Dividend Policy and Internal Financing

1. Dividend Policy and Internal Financing Chapter 17 .

2. Dividend Policy and Internal Financing Dividend Policy Dividend per Share Earnings per Share Dividend Payout Ratio =

3. Dividend Policy and Internal Financing Dividend Policy Dividend per Share Earnings per Share • A firm calculates and reports Earnings per Share Dividend Payout Ratio =

4. Dividend Policy and Internal Financing Dividend Policy Dividend per Share Earnings per Share • A firm calculates and reportsearn Earnings per Share • Management will reinvest part of earnings per share in the company and pay part as dividend Dividend Payout Ratio =

5. Dividend Policy and Internal Financing Dividend Policy Dividend per Share Earnings per Share • A firm calculates and reportsearn Earnings per Share • Management will reinvest part of earnings per share in the company and pay part as dividend Dividend Payout Ratio = Income Statement Sales $3,000,000 Net Income $1,000,000 Dividends Paid Addition to RE 1 Million Shares Outstanding

6. Dividend Policy and Internal Financing Dividend Policy Dividend per Share Earnings per Share • Stockholders earn Earnings per Share • Management will reinvest part of earnings per share in the company and pay part as dividend Dividend Payout Ratio = Income Statement Sales $3,000,000 Net Income $1,000,000 Dividends Paid Addition to RE 1 Million Shares Outstanding EPS = $1.00

7. Dividend Policy and Internal Financing Dividend Policy Dividend per Share Earnings per Share • Stockholders earn Earnings per Share • Management will reinvest part of earnings per share in the company and pay part as dividend Dividend Payout Ratio = Income Statement If have a 50% dividend payout each share of stock will receive a 50¢ dividend Sales $3,000,000 Net Income $1,000,000 Dividends Paid Addition to RE 1 Million Shares Outstanding

8. Dividend Policy and Internal Financing Dividend Policy Dividend per Share Earnings per Share • Stockholders earn Earnings per Share • Management will reinvest part of earnings per share in the company and pay part as dividend Dividend Payout Ratio = Income Statement If have a 50% dividend payout each share of stock will receive a 50¢ dividend Sales $3,000,000 Net Income $1,000,000 Dividends Paid 500,000 Addition to RE $500,000 $500,000 paid to stockholders and $500,000 is reinvested in the firm 1 Million Shares Outstanding

9. Dividend Policy and Internal Financing Dividend Policy Dividend per Share Earnings per Share • Stockholders earn Earnings per Share • Management will reinvest part of earnings per share in the company and pay part as dividend Dividend Payout Ratio = Income Statement If it has a 0% dividend payout, all earnings are reinvested in the firm Sales $3,000,000 Net Income $1,000,000 Dividends Paid Addition to RE 1 Million Shares Outstanding

10. Dividend Policy and Internal Financing Dividend Policy Dividend per Share Earnings per Share • Stockholders earn Earnings per Share • Management will reinvest part of earnings per share in the company and pay part as dividend Dividend Payout Ratio = Income Statement If have a 0% dividend payout, all earnings are reinvested in the firm Sales $3,000,000 Net Income $1,000,000 Dividends Paid 0 Addition to RE $1,000,000 $0 paid to stockholders and $1,000,000 is reinvested in the firm 1 Million Shares Outstanding

11. Can Dividend Policy Affect Share Price • Three Theories of Dividends • Irrelevance • Dividends Increase Stock Price • Dividends Decrease Stock Price

12. Can Dividend Policy Affect Share Price View 1: Irrelevance Dividend Policy does not affect stock price • If the world was perfect (in perfect markets) • No brokerage fees • No floatation costs of issuing shares • No taxes • Equal access to information • Manager's act in shareholders' best interests

13. Can Dividend Policy Affect Share Price View 1: Irrelevance Dividend Policy does not affect stock price • If the world was perfect (in perfect markets) • No brokerage fees • No floatation costs of issuing shares • No taxes • Equal access to information • Manager's act in shareholders' best interests 52 Weeks Yld Vol Net Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg s 42½ 29 MKPS MK 1.75 5.1 24 5067 35 33 34¼ -1 When dividend of $1.75 is paid. the stock price falls by exactly the same amount.

