Returning Cash to the Owners: Dividend Policy

1. Returning Cash to the Owners: Dividend Policy Aswath Damodaran

2. First Principles • Invest in projects that yield a return greater than the minimum acceptable hurdle rate. • The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt) • Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. • Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. • If there are not enough investments that earn the hurdle rate, return the cash to stockholders. • The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics. Objective: Maximize the Value of the Firm

3. Dividends are sticky

4. Dividends tend to follow earnings

5. More and more firms are buying back stock, rather than pay dividends...

6. Measures of Dividend Policy • Dividend Payout: • measures the percentage of earnings that the company pays in dividends • = Dividends / Earnings • Dividend Yield : • measures the return that an investor can make from dividends alone • = Dividends / Stock Price

7. Dividend Payout Ratios: January 2002

8. Dividend Yields in the United States: January 2002

9. Three Schools Of Thought On Dividends • 1. If • (a) there are no tax disadvantages associated with dividends • (b) companies can issue stock, at no cost, to raise equity, whenever needed • Dividends do not matter, and dividend policy does not affect value. • 2. If dividends have a tax disadvantage, • Dividends are bad, and increasing dividends will reduce value • 3. If stockholders like dividends, or dividends operate as a signal of future prospects, • Dividends are good, and increasing dividends will increase value

10. The balanced viewpoint • If a company has excess cash, and few good projects (NPV>0), returning money to stockholders (dividends or stock repurchases) is GOOD. • If a company does not have excess cash, and/or has several good projects (NPV>0), returning money to stockholders (dividends or stock repurchases) is BAD.

11. Why do firms pay dividends? • The Miller-Modigliani Hypothesis: Dividends do not affect value • Basis: • If a firm's investment policy (and hence cash flows) don't change, the value of the firm cannot change with dividend policy. If we ignore personal taxes, investors have to be indifferent to receiving either dividends or capital gains. • Underlying Assumptions: • (a) There are no tax differences between dividends and capital gains. • (b) If companies pay too much in cash, they can issue new stock, with no flotation costs or signaling consequences, to replace this cash. • (c) If companies pay too little in dividends, they do not use the excess cash for bad projects or acquisitions.

12. The Tax Response: Dividends are taxed more than capital gains • Basis: • Dividends are taxed more heavily than capital gains. A stockholder will therefore prefer to receive capital gains over dividends. • Evidence: • Examining ex-dividend dates should provide us with some evidence on whether dividends are perfect substitutes for capital gains.

13. Price Behavior on Ex-Dividend Date Let Pb= Price before the stock goes ex-dividend Pa=Price after the stock goes ex-dividend D = Dividends declared on stock to, tcg = Taxes paid on ordinary income and capital gains respectively $ P $ P b a _ _ _ _ _ _ _ _ _ _ _ _ _ _ | _ _ _ _ _ _ _ E x - D i v i d e n d D a y _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ |

14. Cashflows from Selling around Ex-Dividend Day • The cash flows from selling before then are- Pb - (Pb - P) tcg • The cash flows from selling after the ex-dividend day are- Pa - (Pa - P) tcg + D(1-to) Since the average investor should be indifferent between selling before the ex-dividend day and selling after the ex-dividend day - Pb - (Pb - P) tcg = Pa - (Pa - P) tcg + D(1-to) Moving the variables around, we arrive at the following:

15. Price Change, Dividends and Tax Rates P  P ( 1 - t ) b a o = D ( 1  t ) cg If Pb - Pa = D then to = tcg Pb - Pa < D then to > tcg Pb - Pa > D then to < tcg

16. The Evidence on Ex-Dividend Day Behavior O r d i n a r y I n c o m e C a p i t a l G a i n s ( P - P ) / D b a B e f o r e 1 9 8 1 7 0 % 2 8 % 0 . 7 8 ( 1 9 6 6 - 6 9 ) 1 9 8 1 - 8 5 5 0 % 2 0 % 0 . 8 5 1 9 8 6 - 1 9 9 0 2 8 % 2 8 % 0 . 9 0 1 9 9 1 - 1 9 9 3 3 3 % 2 8 % 0 . 9 2 1 9 9 4 . . 3 9 . 6 % 2 8 % 0.90

