FINANCIAL MANAGEMENT

1. FINANCIAL MANAGEMENT Dividends, dividend policy and stock splits

2. Introduction • Some investors prefer large and frequent dividends, some are happy with small but steady dividends, and some want no dividends at all. • (1) Why do companies pay cash dividends to shareholders? • (2) Is it better not to pay dividends at all and instead invest the money in positive net present value projects and increase the overall value of the company? • (2+) A policy of retaining funds avoids taxes for the shareholders until they sell their shares and lets the company pursue more growth. • (3) Is it better to distribute cash to shareholders each year, even though they will be taxes immediately on this distribution.

3. Introduction • The mechanics of dividends are straightforward, but the choice of dividend policy for a company is not; it is more subjective than objective and – surprise- may not be important at all. • Keep in mind that what is important to individuals, and especially to owners of a company, is the after-tax cash flow they receive, in terms of both the timing and amount of cash received.

4. 17.1 Cash dividends • Cash dividends = payment of cash to the owners of a company (they are taxable as income); • At one time, nearly 85% of all firms listed on the NYSE paid cash dividends; with the downturn in the economy in the early 2000’s the number felt to around 65%, continuing to fall.

5. 17.1 Cash dividends • 1. Declaration date: The day in which the decision of paying dividends is made (Board of directors – US; Shareholders’ General Meeting - Romania); • “PepsiCo will pay a 0.425$ dividend per share to all shareholders on record as of March 2, 2010, and payment will be mailed on Wednesday, March 4, 2010”. • 2. Ex-dividend date (ex-date): is the date that establishes the recipient of the dividend. It is two days before the date of record. • If you buy before the ex-date, you get any declared dividend; the seller does not. • If you buy on or after the ex-date, the seller gets any declared dividends. • The price on the morning of the ex-date will reflect the stock trading ex-dividend (without the dividend). Theoretically, the price of the stock will fall by the size of the declared dividends. Of course, other factors affects price as well.

6. 17.1 Cash dividends • 3. The record date: determines the shareholders entitled to receive a dividend. • 4. Payment date: the actual day on which the declared cash dividend is paid. • If you buy a stock today, your order is executed today, but you do not become the official shareholder for another two days when the actual trade is completed. • Different types of dividends: • 1. Regular cash dividends; • 2. Special or extra cash dividends; • 3. Stock dividends; • 4. Liquidating dividends.

7. 17.1 Cash dividends • 1. Regular cash dividends: a dividend that is routinely paid out to shareholders, often quarterly and often the same from quarter to quarter (in Romania is paid annually). • There is a typical dividend pattern with the same quarterly dividend for four consecutive quarters and then a slight increase in the cash dividend each June. • Some companies choose to raise dividends every fourth quarter by the same percentage amount, some by the same dollar/cent amount, and others by at least the prior increase and occasionally more. • Investors are inclined to interpret the lowered dividends as a sign that the company does not believe it can maintain the current payout level into the future.

8. 17.1 Cash dividends • 2. Special/extra dividends: Some companies add a special or extra dividend during periods of good company performance but is not guaranteed in the following period. [one-time, nonrecurring payment]. • 3. Stock dividends: a dividend in the form of shares of stock instead of cash. For example, a 10% stock dividend means you will receive one new share of common stock for every ten shares you currently hold (attention to the ex-date). • 4. Liquidating dividends: is issued to shareholders when the company is discontinuing operations or when a major portion of the business has been sold off. • For an individual owner, though, the liquidating dividend can also be the selling price because that is the day the owner liquidates his or her holdings of that stock.

9. 17.2 Dividend policy • Dividend policy deals with whether the firm should pay out a large amount now or invest more in the company. It is actually just a matter of timing of the dividends. • Some owners like high-dividend payouts because they are using the dividend stream as income (those living on fixed incomes - retirees). • Some investors have an incentive to want small dividends or even no dividends at all because dividends are taxed as income. These individuals, sometimes wealthy, want to postpone taxes. In addition, they believe pouring more money back into the company will raise the stock price. (different taxation of capital gain versus dividend income) • Different groups of shareholders with different desires on dividend policies are called dividend clienteles.

