FINS5514: Capital Budgeting and Financing Decisions Lecture 8: The Dividend Decision RWJ – Chap 17 Topics Covered Today _________________________________________________________________________________ What Dividends Are and How They are Paid The Theories Relating Dividends to Firm Value Share Repurchases Stock Dividends and Stock Splits Dividend Imputation 2 Dividends _________________________________________________________________________________ A sum of money paid regularly (typically quarterly) by a company to its shareholders out of its profits (or reserves) – Mainly made in cash but stock dividends are occasionally given. The most popular types of dividends are: – Regular dividends : firm expects to maintain payments in the future – Special dividends : one off payment that is highly unlikely to be repeated 3 Dividends (continued) _________________________________________________________________________________ The way that dividends are distributed is carefully laid out by law. In Australia, one day between ex divided and record date 1 working days later Declaration date Ex-dividend date Record date Payment date Dividend goes with shares 4 Dividends (continued) _________________________________________________________________________________ Declaration date – The dividend is announced Ex-dividend date – Stocks purchased before this date (with/cum dividend), get the next dividend. – Stocks purchased after this date (ex-dividend) do not. Record date – Recorded owners on this date get the next dividend. – The delay allows firm records to be up-dated after the ex- dividend date Payment date – Dividends are distributed to the shareholders 5 Dividends (cont) _________________________________________________________________________________ Price around ex dividend date: If include taxes, price drops by less than dividend 6 Miller-Modigliani Dividend Irrelevancy Theory _________________________________________________________________________________ (M&M, 1961) showed that in absence of frictions: – Dividend policy has no effect on the value of a firm’s share prices or the cost of equity. – Dividend policy is, therefore, irrelevant 7 Miller-Modigliani Dividend Irrelevancy Theory _________________________________________________________________________________ Relies on the assumption that perfect capital markets exist: – There are no transaction costs or taxes – Investors have homogeneous expectations – Investors are rational and price takers – Investors know the decisions managers have taken regarding current and future production and investment – All firms belong to the same risk class and do not grow 8 Miller-Modigliani Dividend Irrelevancy Theory _________________________________________________________________________________ Shareholders do not need the firm to issue dividends as they can achieve the same effect “at home” – If an investor requires cash, they can sell some of their shares. – This has the same effect as receiving a dividend, so dividends are irrelevant 9 MM Dividend Irrelevancy, An Example _____________________________________________________________________ A company is valued at $1 million and has 1 million shares outstanding. – The shares are trading at $1 each The firm’s income exactly covers its needs for investment so any dividend will be paid for with an issue of new shares. The firm wants to issue a dividend of $0.20 10 MM Dividend Irrelevancy, An Example _____________________________________________________________________________________ The impact on the firm and the share price will be: Firm Share Price Current Value 1,000,000 1.00 Dividend payments 200,000 0.20 @ 0.2 per share Remaining 800,000 0.80 Amount from new issue 200,000 Value after issue 1,000,000 11 MM Dividend Irrelevancy, An Example ___________________________________________________________________ The new shares will be issued at $0.80 each (the value of the shares after paying the “old” shareholders). To raise $200,000 it is necessary to issue 250,000 new shares at $0.8 each After the issue, there will be 1,250,000 shares and the firm is worth $1m so the price will be $0.8 per share 12 MM Dividend Irrelevancy, An Example _________________________________________________________________________________ Now consider a shareholder with 100 shares in this firm. What happens to the wealth of this shareholder under the MM theory There are two options to consider – The firm pays the dividend, – The firm does not pay and the shareholder creates the same effect for themselves 13 MM Dividend Irrelevancy, An Example ___________________________________________________________________ If the firm pays the dividend, the effect is: Value of investment at beginning 100 Cash dividend @ $0.2 per share 20 (funded through the issue of new stock) Residual value of investment 80 (taking into account the issue of new shares) Composition of investment: 100 shares @ 0.8 and $20 cash Shareholder total wealth at end: $100 14 MM Dividend Irrelevancy, An Example ___________________________________________________________________ Alternatively, the shareholder can achieve the same effect without the dividend: Value of investment at beginning 100 Sell 20 shares at $1 each share 20 Residual value of investment 80 Composition of investment: 80 shares at $1 each and 20 cash Shareholder