15
&

16

Dividends and Other Payouts

CF-II (Term III 2012)

Dr. Kulbir Singh (IMT-Nagpur)

1. Different Types of Dividends

Public companies often pay quarterly. Sometimes firms will pay an extra cash dividend. The extreme case would be a liquidating dividend.

Slide 2

Many companies pay a regular cash dividend.

Companies will often declare stock dividends.

No cash leaves the firm. The firm increases the number of shares outstanding.

Some companies declare a dividend in kind.

Wrigleys Gum sends a box of chewing gum. Dundee Crematoria offers shareholders discounted cremations.
Term III (2012)
Dr. Kulbir Singh (IMT-Nagpur)

Slide 3

2. Standard Method of Cash Dividend

Cash Dividend - Payment of cash by the firm to its shareholders. Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock immediately before this date is entitled to a dividend. Record Date Date on which company determines existing shareholders.
Term III (2012)
Dr. Kulbir Singh (IMT-Nagpur)

Procedure for Cash Dividend

25 Oct. 1 Nov. 2 Nov. 5 Nov.

Slide 4

7 Dec.

Declaration Date ExCumdividend dividend Date Date Record Date Payment Date

Declaration Date: The Board of Directors declares a payment of dividends. Cum-Dividend Date: Buyer of stock still receives the dividend. Ex-Dividend Date: Seller of the stock retains the dividend. Record Date: The corporation prepares a list of all individuals believed to be stockholders as of 5 November.
Term III (2012)
Dr. Kulbir Singh (IMT-Nagpur)

Price Behavior

Slide 5

In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date.
-t $P $P - div The price drops Exby the amount of dividend Date the cash Taxes complicate things a bit. Empirically, the dividend. price drop is less than the dividend and occurs within the first few minutes of the ex-date.
Term III (2012)
Dr. Kulbir Singh (IMT-Nagpur)

-2

-1

+1

+2

3. The Irrelevance of Dividend Policy

Slide 6

A compelling case can be made that dividend policy is irrelevant. Since investors do not need dividends to convert shares to cash; they will not pay higher prices for firms with higher 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.
Term III (2012)
Dr. Kulbir Singh (IMT-Nagpur)

Example

Slide 7

Term III (2012)

Dr. Kulbir Singh (IMT-Nagpur)

Example
After the imminent dividend is paid, the stock price will immediately fall to $9.09 (= $19.09 - $10).

Slide 8

Several members of Bristols board have expressed dissatisfaction with the current dividend policy and have asked you to analyze an alternative policy.

Term III (2012)

Dr. Kulbir Singh (IMT-Nagpur)

Example: Alternative Policy

Slide 9

Another policy is for the firm to pay a dividend of $11 per share immediately - the extra $1,000 must be raised in one of a few ways. Issue $1,000 of bonds or stock now (at date 0). Assume that stock is issued and the new stockholders will desire enough cash flow at date 1 to let them earn the required 10 percent return on their date 0 investment. The new stockholders will demand $1,100 of the date 1 cashflow, leaving only $8,900 to the old stockholders. The dividends to the old stockholders will be these:
Term III (2012)
Dr. Kulbir Singh (IMT-Nagpur)

Example: Alternative Policy

Date 0 Aggregate Dividends to Old Shareholders Dividends per Share $11,000 $11.00 Date 1

Slide 10

$8,900 $8.90

Term III (2012)

Dr. Kulbir Singh (IMT-Nagpur)

Homemade Dividends

Slide 11

Bianchi Inc. is a $42 stock about to pay a $2 cash dividend. Bob Investor owns 80 shares and prefers a $3 dividend. Bobs homemade dividend strategy:
Sell 2 shares ex-dividend
homemade dividends Cash from dividend $160 Cash from selling stock $80 Total Cash $240 Value of Stock Holdings $40 78 = $3,120
Term III (2012)

$3 Dividend $240 $0 $240 $39 80 = $3,120

Dr. Kulbir Singh (IMT-Nagpur)

Dividend Policy is Irrelevant

Slide 12

In the above example, Bob Investor began with a total wealth of $3,360:
$42 $3,360 = 80 shares share
After a $3 dividend, his total wealth is still $3,360:

$39 $3,360 = 80 shares + $240 share

After a $2 dividend and sale of 2 ex-dividend shares, his

total wealth is still $3,360:

$3,360 = 78 shares
Term III (2012)

$40 + $160 + $80 share

Dr. Kulbir Singh (IMT-Nagpur)

Dividends and Investment Policy

Slide 13

Firms should never forgo positive NPV projects to increase a dividend (or to pay a dividend for the first time). Recall that one of the assumptions underlying the dividend-irrelevance argument is: The investment policy of the firm is set ahead of time and is not altered by changes in dividend policy.
Term III (2012)

Dr. Kulbir Singh (IMT-Nagpur)

Slide 14

4. Repurchase of Stock
Instead of declaring cash dividends, firms can rid themselves of excess cash through buying shares of their own stock. Recently, share repurchase has become an important way of distributing earnings to shareholders.