10. 17.2 Dividend policy • Dividend policy in a world of no taxes and no transaction costs: • Example 17.1: Assume you have a target income of 20,000$ per year. How can you get this income (in a world of no taxes) if your only wealth is the 10,000 shares of Stark Industries? • Policy 1: 2$ annual dividend; current price per share is 10$ before cash dividend and 8$ after; • Policy 2: no cash dividend; current price is and will remain at 10$. • Objective: Receive 20,000$ income; current paper wealth is 10$ x 10,000 shares = 100,000 $. • Policy 1: receive 20,000$ as cash dividends plus the paper wealth of 80,000$ (8$ x 10,000) = 100,000$; • Policy 2: you need to sell 2,000 shares of Stark to get the 20,000$ and you are left with 8,000 shares at 10$ each => your wealth is 100,000$. • You achieved your dividend objective under either scenario and in the process have rendered the dividend policy irrelevant.

11. 17.2 Dividend policy • Example 17.2: Assume you have a target income of 10,000$ per year. How can you get this income (in a world of no taxes) if your only wealth is the 10,000 shares of Stark Industries? • Policy 1: 2$ annual dividend; current price per share is 10$ before cash dividend and 8$ after; • Policy 2: no cash dividend; current price is and will remain at 10$. • Objective: Receive 10,000$ income; current paper wealth is 10$ x 10,000 shares = 100,000 $. • Policy 1: receive 20,000$ as cash dividends, you keep 10,000$ and buy 10,000$/8$ = 1,250 shares. Your wealth is 10,000$ + 90,000$ (8$ x 11,250) = 100,000$; • Policy 2: you need to sell 1,000 shares of Stark to get the 10,000$ and you are left with 9,000 shares at 10$ each => your wealth is 100,000$. • You can therefore undo any dividend policy of Stark industries to get the dividend policy that meets your personal cash flow needs.

12. 17.2 Dividend policy • Known as the dividend policy irrelevance theory (Merton Miller and Franco Modigliani, 1961), it says that a company’s dividend policy is irrelevant to investors because they can buy back shares with the cash dividends or sell a portion of their shares to get their desired current cash flow. • Dividends in the world of taxes: • It turns out that the result will not change, even when taxes enter the picture, if we assume the same rate for dividends and stock price appreciation and if the original purchase price of the stock equals the current price. • If we add a tax rate of 25% for both ordinary income (the dividend distribution) and for capital gains (profit from sale of the stock), the dividend policy remains irrelevant to you as long as we assume the stock price falls not by the size of the dividend but by the size of the after-tax cash dividend.

13. 17.2 Dividend policy • Example 17.3: you have a target income of 10,000$ for the year, and Stark Industries has the following policies under consideration: 2$ dividend per share or no dividends. You originally purchased the stock for 10$, and the before dividend payout price is 10$. • Policy 1: Dividend income is 10,000 shares x 2$ = 20,000 $ from which the tax is deducted: 20,000$ x 25% = 500 $ so you are left with 15,000$. Since the target is only 10,000 $ you will use 5,000$ to buy shares at the new price: 10$ - 2$x25% = 8.5$ /share. You will buy a total of 588.2353 shares and your total wealth will be: 10,000$ [cash] + 10,588.2353 x 8.5$ [paper] = 100,000 $; • Policy 2: You sell 1,000 shares to get 10,000 $ but you need to pay taxes on your capital gain. Since this is zero, you keep the entire proceeds from the sale. Your total wealth will be: 10,000$ [cash] + 9,000 shares x 10$ [paper] = 100,000 $.

