AFM 371 Winter 2008 Chapter 19 - Dividends And Other Payoutskvetzal/AFM371/div.pdf · Chapter 19 -...

AFM 371 Winter 2008Chapter 19 - Dividends And Other Payouts

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Outline

Background

Dividend Policy In Perfect Capital Markets

Share Repurchases

Dividend Policy In Imperfect Markets

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IntroductionWhy do corporations pay dividends? Why do investors pay attention

to dividends? Perhaps the answers to these questions are obvious.Perhaps dividends represent the return to the investor who put his moneyat risk in the corporation. Perhaps corporations pay dividends to rewardexisting shareholders and to encourage others to buy new issues ofcommon stock at high prices. Perhaps investors pay attention todividends because only through dividends or the prospect of dividends dothey receive a return on their investment or the chance to sell their sharesat a higher price in the future.

Or perhaps the answers are not so obvious. Perhaps a corporationthat pays no dividends is demonstrating confidence that it has attractiveinvestment opportunities that might be missed if it paid dividends. If itmakes these investments, it may increase the value of its shares by morethan the amount of the lost dividends. If that happens, its shareholdersmay be doubly better off. They end up with capital appreciation greaterthan the dividends they missed out on, and they find they are taxed atlower effective rates on capital appreciation than on dividends.

In fact, I claim that the answers to these questions are not obvious atall. The harder we look at the dividend picture, the more it seems like apuzzle, with pieces that just don’t fit together.

– F. Black, “The Dividend Puzzle”, Journal of Portfolio Management, Winter1976, pp. 5-8.

Background 3 / 29

Different Types of Payouts

the two main ways that firms distribute cash to equityinvestors are dividends and share repurchasesdifferent types of dividends:

cash dividends are a distribution of cash

normally paid on a quarterly basis

stock dividends are a distribution of stock

no cash leaves the firmthere is an increase in the number of shares outstandinge.g. with a 10% stock dividend, investors receive oneadditional share for each ten shares that they own

stock splits are large stock dividends (a stock dividend ofgreater than 25%)

usually expressed as a ratio, e.g. 2:1 means that investors getone new share for each share that they own (so the totalnumber of shares outstanding doubles)

a share repurchase (a.k.a. buyback) is a transaction where thefirm buys its own stock back from investors

can be either an open market repurchase (the firm buys on anexchange like any other investor) or a tender offer (the firmannounces to all of its shareholders that it is willing to buy afixed number of shares at a specified price)

Background 4 / 29

Standard Method of Cash Dividend Payment

on the declaration date, the board of directors declares apayment of dividends to shareholders of record on the recorddate

dividend cheques are mailed out to shareholders on thepayment date

as stock trades can take up to three business days to settle,you must have purchased the stock at least three businessdays before the record date in order to be assured of receivingthe dividend

the date two days before the record date (i.e. the first tradingdate on which you are no longer entitled to the dividend) iscalled the ex-dividend date

example: on Feb. 29, 2008 RBC declared a dividend of $0.50per share payable on May 23, 2008 to common shareholdersof record on April 24, 2008

Background 5 / 29

Ex-Dividend Date Stock Price Behaviour

in a world without taxes or transaction costs, the stock pricewill fall by the amount of the dividend on the ex-dividend date(ignoring some slight time value of money considerations)taxes complicate matters: empirically, the price drop is lessthan the dividend and occurs within the first few minutes oftrading on the ex-dividend datenotation:

original purchase price: P0

price just before stock goes ex-dividend: Pb

price just after stock goes ex-dividend: Pa

dollar amount of dividend per share: Dtax rate paid on dividend income: TD

tax rate paid on capital gains: TG

cash flows from selling just before stock goes ex-dividend:

Pb − (Pb − P0)× TG

cash flows from selling just after stock goes ex-dividend:

Pa − (Pa − P0)× TG + D × (1− TD)