Term III (2012)

Dr. Kulbir Singh (IMT-Nagpur)

Stock Repurchase versus Dividend

Consider a firm that wishes to distribute $100,000 to its shareholders. Assets A.Original balance sheet Liabilities & Equity

Slide 15

Cash $150,000 Debt 0 Other Assets 850,000 Equity 1,000,000 Value of Firm 1,000,000 Value of Firm 1,000,000 Shares outstanding = 100,000 Price per share= $1,000,000 /100,000 = $10

Term III (2012)

Dr. Kulbir Singh (IMT-Nagpur)

Stock Repurchase versus Dividend

Assets Cash Other Assets $50,000 850,000 Debt Equity Liabilities & Equity 0 900,000

Slide 16

If they distribute the $100,000 as a cash dividend, the balance sheet will look like this: B. After $1 per share cash dividend

Value of Firm 900,000

Value of Firm 900,000

Shares outstanding = 100,000 Price per share = $900,000/100,000 = $9

Term III (2012)

Dr. Kulbir Singh (IMT-Nagpur)

Stock Repurchase versus Dividend

Slide 17

If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this: Assets C. After stock repurchase Liabilities& Equity

Cash $50,000 Debt 0 Other Assets 850,000 Equity 900,000 Value of Firm 900,000 Value of Firm 900,000 Shares outstanding= 90,000 Price pershare = $900,000 / 90,000 = $10

Term III (2012)

Dr. Kulbir Singh (IMT-Nagpur)

Slide 18

Share Repurchase
Flexibility for shareholders Keeps stock price higher..Executive compensation
Good for insiders who hold stock options Existing stock options have greater value due to share repurchase...

As an investment of the firm (undervaluation) Tax benefits

Term III (2012)
Dr. Kulbir Singh (IMT-Nagpur)

Slide 19

5. Personal Taxes and Dividends

To get the result that dividend policy is irrelevant, we needed three assumptions:
No taxes No transactions costs No uncertainty

In the United States, both cash dividends and capital gains are taxed at a maximum rate of 15 percent. Since capital gains can be deferred, the tax rate on dividends is greater than the effective rate on capital gains.
Term III (2012)
Dr. Kulbir Singh (IMT-Nagpur)

Slide 20

Firms without Sufficient Cash

Investment Bankers

The direct costs of stock issuance will add to this effect.

Stock Holders

Cash: stock issue Firm Cash: dividends Taxes Gov.

Term III (2012)

In a world of personal taxes, firms should not issue stock to pay a dividend.
Dr. Kulbir Singh (IMT-Nagpur)

Firms with Sufficient Cash

Slide 21

The above argument does not necessarily apply to firms with excess cash. Consider a firm that has $1 million in cash after selecting all available positive NPV projects.
Select additional capital budgeting projects (by assumption, these are negative NPV). Acquire other companies Purchase financial assets Repurchase shares
Term III (2012)
Dr. Kulbir Singh (IMT-Nagpur)

Slide 22

Taxes and Dividends

In the presence of personal taxes:
1. A firm should not issue stock to pay a dividend. 2. Managers have an incentive to seek alternative uses for funds to reduce dividends. 3. Though personal taxes mitigate against the payment of dividends, these taxes are not sufficient to lead firms to eliminate all dividends.
Term III (2012)
Dr. Kulbir Singh (IMT-Nagpur)

Slide 23

6. Real-World Factors Favoring High Dividends

Desire for Current Income Behavioral Finance
It forces investors to be disciplined.

Tax Arbitrage
Investors can create positions in high dividend yield securities that avoid tax liabilities.

Agency Costs
High dividends reduce free cash flow.
Term III (2012)
Dr. Kulbir Singh (IMT-Nagpur)

Slide 24

7. The Clientele Effect

Clienteles for various dividend payout policies are likely to form in the following way: Group Stock Type
High Tax Bracket Individuals Low Tax Bracket Individuals Tax-Free Institutions Corporations Zero-to-Low payout Low-to-Medium payout Medium payout High payout

Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy.
Term III (2012)
Dr. Kulbir Singh (IMT-Nagpur)

Slide 25

8. What We Know and Do Not Know

Corporations smooth dividends ..Lintners Study Fewer companies are paying dividends. Dividends provide information to the market
investors look for current dividends as a clue to future earnings & dividends

Firms should follow a sensible policy:

Do not forgo positive NPV projects just to pay a dividend. Avoid issuing stock to pay dividends. Consider share repurchase when there are few better uses for the cash.
Dr. Kulbir Singh (IMT-Nagpur)

Term III (2012)

Slide 26

9. Stock Dividends
Pay additional shares of stock instead of cash Increases the number of outstanding shares Small stock dividend
Less than 20 to 25% If you own 100 shares and the company declared a 10% stock dividend, you would receive an additional 10 shares.

Large stock dividend more than 20 to 25%

Term III (2012)

Dr. Kulbir Singh (IMT-Nagpur)

Slide 27

Stock Splits
Stock splits essentially the same as a stock dividend except it is expressed as a ratio
For example, a 2 for 1 stock split is the same as a 100% stock dividend.

Stock price is reduced when the stock splits. Common explanation for split is to return price to a more desirable trading range.
Term III (2012)
Dr. Kulbir Singh (IMT-Nagpur)