14. Can Dividend Policy Affect Share Price View 1: Irrelevance Dividend Policy does not affect stock price • Assumes Perfect Markets • No brokerage fees • No floatation costs of issuing shares • No taxes • Equal access to information • Manager's act in shareholders' best interests 52 Weeks Yld Vol Net Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg s 42½ 29 MKPS MK 1.75 5.1 24 5067 35 33 34¼ -1 When dividend of $1.75 is paid. the stock price falls by exactly the same amount. $34.25 – $1.75 = $32.50

15. Can Dividend Policy Affect Share Price View 1: Irrelevance Dividend Policy does not affect stock price • If the world was perfect (in perfect markets) • No brokerage fees • No floatation costs of issuing shares • No taxes • Equal access to information • Manager's act in shareholders' best interests Dividends are Irrelevant Since: • No net gain to investor

16. Can Dividend Policy Affect Share Price View 1: Irrelevance Dividend Policy does not affect stock price • Assumes Perfect Markets • No brokerage fees • No floatation costs of issuing shares • No taxes • Equal access to information • Manager's act in shareholders' best interests Dividends are Irrelevant Since: • No net gain to investor • Without receiving dividend, an investor can sell shares of stock costlessly and create their own "dividend"

17. Can Dividend Policy Affect Share Price View 1: Irrelevance Dividend Policy does not affect stock price • Assumes Perfect Markets • No brokerage fees • No floatation costs of issuing shares • No taxes • Equal access to information • Manager's act in shareholders' best interests Dividends are Irrelevant Since: • No net gain to investor • Without receiving dividend, an investor can sell shares of stock costlessly and create their own "dividend" • If the firm pays a large dividend, but needs cash to invest can sell additional shares of stock costlessly.

18. Can Dividend Policy Affect Share Price View 2: High Dividends Increase Stock Value • Theory states: • Dividends are more predicable that capital gains, so investors prefer dividends--"Bird in the Hand theory”

19. Can Dividend Policy Affect Share Price View 2: High Dividends Increase Stock Value • Theory states: • Dividends are more predicable that capital gains, so investors prefer dividends--"Bird in the Hand theory" • To be indifferent, investors will require a higher rate on capital gains than dividends

20. Can Dividend Policy Affect Share Price View 2: High Dividends Increase Stock Value • Theory states: • Dividends are more predicable that capital gains, so investors prefer dividends-- "Bird in the Hand theory” • To be indifferent, investors will require a higher rate on capital gains than dividends • Critics of this theory • Point out cash flows of overall firm are not affected by dividends • If investors want cash, they should leave money in a bank account

21. Can Dividend Policy Affect Share Price View 3: Low Dividends Increase Stock Value • Based on Tax Effects: • Individual investors must pay taxes on dividends as the dividends are received

22. Can Dividend Policy Affect Share Price View 3: Low Dividends Increase Stock Value • Based on Tax Effects: • Individual investors must pay taxes on dividends as the dividends are received • Individual investors can defer taxes on capital gains until they sell the stock Before 1987, Capital Gains were taxed at a lower rate than dividends. Once again, capital gain taxes are lower than current income taxes today.

23. Can Dividend Policy Affect Share Price View 3: Low Dividends Increase Stock Value • Based on Tax Effects: • Individual investors must pay taxes on dividends as the dividends are received • Individual investors can defer taxes on capital gains until they sell the stock. • However, corporations may exclude 70% of dividends from corporate income taxes, so they may actually prefer a higher level of dividends

24. Can Dividend Policy Affect Share Price View 3: Low Dividends Increase Stock Value • Based on Tax Effects: • Individual investors must pay taxes on dividends as the dividends are received • Individual investors can defer taxes on capital gains until they sell the stock • However, corporations may exclude 70% of dividends from corporate income taxes, so they may actually prefer a higher level of dividends • Investors prefer the dividend policy that gives the highest after-tax return

25. Residual Dividend Theory Recognizes that floatation costs are involved in issuing new stock are very high

26. Residual Dividend Theory Recognizes that floatation costs are involved in issuing new stock are very high Companies with investment opportunities which require capital would prefer to use internal funds rather than issue new stock

27. Residual Dividend Theory Recognizes that floatation costs are involved in issuing new stock are very high • Residual Dividend Method • Accept all investments with positive net present values Companies with investment opportunities which require capital would prefer to use internal funds rather than issue new stock

28. Residual Dividend Theory Recognizes that floatation costs are involved in issuing new stock are very high • Residual Dividend Method • Accept all investments with positive net present values • Use retained earnings to finance investments to the extent possible Companies with investment opportunities which require capital would prefer to use internal funds rather than issue new stock

29. Residual Dividend Theory Recognizes that floatation costs are involved in issuing new stock are very high • Residual Dividend Method • Accept all investments with positive net present values • Use retained earnings to finance investments to the extent possible • If earnings left over after making investments, pay a dividend with the residual Companies with investment opportunities which require capital would prefer to use internal funds rather than issue new stock