Background 6 / 29

Ex-Dividend Date Stock Price Behaviour

the average investor should be indifferent between selling justbefore and selling just after, so

Pb − (Pb − P0)×TG = Pa − (Pa − P0)×TG + D × (1−TD)

rearranging the above expression yields

Pb − Pa

D=

1− TD

1− TG

cases:

if TD = TG , then Pb − Pa = ∆P = Dif TD > TG , then Pb − Pa = ∆P < Dif TD < TG , then Pb − Pa = ∆P > D

in Canada we have TD > TG , and the ex-dividend date pricedrop is smaller than the amount of the dividend

Background 7 / 29

Dividend Policy In Perfect Capital Markets

for the time being, consider a world with perfect capitalmarkets (i.e. no taxes, transactions costs, informationasymmetry, etc.)

also assume that future investments and cash flows are knownwith perfect certainty

further assume that the investment policy of the firm is fixed,and, for simplicity, consider an all-equity firm

consider an all-equity firm in which

as of now (t = 0), managers know that the firm will beliquidated after 2 years (t = 2)at t = 0 the manager knows that the firm will generate cashflows of $110,000 at t = 1 and $121,000 at t = 2the firm has no additional positive NPV projects availablereturn on equity is 10%there are currently 10,000 shares outstanding

Dividend Policy In Perfect Capital Markets 8 / 29

Dividend Policy In Perfect Capital Markets (Cont’d)

for simplicity assume that the ex-dividend date is the same asthe payment datedividend policy #1: set dividends equal to cash flow

in this case, the total dividend paid out is $110,000 at t = 1and $121,000 at t = 2, so the value of the firm is

V0 =$110,000

1.1+

$121,000

1.12= $200,000

since there are 10,000 shares outstanding, the price per shareis $20 and the dividends per share are $11 at t = 1 and $12.10at t = 2

dividend policy #2: pay higher dividend at t = 1, e.g. $14 pershare

total cash required at t = 1 is $14× 10,000 = $140,000, butthe firm only has $110,000 available ⇒ the firm must issuenew equity to raise $30,000 at t = 1


Dividend Policy In Perfect Capital Markets (Cont’d)

are the old shareholders better off with policy #2?

the time pattern of dividends should not matter as long as theinvestor is fairly compensated through the return on equityshareholders will not pay more for a firm if the shareholdercan either replicate or undo the dividend decision—calledhomemade dividendsif this argument reminds you of homemade leverage in thecontext of capital structure, that is not a coincidence: theproposition that in perfect capital markets the value of a firmvalue is independent of its dividend policy was first shown byModigliani and Miller (MM)


Homemade Dividends

since investors do not need dividends to convert shares tocash, they will not pay higher prices for firms with higherdividend payoutsin other words, dividend policy has no impact on the value ofa firm because investors can create whatever income streamthey prefer by using homemade dividendscontinuing with our example, suppose the firm sticks withpolicy #1 but an investor who owns 50 shares prefers policy#2:


Homemade Dividends (Cont’d)

alternatively, suppose the firm switches to policy #2 and aninvestor who holds 30 shares prefers the old policy:


Homemade Dividends (Cont’d)

problem: The MM Company earns a perpetual operatingincome of $2.5 million per year which it pays as dividends onits 200,000 outstanding shares. MM is all-equity financed witha required rate of return of 10%. The VP of Finance feelsthat shareholders would benefit if dividends were increased by$7.50 next year, but only next year. Assume that issuing stockis the only financing alternative.

(a) What is the stock price under the current dividend policy?(b) How many new shares must MM issue in order to finance the

new policy?(c) Mr. Jones owns 1,000 shares and prefers the current dividend

policy? How can he achieve it if the firm switches to the newpolicy?


