Dividend Policy

1. Dividend Policy

2. What can a firm with its free cash? Buy another plane

3. Types of Dividends • Regular dividend • A direct cash payment from the firm to shareholders. Generally these occur quarterly • Special dividend • This is a one time dividend that is made in addition to the regular dividend.

4. Declaration Date Ex-Dividend Date Record Date Payment Date • Oct 25th Nov 2nd Nov 5th Dec 7th Dividend Payment Timeline • Declaration: The board declares a dividend • Ex-Dividend: Buy the share before and you are entitled to the dividend (cum-dividend), buy after and you don’t get the dividend • Record:Dividends are distributed to the shareowner on record as of this date • Record is after Ex-Div to allow for record keeping • Payment: Check is mailed out

5. Price Reaction • In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date • In the real world, the price drop within the first few minutes of the ex-div date, but it is slightly less than the dividend. WHY? -t … -2 -1 0 +1 +2 … $P $P - div The dividend price drop Ex-Dividend Date

6. The Dividend Tradeoff • Buy the stock on Friday • Get the dividend, but must pay taxes on it • Buy the stock on Monday • Forgo the dividend, get the stock at the lower price • The return, after taxes, needs to be the same for selling before Ex-div as after Ex-Div or else there is an arbitrage opportunity • The stock price needs to fall by the after tax dividend amount

7. Ex-Div Date Price Drop • Let pbbe the stock price right before Ex-Div • Let pa be the stock price right after Ex-Div • If you bought at pi (pi < pb) When do you sell • τcgbe tax rate on capital gains • τp be tax rate on dividend income • If you sell after the ex-dividend date you still get dividend

8. Ex-Div Date Price Drop • If you sell before Ex-Div, the after tax gain is: (1- τcg)(pb–pi) • If you sell after Ex-Div, the after tax gain • Cap Gain: (1- τcg)(pa –pi) • Div: (1- τp)*D • The two returns must be equal or _________ • (1- τcg)(pb–pi) = (1- τcg)(pa –pi) + (1- τp)*D • pa = pb- (1- τp) / (1- τcg) * D

9. Ex-Div Date Price Drop Ex • If τp = 39%,τcg = 28%, and the Div is $5 then the price should drop by: • pa = pb- (1- τp) / (1- τcg) *D

10. Do Cash Dividends Affect Firm Value • Three view: • Cash dividend do not affect firm value • Cash dividend increase firm value • Cash dividend decrease firm value

11. View 1: Cash Dividends Do Not Affect Firm Value • Since investors can exchange shares for cash, and cash for shares they will not pay a higher price for firms with higher, or lower dividend payouts • Dividend policy has no impact on firm value because investors can create whatever income stream they want with homemade dividends

12. Dividend Irrelevance Assumptions • There are 4 key assumptions underlying the view • The firm never forgoes a positive NPV project to pay or increase dividends • Forgoing a positive NPV Project destroys value • No taxes • No transactions costs • No uncertainty

13. Homemade Dividends • Bianchi Inc.’s stock is @ $42, and is about to pay a $2 cash div • Investor Bob owns 80 shares but wants a $3 cash dividend. • How can Bob get his $3 dividend?

14. Calculations

15. Cash Dividends are Irrelevant • As we just saw while Bob wants a $3 dividend he does not need the firm to pay $3 • Bob is able to create a $3 dividend by selling shares • If this was reversed wanted a $2, but firm did $3 Bob would buy shares • Since Bob can create whatever stream he wants, he will not pay a premium for a firm because of its dividend stream

16. Personal Taxes and Dividends • In the US currently dividends and capital gains are taxed at 15%, • But investor decide when to incur capital gains reducing the effective rate on capital gains • This difference in the effective rates implies • Firms should not issue stock to pay a dividend • Dividends are less valuable to investors than capital gains • While taxes make paying dividends less desirable, taxes are not large enough to eliminate dividends

17. Don’t Issue Stock to Pay Dividends InvestmentBankers Issuance Costs Cash for Stock Firm Stock Holders Cash Dividends Taxes, on Dividend Gov.