total wealth at end $100 15 MM Dividend Irrelevancy, An Example ___________________________________________________________________ Thus, according to M&M, dividends are irrelevant Investors will not pay more for a share that pays high dividends than a share that pays low dividends – Therefore, dividend policy cannot influence the share price or the cost of equity of the firm. 16 MM Dividend Irrelevancy (continued) _____________________________________________________________________________ The assumptions underlying M&M are not realistic. Relaxing these assumptions leads to the alternative theories for dividend policy. – homogenous expectations – taxes 17 The Bird-in-the-Hand Theory _________________________________________________________________________________ Contrary to the assumption in M&M, investors are not homogenous and have different preferences. Some investors are risk averse – This means that they would prefer to have a certain dividend now rather than wait for potential capital gains in the future. – This is the Bird-in-the-Hand theory “a bird in the hand is worth two in the bush” 18 The Bird-in-the-Hand Theory (continued) _________________________________________________________________________________ Implies that investors value companies that pay high dividends more than companies that pay low dividends. – Therefore, dividend policy is positively related to share price. Also suggested that the cost of capital will decrease as dividends increase. – Investors are more confident of receiving dividends than capital gains therefore the cost of equity (cost of capital) goes down 19 The Tax Preference Theory _________________________________________________________________________________ Another assumption in M&M is that there are no taxes. – Again, this is unrealistic Tax rates will influence shareholders preferences for dividends compared to capital gains. 20 The Tax Preference Theory (cont) _________________________________________________________________________________ Two ways that tax can influence investors preferences: – Dividends are taxed as income. Income tax is usually higher than capital gains tax. – Capital gains tax can be deferred if the shareholder does not sell their shares. Suggests that shareholders would prefer capital gains to dividends 21 The Tax Preference Theory (cont) _________________________________________________________________________________ Thus investors value companies that pay low dividends and invest for future capital gains more than companies that pay high dividends. – Therefore, dividend policy is negatively related to share price. This implies that shareholders will want higher capital gains to make up for their greater exposure to income tax. – Thus the cost of equity will increase 22 Other Aspects of Dividend Policy _________________________________________________________________________________ Two other important aspects of dividend policy – The informational content of dividends and the signaling hypothesis – The clientele effect of dividends 23 The Signaling Hypothesis for Dividends _________________________________________________________________________________ M&M assumed that all investors have the same information about the firm as the managers: – This is unrealistic Differences in how much information individual investors have about their company Asymmetric information between investors and managers allows the managers to use the company’s dividend policy to signal information 24 The Signaling Hypothesis for Dividends (cont) _________________________________________________________________________________ Dividends can be used to signal information about the future prospects of the firm. – Managers like to keep dividends stable – Will not increase dividends if they are not confident of maintaining that payout ratio. – Therefore, increasing dividends can be a signal that the managers are confident about the future prospects of the firm. 25 The Clientele Effect _________________________________________________________________________________ Dividends have a “clientele effect” People invest in companies whose dividend policy matches their preferences. – Past dividend policy will influence the kinds of people who own shares in the company now. – Thus current investors are people who have decided that the firm matches their preferences. – Can make it difficult for the firm to change its dividend policy. 26 Dividend Stability _________________________________________________________________________________ Investors prefer firms that do not make too many changes in their dividends over time. If the firm keeps increasing dividends, then is seen as a positive signal. – However, can result in problems funding investments or maintaining future dividends. If the firm cuts dividends, is often perceived as a negative signal even if the firm uses the money to invest in other projects 27 Dividend Stability (continued) _________________________________________________________________________________ The solution is for the firm to try to balance the shareholders desires and its needs for money for investment. Keeping dividends stable is very important. – The firm needs to consider its growth rate for the future and the stability of its earnings when deciding on the dividend payout. 28 Share