Irrelevance of Stock Splits and Stock Dividends

XYZ Inc. is an all-equity firm with 2 million sharesoutstanding that are trading at $15 per share. The companydeclares a 50% stock dividend. How many shares will beoutstanding after the stock dividend is paid? After the stockdividend what is the new price per share and the new value ofthe firm?

a 50% stock dividend will increase the number of shares by50% to 2× 1.5 = 3 million (in fact, this is really a 3:2 split)the value of the firm was 2× $15 = $30 million, which isunchanged after the dividendthe price per share is $30,000,000÷ 3,000,000 = $10note that there is no effect on any investor’s wealth: aninvestor who owned 50 shares had a total value of50× $15 = $750 before the stock dividend and a total value of75× $10 = $750 after it


Summary: Perfect Capital Markets

given the MM assumptions of perfect capital markets, then:

dividend policy is irrelevant—given the firm’s investmentdecisions, how the firm decides to pay dividends doesn’tmatter since shareholders can achieve any desired incomepattern with homemade dividendsdividends are relevant—shareholders prefer high dividends tolow dividends at any single date if this higher dividend levelcan be maintained over time (however, this is possible only ifnet cash flows increase due to a change in the firm’sinvestment policy)

main implication: if dividend policy does matter, it is becauseof market imperfections such as taxes, transactions costs,asymmetric information, etc.

another important point: firms should never give up a positiveNPV project in order to increase a dividend


Share Repurchases

instead of declaring cash dividends, firms can get rid of excesscash by buying shares of their own stock

in the U.S., the amount of cash distributed by a sharerepurcahse in recent years has been roughly equivalent to theamount paid out as dividends

there are potential tax advantages to repurchases:

if you choose to sell back your shares, you pay capital gainstaxesif you choose to hold on to your shares, your wealth is notaffected by taxes

alternatively, with dividends you pay taxes on them (at ahigher effective rate than you would with capital gains)

when tax minimization is important, share repurchases are apotentially useful alternative to dividends

Share Repurchases 16 / 29

Share Repurchase vs. Dividend

consider a firm with the following market value balance sheetthat wants to distribute $100,000 to its shareholders:

Assets Liabilities & Equity(Original Balance Sheet)

Cash $150,000 Debt $0Other assets $850,000 Equity $1,000,000Firm value $1,000,000 Firm value $1,000,000

Shares outstanding: 100,000

Price per share: $1,000,000/100,000 = $10if the $100,000 is distributed as a cash dividend, the balancesheet will look like this:

Assets Liabilities & Equity(Balance Sheet After $1 Per Share Dividend)

Cash $50,000 Debt $0Other assets $850,000 Equity $900,000Firm value $900,000 Firm value $900,000


Price per share: $900,000/100,000 = $9


Share Repurchase vs. Dividend (Cont’d)

if the $100,000 is distributed through a repurchase, thebalance sheet will look like this:

Assets Liabilities & Equity(Balance Sheet After Share Repurchase)

Cash $50,000 Debt $0Other assets $850,000 Equity $900,000Firm value $900,000 Firm value $900,000


Price per share: $900,000/90,000 = $10

with the dividend, the holder of a share receives $1 andretains a share worth $9

with a repurchase, the holder of a share either sells it for $10or keeps it

this shows that, absent imperfections such as taxes, there isno reason to prefer one method of distribution over the other


Real World Factors Affecting The Repurchase Decisionbesides taxes, what other potential advantages do sharerepurchases offer?

flexibility: an increase in a dividend is often viewed as anongoing commitment, whereas a repurchase is more of aone-time deal → firms which have temporary increases in cashflow are more likely to repurchase, while firms with permanentincreases in cash flow are more likely to pay dividendsexecutive compensation: firms with lots of executive stockoptions are more likely to prefer repurchases (the share pricewill fall when dividends are paid out, reducing the value of theoptions)offset to dilution: this is another reason why firms with lots ofexecutive stock options often use repurchases (i.e. to counterthe dilution that occurs when the options are exercised)repurchase as investment: managers may believe that theirfirm’s stock price is temporarily undervalued, and so buyingback shares represents a good investment (and empiricalevidence supports this—long term stock price performance offirms after a repurchase tends to be substantially better thanthe stock price performance of similar firms which do notrepurchase)


