Del Hawley FIN 634

1. Chapter 14 Dividend Policy Del HawleyFIN 634 Fall 2003

2. Dividend Fundamentals • Relevant dates for dividend payments • Announcement date: information is released to the public • Date of record: Listed as owner on this day – get dividend • Ex dividend date: Stock sells without dividend – several (3) days before date of record • Payment date: When the dividend is actually paid The stock price should drop by the amount of the dividend on the ex-dividend date, other things equal.

3. Dividend Fundamentals • Legal factors affecting dividend policy • Capital impairment constraint: Cannot pay dividends that exceed “legal capital” • The par value of the outstanding common stock in most states • The par value plus paid-in capital in excess of par (all of the funds collected from the sale of the shares) in a few states. • Nothing prohibits a company from paying more than its current earnings as dividends • Cannot accumulate earnings so owners can escape taxes

4. Calculating The Maximum Amount a Firm Can Pay in Cash Dividends Where legal capital is defined as the par value of the common stock, maximum payout is $340,000 (Paid-in capital + RE) In states where legal capital includes all paid-in capital, the maximum payout is $140,000 (only Retained Earnings)

5. Dividend Fundamentals • Contractual constraints on dividend payments • Loan covenants restrict, but don’t prevent, dividend payments • May establish a “pool” of earnings that can be paid out

6. Types of Dividends • Types of dividend policies • Constant payout ratio policy (almost never observed) • Constant nominal payments (standard worldwide) • Maintain steady dividends • Increase only after a proven and continuing increase in earnings • Low regular and extra dividend

7. Types of Dividends • Stock dividends and stock splits • Are the same thing except for the accounting method used to record them • Neither should affect the total value of equity • Stock dividends assume that shareholders are stupid (they aren’t) • Signaling rationale • Make your own cash dividend rationale • Stock repurchase – a substitute for a cash dividend • Buy shares in the open market • Make tender offer to shareholders • Enter into private negotiation (Green Mail)

8. Patterns Observed In Dividend Policies • Dividend policies have pronounced industry patterns, and these are the same worldwide • profitable firms in mature industries tend to pay out much larger fractions of their earnings • Within industries, dividend payout tends to be directly related to • asset intensity (tangible vs intangible assets) • presence of regulation • Within industries, dividend payout tends to be inversely related to • The growth rate of sales and earnings

9. The Fraction of All Publicly Traded U.S. Firms Paying Cash Dividends - 1926-1999 Frame A 100 80 60 Percent 40 20 0 1926 1936 1946 1956 1966 1976 1986 1996 Year

10. Fraction of Publicly Traded U.S. Firms Paying Dividends, By Exchange Frame B 100 NYSE 80 60 AMEX Percent 40 NASDAQ 20 0 1926 1936 1946 1956 1966 1976 1986 1996 Year

11. Market Value of Share Repurchase Announcements, 1980-1999 $US Bns

12. Average Stock Market Reaction to Share Repurchase Announcements 25% 20% 15% 10% 5% CUMULATIVE MEAN RATE OF RETURN 0% -5% -10% -60 -50 -40 -30 -20 -10 0 +10 +20 +30 +40 +50 +60 TRADING DAY

13. Aggregate Dividend Payout Ratio for the U.S. Corporate Sector, 1970-2000 %

14. Dividend Payout Ratios For Selected U.S. Industries Source: Standard & Poors Industry Reports, various issues (2001)

15. Dividend Ratios for Selected U.S. Corporations in 2002 Generally, high Market-to-Book firms have low dividend payouts & yields

16. Relationship Between Dividend Policy and Earnings Growth • Growth is influenced by the dividend policy in a very direct way: Growth of earnings = ROE x (1 – Payout Ratio) This is an estimator of earnings growth, but in general: Higher retention ratios will produce higher earnings growth as long as the firm has profitable projects in which to invest.