14. 17.2 Dividend policy • Example 17.4: you have a target income of 10,000$ for the year, and Stark Industries has the following policies under consideration: 2$ dividend per share or no dividends. You originally purchased the stock for 5$, and the before dividend payout price is 10$. • Policy 1: The same as previous: your total wealth will be: 10,000$ [cash] + 10,588.2353 x 8.5$ [paper] = 100,000 $; • Policy 2: You will need to sell enough shares to get your 10,000$ and pay the capital gains tax: • For every share you sell you will pay as tax: (10$-5$)x25% = 1.25$; • Net cash flow per share: 10$ - 1.25$ = 8.75$. • You need then 10,000 $/ 8.75 $ = 1,142.8571 shares to sell; • Your total wealth will be: 10,000$ [cash] + (10,000 – 1,142.8571) x 10$ [paper] = 98,571.43 $.

15. 17.2 Dividend policy • We could say that the policy 1 (cash dividend) outperforms the noncash dividend but we should remember that in the last case funds remaining in the firm will be reinvested raising the stock in policy 2 over the price in policy 1. • With taxes, potential capital gains, and reinvestment opportunities of the company, the dividend policy does become relevant to the shareholders; • The answer to which policy is to be preferred must now incorporate not only your desired income level but also your personal marginal tax rates, original basis in the stock, and expectations about the future stock price. • Thus, the optimal dividend policy will take into account these differentials and will vary for different shareholders.

16. 17.2 Dividend policy • Reasons favoring a low or no-dividend-payout policy: • 1. The avoidance or postponement of taxes on distributions for shareholders; • 2. Higher potential future returns for shareholders; • 3. Less need for additional costly outside funding. • Reasons favoring a high-dividend payout policy: • 1. Avoidance of transaction costs for selling shares; • Cash payments today versus uncertain cash payments tomorrow. • Is there an optimal dividend policy, and is dividend policy relevant to an investor? • A company can have only one dividend policy and it must choose one that fits a large percentage of its shareholders.

17. 17.3 Selecting a dividend policy • Prior to selecting a dividend policy, a firm should review its cash flow requirements and future funding requirements; The goal is to produce sufficient cash flow to pay off debts in a timely fashion, maintain operations, and provide cash for reinvesting. • When these three areas are covered, the remaining cash flow from operations can be distributed to owners through dividends. • Residual dividend policy versus sticky dividends • Investors do not like dividend fluctuations, especially decreases: • 1. individuals living off their dividend streams do not like reductions in their quarterly payments; on the contrary they want to offset inflation; • 2. A cut in dividends may signal poor future performance or the inability of the company to maintain a given level of dividends in the future. • The idea is to set the dividend policy low enough in order to maintain dividends regardless variances in cash flows.

18. 17.3 Selecting a dividend policy • Selecting a dividend payout rate: residual versus sticky • Considering the case of a firm that estimates three different scenarios relative to the future excess cash and has 2,000,000 shares outstanding [Example 17.5, see next slide]; • What are the highest dividends the firm can pay each year under the anticipated cash flow, the best-case scenario, and the worst case scenario if a residual dividend policy is maintained. • If the firm wants to avoid cutting dividends and use a sticky dividend policy, what is the largest dividend it should declare considering the income in the worst case scenario?

19. 17.3 Selecting a dividend policy • Forecasting future excess cash flow: a three scenario approach.

20. 17.3 Selecting a dividend policy • Under the residual dividend policy, the dividends will vary from 0.305$ to 0.89$ /year, a significant variance of dividends. • Under the sticky dividends policy, the company will declare a 0.305$ dividend and not raise the dividend until sufficient cash is saved to cover the downside potential of the fourth year’s worst-case scenario.