17. Dividend Arbitrage • Assume that you are a tax exempt investor, and that you know that the price drop on the ex-dividend day is only 90% of the dividend. How would you exploit this differential? • Invest in the stock for the long term • Sell short the day before the ex-dividend day, buy on the ex-dividend day • Buy just before the ex-dividend day, and sell after. • ______________________________________________

18. Example of dividend capture strategy with tax factors • XYZ company is selling for $50 at close of trading May 3. On May 4, XYZ goes ex-dividend; the dividend amount is $1. The price drop (from past examination of the data) is only 90% of the dividend amount. • The transactions needed by a tax-exempt U.S. pension fund for the arbitrage are as follows: • 1. Buy 1 million shares of XYZ stock cum-dividend at $50/share. • 2. Wait till stock goes ex-dividend; Sell stock for $49.10/share (50 - 1* 0.90) • 3. Collect dividend on stock. • Net profit = - 50 million + 49.10 million + 1 million = $0.10 million

19. The wrong reasons for paying dividendsThe bird in the hand fallacy • Argument: Dividends now are more certain than capital gains later. Hence dividends are more valuable than capital gains. • Counter: The appropriate comparison should be between dividends today and price appreciation today. (The stock price drops on the ex-dividend day.)

20. The excess cash hypothesis • Argument: The firm has excess cash on its hands this year, no investment projects this year and wants to give the money back to stockholders. • Counter: So why not just repurchase stock? If this is a one-time phenomenon, the firm has to consider future financing needs. Consider the cost of issuing new stock:

21. The Cost of Raising Funds • Issuing new equity is much more expensive than raising new debt for companies that are already publicly traded, in terms of transactions costs and investment banking fees • Raising small amounts is much more expensive than raising large amounts, for both equity and debt. Making a small equity issue ( say $ 25-$ 50 million might be prohibitively expensive)

22. Are firms perverse? Some evidence that they are not

23. Evidence from Canadian Firms Company Premium for Cash dividend over S t o c k D i v i d e n d S h a r e s C o n s o l i d a t e d B a t h u r s t 1 9 . 3 0 % D o n f a s c o 1 3 . 3 0 % D o m e P e t r o l e u m 0 . 3 0 % I m p e r i a l O i l 1 2 . 1 0 % N e w f o u n d l a n d L i g h t & P o w e r 1 . 8 0 % R o y a l T r u s t c o 1 7 . 3 0 % S t e l c o 2 . 7 0 % T r a n s A l t a 1 . 1 0 % A v e r a g e 7 . 5 4 %

24. A clientele based explanation • Basis: Investors may form clienteles based upon their tax brackets. Investors in high tax brackets may invest in stocks which do not pay dividends and those in low tax brackets may invest in dividend paying stocks. • Evidence: A study of 914 investors' portfolios was carried out to see if their portfolio positions were affected by their tax brackets. The study found that • (a) Older investors were more likely to hold high dividend stocks and • (b) Poorer investors tended to hold high dividend stocks

25. Results from Regression: Clientele Effect D i v i d e n d Y i e l d = a + b  + c A g e + d I n c o m e + e D i f f e r e n t i a l T a x R a t e +  t t t t t t V a r i a b l e C o e f f i c i e n t I m p l i e s C o n s t a n t 4 . 2 2 % B e t a C o e f f i c i e n t - 2 . 1 4 5 H i g h e r b e t a s t o c k s p a y l o w e r d i v i d e n d s . A g e / 1 0 0 3 . 1 3 1 F i r m s w i t h o l d e r i n v e s t o r s p a y h i g h e r d i v i d e n d s . I n c o m e / 1 0 0 0 - 3 . 7 2 6 F i r m s w i t h w e a l t h i e r i n v e s t o r s p a y l o w e r d i v i d e n d s . D i f f e r e n t i a l T a x R a t e - 2 . 8 4 9 I f o r d i n a r y i n c o m e i s t a x e d a t a h i g h e r r a t e t h a n c a p i t a l g a i n s , t h e f i r m p a y s l e s s d i v i d e n d s .