Repurchases _________________________________________________________________________________ An alternative to cash dividends Firm buys back its own shares This can be done in three ways 1. Buying on the market (on market) 2. A tender offer to the shareholders 3. Private negotiation (Greenmail) 29 Share Repurchases, An Example _________________________________________________________________________________ Consider the following firm: Earnings for distribution $1,000,000 Number of shares 400,000 Earnings per share $2.50 Market price per share (P) $50.00 Market value of firm $20,000,000 P/E ratio (P/EPS) 20 This firm wants to distribute $800,000 to its shareholders as either a share repurchase or a cash dividend 30 Share Repurchases, An Example _________________________________________________________________________________ Share repurchase: The firm decides to pay $50 per share in the repurchase – The firm can afford to buy _16000____ shares – That will leave __384000_________ shares outstanding After the repurchase: – share price = (pre MV-cash for repurchase)/number of shares outstanding after repurchase =_____$50___________________________ 31 Share Repurchases, An Example _________________________________________________________________________________ How does this compare to paying a dividend – If the firm paid the same amount ($800,000) out as a cash dividend, it would be ___$2___ per share – Price per share after dividend : __$48__________ – In terms of the shareholder total wealth, there is no difference between a share repurchase and a dividend. Only difference is how the money is paid to the shareholder: – With the cash dividend, the shareholder receives _$2_ per share + hold share worth _$48__= __$50___ – With the repurchase, either sell share for _$50___or hold share worth __$50___ after repurchase 32 Share Repurchases (cont.) _________________________________________________________________________________ Three main reasons for share repurchases: 1. The firm has excess cash distribute cash to shareholders by repurchasing stock instead of paying dividends 2. The capital structure has too much equity raises debt finance and uses that money to repurchase shares alters the capital structure to a more preferable arrangement 33 Share Repurchases (cont.) _________________________________________________________________________________ 3. Firm has given employees stock options which dramatically increase the number of shares when the options are exercised. Firm repurchases stock from the market to maintain a reasonable share price. 34 Advantages to Share Repurchases _________________________________________________________________________________ Investors see repurchases as a positive signal implying that shares are undervalued. – However, there is no negative signal if a firm does not repurchase shares. Shareholders have more choice. – If they need cash, they sell some shares. If not, they retain their stock. – With cash dividends, there is no choice and income tax must be paid 35 Advantages to Share Repurchases _________________________________________________________________________________ Managers are reluctant to increase dividends in case they cannot sustain the new level in future. – If the firm has excess cash, a repurchase is a good way to distribute it without altering dividends Companies decide on a target cash distribution level and split that amount into dividend and repurchase portions. – Firm keeps dividends low and stable but it has flexibility to respond if earnings change. 36 Disadvantages to Share Repurchases _________________________________________________________________________________ Shareholders may have preferences between dividends and capital gains. – Dividends are dependable but future share prices are uncertain. Firm must avoid paying too high a price for the shares or they will disadvantage shareholders who retain their shares. – Could depress the price too far and the remaining owners lose out. 37 Stock Dividends _________________________________________________________________________________ An issue of dividends made in the form of additional shares rather than as a cash payment. – This does not affect the proportion of the total shares that each shareholder owns. 38 Stock Dividends, An example _________________________________________________________________________________ A shareholder has 200 shares in a firm. The company issues a 5% stock dividend – This means that the shareholder gets an extra _10__ shares for free – The proportion of the firm that the shareholder owns is the same after the dividend as it was before. Issuing a stock dividend will reduce the share price, the earnings per share and the dividends per share. Usually issued to constrain the firms share price – Any increase in the dividend each year is matched to any increase in the firm’s earnings over the same time period. 39 Stock Splits _________________________________________________________________________________ A stock split occurs when a firm increases the number of shares it has outstanding – This is done by multiplying the shares by some number. – For example, in a 3 for 1 stock split, each outstanding share becomes 3 shares. Often used to reduce the share price if the managers believe the stock price is too high. 40 Stock Splits (continued) _________________________________________________________________________________ When a stock split occurs, the share price and earnings per share will fall – The shareholder total wealth, however, is unaffected. – For example, a shareholder has 10 shares worth $20 each before a 2 for 1 stock split. – After the split, each share is worth $10__ but the shareholder now has _20__ shares. 