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Transcript of Ross=7e Ch=18
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5/27/2018 Ross=7e Ch=18
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McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18-0
CHAPTER
18Dividends and OtherPayouts
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McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18-1
Chapter Outline
18.1 Different Types of Dividends
18.2 Standard Method of Cash Dividend Payment
18.3 Home made Dividend Policy
18.4 Repurchase of Stock18.5 Personal Taxes, Issuance Costs, and Dividends
18.6 Real World Factors Favoring a High Dividend Policy
18.7 The Clientele Effect
18.8 What We Know and Do Not Know About DividendPolicy
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Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18-2
18.1 Different Types of Dividends
Many companies pay a regular cash dividend.Public companies often pay quarterly.
Sometimes firms will throw in an extra cash dividend.
The extreme case would be a liquidating dividend.Often companies will 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 around a box of chewing gum.
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Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18-3
18.2 Standard Method of Cash
Dividend Payment
Ex-Dividend DateThe second day before
the date of record which is January 28 is
called the Ex-dividend date..
Cash Dividend- Payment of cash by the firm
to its shareholders.
The mechanics of dividend payment:Declaration Date: On January 1(diclaration
date) the board of directors passes a resolution
to pay a dividend of $1 per share on February
16 to all holders.
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McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18-4
18.2 Standard Method of Cash
Dividend Payment
Ex-Dividend Date- Date that determines whether a
stockholder is entitled to a dividend payment; anyone
holding stock before this date is entitled to a dividend.
Record Date- Person who owns stock on this date
received the dividend. The corporation prepares a list on
January 30 of all individuals/shareholders as of this date.
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McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18-5
Procedure for Cash Dividend Payment
15 Jan.Thursday
27 Jan.Tuesday
28Jan.Wenday
30Jan. Fri. 16 Feb.Mon.
Declaration
Date
Cum-
dividend
Date
Ex-
dividend
Date
Record
Date
Payment
Date
Declaration Date: The Board of Directors declares a payment of dividends.
Cum-Dividend Date: The last day that the buyer of a stock is entitled to the
dividend.
Ex-Dividend Date: The first day that the seller of a stock is entitled to the
dividend.Record Date: The corporation prepares a list of all individuals believed to be
stockholders as of 30 January.
Payment Date: The dividend cheques are mailed to shareholders of records.
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Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18-6
Price Behavior around the Ex-Dividend Date
In a perfect world, the stock price will fall by the
amount of the dividend on the ex-dividend date.
$P
$P - div
Ex-dividend
Date
The price drops
by the amount of
the cash
dividend
-t -2 -1 0 +1 +2
Taxes complicate things a bit. Empirically, the price
drop is less than the dividend and occurs within the first
few minutes of the ex-date.
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Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18-7
18.3 The Benchmark Case: An Illustration ofthe Irrelevance of Dividend Policy
A compelling case can be made that dividend
policyis irrelevant.
Dividend policy will have no impact on the valueof the firm because investors can create whatever
income stream they prefer by using homemade
dividends.
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Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18-8
Homemade Dividends
Bianchi Inc. is a $42 stock about to pay a $2 cash dividend.
Bob Investor owns 80 shares and prefers $3 cash dividend.
Bobs homemade dividend strategy:
Sell 2 shares ex-dividend
homemade dividends
Cash from dividend $160
Cash from selling stock $80Total Cash $240
Value of Stock Holdings $40 78 =
$3,120
$3 Dividend
$240
$0$240
$39 80 =
$3,120
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Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18-9
Dividend Policy is Irrelevant
Since investors do not need dividends to convert shares to cash,
dividend policy will have no impact on the value of the firm.