Personal Taxes, Issuance Costs, and Dividends

as noted above, the effective tax rate on capital gains is lowerthan the effective tax rate on dividends for individual investorssuppose a firm does not have sufficient cash to pay adividend:

if it issues shares worth, say $1 million, in order to pay adividend, then in aggregate investors contribute $1 million butthey get back less because of taxes on dividendsas a result, in general firms should not issue stock in order topay a dividendflotation costs to issue the new shares add to this effect

if instead that a firm does have enough cash to pay adividend:

if the firm already has no further positive NPV projects toinvest in, then any additional capital expenditures will be innegative NPV projects (which could be worse than subjectinginvestors to taxes on dividends)the firm could acquire other companies (but this is often verycostly and the general tendency is that acquiring firms is anunprofitable strategy)it might go with a share repurchase instead of a dividend

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Personal Taxes, Issuance Costs, and Dividends (Cont’d)

another possibility for a firm with enough cash to pay adividend is to purchase financial assets insteadexample: a firm has $10,000 of extra cash. It can retain thecash and invest it in Treasury bills yielding 4% or it can paythe cash out to shareholders as a dividend. Shareholders canalso invest in Treasury bills with the same yield. Assume thatTreasury bills pay interest annually. Both the firm and theshareholders reinvest the interest income received from theTreasury bills. The corporate tax rate is 40% and theindividual tax rate for dividend income is 30% and for interestincome is 40%. What amount of cash will shareholders haveafter 5 years if (i) the firm pays out the $10,000 today as adividend; and (ii) the firm invests the $10,000 in Treasury billsand distributes the cash as a dividend after 5 years?


Personal Taxes, Issuance Costs, and Dividends (Cont’d)

does anything change if we reduce the dividend tax rate to20%?

how about changing the personal tax rate on interest incometo (i) 25%, and (ii) 45%?

other things equal, if Ti is the tax rate on investment incomefor investors (either interest or capital gains), and TC is thecorporate tax rate, then the firm has an incentive to pay outdividends now if Ti < TC and an incentive to retain the cashif Ti > TC

in other words, higher personal tax rates (compared tocorporate tax rates) give firms an incentive to reduce payouts

other points:

also recall that firms pay no tax on dividend income receivedhowever, some investors are tax exempt (e.g. pension funds),giving an incentive to increase payouts


Expected Returns, Dividend Yields, and Personal Taxes

consider two firms, A and B, which are equally riskyfirm A does not pay any dividends, whereas firm B doesassume effective capital gains taxes are zero (or that investorsare going to hold onto their shares)since the firms are equally risky, they will offer the sameafter-tax expected return:

E (PA1 )− PA

0

PA0

=E (PB

1 ) + E (dB1 )(1− Td)− PB

0

PB0

(where Td is the tax rate on dividend income)therefore, on a pre-tax basis:

E (PA1 )− PA

0

PA0

<E (PB

1 ) + E (dB1 )− PB

0

PB0

in other words, expected returns (pre-tax) will be higher forfirms paying higher dividendsthis implies that tax-exempt institutional investors (e.g.pension funds) should hold stocks which pay high dividends


Real World Factors in Favour of High Dividends

from a tax perspective, the higher effective tax rate ondividends compared to capital gains suggests that dividendsshould be reducedother considerations, however, indicate that dividends shouldbe increased:

desire for current income: the homemade dividend argument inperfect markets ignores transaction costs, so investors whowant income now may prefer to receive it directly rather thanincurring costs of selling securitiesagency costs of equity:

recall the free cash flow argument from Ch. 17, i.e. thatmanagers will tend to waste the firm’s resources onthemselves rather than trying to benefit the shareholderspaying out dividends reduces the ability of managers to do thisbut repurchases would also accomplish this

tax arbitrage: some people argue that investors may be able toavoid taxes on dividends (e.g. if you borrow money to invest,interest payments are tax deductible against investmentincome received; moreover, if you don’t like the extra risk dueto borrowing, you can invest in safe bonds in a tax-deferredsavings plan such as an RRSP to offset the leverage)