41 Reverse Stock Splits – proportional to the investor’s current holdings – 1: 5 five reverse split, each investor swaps five old shares for one new one – reducing the number of shares – Transaction costs may reduce – Share liquidity may improve – Share price increases may improve the firm’s image 42 Impact of Share Dividends and Stock Splits on the Share Price _________________________________________________________________________________ Both activities increase the number of shares, so it is no surprise that the share price falls. However when the split / stock dividend is announced, the share price (on average) rises. – Splits and stock dividends are thought to signal future increases in earnings and managerial confidence in the performance of the company – But if the firm does not announce high earnings within a short time period, the price will fall again. 43 Impact of Share Dividends and Stock Splits on Share Liquidity _________________________________________________________________________________ Stock splits and dividends can decrease the liquidity of the shares: – Lower priced stocks are harder to sell and have higher transaction costs, in percentage terms, than high priced shares could make it harder for the shareholder to sell their stock – Conversely, more shares makes things easier and can reduce transaction costs 44 Dividends in Australia _________________________________________________________________________________ There are two tax systems used in the world today – The classical taxation system – The imputation system The tax system can have a big impact on dividends and shareholder preferences 45 The Classical Taxation System, An Example _________________________________________________________________________________ Dividends are effectively taxed twice – Corporate tax and then personal income tax Consider the following firm: Firm operating income $1000 Corporation tax @ 40% $ 400 After-tax income (dividends) $ 600 Income tax @ 47% $ 282 Cash received by shareholders $ 318 46 The Imputation System _________________________________________________________________________________ The dividend imputation system was introduced in Australia in 1987. The imputation system works by: – The company generates income which is taxed at the company tax rate. – The amount that remains after the corporate tax has been paid is then distributed to the shareholders as dividends. 47 The Imputation System (cont) _________________________________________________________________________________ These dividends are known as fully-franked dividends as the tax has been paid in full. – A dividend on which the tax has not been paid is an unfranked dividend The shareholders are informed about their franking credits with their dividends. – Franking credits off-set the shareholders income tax liability. 48 The Imputation System, An Example _________________________________________________________________________________ Consider an individual who pays income tax at 15% Operating income $1000 Corp tax @ 40% $ 400 After-tax income $ 600 Grossed-up Div $1000 Income tax $ 150 Tax credit $ 400 Tax due from shareholder -$ 250 Cash to shareholder $ 850 The calculation of corporate tax is the same as under the classical system The shareholder receives the total (or grossed-up) dividend 49 The Imputation System, An Example _________________________________________________________________________________ Operating income $1000 Corp tax @ 40% $ 400 After-tax income $ 600 Grossed-up Div $1000 Income tax $ 150 Tax credit $ 400 Tax due from shareholder -$ 250 Cash to shareholder $ 850 This income is taxed at the individual’s income tax rate, here it is 15% The shareholder has a tax credit to the value of the tax paid by the firm 50 The Imputation System, An Example _________________________________________________________________________________ Operating income $1000 Corp tax @ 40% $ 400 After-tax income $ 600 Grossed-up Div $1000 Income tax $ 150 Tax credit $ 400 Tax due from shareholder -$ 250 Cash to shareholder $ 850 This leaves the balance of the tax either owing to the government or, as in this case, owed to the shareholder The shareholder’s cash is calculated using the taxes paid and the tax credit 51 The Imputation System _________________________________________________________________________________ Depending on the shareholders personal tax rate, the amount of tax owing (or owed) will be different and the amount received by the shareholder will also differ For example: 52 The Imputation System, An Example _____________________________________________________________________________ Income tax rate 15% 30% 47% Operating income 1000 1000 1000 Corporate tax @ 40% 400 400 400 After tax income 600 600 600 Grossed up Dividend 1000 1000 1000 Income tax 150 300 470 Tax credit 400 400 400 Tax due from shareholder -250 -100 70 S’holder cash received 850 700 530 53