In the above example, Bob Investor began with total wealth of
$3,360:
share
42$
shares80360,3$=
240$
share
39$shares80360,3$ +=
80$160$share
40$shares78360,3$ ++=
After a $3 dividend, his total wealth is still $3,360:
After a $2 dividend, and sale of 2 ex-dividend shares,his totalwealth is still $3,360:
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Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18-10
Irrelevance of Stock Dividends: Example
Shimano USA has 2 million shares currently outstanding at $15 per
share. The company declares a 50% stock dividend. How many
shares will be outstanding after the dividend is paid?
A 50% stock dividend will increase the number of shares by 50%:
2 million1.5 = 3 million shares
After the stock dividend what is the new price per share and what is
the new value of the firm?
The value of the firm was $2m $15 per share = $30 m. After thedividend, the value will remain the same.
Price per share = $30m/ 3m shares = $10 per share
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Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18-11
Dividends and Investment Policy
Firms should never forgo positive NPV projects
to increase a dividend.
Recall that on of the assumptions underlying thedividend-irrelevance arguments was The
investment policy of the firm is set ahead of time
and is not altered by changes in dividend policy.
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Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18-12
18.4 Repurchase of Stock
Instead of declaring cash dividends, a firm may
use excess cash to repurchase shares of its own
stock.Recently share repurchase has become an
important way of distributing earnings to
shareholders.
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Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18-13
18.4 Repurchase of Stock
Three ways of Share Repurchase:Open Market Purchases
Firms may simply purchase their own stock like other
investors.The firm does not reveal itself as buyer
Tender Price
The firm announces to all of its shareholders to buy a fixed
number of share at specified price.Targeted repurchase
Firms may repurchase share from specified individualstockholder are called targeted repurchase.
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Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18-14
Stock Repurchase versus Dividend
$10=/100,000$1,000,000=Price per share
100,000=outstandingShares1,000,000Value of Firm1,000,000Value of Firm
1,000,000Equity850,000assetsOther
0Debt$150,000Cash
sheetbalanceOriginalA.Equity&LiabilitiesAssets
Consider a firm that wishes to distribute $100,000 to its
shareholders.
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18-15
Stock Repurchase versus Dividend
$9=00,000$900,000/1=shareperPrice
100,000=goutstandingShares
900,000FirmofValue900,000FirmofValue
900,000Equity850,000assetsOther
0Debt$50,000Cash
dividendcashshareper$1AfterB.Equity&sLiabilitiesAssets
If they distribute the $100,000 as cash dividend, the balance
sheet will look like this:
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Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18-16
Stock Repurchase versus Dividend
Assets L iabil i ties & EquityC. After stock repurchase
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
If they distribute the $100,000 through a stock repurchase, the
balance sheet will look like this:
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18-17
Stock Repurchase versus DividendWhy some firms choose repurchase over dividend?
FlexibilityFirms view dividend as a commitment to their shareholders.
Repurchases do not represent a similar commitment.
Executive CompensationExecutives are given stock options a part of theircompensation.
Offset dilutionExercise of stock option increases the number of shareoutstanding causes dilution of stock.
Firms buy back shares of stock to offset this dilution.
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Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18-18
Stock Repurchase versus DividendWhy some firms choose repurchase over dividend?
Repurchase as investment
Recent studies has shown that the long-term stock
price performance of securities after a buyback is
significantly better than the stock price performance
of comparable companies that do not repurchase.
Taxes
Repurchases provide a tax advantage over dividend.
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18-19
18.5 Personal Taxes, Issuance Costs,and Dividends
To get the result that dividend policy is irrelevant, weneeded three assumptions:
No taxes
No transactions costsNo uncertainty
In the United States, both cash dividends and capitalgains are taxed at a maximum rate of 15 percent.
Since capital gains can be deferred, the tax rate ondividends is greater than the effectiverate on capitalgains.
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18-20
Firms Without Sufficient Cashto Pay a Dividend
In a world of personal taxes,
firms should not issue stock
to pay a dividend.
FirmStock
Holders
Cash: stock issue
Cash: dividends
Gov.
Taxes
Investment Bankers The direct costs ofstock issuance willadd to this effect.
