Dividends policy

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  • The dividend and capital gains tax rates are subject to change at the discretion of Congress.
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  • Dividends policy

    1. 1. Dividends Policy 19-1
    2. 2. 8.1 Different Types of Payouts• Many companies pay a regular cash dividend. – Public companies often pay quarterly. – Sometimes firms will pay an extra cash dividend. – The extreme case would be a liquidating 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. – Wrigley’s Gum sends a box of chewing gum.• Other companies use stock buybacks. 19-2
    3. 3. Advantages of paying dividend• Cash dividend can underscore good results and provides support to the share price.• Dividends may attract institutional investors who prefer some mix return in the form of dividends. A mix of institutions and individual investors may allow a firm to raise capital at lower cost because of the ability of the firm to reach a wider market.• Share price usually increase with the announcement of a new or increased dividends.• Dividends absorb excess cash flow and many reduce agency costs that arise from conflicts between management and shareholders. 19-3
    4. 4. Disadvantages of paying dividend• Dividends can reduce internal sources of financing. Dividends may force the firm to forgo positive NPV projects or to rely on costly external equity financing.• Once established, dividends cuts are hard to make without adversely affecting the firm’s share price. 19-4
    5. 5. 19.2 Standard Method of Cash DividendCash Dividend - Payment of cash by the firmto its shareholders.Ex-Dividend Date - Date that determineswhether a stockholder is entitled to a dividendpayment; anyone holding stock immediatelybefore this date is entitled to a dividend.Record Date – Date on which companydetermines existing shareholders. 19-5
    6. 6. Procedure for Cash Dividend 25 Oct. 1 Nov. 2 Nov. 5 Nov. 7 Dec. … Declaration Cum- Ex- Record Payment Date dividend dividend Date Date Date DateDeclaration Date: The Board of Directors declares a paymentof 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 individualsbelieved to be stockholders as of 5 November. 19-6
    7. 7. Price Behavior• In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date. -t … -2 -1 0 +1 +2 … $P $P - div The price drops Ex- by the amount of dividend the cash Date dividend. 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. 19-7
    8. 8. 8.3 The Irrelevance of Dividend Policy• 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. 19-8
    9. 9. Homemade Dividends• Bianchi Inc. is a $42 stock about to pay a $2 cash dividend.• Bob Investor owns 80 shares and prefers a $3 dividend.• Bob’s homemade dividend strategy: – Sell 2 shares ex-dividend homemade dividends $3 Dividend Cash from dividend $160 $240 Cash from selling stock $80 $0 Total Cash $240 $240 Value of Stock Holdings $40 × 78 = $39 × 80 = $3,120 $3,120 19-9
    10. 10. Dividend Policy Is Irrelevant• 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: $40 $3,360 = 78 shares × + $160 + $80 share 19-10
    11. 11. Dividends and Investment Policy• 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.” 19-11
    12. 12. 8.4 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. 19-12
    13. 13. Stock Repurchase versus DividendConsider a firm that wishes to distribute $100,000 to itsshareholders. Assets Liabilities & Equity A.Original balance sheet 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 19-13
    14. 14. Stock Repurchase versus DividendIf they distribute the $100,000 as a cash dividend, the balancesheet will look like this: Assets Liabilities & Equity B. After $1 per share cash dividend Cash $50,000 Debt 0 Other Assets 850,000 Equity 900,000 Value of Firm 900,000 Value of Firm 900,000 Shares outstanding = 100,000 Price per share = $900,000/100,000 = $9 19-14
    15. 15. Stock Repurchase versus DividendIf they distribute the $100,000 through a stock repurchase, thebalance sheet will look like this: Assets Liabilities& Equity C. 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 19-15
    16. 16. Share Repurchase• Flexibility for shareholders• Keeps stock price higher – Good for insiders who hold stock options• As an investment of the firm (undervaluation)• Tax benefits 19-16
    17. 17. Share repurchase and cash dividend• Similarities • Share repurchase and cash dividend programs are mechanism for transferring excess finds from a corporation to its shareholders.• Differences • Dividend programs require an ongoing cash outflow that is difficult to reduce or terminate. • Share repurchase programs on the other hand, are structured such that a firm can be control both the timing and the amount of the cash outflows. • While a share program is frequently announced, there is no commitment to actually purchase the shares. • This provides a lot more flexibility to the firm than a dividend program. 19-17
    18. 18. 8.5 Personal Taxes, Dividends, and Stock Repurchases• 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 (currently) 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. 19-18
    19. 19. Firms without Sufficient Cash The direct costs of Investment Bankers stock issuance will add to this effect. Cash: stock issue StockFirm Holders Cash: dividends Taxes In a world of personal taxes, firms should not issue stock to Gov. pay a dividend. 19-19
    20. 20. Firms with Sufficient Cash• 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 19-20
    21. 21. 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. 19-21
    22. 22. 8.6 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. 19-22
    23. 23. 8.7 The Clientele Effect• Clienteles for various dividend payout policies are likely to form in the following way: Group Stock Type High Tax Bracket Individuals Zero-to-Low payout Low Tax Bracket Individuals Low-to-Medium payout Tax-Free Institutions Medium payout Corporations High payout Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy. 19-23
    24. 24. 8.8 What We Know and Do Not Know• Corporations “smooth” dividends.• Fewer companies are paying dividends.• Dividends provide information to the market.• 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. 19-24
    25. 25. 8.9 Putting It All Together• Aggregate payouts are massive and have increased over time.• Dividends are concentrated among a small number of large, mature firms.• Managers are reluctant to cut dividends.• Managers smooth dividends.• Stock prices react to unanticipated changes in dividends. 19-25
    26. 26. 8.10 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% 19-26
    27. 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.” 19-27

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