30. Residual Dividend Theory Recognizes that floatation costs are involved in issuing new stock are very high • Residual Dividend Method • Accept all investments with positive net present values • Use retained earnings to finance investments when possible • If retained earnings left over after making investments, pay a dividend with the residual • If there are no residual funds, pay no dividend Companies with investment opportunities which require capital would prefer to use internal funds rather than issue new stock

31. Residual Dividend Theory Recognizes that floatation costs when issuing new stock are very high • Residual Dividend Method • Accept all investments with positive net present values • Use retained earnings to finance investments when possible • If retained earnings left over after making investments, pay a dividend with the residual • If there are no residual funds, pay no dividend Companies with investment opportunities which require capital would prefer to use internal funds rather than issue new stock Residual Theory minimizes floatation costs

32. The Clientele Effect Recognizes that investors are not all alike • There are all kinds of investors, some like dividends, others do not. • According to clientele effect, investors who prefer dividends over capital gains will gravitate to high dividend paying firms. Others will choose to invest in no or low dividend paying firms. • As an investor’s circumstances and or outlook for dividends changes, he will sell one kind of shares to invest in another kind.

33. Earnings UP 10% 50¢ Dividend Increase The Information Effect Changes in dividends may provide a signal of firm's financial condition Dividend Increase - May signal managers expect higher earnings in the future

34. Earnings OFF 10% 25¢ Dividend Cut The Information Effect Changes in dividends may provide a signal of firm's financial condition Dividend Decrease - May signal managers expect earnings downturn

35. Earnings OFF 10% 25¢ Dividend Cut The Information Effect Changes in dividends may provide a signal of firm's financial condition Dividend Decrease - May signal managers expect earnings downturn In practice, stock price usually rises with a unexpected dividend increase and falls with a dividend decrease

36. Drop Agency Costs

37. Expectations Theory Investors have expectations of managers' actions If managers announce a dividend at the level that investors expect, stock price will not be affected

38. $2.25 share? Expectations Theory Investors have expectations of managers' actions If managers announce a dividend at the level that investors expect, stock price will not be affected $2.25/share Manager Investor

39. $2.25 share? Expectations Theory Investors have expectations of managers' actions If managers announce a dividend at the level that investors expect, stock price will not be affected $2.25/share Manager Investor

40. Expectations Theory Investors have expectations of managers' actions If managers announce unexpectedly high or low dividend, stock price will be affected

41. $3.25 share? Expectations Theory Investors have expectations of managers' actions If managers announce unexpectedly high or low dividend, stock price will be affected $2.25/share Manager Investor

42. $3.25 share? Expectations Theory Investors have expectations of managers' actions If managers announce unexpectedly high or low dividend, stock price will be affected $2.25/share Manager Investor

43. $3.25 share? Expectations Theory Investors have expectations of managers' actions If managers announce unexpectedly high or low dividend, stock price will be affected $2.25/share If dividend is lower than expected, investors may believe earnings will be lower than expected and stock price will go down Manager Investor

44. $1.75 share? Expectations Theory Investors have expectations of managers' actions If managers announce unexpectedly high or low dividend, stock price will be affected $2.25/share Manager Investor

45. $1.75 share? Expectations Theory Investors have expectations of managers' actions If managers announce unexpectedly high or low dividend, stock price will be affected $2.25/share Manager Investor

46. $1.75 share? Expectations Theory Investors have expectations of managers' actions If managers announce unexpectedly high or low dividend, stock price will be affected $2.25/share If dividend is higher than expected, investors may believe earnings will be higher than expected and stock price will go up Manager Investor

47. Summary of Dividend Theories • Tests of dividend policy have not found conclusively that dividends affect stock price • The majority of managers believe that dividend policy is important • There are tax disadvantages to paying dividends • Almost all companies pay regular dividends • Dividend Policy is a "puzzle" to academic researchers

48. Dividends in Practice What determines dividends? • There may be legal restrictions on dividends • State laws have restrictions on dividends if company is not financially sound • Bond and Preferred Stock contracts may restrict dividends • Liquidity Position • The firm must have sufficient cash to pay the dividend • Sources of Financing • Small firms may be able to easily raise money in the capital markets so they will have low dividends • Earnings Predictability • Firms with stable earnings typically pays higher dividends as it expects to have future profits needed to pay dividend

49. Alternative Dividend Policies Constant Dividend Payout Ratio every year firm pays the same percentage of earnings as a dividend to shareholders

50. Alternative Dividend Policies Constant Dividend Payout Ratio every year firm pays the same percentage of earnings as a dividend to shareholders Example: Firm pays a constant 40% dividend annually