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Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18-21
Firms With Sufficient Cash toPay a Dividend
The above argument does not necessarily apply to firms
with excess cash.
Consider a firm that has $1 million in cashafter
selecting all available positive NPV projects.
The firm has several options:
Select additional capital budgeting projects (by assumption,
these are negative NPV).Acquire other companies
Purchase financial assets
Repurchase shares
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18-22
Taxes, Issuance Costs,
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 usesfor 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.
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18-23
18.6 Real World Factors Favoringa High Dividend Policy
Desire for Current Income
Resolution of Uncertainty
Tax ArbitrageAgency Costs
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Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18 24
Desire for Current Income
The homemade dividend argument relies on no
transactions costs.
To put this in perspective, mutual funds canrepackage securities for individuals at very low
cost: they could buy low-dividend stocks and
with a controlled policy of realizing gains, pay
their investors at a higher rate.
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18 25
Resolution of Uncertainty
It would be erroneous to conclude that increased
dividends can make the firm less risky.
A firms overall cash flows are not necessarilyaffected by dividend policyas long as capital
spending and borrowing are not changes.
Thus, it is hard to see how the risks of the overallcash flows can be changed with a change in
dividend policy.
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Tax Arbitrage
Investors can create positions in high dividend-
yield securities that avoid tax liabilities.
Thus, corporate managers need not viewdividends as tax-disadvantaged.
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18 27
Agency Costs
The potential conflict between bondholders andshareholders; bondholders would like shareholders toleave as much cash as possible in the firm to
bondholders.
Conversely, Shareholders would like to keep this extracash for themselves.
Agency Cost of DebtFirms in financial distress are reluctant to cut dividends. To
protect themselves, bondholders frequently create loanagreements stating dividends can only be paid if the firm hasearns, cash flow and working capital above pre-specifiedlevels.
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Agency Costs
The conflict between bondholders and shareholders; the
manager may per sue selfish goal at the expense of
shareholders when firm has plenty of cash flow.
Agency Costs of Equity
Managers will find it easier to squander funds if they have a
low dividend payout.
By paying dividends equal to the amount of surplus cashflows, a firm can reduce managements ability to
squander the funds.
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Information Content of dividends anddividend Signaling
The stock price of a firm will rise when the firmannounces an increase in the dividend & fall when adividend reduction is announced.
A dividend increase is managements signal to themarket the firm is expected to do well.The rise in the share price following the dividend signalis called the information-content effect.This rises an interesting corporate strategy. Increase individends just to make the market think that cash flowwill be higher even though management knows that cashflows will not rise.
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18.7 The Clientele Effect
Different types of shareholders that prefer one kind of
dividend policy due to the difference in tax brackets.
Clienteles for various dividend payout policies are likely
to form in the following way:Group Stock
High Tax Bracket Individuals
Low Tax Bracket IndividualsTax-Free Institutions
Corporations
Zero to Low payout stocks
Low-to-Medium payoutMedium Payout Stocks
High Payout Stocks
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18.8 What We Know and Do Not KnowAbout Dividend Policy
Corporatedividends are substantialDividends are tax disadvantage relative to capital gains;nevertheless, dividends are substantial.
Taxation on dividends is minimal for low tax bracketindividuals or tax free for pension fund.
Corporations Smooth DividendsFirms set long-term target ratios of dividend to earnings.
Low target ratios if many NPV project; i. e. good times.High target ratios if few NPV projects; i. e. bad times.
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18.8 What We Know and Do Not KnowAbout Dividend Policy
Dividends Provide Information to the Market
The price of stock rises when current dividend isincreased or stock purchased is announced.
Conversely, the price of stock falls when its dividend
is cut.Firms should follow a sensible dividend policy:
Dont forgo positive NPV projects just to pay adividend.
Avoid issuing stock to pay dividends.
Consider share repurchase when there are few betteruses for the cash.