Dividend Policy

The Dividend Decision

How can firms return cash to its shareholders? Pay Dividends Repurchase stock Forward Contracts

The questions we want to address are:Does paying dividends affect the value of the firm?

If so, How? and Why?Do investors have a preference for dividends?

Dividend Terminology

Declaration Date: The date that management declares the DividendEx-Dividend Date: The date by which an investor must own the stock to receive the dividendPayment Date the date that the check is actually mailed to investors

Which of these dates is most important to the market

(important: stock prices react to the announcement)

Dividend Changes in Publicly Owned Firms

Dividends Follow Earnings

Measures of Dividend Policy – Dividend Payout

Measures the percentage of earnings that the company pays in dividends= Dividends / Earnings

2004 –Approx 64% of firms paid no dividendOf those that did approximately 6% paid more than 100% of earnings!The median payout in 2004 was 30% where the average payout was 35%

Measures of Dividend Policy – Dividend Yield

Measures the return that an investor can make from dividends alone= Dividends / Stock PriceAmong firms that do pay dividends the median yield is between 1 and 2%, (2004: median = 1.8%, average = 2.12%) the historical average is close to 3%.What has caused the current yield to be lower than average?Increase in Stock PricesStock Buybacks

Dividends and the Life Cycle of the Firm

There is a tradeoff between growth and dividends. To fuel rapid growth more earnings are retained

Dividends peak during as the firm matures as cash flows are increasing relative to firm value.

Both the dividend yield and dividend payout ratio are inversely related to the growth rate of the firm

Simple Example

Assume constant growth:P=D0(1+g)/(ks-g)

If the firm decides to payout a higher ratio of earnings in dividends (D increases) then P should increase.

However, if the increase in dividends causes g to decline, then the price would decrease.

Schools of Thought

1. Dividends are Irrelevant

2. Increasing dividends reduces firm value

3. Increasing dividends will increase firm value

4. Dividend policy should depend on the number of available projects (2 and 3 combined)

Dividend Irrelevance Modigilani and Miller

Assumptions:There are no transaction costs associated with converting price appreciation into cash

Firms that pay dividends can issue stock without incurring floatation costs or transaction costs

The investment decision is not affected by the firms dividend policy

Managers use excess cash in the best interest of the firm.

Intuition

Given the assumptions above, an investor can create any dividend policy they wish.The stockholder will receive the same total return (equal to price appreciation plus dividends) in every case.The firm can raise new funds without a negative impact on firm value. The value of the firm is determined by the cash flows on the projects not its dividend policy.

Implications

It is unlikely that the assumptions hold and dividends are in fact irrelevant.

It does illustrate that firms that undertake bad projects can not rehabilitate their image with stockholders by increasing dividends

Tax Implications

Historically dividends were taxed at a different rate (higher) than the alternative of capital gains. In 2003 this was changed and the tax rates are equal.Taxes on capital gains are not paid until the future. (Capital gains are only taxed if the investor sells the stock).This implies that investors should have a preference for capital gains as opposed to dividends.

A Simple Example

You invest $100 in a stock with a return of 10% a year for 20 years. You must pay 40% in taxes on either realized capital gains or dividends.

Option 1: The firm reinvests your earnings each year. Your value before taxes will be 100(1+.1)20 = 672.75 After Taxes you have:

100 + 572.75(1-.4) = 443.65

Option 2: The firm pays you dividends and you reinvest your after tax dividend in the firm. Your after tax return will be:

100(1+(1-.4).1)20=320.71

Implications

Firms with an investor base composed of individuals (instead of tax exempt institutions) should pay out lower dividendsIndividuals who have a higher income have are hurt more by paying taxes on dividends. They are also the least likely to need dividends as a form of income

As the tax disadvantage increases the amount paid out by firms should decrease.

Why Pay Dividends? Often Used, Poor Reasons

Bird-in-a hand Theorydividends are certain and capital gains are uncertain so risk averse investors will refer dividendsModel predicts a choice between dividends and equal price appreciation, not future uncertain gains

Temporary Excess CashIf the firm expects a future cash shortfalls it should not use the excess cash to pay dividends. It is not practical for the firm to pay dividends then pay the large flotation cost associated with issuing new stock in the future.

Better Reasons to Pay Dividends

Clientele Effects

Agency Considerations

Information Signaling

Clientele Effects

Some investors do prefer dividendsFor example: elderly investors who are using a portion of the dividend flows as income.These investors are willing to pay the extra cost associated with receiving dividends

Empirically it has been shown that investors are willing to pay a premium for stocks that are expected to pay a dividend

Clientele Effect

Some investors are also happy without receiving dividends (Microsoft does not pay dividends for example)Naturally over time investors with different preferences will invest in firms that meet their expectations.It has been shown that firms should attempt to attract both kinds of investors. Otherwise the market portfolio (think CAPM) will be incorrect.

Agency Considerations

The payment of dividends increases interaction with investors, and the SECTherefore it is likely that monitoring will be increased.

Information Signaling

Dividends as a positive signal: Belief is that paying higher dividends is not an action that a firm without good projects can undertake. Therefore paying dividends sends a positive signal to the market.

Dividends as a negative signal. If a firm that has not been paying dividends decides to start paying dividends is it a good sign or a sign that their projects are no longer profitable so they have extra cash to spend?

Establishing Dividend Policy

One approach is the Residual Dividend ModelAllowing dividends to be equal to earnings minus the amount necessary to finance the optimal capital budgetDividends = Net Income – (TargetEquityRatio)(TotalCapitalBudget)

Long Term Policy

The firm could then estimate earnings and investments over a short periodUse the forecast to estimate a payout ratioThen set the target range for payout (set the range instead of the actual dividend in each year.One possibility is to set the target a low easily attainable rate.