26. Dividend Policy and Clientele • Assume that you run a phone company, and that you have historically paid large dividends. You are now planning to enter the telecommunications and media markets. Which of the following paths are you most likely to follow? • Courageously announce to your stockholders that you plan to cut dividends and invest in the new markets. • Continue to pay the dividends that you used to, and defer investment in the new markets. • Continue to pay the dividends that you used to, make the investments in the new markets, and issue new stock to cover the shortfall • Other

27. The Signaling Hypothesis

28. An Alternative Story..Dividends as Negative Signals

29. The Wealth Transfer Hypothesis EXCESS RETURNS ON STRAIGHT BONDS AROUND DIVIDEND CHANGES 0.5 0 t:- -12 -9 -6 -3 0 3 6 9 12 15 15 -0.5 CAR (Div Up) CAR CAR (Div down) -1 -1.5 -2 Day (0: Announcement date)

30. Management Beliefs about Dividend Policy • A firm’s dividend payout ratio affects its stock price. • Dividend payments operate as a signal to financial markets • Dividend announcements provide information to financial markets. • Investors think that dividends are safer than retained earnings • Investors are not indifferent between dividends and price appreciation. • Stockholders are attracted to firms that have dividend policies that they like.

31. Determinants of Dividend Policy • Investment Opportunities: More investment opportunities - > Lower Dividends • Stability in earnings: More stable earnings -> Higher Dividends • Alternative sources of capital: More alternative sources -> Higher Dividends • Constraints: More constraints imposed by bondholders and lenders -> Lower Dividends • Signaling Incentives: More options to supply information to financial markets - Lower need to pay dividends as signal • Stockholder characteristics: Older, poorer stockholders -> Higher dividends

32. Questions to Ask in Dividend Policy Analysis • How much could the company have paid out during the period under question? • How much did the the company actually pay out during the period in question? • How much do I trust the management of this company with excess cash? • How well did they make investments during the period in question? • How well has my stock performed during the period in question?

33. A Measure of How Much a Company Could have Afforded to Pay out: FCFE • The Free Cashflow to Equity (FCFE) is a measure of how much cash is left in the business after non-equity claimholders (debt and preferred stock) have been paid, and after any reinvestment needed to sustain the firm’s assets and future growth. Net Income + Depreciation & Amortization = Cash flows from Operations to Equity Investors - Preferred Dividends - Capital Expenditures - Working Capital Needs - Principal Repayments + Proceeds from New Debt Issues = Free Cash flow to Equity

34. Estimating FCFE when Leverage is Stable Net Income - (1- ) (Capital Expenditures - Depreciation) - (1- ) Working Capital Needs = Free Cash flow to Equity  = Debt/Capital Ratio For this firm, • Proceeds from new debt issues = Principal Repayments + d (Capital Expenditures - Depreciation + Working Capital Needs)

35. An Example: FCFE Calculation • Consider the following inputs for Microsoft in 1996. In 1996, Microsoft’s FCFE was: • Net Income = $2,176 Million • Capital Expenditures = $494 Million • Depreciation = $ 480 Million • Change in Non-Cash Working Capital = $ 35 Million • Debt Ratio = 0% • FCFE = Net Income - (Cap ex - Depr) (1-DR) - Chg WC (!-DR) = $ 2,176 - (494 - 480) (1-0) - $ 35 (1-0) = $ 2,127 Million

36. Microsoft: Dividends? • By this estimation, Microsoft could have paid $ 2,127 Million in dividends/stock buybacks in 1996. They paid no dividends and bought back no stock. Where will the $2,127 million show up in Microsoft’s balance sheet?

37. Dividends versus FCFE: U.S.

38. The Consequences of Failing to pay FCFE

39. 6 Application Test: Estimating your firm’s FCFE In General,If cash flow statement used Net Income Net Income + Depreciation & Amortization + Depreciation & Amortization - Capital Expenditures + Capital Expenditures - Change in Non-Cash Working Capital + Changes in Non-cash WC - Preferred Dividend + Preferred Dividend - Principal Repaid + Increase in LT Borrowing + New Debt Issued + Decrease in LT Borrowing + Change in ST Borrowing = FCFE = FCFE Compare to Dividends (Common) -Common Dividend + Stock Buybacks - Decrease in Capital Stock + Increase in Capital Stock

