Chapter 18: Dividends and other payouts

1. Chapter 18: Dividends and other payouts • Dividend irrelevance in a world of perfect financial markets (Modigliani and Miller) • Dividend policy in the real world where asymmetric information exists • More on dividend policy decisions • Stock repurchases • Stock splits WSU EMBA Corporate Finance

2. Methods used to pay out cash (excess capital) to shareholders • Dividends • Paid on a per share basis, e.g., $0.80 per share • Stock repurchases • Repurchases have grown substantially since 1982. • Each payout method transfers cash from the firm to the markets. • A dividend change (increase) is likely to be interpreted as a stronger management signal since managers are averse to decreasing dividends. WSU EMBA Corporate Finance

3. How dividends are paid out; an example using Kodak • Dividend payments have four associated dates: announcement, record, ex dividend, and payment dates. • Kodak Board Declares Semi-Annual Cash Dividend ROCHESTER, N.Y.--(BUSINESS WIRE)--April 11, 2002--Eastman Kodak Company's board of directors today declared a semi-annual cash dividend of 90 cents per share on the outstanding common stock of the company. The 90 cent per share dividend declared today will be payable July 16, 2002, to shareholders of record at the close of business on June 3, 2002. • April 11 is the announcement date, June 3 is the record date, July 16 is the payment date, and the ex date will be two business days before the record date. If you purchase the stock on or after the ex date, you will not receive the dividend. WSU EMBA Corporate Finance

4. Dividend irrelevance in a Modigliani and Miller world • Under perfect financial markets, there is no asymmetric information. • Dividend policy decisions would just pay already publicly known amounts of cash to the shareholders. There would be no signaling. However, this is a good place to start in understanding dividend implications. • Sources of cash = uses of cash, better expressed as: • Operating cash flow + new capital raised = dividends + investments • The value of the firm is determined by its investment policy (its assets) and not by its dividend policy. • Refer to example of dividend irrelevance on Chapter 18 Lecture Notes, pages 1 and 2. WSU EMBA Corporate Finance

5. Dividend policy in the real world, i.e., asymmetric information exists • Announcements of increased cash payouts, i.e., dividend initiations and increases and also share repurchases, are usually associated with an immediate increase in stock prices. • Announcements of decreased cash payments, i.e., dividend decreases and omissions, are usually associated with an immediate decrease in stock prices. WSU EMBA Corporate Finance

6. Dividend policy in the real world • We assume that managers possess superior information concerning the firm's value (the firm’s future cash flows and risk). • Why do these dividend and repurchase announcements change stock prices? • These announcements constitute selective management actions that communicate or signal important private information regarding management’s perception of the firm. WSU EMBA Corporate Finance

7. Lintner (1956) observations on dividend policy • Lintner observed the following in interviews with executives: • Managers perceive dividends as a proportion of earnings. A target payout ratio preferred by managers. • Managers will not make changes in the level of dividend payments if they perceive that the new level of payments cannot be sustained. • Dividend changes follow or lag behind changes in the long run (perceived permanent) earnings potential of firms. • Investments or capital spending had little effect on modifying the pattern of dividend behavior. WSU EMBA Corporate Finance

8. Lintner’s theories on dividend policy • Partial Adjustment Hypothesis: • Dividend(t=1) = Dividend(t=0) + s[pEPS(t=1) – Dividend(t=0)] • p is the target proportion of earnings to be paid out, and s is the speed of adjustment to the new target dividend payout. Let s=0.35, p=0.40, and this year's Earnings per Share is $6.00. Last year's dividend was $2.00 per share. • This year's dividend is 2.00 + [0.35][(0.40)(6.00) – 2.00] = $2.14. • The dividend does not immediately move to 40% of the new earnings or (0.4)($6.00) = $2.40. WSU EMBA Corporate Finance

9. Lintner’s theories on dividend policy • Permanent Earnings Hypothesis: • Dividend(t=1) = (p)(Permanent Earnings for period t=1) • Managers examine the current level of earnings and ascertain what portion is permanent (sustainable) and what portion is temporary. • Dividend payments are then based on the permanent portion of earnings – a sustainable dividend. • If permanent earnings ↑, then dividends ↑ and vice versa. • Temporary or transitory (whether high or low) changes in earnings should not affect the level of dividends. WSU EMBA Corporate Finance