Determinants of Dividend Policy

Investment Opportunities: More investment opportunities Lower Dividends

Stability in earnings: More stable earnings Higher Dividends

Alternative sources of capital: More alternative sources Higher Dividends

Constraints: More constraints imposed by bondholders and lenders Lower Dividends

Signaling Incentives: More options to supply information to financial markets Lower need to pay dividends as signal

Stockholder characteristics: Older, poorer stockholders Higher dividends

Management Beliefs about Dividend Policy

A firm’s dividend payout ratio affects its stock price.Dividend payments operate as a signal to financial marketsDividend announcements provide information to financial markets.Investors think that dividends are safer than retained earningsInvestors are not indifferent between dividends and price appreciation.Stockholders are attracted to firms that have dividend policies that they like.

Share buybacks – An Alternative to Dividends?

Repurchase Tender OffersShareholders are asked to submit shares at a set price for a given period of time.

Open Market RepurchasesFirms buy shares on the open market at the prevailing price.

Privately Negotiated RepurchasesBuyback shares from large shareholders at a privately negotiated price

Increase in Buyback Activity S&P 500

Benefits to Repurchases

No commitment to future buybacksFlexibility in timing of buybacksMay increase insider control (is this also a negative?)Stock Price supportPayout dollars only to those shareholders who choose to take advantage of buyback program.

Share Repurchases – Dilution Illusion

Some repurchase programs are motivated by a desire to reduce the number of shares outstanding, and increasing earnings per share.Buybacks are offset by an increased debt ratio.Impact should depend upon whether firm is moving toward or away from the optimal capital structure.

An example

Assume a firm that is 100% equity financed with 100 shares outstanding.The current market value of the firm is $1500.It borrows $300 and uses the proceeds to buyback 20 shares of its stock. Whether or not this increases the price per share will depend upon the interest expense.

An example

B4 Repo

After Repurchase

Int Exp=$30

Int Exp=$55

EBIT $200 $200 $200

- Interest 0 $30 $55

=Taxable Income

$200 $170 $145

-Taxes $100 $85 $72.50

=Net Income $100 $85 $72.50

# Shares 100 80 80

E Per Share $1.00 1.0625 $.91

Impact on Share price

If the Price earnings ratio stays constant (originally 15) the price per share will increase if the earnings per share increases.However the increase debt should make equity riskier dropping the Price Earnings ratio. This implies that in an increase in the earnings per share may be offset by the increased riskiness of the firm.

What the Firm could Pay Shareholders: FCFE

The Free Cash flow to Equity (FCFE) is a measure of how much cash is left in the business after non-equity claimholders (debt and preferred stock) have been paid, and after any reinvestment needed to sustain the firm’s assets and future growth.

Measuring FCFE

Net Income+ Depreciation & Amortization= Cash flows from Operations to Equity Investors- Preferred Dividends- Capital Expenditures- Working Capital Needs- Principal Repayments+ Proceeds from New Debt Issues = Free Cash flow to Equity

FCFE and Dividends

If the Firm pays out more in dividend than FCFE it will have a cash shortfall and need to find ways to raise new cash (issue equity or borrow)If the firm pays out less in dividends than FCFE it will have extra cash on hand and is a possible takeover target, creates agency problems

Chrysler: FCFE, Dividends and Cash Balance

($500)

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

Year

Cash

Flo

w

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

$8,000

$9,000

Cash

Bala

nce

= Free CF to Equity

= Cash to Stockholders

Cumulated Cash

Four Possibilities

The two key questions areDoes the firm have good projects?Is the Firm paying out More or Less than FCFE?

This leaves four possibilitiesThe Firm has Poor Projects and Low PayoutsThe Firm has Poor Projects and High PayoutsThe Firm Has Good Projects and Low PayoutsThe Firm has Good Projects and High Payouts

Poor Projects and Low Payout

Consequences of Low PayoutFirm accumulates cash - possible target for acquisitionManagers may take on poor projects or acquisition

Stockholder ReactionStockholders demand more dividends

Management ResponseNeed Cash for future shortfalls (cyclical firms)Behavior of comparable firms

Poor Projects and High Payout

Consequences of High PayoutCreates Cash deficit, must issue stock or bondsEither debt ratio increases or cost of stock increases(is it paying to little or earning to little?)

Stockholder ReactionTry to get improvements in projects or eliminate some spending

Management ResponseIndustry wide problem, lack of good projects at this time

Good Projects and Low Payout

Consequences of Low PayoutFirm accumulates cash - possible target for acquisitionProvides opportunities to invest smaller chance of undertaking poor projects

Stockholder ReactionStockholders are patient because of good track record of firm

Management ResponseEasier to convince shareholders that dividend increases are not needed

Good Projects and High Payout

Consequences of Low PayoutCreates Cash deficit, must issue stock or bondsPaying a price for dividend policy

Stockholder ReactionStockholders should desire less dividends

Management DefenseNeed to cut dividends and signal that they have good projects

Mandated Dividend Payouts

There are many countries where companies are mandated to pay out a certain portion of their earnings as dividends. Given our discussion of FCFE, what types of companies will be hurt the most by these laws?

Large companies making huge profitsSmall companies losing moneyHigh growth companies that are losing moneyHigh growth companies that are making money

Growth Firms and Dividends

High growth firms are sometimes advised to initiate dividends because its increases the potential stockholder base for the company (since there are some investors - like pension funds - that cannot buy stocks that do not pay dividends) and, by extension, the stock price. Do you agree with this argument?

YesNo

Why?

A comparative analysis

It is possible to analyze dividend policy by comparing to other firms in similar industriesAt best this provides generalities because of firm specific traits.