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Chapter 16 Dividend Policy

Chapter 16 Dividend Policy. Slide Contents. Learning Objectives Principles Applied in This Chapter How Do Firms Distribute Cash to Their Shareholders? Does Dividend Policy Matter? Cash Distribution Policies in Practice Key Terms. Learning Objectives.

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Chapter 16 Dividend Policy

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  1. Chapter 16Dividend Policy

  2. Slide Contents • Learning Objectives • Principles Applied in This Chapter • How Do Firms Distribute Cash to Their Shareholders? • Does Dividend Policy Matter? • Cash Distribution Policies in Practice • Key Terms

  3. Learning Objectives • Distinguish between the use of cash dividends and share repurchases. • Understand the tax treatments of dividends and capital gains, and stock dividends and stock splits, and the conditions under which dividend policy is an important determinant of stock value. • Describe corporate dividend policies that are commonly used in practice.

  4. Principles Applied in This Chapter • Principle 1: Money Has a Time Value. • Principle 3: Cash Flows Are the Source of Value. • Principle 4: Market Prices Reflect Information.

  5. Introduction When a firm generates cash from operations, what can the firm do with the cash? • Use the cash to fund new investments, • Use the cash to pay off some of the firm’s debt, and/or • Distribute the cash back to the firm’s shareholders either as a cash dividend or as stock repurchases.

  6. Introduction (cont.) This chapter provides answers to three questions regarding a firm’s dividend policy: • What are the pros and cons of the methods the firm can use to distribute cash? • Why should the firm’s shareholders care about the firm’s dividend policy given that they can generate cash when they need it by selling some of their shares? • What cash distribution policies do most firms use in practice?

  7. 16.1 How Do Firms Distribute Cash to their Shareholders?

  8. How Do Firms Distribute Cash to their Shareholders? Cash distributions can take two basic forms: • Cash dividend - cash is paid directly to the shareholders. • Share repurchase - a company uses cash to buy back its own shares from the market place, thereby reducing the number of outstanding shares.

  9. How Do Firms Distribute Cash to their Shareholders? (cont.) The impact on the balance sheet will be as follows: • Assets side - cash will be reduced due to cash dividend or share repurchase. • Equity side - there will be a corresponding decrease.

  10. Figure 16.1 Historical Distributions to Shareholders through Dividends and Share Repurchases

  11. Figure 16.1 Historical Distributions to Shareholders through Dividends and Share Repurchases (cont.)

  12. Cash Dividends A firm’s dividend policy determines how much cash it will distribute to its shareholders and when these distributions will be made. Dividend policy has two main attributes: • dividend payout ratio, and • the pattern of dividends followed over time.

  13. Dividend Payment Procedures

  14. Stock Repurchases (Stock Buyback) Stock repurchase is when a firm uses its cash to repurchase some of its own stock. This results in a reduction in the firm’s cash balance as well as the number of shares of stock outstanding.

  15. How do Firms Repurchase Their Shares? • Open Market Repurchase -Here the firm acquires the stock on the market, often buying a relatively small number of shares everyday. Most common. • Tender Offer - Here the company makes a formal offer to buy a large specified number of shares at a stated price. The price is set above the market price to attract sellers.

  16. How do Firms Repurchase Their Shares? (cont.) Direct Purchase from a large investor - Here the firm purchases the stock from one or more major stockholders on a negotiated basis. This method is not used frequently.

  17. Personal Tax Considerations – Dividend Versus Capital Gains Income Historically, tax laws have favored capital gains income over dividend income. However, the 2006 Tax Act lowered the tax rate on dividends and long-term capital gains (stock held for more than 1 year) to 15% for most people.

  18. Non-Cash Distributions: Stock Dividends and Stock Splits • A stock dividend is a pro-rata distribution of additional shares of stock to the firm’s current stockholders. • For example, a firm might pay a stock dividend of .20 shares of stock per share or 2 shares for every 10 held.

  19. Non-Cash Distributions: Stock Dividends and Stock Splits (cont.) • Stock split is essentially a very large stock dividend. • For example, a 2-for-1 split would entail receiving two new shares for every old share currently held and the share price will drop in half.

  20. Rationale for a Stock Dividend or Split One rationale is that there is an optimal trading price range for the firm’s stock. If the price exceeds that optimal range, it can be brought back to the optimal range by doing a stock split or paying stock dividend.

  21. 16.2 Does Dividend Policy Matter?

  22. Does Dividend Policy Matter? • Modigiliani and Miller suggest that without taxes and transaction costs, cash dividends and share repurchases are equivalent and the timing of the distribution is unimportant. • This is known as the Modigiliani and Miller dividend irrelevancy proposition.

  23. The Irrelevance of the Distribution Choice The distribution choice is irrelevant under the following conditions or assumptions: • There are no taxes. • No transaction costs are incurred in either buying or selling shares of stock. • The firm’s operating and investment policies are fixed.

