Chapter 16 Dividend Policy

1. Chapter 16 Dividend Policy

2. Chapter 16 Outline

3. 16.1 Distributions to Shareholders A corporation has no legal obligation to make any type of distribution to common shareholders, whether this is a distribution of cash or a distribution of shares. • A company’s board of directors declares a dividend, and only then does a dividend become a contractual commitment of the company. • Shareholders cannot force the members of the boardto declare a dividend, and there may be legal restrictions on whether or not the companycan declare a dividend.

4. Cash Dividends Aggregate Dividends and Profits, 1871 Through 2010 The dividend payout ratio is dividends as a percentage of earnings, as shown in the graph for the stocks that comprise the S&P 500 Index.

5. Dividend Payout Ratio We can draw a few conclusions from the graph: • The payout rate is normally around 40 to 60%, but increased to over 100% during economic downturns, when profits dropped dramatically but dividends remained relatively stable. • The payout rate has been trending downward over time. • The median payout for the most recent 10 years is 35.5%.

6. Dividend Yield Dividend Yields of Stocks in the S&P 500 Index, 1871 Through 2010 We can also look at dividends from another perspective. Consider the dividend yield of stocks in the S&P 500 Index, as shown in the graph. The dividend yield is the ratio of the dividend to the price of the stock; with the price of the stock in the denominator.

7. The Mechanics of Cash Dividends On the declaration date, the board specifies: • The amount of the dividend, generally stated as an amount per share of stock • The record date or date of record, which is the date used to determine the shareholders who will receive the dividend • The payment date or payable date, which is the day the dividend is actually paid by the company.

8. Holder of Record Because shares of stock are traded in markets on a continual basis, it can take a day or so to determine who actually owns the shares at a point in time; in this case, who the holder of record is on a particular day. The holder of record is resolved by the markets, which specify the ex-dividend date as two trading days prior to the record date.

9. Holder of Record How this works is as follows: • If you buy the stock on the ex-dividend date or later, you do not get the forthcoming, declared dividend. • If you buy the stock before the ex-dividend date and own it at least until the day before the ex-dividend date, you will receive the forthcoming dividend. This explains why we typically see a drop in the share price of a dividend-paying stock from the day before to the ex-dividend date: If you buy the stock on the day before the ex-dividend date, you receive the dividend; if you buy the stock on the ex-dividend date, you do not receive the dividend.

10. Timeline of IBM’s Cash Dividend Paid November 8, 2010

11. Dividend Reinvestment Plans If the investor does not want to receive a dividend, many corporations offer the option of using the cash dividend proceeds to buy new shares by way of a dividend reinvestmentplan (DRIP or DRP). Why wouldn’t an investor want a cash dividend?

12. DRPS, continued DRIPs are popular with both investors and companies. For the company, it means that it can issue shares on a regular basis continuously at no cost, whereas investors perceive that it is paying a regular dividend.

13. Stock Dividends A stock dividend is generally defined as any share distribution, but typically we use the term “stock dividend” when the number of shares issued is less than 25% of the outstanding shares. • If a company declares a 10% stock dividend, each investor will get 10% more shares.

14. Stock Dividends In terms of accounting, a company paying a stock dividend transfers the value of the shares from retained earnings into the capital stock account. • As a result, a company cannot issue a stock dividend if there are no available retained earnings.

15. Stock Dividends A stock dividend will likely have the effect of reducing the share price proportionately. • If a company had 10 million shares outstanding and a share price of $20, and then pays a 15% stock dividend, the expected share price after the dividend is the total market value of the company, divided by the new number of shares: ($20 × 10,000,000) ÷ (10,000,000 × 1.15) = $17.9 per share.

16. Stock Splits • A stock split is similar (but not identical) to a stock dividend. • Typically, when a company has a goal of issuing more than 25% additional shares, it uses a stock split; however, there is no rule or restriction with regard to this. • We refer to a stock split in terms of shares after compared to shares before. Examples: • 2:1 • 3:2 • 4:1

17. Reverse Stock Split Related to the stock split is the reverse stock split. Like the stock split that we have already discussed, a company might try to lift its stock price by undergoing a reverse stock split, in which the company issues fewer shares for the existing outstanding shares. Why reverse stock split? The typical stock split reduces the share price, so the logic is that the reverse stock split will increase the share price

18. Summary of Dividends

19. Share Repurchases A share repurchase (or stock repurchase) is an outright purchase of the company’s own shares, either through open market purchases through a broker or through a tender offer in which shareholders can elect to sell their shares.

20. Share Repurchases or, using notation: To see the effect of a repurchase on share price, consider that the value of a share of stock is the present value of future cash flows. If a company is expected to pay a dividend next period of D1, has a market value of the shares at the end of next period P1, and has S0 shares outstanding, the present value of a share of stock is:

21. Why Repurchase? Remove cash without generating expectations for future distributions Information or signaling effects Offsetting the exercise of executive stock options Leveraged recapitalizations Repurchase dissidents’ shares (a.k.a. greenmail) Take the company private

22. Repurchase Methods • Open market repurchase • Tender offer • Traditional tender offer • Dutch Auction tender offer

23. Repurchase Methods In a Dutch auction tender offer, shareholders submit bids for the price they are willing to sell their shares; the company will pay the minimum price necessary to acquire the stated number of shares.

