Chapter 16 Payout Policy

1. � 2009 McGraw-Hill Ryerson Limited Chapter 16 -1 Chapter 16Payout Policy Prepared by Shahriar Hasan Thompson Rivers University

2. � 2009 McGraw-Hill Ryerson Limited Chapter 16 -2 Chapter Outline How Dividends are Paid Share Repurchase How do Companies Decide on Dividend Payments? Why Payout Policy Should Not Matter Why Dividends May Increase Firm Value Why Dividends May Decrease Firm Value

3. � 2009 McGraw-Hill Ryerson Limited Chapter 16 -3 16.1 How Dividends are Paid Terminology Cash Dividend: Payment of cash by the firm to its shareholders. Regular cash dividends are generally paid quarterly. Extra dividends are one-time dividends and unlikely to be repeated. Ex-Dividend Date: Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend. Record Date: Person who owns stock on this date received the dividend.

4. � 2009 McGraw-Hill Ryerson Limited Chapter 16 -4 How Dividends are Paid A company has declared a dividend with a payment date of June 30th. The date of record is Monday, June 6th.

5. � 2009 McGraw-Hill Ryerson Limited Chapter 16 -5 How Dividends are Paid ? Stock dividend: Distribution of additional shares, instead of cash, to the firm�s shareholders. ? Stock split: Issue of additional shares to a firm�s shareholders. ? Reverse split: Issue of new shares in exchange for old shares, which results in the reduction of outstanding shares. ? Dividend Reinvestment Plan (DRIP): Enables shareholders to reinvest dividends into additional new shares. ? Share purchase plan: Allows shareholders to make cash contributions toward the acquisition of new shares.

6. � 2009 McGraw-Hill Ryerson Limited Chapter 16 -6 How Dividends are Paid An example of stock dividend: XYZ Inc. has 2 million shares currently outstanding at a price of $15 per share. The company declares a 50% stock dividend. How many shares will be outstanding after the dividend is paid? After the stock dividend what is the new price per share and what is the new value of the firm? Additional shares issued = 2 mil ? 0.50 = 1 mil New total shares outstanding = 2 mil + 1 mil = 3 mil Old value = 2 mil ? $15 = $30 mil = New value New price per share = $30 mil/3 mil = $10

7. � 2009 McGraw-Hill Ryerson Limited Chapter 16 -7 16.2 Share Repurchase Dividend vs Stock Repurchase Stock repurchase: Firm buys back stock from its shareholders. Note that a cash dividend and a share repurchase leave a shareholder in the same financial position. In the next three slides we show the example of a firm that has a choice of giving $1 dividend to its shareholders or to buy back 10,000 shares from the market with the money. The slides show the (1) firm before the dividend, (2) firm after the dividend and (3) firm after the stock repurchase. The value is the same if we consider that the cash dividend of $1 plus the stock price is $10.

8. � 2009 McGraw-Hill Ryerson Limited Chapter 16 -8 Share Repurchase

9. � 2009 McGraw-Hill Ryerson Limited Chapter 16 -9 Share Repurchase

10. � 2009 McGraw-Hill Ryerson Limited Chapter 16 -10 Share Repurchase

11. � 2009 McGraw-Hill Ryerson Limited Chapter 16 -11 16.3 How Do Companies Decide on Dividend Payments? Dividend payout ratio: Percentage of earnings paid out as dividends. Information content: dividend increases send good news about the future cash flow and earnings. Dividend cuts send bad news. Firms have longer term target dividend payout ratios. Managers focus more on dividend changes than on absolute levels. Dividends changes follow shifts in long-run, sustainable levels of earnings rather than short-run changes in earnings. Managers are reluctant to make dividend changes that might have to be reversed.

12. � 2009 McGraw-Hill Ryerson Limited Chapter 16 -12 16.4 Why Payout Policy Should Not Matter The Irrelevancy of Dividend Policy Since investors do not need dividends to convert shares to cash they will not pay higher prices for firms with higher dividend payouts. In other words, dividend policy will have no impact on the value of the firm. Modigliani and Miller (MM) maintain that under ideal conditions, dividend policy is irrelevant. Assuming perfect capital markets with no taxes or costs of financial distress. Assuming efficient markets and fairly priced assets.

13. � 2009 McGraw-Hill Ryerson Limited Chapter 16 -13 16.5 Why Dividends May Increase Firm Value Clientele Effect There are natural clients for high-payout stocks, but it does not follow that any particular firm can benefit by increasing its dividends. These clients increase the price of the stock through their demand for a dividend paying stock. Because a high dividend payout policy will be costly to firms that do not have the cash flow to support it, dividend increases signal a company�s good fortune and its manager�s confidence in future cash flows. Since dividends are interpreted by investors as a signal about future earnings, announcements of dividend cuts are usually taken as bad news.

14. � 2009 McGraw-Hill Ryerson Limited Chapter 16 -14 16.6 Why Dividends May Reduce Firm Value If dividends are taxed more heavily than capital gains, then a policy of paying high dividends would hurt firm value. In Canada, both capital gains and dividends are taxed at a lower rate than interest and other types of income.

15. � 2009 McGraw-Hill Ryerson Limited Chapter 16 -15 Why Dividends May Reduce Firm Value

16. � 2009 McGraw-Hill Ryerson Limited Chapter 16 -16 Summary of Chapter 16 Dividends come in many forms, including cash dividends, stock dividends, and extra dividends. Studies have shown that managers have a target dividend payout ratio. Furthermore, managers look to future cash flows when setting the dividend. MM proved in perfect and efficient capital markets dividend policy is irrelevant. However, in the absence of perfect capital markets, dividend policy might be relevant.