10. Observations concerning dividends • When firms increase dividends, future earnings generally do not fall below the new earnings level. • Evidence supports the Permanent Earnings Hypothesis • When earnings are temporarily higher, firms often issue a special dividend or a stock repurchase. • After dividend initiations or increases, future risk generally falls (and also the discount rate rE). The opposite risk effect is observed for dividend decreases or omissions. • Strong operating performance usually precedes initiations. WSU EMBA Corporate Finance

11. More on dividend policy decisions • Reasons stated for low dividends: • Taxes (usually higher on dividends) • Transactions costs or reinvesting dividends • Reasons stated for high dividends: • Lower agency costs of free cash flow: firm is committed to paying out excess cash, rather than wasting it on negative NPV projects. Relatively high levels of debt can also mitigate this agency problem by forcing or binding the firm to pay out cash as interest rather than as dividends. • Bird-in-the-hand (theory or fallacy) • Desire for current income • Clientele effect • Really just affects who owns what type of stocks WSU EMBA Corporate Finance

12. Stock repurchases: PepsiCo announcement of Nov. 21, 2000 PepsiCo Board Clears New Stock Buyback PURCHASE, N.Y. (Reuters) - PepsiCo Inc. (NYSE:PEP - news) said on Tuesday its board has authorized a new share repurchase program under which the soft drink and snack company plans to buy back $4 billion worth of stock over the next three years. The new program will go into effect once the current $3 billion program is complete. PepsiCo expects the current program, which was authorized in March 1999, to be completed by early 2001. “This new share repurchase program is a reflection of the strength of our businesses and our confidence in the consistent growth of PepsiCo's already powerful cash flow,” Chairman and Chief Executive Officer Roger Enrico said in a statement. “We are fortunate in being able to invest in growth opportunities, pay a healthy dividend and buy back a substantial number of shares all at the same time.” Just last week, Chief Financial Officer Indra Nooyi said the current buyback program is on track to be completed a year ahead of the original schedule. Since the beginning of 1996, PepsiCo has invested about $9 billion in share repurchases, including $1.3 billion so far this year. Shares of Purchase, N.Y.-based PepsiCo were up$1-1/4, or 2.78 percent, at $46-1/4 in late Tuesday morning trading. WSU EMBA Corporate Finance

13. Stock repurchases • Traditionally, shareholders pay lower effective taxes on capital gains versus dividend income. • Most shareholders are better off with repurchase • Repurchases are often used to signal the market that the stock price is too low (often cited by managers). • An equity repurchase is the opposite of an equity issue (Pecking Order Theory from Chapter 16) • Types of repurchases: • Open market (by far most common) • Tender offer (fixed price or Dutch auction) WSU EMBA Corporate Finance

14. Stock splits (and reverse splits) • HiTek has a total stock market value of $1 billion and 10 million shares of stock. HiTek’s stock price is thus ($1 billion)/(10 million shares) = $100/share. • HiTek issues a 5 for 1 stock split. Effectively, each existing share of stock is now five shares. The firm now has 50 million shares outstanding. • New stock price is ($1 billion)/(50 million shares) = $20 per share. • Ignoring any signaling or information effect, receiving a stock split appears analogous to exchanging a $100 bill for five $20 bills. WSU EMBA Corporate Finance

15. Stock splits and asymmetric information • In reality, stock prices usually increase by around 3% at the announcement of a stock split. Managers must be trying to signal or convey something positive about the firm. • Stock splits are typically issued by firms that have experienced strong increases in both stock price and operating performance in the year prior to the split – these are not ordinary firms. • Splits produce a lower post-split stock price. Evidence suggests that managers are signaling that there will be no disappointing future new that will send the price down even further, and thus managers are attempting to signal the quality of the firm. Managers are attempting to signal that the prior good performance is permanent in nature. • Dividend increases often follow splits (for those firms that pay dividends). WSU EMBA Corporate Finance

16. Stock splits • Some executives feel differently about stock splits. Berkshire Hathaway (run by Warren Buffett) has never issued a stock split. The firm has performed very well the last 40 years, hence the nearly $90,000 stock price! • BH’s 1983 annual report has very interesting opinions concerning stock splits! • Reverse stock splits do the opposite of a stock split. The post-split stock price will be higher since the number of outstanding shares is decreases. • Reverse splits are viewed as negative events WSU EMBA Corporate Finance