Corporate Finance

1. Corporate Finance Topic 7 (Ch.19) Lecturer: I-Ju Chen College of Management Yuan Ze University

2. Key Concepts and Skills • Understand dividend types and how they are paid • Understand the issues surrounding dividend policy decisions • Understand why share repurchases are an alternative to dividends • Understand the difference between cash and stock dividends

3. Chapter Outline 19.1 Different Types of Payouts 19.2 Standard Method of Cash Dividend Payment 19.3 The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy 19.4 Repurchase of Stock 19.5 Personal Taxes, Dividends, and Stock Repurchases 19.6 Real-World Factors Favoring a High Dividend Policy 19.7 The Clientele Effect: A Resolution of Real-World Factors? 19.8 What We Know and Do Not Know about Dividend Policy 19.9 Putting It All Together 19.10 Stock Dividends and Stock Splits

4. 19.1 Different Types of Payouts • Many companies pay a regular cash dividend. • Public companies often pay quarterly (Taiwanese listed companies usually pay dividends in yearly base). • 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. • Taiwan listed companies use this way more than US firms. • Some companies declare a dividend in kind. • Wrigley’s Gum sends a box of chewing gum. • Other companies use stock buybacks.

5. 19.2 Standard Method of Cash Dividend Cash Dividend - Payment of cash by the firm to its shareholders. Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock immediately before this date is entitled to a dividend. Record Date – Date on which company determines existing shareholders.

6. Procedure for Cash Dividend 25 Oct. 1 Nov. 2 Nov. 5 Nov. 7 Dec. … Ex-dividend Date Declaration Date Cum-dividend Date Record Date Payment Date Declaration Date: The Board of Directors declares a payment of 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 individuals believed to be stockholders as of 5 November.

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 by the amount of the cash dividend. Ex-dividend Date 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.

8. 19.3 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.

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 Cash from dividend $160 Cash from selling stock $80 Total Cash $240 Value of Stock Holdings $40 × 78 = $3,120 $3 Dividend $240 $0 $240 $39 × 80 = $3,120

10. Dividend Policy Is Irrelevant • In the above example, Bob Investor began with a total wealth of $3,360: • After a $3 dividend, his total wealth is still $3,360: • After a $2 dividend and sale of 2 ex-dividend shares, his total wealth is still $3,360:

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.”

12. 19.4 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. • Taiwan allows repurchase mechanism since 2000.

13. 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 = Stock Repurchase versus Dividend Consider a firm that wishes to distribute $100,000 to its shareholders.

14. Assets Liabilitie s & 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 outstandin g = 100,000 Price per share = $900,000/1 00,000 = $9 Stock Repurchase versus Dividend If they distribute the $100,000 as a cash dividend, the balance sheet will look like this:

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

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

17. 19.5 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.

18. Firms without Sufficient Cash In a world of personal taxes, firms should not issue stock to pay a dividend. InvestmentBankers The direct costs of stock issuance will add to this effect. Cash: stock issue Firm Stock Holders Cash: dividends Taxes Gov.

19. 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

20. Taxes and Dividends • In the presence of personal taxes: • A firm should not issue stock to pay a dividend. • Managers have an incentive to seek alternative uses for funds to reduce dividends. • Though personal taxes mitigate against the payment of dividends, these taxes are not sufficient to lead firms to eliminate all dividends.

21. 19.6 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.

22. 19.7 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.

23. 19.8 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.

24. 19.9 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.

25. 19.10 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% • Stock dividends are more popular in Taiwan • Only stock dividends paid by retained earnings are taxable, stock dividends from additional paid-in capital is tax free).

26. 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.”

27. Exercise 1 • The Rent It Company declared a dividend of $.60 a share on October 20th to holders of record on Monday, November 1st. The dividend is payable on December 1st. You purchased 100 shares of Rent It Company stock on Wednesday, October 27th. How much dividend income will you receive on December 1st from the Rent It Company? • Ans: $0.60

28. Exercise 2 • Robinson’s has 15,000 shares of stock outstanding with a par value of $1.00 per share and a market price of $36 a share. The balance sheet shows $189,000 in the retained earnings account. The firm just announced a 3-for-2 stock split. How many shares of stock will be outstanding after the split? • Updated shares=150008*(3/2)=22,500