24. 16.2 Why Do Companies Pay Cash Dividends? Explanations of why companies pay dividends include the following: • Residual cash flow • Agency costs • “Bird in the hand” • Signaling • Taxes

25. Residual Theory Residual theory of dividends -theory that the dividends paid out should be the residual cash flowthat remains after the company has taken care of all of its investment requirements. Faced with significant costs attached to raising new money, cash-poor growth companies have little incentive to pay a dividend because all they are doing is compounding their financing problems.

26. Residual Theory • Similarly, companies that face volatile earnings, so that their cash fluctuates significantly from year to year, will attempt to “store” cash from one period to another. As a result, companies maintain their dividend payments conservatively and at a level that minimizes the need to constantly access the capital markets. BOTTOM LINE: companies will pay dividends if they do not need additional capital and they have cash flows remaining after all profitable investment projects. If dividends are paid based on residual cash flows, we should see profitable, mature companies paying dividends, but also observe that high-growth companies do not.

27. Agency Costs • The announcement of a dividend increase is generally associated with the increase in the share price. • The fear is that senior management may waste corporate resources by overinvesting in poor (that is, negative NPV) projects because it is not “their” money but the shareowners’.

28. The “Bird in the Hand” Argument • This idea of the bird in the hand argument is that a “bird in the hand” (that is, a cash dividend) is worth more than “two in the bush” (twice as much in capital gains). • Dividends are more stable than capital gains and, as a result, more highly valued.

29. Signaling Management usually knows more than external investors, so the company has to have some way of signaling to investors that their press releases can be believed because investors tend to view such information with a great deal of skepticism. One way of doing this is to increase the dividend only when the company believes that it will not have to cut it in the future.

30. Taxes • Describing how taxes affect financial policy is very difficult because different classes of investors have different tax brackets, so with taxes the general rule is that “one size does not fit all.” • Corporations pay little or no tax on dividend income if it is from another corporation. • This is because of the dividends received deduction, which provides a deduction for 70, 80, or 100% of dividends received. • As a result, there is a preference by corporate owners of equity for dividend income.

31. Taxes For individuals, the preference for dividend versus capital gains income depends on whether the dividends are considered qualifying dividends and whether the price appreciation is short or long term. The current tax system, with individual investors, corporations, and institutional investors facing different tax rates on dividends, gives rise to tax clienteles.

32. 16.3 Dividend Policy in Practice The dividends of most companies follow some pattern, though these patterns may be in terms of a steady payout ratio, a constant dividend per share, or a constantly growing dividend per share. There is no requirement that a company follow a consistent pattern in its dividend, but many shareholders acquire stock with the expectation of dividends following a pattern.

33. Dividend Policy in Practice We can classify many companies’ dividends as falling into one of these patterns:

34. Dividend Ratios

35. Johnson & Johnson’s Dividend Source of data: Standard & Poor’s Compustat

36. What Do We Know about Dividends? • Observation 1: Dividends follow earnings. • We observe that many companies do not vary their dividend each period based on their performance, but rather smooth the dividends over time so that they grow from year to year at a constant rate. • Observation 2: Dividends are sticky. • We observe that companies are reluctant to cut dividends when earnings decline, perhaps because of the anticipated market reaction to a dividend cut.

37. Johnson & Johnson: EPS & DPS

38. Summary Corporations may distribute funds to owners by paying dividends or buying back shares in a share repurchase. Corporations may also provide shareholders with additional shares either through a stock dividend or a stock split, but both of these transactions are merely slicing the equity “pie” into more pieces. Investors tend to react favorably to dividend initiations and increases and react unfavorably to dividend cuts or omissions. We gauge investors’ reaction to these dividend decisions by looking at the stock price movements associated with dividend policy changes.

39. Summary • There are various theories and explanations for why companies pay dividends: • Residual theory - companies pay dividends when they have no profitableinvestment opportunities) • Agency theory - by paying dividends, companies have to go to the capital market more often, and are therefore monitored more often • The “bird in the hand” explanation - investors prefer the certain cash flow of dividends to the uncertain price appreciation s • Signaling - by committing to paying more dividends, the company’s management is signaling that the company will be able to sustain this dividend into the future • The dividend tax clientele explanation - some investors prefer dividends because of their tax situation, whereas others do not

40. Summary • We observe that companies that do pay dividends do so on a regular basis, either with dividends increasing at a relatively constant rate or a dividend payout rate that is consistent over time. • However, in tough economic periods, some companies do cut their dividend and wait to restore their dividend until the economy—and company—has recovered.