17. Patterns Observed In Dividend Policies (Continued) • Almost all firms maintain constant nominal dividend payments per share for long periods of time • Companies tend to "smooth" dividends, and these are far less variable than are corporate profits • Taxes clearly influence dividend payouts, but the net effect is ambiguous. Taxes neither cause nor prevent dividends • Firms paid dividends before and after income tax • Clearly influences pay-out, though perhaps perversely (tax increases lead to higher payouts, rather than lower)

18. Market Reactions to Dividend Policies • The stock market reacts positively to dividend initiations and increases • 2-3% abnormal announcement period return • Market reacts even more (negatively) to dividend decreases or cuts • Dividend changes clearly convey information about management’s expectations regarding firm’s prospects • Dividend changes are deemed to be informative about the firm’s current and future earnings • In spite of intensive research, it is unclear how dividends affect the required return on a firm's common stock • Some studies show positive relationship, others none at all

19. Note on the effect of dividends on the required return on common stock Recall that we can write the required return on common stock as: Re = (Div1/Price0) + g You can think of (Div1/Price0) as the current dividend yield and g as the price appreciation or capital gains rate on the shares. The dividend irrelevance hypothesis says that investors don’t care how Re is composed – all dividend yield, all capital gains, or any mix in between. Return is return. Can make your own dividend or growth…

20. Note on the effect of dividends on the required return on common stock Arguments that favor the relevance of dividends: Tax differences: For a long time, capital gains were taxed at a lower rate than dividend income. Therefore, some investors may have preferred low-dividend high-gain stocks. Now, dividends are taxed at a lower rate, too. Risk (Bird-in-the-Hand Theory): Return that comes from capital gains is riskier than return that comes from dividends since you have the dividend but must wait for the uncertain capital gain. Clienteles: There may be groups of investors who prefer the steady income provided by dividends and others who prefer no dividends in lieu of long term growth in value. Liquidity: Stocks that are traded in blocks (100 or 1000 shares) are more readily bought and sold than odd-lot trades. Less of an issue now than 10 or 20 years ago.

21. The Agency Cost / Contracting Model Of Dividend Payments It’s very hard to explain all of the observed patterns of dividend policy in one theory, so several competing theories have been advanced. Mainstream favorite: The Agency Cost/Contracting Model • Dividends exist to overcome agency problems between managers and diffuse shareholders. Managers “commit” to paying out free cash flow as dividends. Dividends force the company to be monitored by the capital markets. • Partly based on ownership structure: Private and closely held firms rarely pay dividends; big public firms have high payouts • Partly based on investment opportunity set (IOS): mature firms have high payout; high-growth firms have low payouts

22. The Signaling Model Of Dividend Payments Major competitor: the Signaling Model of Dividends • Firms pay dividends to “burn money” that is not needed for internal investments • This signals the market that earnings are expected to remain high, or if dividends are increased, that earnings are expected to remain at the higher level at least • Dividends separate a company from its weaker rivals

23. The Residual Model Of Dividend Payments The most correct model in theory: the Residual Model of Dividends • Firms make a long-term capital budget to take advantage of all positive-NPV projects that are within the strategic niche of the company • Earnings are projected over the term of the planning horizon • The expected excess of earnings over the amount needed for investments is paid out as dividends – smoothly or with a built-in rate of increase If most companies followed this model, dividends would be higher and more volatile than we see.

24. Dividend Policy Irrelevance In A World Without Market Imperfections • Miller & Modigliani (1961) showed dividend policy cannot impact firm value in a world without market frictions • Value is determined solely by investment policy • If Investment is fixed, you can set dividends at any level desired • Must be sure to compare equal investment levels • Assume two firms, initially equal in size, value, profitability • Both have total assets worth $235 million today (YE 2002) • Both are in the same industry, with 10% profitability rate • Both will earn $23.5 million during period 1 (year 2003) • Both expect to invest $23.5mn in +NPV projects at YE2003 • Both have 25 million shares now, worth $9.40/share