21. 17.3 Selecting a dividend policy • Further considerations in the selection of a dividend policy: • (I) Restrictions on legal capital: • generally, firms cannot pay out cash dividends from their legal capital, so reductions of the legal capital are forbidden if intended to serve this goal. The concern is that exorbitant dividend payments will not leave enough to pay the company’s bills, thereby placing the claims of suppliers, customers and employees at risk. • (II) Restrictive bond covenants: • Bond holders may have covenants stating that dividends cannot be paid unless sufficient cash is currently available to cover the next coupon payments. Other constraints may prohibit dividends above a certain percentage of current earnings. • (III) Cash availability: • The net income and retained earnings do not reflect the amount of cash in the bank. Lenders will question this usage of the money.

22. 17.4 Stock dividends, stock splits and reverse splits • A stock dividend: is a payment of shares to current shareholders in which the payment is less than 25% of the current shares held. • A 10% stock dividend means that a shareholder with 100 shares of stock will be issued and additional 10 shares. • With stock dividends, however, there is no real change in wealth. • In a stock split: a company’s existing shares are divided into multiple shares, with the total dollar value remaining the same. • The most common split is 2-for-1, in which the number of outstanding shares double. • The process of declaring a split is the same as that for a cash dividend declaration and follows the same chronology.

23. 17.4 Stock dividends, stock splits and reverse splits • Reasons for stock splits: • (I) Preferred trading range: • “the span between the highest and lowest prices at which investors prefer to buy stock”. For the US stock market there is the 20$-40$ range; When prices are exceeding the upper limit there is a tendency of bring them back by deciding a stock split. • (II) Signaling hypothesis: • Current management can signal information to both current and potential shareholders that the strong past performance that caused the price to rise out of the preferred trading range will continue into the future. {In general, stock prices tend to rise after splits} • (III) Increased liquidity: • There will be more shares available and more buyers and sellers will be interested. {the speed at which one can buy and sell an asset is one dimension of liquidity; not so many empirical proofs for this III) reasons}

24. 17.4 Stock dividends, stock splits and reverse splits • Reverse splits: is the division of a company’s stock into lesser number of outstanding shares; it is often taken to engineer the stock price up into the preferred trading range to meet listing standards and avoid delisting. • (I) trading activity and attractiveness of the stock: if a company’s stock trades bellow the preferred trading range it may be a sign that the market believes the company is not competitive. {not so much empirical proofs} • (II) an institutional reason: if a firm is trading bellow 1$ for more than thirty days, NASDAQ has the option to delist the stock. Reverse splits increased in the early 2000’s following the bursting of the technology bubble. • The most extreme proposed reverse stock split was the case of General Motors (May 2009) with a 1 for 100 reverse split. Soon after GM filled for Chapter 11 bankruptcy.

25. 17.5 Specialized dividend plans • (1) Stock repurchases and (2) Dividend reinvestment programs. • (1) Stock repurchases: • Many companies forgo the formal cash dividend process and use the cash to buy back their own shares on the open market. • The effect is to reduce the number of shares outstanding and increase the earnings per share (the price/share is 50$).

26. 17.5 Specialized dividend plans • (1) Stock repurchase: repurchase for 250,000$ and buy back 5,000 shares. The new EPS=1,000,000$ / 195,000 = 5.13; P=50$ • (2) Cash dividend payout: pays out a dividend of 1.25$; the EPS remains the same, but the stock price falls: 9,750,000/200,000 => 48.75$. • The EPS does go up with a share repurchase but the value of the firm is the same: 1.25$ + 48.75$ = 50,00 $.

27. 17.5 Specialized dividend plans • (2) Dividend reinvestment plans (DRIP): • The automatic reinvestment of the shareholder’s cash dividend in more shares of the company stock. • Many DRIPs provide shares commission-free, so they are an attractive way to increase holdings in accompany over time without going to the secondary market to buy additional shares. • Some companies offer optional cash purchase plans attached to DRIPs in which a shareholder can purchase additional shares through the DRIP for a small fee and small initial investment. • DRIPs can be found in three types of investment programs: • A. Company-run programs: • B. Transfer-agent-run programs: • C. Brokerage-run programs: