Cash distributions
Dividends and Other Payouts Distributions -Firms make distributions to their shareholders in 2 ways: -Cash distributions -cash dividends -share repurchases -Share distributions -stock dividends -stock splits Why Distribute? -Paying dividends reduces agency cost of equity -Dividends reduce free cash flow and so reduce managerial waste -Forces management to run tight ship -Forces managers to face scrutiny of capital markets when new project financing needed
Dividend Policy – The Debate -Academics look at dividend policy as a cash flow issue in an M&M perfect world -Practioners look at dividend policy as a leverage and investment decision -Corporate growth potential -Shareholder reinvestment opportunities -In the absence of taxes, the firm should pay out internally generated funds as a dividends if investors have access to higher positive NPV projects than does the firm M&M on Dividends -In the absence of transactions costs and taxes, dividend policy is irrelevant and does not affect shareholder wealth -Investors do not need dividends to convert shares to cash therefore, they will not pay higher prices for firms with higher dividend payouts -Dividend policy will have no impact on the value of the firm because investors can: -Sell shares off a small part of the stock that has appreciated in value to create dividends -Reinvest dividends in company by purchasing more shares to create capital gains Dividend Policy is Irrelevant -Since investors do not need dividends to convert shares to cash, dividend policy will have no impact on the value of the firm -Dividend policy establishes the trade-off between paying a dividend now or paying a dividend in the future Ex. Wise Holdings has the following market value based balance sheet: In millions Current assets
$25
Long term assets
$75
Total assets
$10 0
Equit y
$100
The company has 5 million shares of common stock outstanding, an EPS of $4 and it has declared a cash dividend of $1 per share. -What are the firm’s stock price and P/E ratio before the ex-dividend date? -What are the stock price, P/E ratio and total market value of equity after the ex-dividend date?
-Suppose Joe owned 50 shares of Wise Holdings. Show that, in the absence of taxes, his wealth is unaffected by the dividend issue
Fundamental Concept -In perfect capital markets, without taxes, dividend policy is irrelevant Taxes and Dividends -In a tax free world, cash dividends are a wash between the firm and its shareholder -In a world with taxes, the government gets a cut What are Practical Issues? -Dividend policy is a decision to give money back to shareholders and NOT invest in a new project -Affects the firm’s capital budgeting decision: -Paying dividends means less internal cash available for other uses -Paying dividends means borrowing money to invest in new projects -Historically firms pa out dividends in both good times and bad times -Firms should never give up a positive NPV project to pay dividends Real World Relevance – Factors Favouring a Low Payout -Taxes, imposing an immediate tax burden on investors -Firm has unusually good investment prospects -Cost if have to issue new equity in the future -Why pay dividends and incur costs to issue securities in the future? -Bond covenants and other restrictions -Growth and control issues -Short term cash position -Inherent firm risk -Restrictions on foreign transfers Real World Relevance – Factors Favouring a High Payout -Desire of current income: -Cost of home-made dividends -Uncertainty resolution: -“Bird-in-the-hand” argument – Investors prefer cash dividend now to uncertain capital gain in future -Tax: -Tax exempt owners -Signalling arguments (Asymmetric information) -Free cash flow issues
The Clientele Effect: A Resolution of Real-World Factors? -Clienteles for various dividend payout policies are likely to form in the following way: Clientele Group
Stock
High tax bracket individuals
Zero to low payout stocks
Low tax bracket individuals
Low-to-medium payout
Tax-free institutions
Medium payout stocks
Canadian corporations
High payout stocks
-Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy Fundamental Concept -Many factors in the real world make dividend policy relevant Guiding Principles and Practical Implementation of a Dividend Policy -Guiding principles: 1. Avoid padding on positive NPV projects to pay dividends 2. Avoid cutting or reducing dividends 3. Avoid the need to sell equity 4. Maintain the target debt/equity ratio -These suggest keeping the payout set low in the first place -Implement: -Set a low per share constant dollar dividend -Set a target payout consistent with long term profitability and long term capital needs -Increase dividends only when the long term profitability supports the new payout level -Reduces dividends reluctantly, but do not risk the viability of the firm Residual Dividend Policy A Theory of Leftovers -Firms may follow a residual dividend policy -Use internally generated funds to finance capital projects and pay out unused earnings as dividends -Determine the capital budget: accept all projects with positive NPV -Determine the equity needed to finance the project while maintaining the firm’s capital structure -Use internally generated funds to supply this equity -Pay a dividend only if there are funds left over Ex. Farside Corporation follows a strict residual dividend policy. Its debt-equity ratio is 3. -If earnings for the year are $150,000, what is the maximum amount of capital spending possible without new equity? -If planned investment outlays for the coming year are $750,000, will Farside pay a dividend? How much? What about if the investment outlay was $500,000? -Does Farside maintain a constant dividend payout?
Ex. Instead of paying a cash dividend, paying out a stock dividend allowing a firm to maintain a payout record when cash is low. Maintaining payout record when cash is low. The market value balance sheet for Ace Manufacturing is shown below. Ace has declared a 15% stock dividend. The stock goes e dividend tomorrow (the chronology for a stock dividend is similar to that for a cash dividend). There are 10,000 shares outstanding. What will be the ex dividend price? Market Value Balance Sheet (in $1000s) Cash
180
Debt
150
Fixed assets
320
Equit y
350
Total
500
Total
500
Ex. National Profit Company has the following shareholder’s equity section before declaring a 5% stock dividend: Shareholder’s equity: Authorized:
500,000 shares without par value
Issued
200,000 common shares
Retained earnings
$2.0 million $0.6 million $2.6 million
a. Show the change in shareholders’ equity section after the 5% stock dividend given that the firm’s shares are currently trading at $15 per share. Assume the firm records the book value of new stock at the current market price of the new shares.
b. If an investor holds 100 shares of National Profit Company, what should the total value of those holdings be before and after the stock dividend.
c. If the company continues to pay its earlier $2 dividend after the stock dividend, what is the incremental cash dividend received by an investor under b).
Stock Dividends vs. Splits -Essentially the same thing: distributing shares instead of cash -10% stock dividend = 11:10 split -2:1 split = 100% stock dividend -There is an accounting difference: -With stock dividends the market value of the new shares are transferred from the firm’s retained earnings to its paid in capital stock Reverse Splits -When share prices gets extremely low firms sometimes propose a reverse split or consolidation -Simple because the share price is now in a more “respectable” range, doesn’t mean it is a better investment Share Repurchases -An alternative way to return value to shareholders; -Especially good for firms with clienteles that prefer capital gains -Repurchased shares are cancelled (no longer outstanding) -3 kinds: -Open market repurchase (normal course issuer bid) -Buy shares at market price (less than 5%) -Fixed-price offer (substantial issuer bid) -Buy target % at premium to market price -Dutch auction -Target % shareholders invited to make offers to sell to firm inside of prescribed range (min and max) -What is the market’s interpretation of a repurchase? Stock price increases Repurchase Irrelevance -Miller and Modigliani argue that dividend policy is irrelevant -The same is true for repurchases: -Shareholders wealth unaffected by repurchase -Investors can create “home-made repurchases” by selling off a small part of the stock that as appreciated in value, or -Undo repurchases by reinvesting proceeds by buying more shares -Once again, “perfect market” assumptions are necessary Advantages of Share Repurchases -Can be a “1 time only” action -Firm can reduce future total dividend payout -This may increase future flexibility -Immediate effect on firm’s capital structure -Signaling effect -In the presence of employee stock options, a repurchase always increases option values compared to dividends -Share repurchases offset dilution caused by the exercise of employee stock options -If stock price is depressed, firm may buy back some of its stock. Firms sometimes see this as a good investment. Disadvantages of Share Repurchases -Empirically, firms did not have good growth opportunities in the long run -Worry about insider price manipulation
-Tax effect: the government normally treats share repurchase as a dividend – may not be an advantage to some customers Ex. Dungeoness Corporation is evaluating an extra dividend versus a share repurchase. In either case $1,500 would be spent. Shares would be repurchased at current market prices. Current earnings are $0.80 per share and the stock currently sells for $30 per share. There are 150 shares outstanding. Ignore taxes and other market imperfections. a. Evaluate the 2 alternatives in terms of the effect on the price per share of the stock and shareholder wealth. What will be the effect on Dungeoness’ EPS and P/E ratio under the 2 different scenarios b. In the real world, which of these actions would you recommend? Why?
Dividend Policy – The Debate -Academics look at dividend policy as a cash flow issue in an M&M perfect world -Practioners look at dividend policy as a leverage and investment decision -Corporate growth potential -Shareholder reinvestment opportunities -In the absence of taxes, the firm should pay out internally generated funds as a dividends if investors have access to higher positive NPV projects than does the firm M&M on Dividends -In the absence of transactions costs and taxes, dividend policy is irrelevant and does not affect shareholder wealth -Investors do not need dividends to convert shares to cash therefore, they will not pay higher prices for firms with higher dividend payouts -Dividend policy will have no impact on the value of the firm because investors can: -Sell shares off a small part of the stock that has appreciated in value to create dividends -Reinvest dividends in company by purchasing more shares to create capital gains Dividend Policy is Irrelevant -Since investors do not need dividends to convert shares to cash, dividend policy will have no impact on the value of the firm -Dividend policy establishes the trade-off between paying a dividend now or paying a dividend in the future Ex. Wise Holdings has the following market value based balance sheet: In millions Current assets
$25
Long term assets
$75
Total assets
$10 0
Equit y
$100
The company has 5 million shares of common stock outstanding, an EPS of $4 and it has declared a cash dividend of $1 per share. -What are the firm’s stock price and P/E ratio before the ex-dividend date? -What are the stock price, P/E ratio and total market value of equity after the ex-dividend date?
-Suppose Joe owned 50 shares of Wise Holdings. Show that, in the absence of taxes, his wealth is unaffected by the dividend issue
Fundamental Concept -In perfect capital markets, without taxes, dividend policy is irrelevant Taxes and Dividends -In a tax free world, cash dividends are a wash between the firm and its shareholder -In a world with taxes, the government gets a cut What are Practical Issues? -Dividend policy is a decision to give money back to shareholders and NOT invest in a new project -Affects the firm’s capital budgeting decision: -Paying dividends means less internal cash available for other uses -Paying dividends means borrowing money to invest in new projects -Historically firms pa out dividends in both good times and bad times -Firms should never give up a positive NPV project to pay dividends Real World Relevance – Factors Favouring a Low Payout -Taxes, imposing an immediate tax burden on investors -Firm has unusually good investment prospects -Cost if have to issue new equity in the future -Why pay dividends and incur costs to issue securities in the future? -Bond covenants and other restrictions -Growth and control issues -Short term cash position -Inherent firm risk -Restrictions on foreign transfers Real World Relevance – Factors Favouring a High Payout -Desire of current income: -Cost of home-made dividends -Uncertainty resolution: -“Bird-in-the-hand” argument – Investors prefer cash dividend now to uncertain capital gain in future -Tax: -Tax exempt owners -Signalling arguments (Asymmetric information) -Free cash flow issues
The Clientele Effect: A Resolution of Real-World Factors? -Clienteles for various dividend payout policies are likely to form in the following way: Clientele Group
Stock
High tax bracket individuals
Zero to low payout stocks
Low tax bracket individuals
Low-to-medium payout
Tax-free institutions
Medium payout stocks
Canadian corporations
High payout stocks
-Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy Fundamental Concept -Many factors in the real world make dividend policy relevant Guiding Principles and Practical Implementation of a Dividend Policy -Guiding principles: 1. Avoid padding on positive NPV projects to pay dividends 2. Avoid cutting or reducing dividends 3. Avoid the need to sell equity 4. Maintain the target debt/equity ratio -These suggest keeping the payout set low in the first place -Implement: -Set a low per share constant dollar dividend -Set a target payout consistent with long term profitability and long term capital needs -Increase dividends only when the long term profitability supports the new payout level -Reduces dividends reluctantly, but do not risk the viability of the firm Residual Dividend Policy A Theory of Leftovers -Firms may follow a residual dividend policy -Use internally generated funds to finance capital projects and pay out unused earnings as dividends -Determine the capital budget: accept all projects with positive NPV -Determine the equity needed to finance the project while maintaining the firm’s capital structure -Use internally generated funds to supply this equity -Pay a dividend only if there are funds left over Ex. Farside Corporation follows a strict residual dividend policy. Its debt-equity ratio is 3. -If earnings for the year are $150,000, what is the maximum amount of capital spending possible without new equity? -If planned investment outlays for the coming year are $750,000, will Farside pay a dividend? How much? What about if the investment outlay was $500,000? -Does Farside maintain a constant dividend payout?
Ex. Instead of paying a cash dividend, paying out a stock dividend allowing a firm to maintain a payout record when cash is low. Maintaining payout record when cash is low. The market value balance sheet for Ace Manufacturing is shown below. Ace has declared a 15% stock dividend. The stock goes e dividend tomorrow (the chronology for a stock dividend is similar to that for a cash dividend). There are 10,000 shares outstanding. What will be the ex dividend price? Market Value Balance Sheet (in $1000s) Cash
180
Debt
150
Fixed assets
320
Equit y
350
Total
500
Total
500
Ex. National Profit Company has the following shareholder’s equity section before declaring a 5% stock dividend: Shareholder’s equity: Authorized:
500,000 shares without par value
Issued
200,000 common shares
Retained earnings
$2.0 million $0.6 million $2.6 million
a. Show the change in shareholders’ equity section after the 5% stock dividend given that the firm’s shares are currently trading at $15 per share. Assume the firm records the book value of new stock at the current market price of the new shares.
b. If an investor holds 100 shares of National Profit Company, what should the total value of those holdings be before and after the stock dividend.
c. If the company continues to pay its earlier $2 dividend after the stock dividend, what is the incremental cash dividend received by an investor under b).
Stock Dividends vs. Splits -Essentially the same thing: distributing shares instead of cash -10% stock dividend = 11:10 split -2:1 split = 100% stock dividend -There is an accounting difference: -With stock dividends the market value of the new shares are transferred from the firm’s retained earnings to its paid in capital stock Reverse Splits -When share prices gets extremely low firms sometimes propose a reverse split or consolidation -Simple because the share price is now in a more “respectable” range, doesn’t mean it is a better investment Share Repurchases -An alternative way to return value to shareholders; -Especially good for firms with clienteles that prefer capital gains -Repurchased shares are cancelled (no longer outstanding) -3 kinds: -Open market repurchase (normal course issuer bid) -Buy shares at market price (less than 5%) -Fixed-price offer (substantial issuer bid) -Buy target % at premium to market price -Dutch auction -Target % shareholders invited to make offers to sell to firm inside of prescribed range (min and max) -What is the market’s interpretation of a repurchase? Stock price increases Repurchase Irrelevance -Miller and Modigliani argue that dividend policy is irrelevant -The same is true for repurchases: -Shareholders wealth unaffected by repurchase -Investors can create “home-made repurchases” by selling off a small part of the stock that as appreciated in value, or -Undo repurchases by reinvesting proceeds by buying more shares -Once again, “perfect market” assumptions are necessary Advantages of Share Repurchases -Can be a “1 time only” action -Firm can reduce future total dividend payout -This may increase future flexibility -Immediate effect on firm’s capital structure -Signaling effect -In the presence of employee stock options, a repurchase always increases option values compared to dividends -Share repurchases offset dilution caused by the exercise of employee stock options -If stock price is depressed, firm may buy back some of its stock. Firms sometimes see this as a good investment. Disadvantages of Share Repurchases -Empirically, firms did not have good growth opportunities in the long run -Worry about insider price manipulation
-Tax effect: the government normally treats share repurchase as a dividend – may not be an advantage to some customers Ex. Dungeoness Corporation is evaluating an extra dividend versus a share repurchase. In either case $1,500 would be spent. Shares would be repurchased at current market prices. Current earnings are $0.80 per share and the stock currently sells for $30 per share. There are 150 shares outstanding. Ignore taxes and other market imperfections. a. Evaluate the 2 alternatives in terms of the effect on the price per share of the stock and shareholder wealth. What will be the effect on Dungeoness’ EPS and P/E ratio under the 2 different scenarios b. In the real world, which of these actions would you recommend? Why?