Information Content and Signalling

empirical evidence shows that stock prices increase when firmsannounce an increase in their dividends and decrease whenfirms announce cuts in dividends or suspensions of dividendpayments

is this because a higher dividend is a good financial decision,or because it conveys favourable information to the market?

some (e.g. Lintner) have argued that a firm’s earnings shouldbe viewed as containing both permanent and temporarycomponents, and that firms have long run dividend payoutratio targets that depend on the permanent component

management will use a dividend increase to signal itsexpectation of high future (permanent) earningschanges in dividends will be smoother than changes in earnings


Information Content and Signalling (Cont’d)

let t be the target dividend payout ratio and let s denote thespeed of adjustment of dividends to target, so that

dt+1 = dt + s × [t × EPSt+1 − dt ]

special cases:s = 1 implies that there is an immediate and full adjustmentto targets = 0 implies that there is no change at all in dividends

there is a good deal of empirical support for this; in additionto the stock price reactions described above:

changes in dividends lag changes in retained earnings (firmsare reluctant to cut dividends during temporarily bad times;firms do not increase dividends as fast as retained earningsduring economic expansions)special dividends (firms sometimes announce an extra dividendpayment but state that it is only temporary): basically a signalthat the firm has been doing very well, but that this is notnecessarily expected to continue


The Clientele Effect

investors may form clienteles based upon their tax brackets

clienteles for various dividend payout policies are likely to formin the following way:

Group StocksHigh tax bracket individuals Zero-to-low payout stocksLow tax bracket individuals Low-to-medium payout stocksTax-exempt institutions Medium-to-high payout stocksCorporations High payout stocks

once the clienteles have been satisfied (e.g. if there arealready enough firms paying high dividends to meet demand),a firm is unlikely to be able to create value by changing itsdividend policy


Summary and Other Considerationsin perfect capital markets, dividend policy is irrelevantfirms should not cut back on positive NPV projects to pay adividend and should generally avoid issuing stock in order topay a dividendrepurchases should be considered when there are few positiveNPV investments available and there is a surplus of cashflotation costs: firms should keep dividends low to avoid costsof issuing new securities (this will be more important to firmswith lots of investment opportunities)transactions costs and indivisibility of shares: the purchase orsale of shares to create homemade dividends incurstransactions costs. This factor could favour either high or lowdividends, depending on investor preferences for dividends vs.capital gains. Indivisibility implies that investors may not beable to create exactly the dividend policy they want. DRIPSand stripped common shares are evidence that these factorsdo matter.corporate control: issuing new shares may mean giving upsome control to new shareholders; this can be limited byreducing dividend payments


Summary and Other Considerations (Cont’d)

agency costs: management will tend to waste excess cash onperks and bad investments, so dividends should be kept highlegal factors, including:

institutional holdings: some institutional investors are legallyprohibited from investing in firms which have not paiddividendsimpairment of capital: some institutional investors are notallowed to spend principaldebt covenants: these provisions may include restrictions onthe amount that can be paid out as a dividend

signalling: dividends can be used to convey information aboutmanagement’s expectations about the firm’s future prospectsclientele effects: for various reasons (e.g. taxes, desire forcurrent income, etc.), different groups of investors areattracted to firms with high or low dividends. When a firmchanges its dividend policy, it just attracts a different clientele(⇒ keep policy stable to avoid transactions costs). Unlessthere is an unsatisfied clientele (e.g. not enough firms payinglow dividends relative to market demand), there is no reasonto change the firm’s dividend policy.


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