  24. The Irrelevance of the Distribution Choice (cont.) The dividend irrelevancy proposition can be illustrated in two ways: • Timing of dividend distributions does not affect firm value. • In the absence of taxes and transaction costs, a cash dividend is equivalent to a share repurchase.

  25. Figure 16.2 Dividend Policy Choices Faced by Clinton Enterprises

  26. Figure 16.2 Dividend Policy Choices Faced by Clinton Enterprises (cont.)

  27. The Timing of Dividend is Irrelevant (cont.) Figure 16-2 considers two alternatives: • Pay $35M now and $135M in one year • Pay $52.5M now and $114.875M in one year • In both cases, the value of share remains the same at $15.24 per share.

  28. CHECKPOINT 16.1: CHECK YOURSELFStock Price and the Timing of Dividend Payments

  29. The Problem Consider Alternative #3 in which Northwest Wire and Cable decides to increase its current period dividend to only $8 million. Show that the firm’s equity under this scenario would be $30.79 million.

  30. Step 1: Picture the Problem The firm is considering two alternatives: • Pay $4 million today and $30 in year 1 as liquidating dividend; or • Pay $8 million today and pay $25.52 in year 1 ($30 million - $4million*1.12 paid to new shareholders)

  31. Step 2: Decide on a Solution Strategy The value of Northwest Wire and Cable company’s equity is equal to the present value of the firm’s expected cash dividends. We can estimate the value using equation 16-1.

  32. Step 3: Solve Value – Alternative 1 Value = $4 million + $25.52 million /(1.12)1 Value = $30.79 million

  33. Step 3: Solve (cont.) Value – Alternative 2 Value = $8 million + $30 million /(1.12)1 Value = $30.79 million

  34. Step 4: Analyze • This example illustrates that the timing of dividend payment does not affect the value of the firm. • This was true because we held constant the firm’s investment cash flows. We also assumed that the new shares could be issued under the same terms as the existing shares.

  35. The form of Payment (Cash Dividend Versus Share Repurchase) is Irrelevant Table 16-1 illustrates two possibilities for the use of $1,000,000 in cash flows: • A $1,000,000 cash dividend. • A $1,000,000 stock repurchase. • It is observed that the value is the same so an investor will be indifferent between the two options.

  36. Table 16.1 Wealth Effects of Cash Distributions: Dividends and Share Repurchases

  37. Individual Wealth Effects: Personal Taxes What are the tax rules with regard to dividends and share repurchases? • 100% of cash dividends are taxable in the year in which they are received. • When individuals sell shares, tax is assessed only on the capital gain. • If investor does not sell the shares to the company making stock repurchase, there will be no taxable gain.

  38. Individual Wealth Effects – Personal Taxes (cont.) • Table 16.2 shows the cash flow consequences of the alternative methods for distributing cash to the shareholders that were introduced in Table 16-1. • It is assumed that both dividends and capital gains are taxed at 15%.

  39. Table 16.2 Dividends versus Share Repurchases with Personal Taxes

  40. Why Dividend Policy is Important? Transactions are costly • Since taxes are incurred when dividends are received and transactions costs are incurred when buying and selling shares, investors will prefer to select companies whose dividend policy match up with their own preferences. Because firms with different dividends attract different dividend clienteles, it is important that dividend policy remain somewhat stable.

  41. Why Dividend Policy is Important? (cont.) The Information Conveyed by Dividend and Share Repurchase Announcement • Information can affect future valuation. • Firms tend to increase their dividends when dividends can be sustained in the future. In such cases, dividend increase is clearly good news.

  42. Why Dividend Policy is Important? (cont.) Share repurchases are also viewed very favorably as it reveals that: • the firm has generated more money than it currently needs, and/or • the equity is currently underpriced.

  43. Why Dividend Policy is Important? (cont.) The Information Conveyed by Stock Dividends and Stock Splits • The announcement of stock dividends and stock splits tend to generate positive stock returns. Some have suggested that firms have a preferred trading range and stock splits help bring stock prices to that trading range.

  44. 16.3 Cash Distribution Policies in Practice

  45. Cash Distribution Policies in Practice Stable Payout In a survey of CEOs, most CEOs recognized the importance of maintaining consistency and stability in dividend policy (see figure 16.3)

  46. Figure 16.3 Survey of CFO Opinions Regarding Dividend Policy Issues

  47. Figure 16.3 Survey of CFO Opinions Regarding Dividend Policy Issues

  48. Cash Distribution Policies in Practice(cont.) • Figure 16-4 reveals that stock repurchase decisions are driven by executive’s feeling that the stock is a good investment relative to its true value and that there are a lack of good investment opportunities to invest in. • Table 16.3 summarizes the views of financial executives about payout policy.

  49. Figure 16.4 Factors Important to Your Company’s Repurchase Decision

  50. Table 16.3 Summary of Financial Executives’ Views about Payout Policy

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