25. Can Differing Dividend Policies Impact Valuations Of Firms Payout And Retention? • If the firms differ in dividend preferences of shareholders • Retention S/Hs want $23.5 mn profits earned during 2003 to be re-invested in firm at YE 2003 (for subsequent year 2004) • Payout S/Hs want $23.5mn profits earned during 2003 to be paid out as a dividend at YE 2003 • Cash needed for $23.5 mn investment at YE 2003 (for 2004) to be raised through $24.5 mn share issue to new investors • The firms thus differ regarding the use of Year 2003 profits and the funding of YE 2003 investments • Retention will finance investment with retained profits • Payout will finance with new shares • Absent taxes or market imperfections, the choice doesn’t impact the relative values of the two firms

26. Can Differing Dividend Policies Impact Valuations Of Firms Payout And Retention?

27. Valuation Of Firm Retention • Retention: Issues no new shares at YE2003, and earns $23.5m profit • Will retain and invest $23.5mn profits, so at YE 2003, will have total assets of $258.5 mn; • Equity will be worth $10.34/share at EOY 2003; still 25 mn O/S so total market value will be $258.5 mn • Return earned by Retention’s S/Hs during 2003: • Retention: What about Year 2004 and later years? • At YE 2003, has $258.5mn assets. With 10% profits rate will earn $25.85 mn during Year 2004, which it will retain • At YE 2004, equity will be worth $284.35 mn ($258.5mn + $25.85mn) • Still 25mn shares, so each worth $11.374; Yr 2004 return 10%

28. Valuation Of Firm Payout • Payout: Also earns $23.5mn during 2003, pays this out to existing shareholders at YE 2003 • At EOY 2003, before issuing new shares but after paying dividends, will have total assets of $235 mn • Still have 25mn shares, each worth $9.4/share • Return earned by Retention’s old S/Hs during 2003: • To finance $23.5mn new investment, must sell 2.5mn shares at $9.4/share, so total assets are $258.5 mn at the start of year 2004 • Will earn 10% profit, or $25.85 mn on assets during 2004; at YE 2004 assets worth $284.35 mn before paying dividends • Will then pay out $25.85 mn Year 2004 profits as dividends, so 27.5 mn shares outstanding worth $9.40 each • Raise $25.85 mn cash by selling 2.75mn share @ $9.4/share

29. Real-World Influences On Dividends Companies operate in the real world, with many frictions. Most of them should discourage dividends • Personal taxes on dividends should discourage payments • Empirical evidence is ambiguous • Dividends were paid before 1936 (no taxes) and after • Security issuance costs should discourage dividends • If costly to issue new stocks & bonds, firm should retain cash • Investor trading costs argue in favor of dividends • But cost of selling shares for income has fallen steadily • Dividends might be a “residual” after funding investments • But dividends are most stable of all CF series • May convey information in markets with info asymmetries • But what specific info & Isn’t there a cheaper way to signal? • Latest empirical evidence: div signals the past, not the future.

30. How Do Corporations Really Set Dividend Payments? Dividends determined today as they were for Lintner (1956) • Managers believe investors value steady dividend payments • Managers seem to have a target payout ratio, but only on average over time • Managers will allow the payout ratio to vary in the short term to keep dividends the same • Managers will only increase dividends if permanent earnings increase • Managers will only cut dividends if the firm is facing financial disaster

31. How Do Corporations Really Set Dividend Payments? Managerial reluctance to change nominal dividend payments gives rise to the partial adjustment model • Assume the target payout ratio = 0.50, with profits initially at $2.00/share • Implies an annual dividend of $1.00/share and a quarterly dividend of $0.25/share • Suppose permanent earnings suddenly rise to $3.00/share • Managers will not increase dividends to $1.50/year immediately. Instead, • May do so in $0.05 quarterly increments, over 2.5 yrs

32. A Checklist For Dividend Payouts The Agency Cost/Contracting Model, and empirical evidence, support these relationships between “optimal” payout levels and key variables