40. A Practical Framework for Analyzing Dividend Policy How much did the firm pay out? How much could it have afforded to pay out? What it could have paid out What it actually paid out Net Income Dividends - (Cap Ex - Depr’n) (1-DR) + Equity Repurchase - Chg Working Capital (1-DR) = FCFE Firm pays out too little Firm pays out too much FCFE > Dividends FCFE < Dividends Do you trust managers in the company with What investment opportunities does the your cash? firm have? Look at past project choice: Look at past project choice: Compare ROE to Cost of Equity Compare ROE to Cost of Equity ROC to WACC ROC to WACC Firm has history of Firm has history Firm has good Firm has poor good project choice of poor project projects projects and good projects in choice the future Give managers the Force managers to Firm should Firm should deal flexibility to keep justify holding cash cut dividends with its investment cash and set or return cash to and reinvest problem first and dividends stockholders more then cut dividends

41. A Dividend Matrix FCFE - Dividends Significant Maximum pressure Flexibility in on managers to Dividend Policy pay cash out Good Projects Poor Projects Investment and Dividend Reduce cash problems; cut payout to dividends but stockholders also check project choice

42. Disney: An analysis of FCFE from 1992-1996 Year Net Income (Cap Ex- Depr) Chg in WC FCFE (1- Debt Ratio) (1-Debt Ratio) 1992 $817 $173 ($81) $725 1993 $889 $328 $160 $402 1994 $1,110 $469 $498 $143 1995 $1,380 $325 $206 $849 1996* $1,214 $466 ($470) $1,218 Avge $1,082 $352 $63 $667 (The numbers for 1996 are reported without the Capital Cities Acquisition) The debt ratio used to estimate the free cash flow to equity was estimated as follows = Net Debt Issues/(Net Cap Ex + Change in Non-cash WC)

43. Disney’s Dividends and Buybacks from 1992 to 1996 Year FCFE Dividends + Stock Buybacks 1992 $725 $105 1993 $402 $160 1994 $143 $724 1995 $849 $529 1996 $1,218 $733 Average $667 $450

44. Disney: Dividends versus FCFE • Disney paid out $ 217 million less in dividends (and stock buybacks) than it could afford to pay out. How much cash do you think Disney accumulated during the period?

45. Can you trust Disney’s management? • During the period 1992-1996, Disney had • an average return on equity of 21.07% on projects taken • earned an average return on 21.43% for its stockholders • a cost of equity of 19.09% • Disney has taken good projects and earned above-market returns for its stockholders during the period. • If you were a Disney stockholder, would you be comfortable with Disney’s dividend policy? • Yes • No

46. Disney: Return Performance Trends

47. The Bottom Line on Disney Dividends • Disney could have afforded to pay more in dividends during the period of the analysis. • It chose not to, and used the cash for the ABC acquisition. • The excess returns that Disney earned on its projects and its stock over the period provide it with some dividend flexibility. The trend in these returns, however, suggests that this flexibility will be rapidly depleted. • The flexibility will clearly not survive if the ABC acquisition does not work out.

48. Aracruz: Dividends and FCFE: 1994-1996 1994 1995 1996 Net Income BR248.21 BR326.42 BR47.00 - (Cap. Exp - Depr)*(1-DR) BR174.76 BR197.20 BR14.96 - ∂ Working Capital*(1-DR) (BR47.74) BR15.67 (BR23.80) = Free CF to Equity BR121.19 BR113.55 BR55.84 Dividends BR80.40 BR113.00 BR27.00 + Equity Repurchases BR 0.00 BR 0.00 BR 0.00 = Cash to Stockholders BR80.40 BR113.00 BR27.00

49. Aracruz: Investment Record 1994 1995 1996 Project Performance Measures ROE 19.98% 16.78% 2.06% Required rate of return 3.32% 28.03% 17.78% Difference 16.66% -11.25% -15.72% Stock Performance Measure Returns on stock 50.82% -0.28% 8.65% Required rate of return 3.32% 28.03% 17.78% Difference 47.50% -28.31% -9.13%

50. Aracruz: Its your call.. • Assume that you are a large stockholder in Aracruz. They have a history of paying less in dividends than they have available in FCFE and have accumulated a cash balance of roughly 1 billion BR (25% of the value of the firm). Would you trust the managers at Aracruz with your cash? • Yes • No