18. View 2 Dividends Increase Firm Value • There are several ways that this can happen • Dividends reduce risk • Clientele effect • Mangers use dividends as a signal

19. Story 1: Dividends Reduce Risk • Dividends put money into investors hands • If investor already have the money there is less risk • What is wrong with this argument?

20. Story 2: Clientele Effect • Argues the existence of investor clienteles with a preference for various dividend streams, that they are willing to pay a premium for • What is wrong with this logic Clientele 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

21. Story 3: Signals • Managers know more about the firm than investors, and use dividend to signal their inside information • A high dividend policy is costly for firms with low cash flows → only firms with strong prospects can increase dividends, manager signals that he is confident in the firms future • Increases signal good news • Cuts send bad news.

22. View 3:Dividends Reduce Firm Value • Intuition: Since capital gains are taxed at a lower rate than dividend income, companies should pay the lowest dividend possible. • As more money flows to Uncle Sam, less money into our pockets • Firms should only repurchase share to give cash back to shareholders

23. Repurchase of Stock • Instead of paying a dividend, the firm buys its own shares back • Share repurchase have become an important way of distributing cash to shareholders • What role do you think stock options play in this?

24. Declining Dividends

25. Value of repurchases

26. Types of Repurchases • Open-market: Firm buy share just like any other investor on the open market • Tender: Firm offers to buy a specific numbers of share at a premium • This is either open to all investors or some subset • Ex. Investors with less than 500 shares • Private Negotiation: Firms buy from a block holder • Generally this is a way to make a hostile bidder go away (Green Mail)

27. Assets Liabilities & Equity 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 = Stock Repurchase versus Dividend Consider a firm that wishes to distribute $100,000 to its shareholders.

28. 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 = $900,000/1 00,000 = $9 Cash Dividend If they distribute the $100,000 as a cash dividend ($1 per share), the situation changes too: Assets Liabilities & Equity

29. Assets Li abilities & 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 per share = $900,000 / 90,000 = $10 Stock Repurchase If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:

30. Stock Repurchase versus Dividend In the simple world there really isn’t much of a difference In the real world with taxes, transactions cost, etc, repurchases are generally a better option

31. Advantages of Repurchases • Flexibility for shareholders • Keeps stock price higher • Good for insiders who hold stock options • Signal that they feel the firm is undervalued • Tax benefits

32. What We Know About Dividends • 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.

33. Lintner’s “Stylized Dividend Facts” • Firms have a long term target payout ratio • Managers focus more on dividend changes than on levels • Dividend changes follow shifts in long-run earnings • Managers are reluctant to make changes that might have to be reversed • Especially decreasing dividends

34. Div/Repurchase CFO Survey • CFOs indicate that: • They pay dividends because they don’t want to cut. • 40% target $ amount • 28% target payout ratio • 4% target dividend yield. • They view shares as cheap when they repurchase shares

35. Non-Cash Dividends • Stock dividends • The firm distributes shares to its current shareholders • No Money Involved • 5% stock div → shareholders receives 5% more shares • Dividend in kind • The firm gives shareholders a non-cash asset • No Money Involved • Wrigley’s sends a box of chewing gum. • Dundee Crematoria offers discounted cremations.

36. Irrelevance of Stock Dividends • Shimano USA has 2 million shares outstanding at $15 per share. The company declares a 50% stock dividend. • How many shares will the company have? • What is the value of the new firm? • What is the new share price?

37. Shimano Investment • You owned 50,000 share of Shimano, how is your portfolio affected • Value of your portfolio: before, after? • Percent of firm own: before, after? • Has anything really changed?

38. 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. • Like with a stock dividend, the stock price falls, but nothing really changes

39. Why Pay a Stock Div or Split? • Companies generally claim to do this so that the stock price is in a “more desirable trading range” • Also a lot of people are like my mother • They think they are getting something from the company, and it makes them feel good so they buy more shares • This artificial increase in demand increases share price

40. Quick Quiz • What are the different types of dividends, and how is a dividend paid? • What is the clientele effect, and how does it affect dividend policy irrelevance? • What is the information content of dividend changes? • What are stock dividends, and how do they differ from cash dividends? • How are share repurchases an alternative to dividends, and why might investors prefer them?

41. Why we care? Example of potential financial smoke and mirrors Better understanding of investing