Slide 19.16 Personal Taxes and Dividends
.A Firms without Sufficient Cash to Pay a Dividend
Slide 19.17 Firms without Sufficient Cash
In the absence of taxes, issuing stock to pay a dividend would be a
zero NPV decision. However, with taxes, it would be a negative
NPV situation, particularly once issuance costs are considered.
.B Firms with Sufficient Cash to Pay a Dividend
Slide 19.18 Firms with Sufficient Cash
If all positive NPV projects have been accepted, extra cash can be
used to select additional projects (negative NPV = not a good
choice), acquire other firms, purchase financial assets, or
repurchase shares. Obviously, the other alternative is to pay
dividends.
.C Summary of Personal Taxes
Slide 19.19 Taxes and Dividends
19.5. Real-World Factors Favoring a High-Dividend Policy
Slide 19.20 Real-World Factors Favoring High Dividends
.A Desire for Current Income
Individuals that want current income can either invest in
companies that have high dividend payouts or they can sell shares
of stock. An advantage to dividends is that you do not have to pay
commission.
Trust funds and endowments may prefer current income because
they may be restricted from selling stock to meet expenses if it will
reduce the fund below the initial principal amount.
Lecture Tip: A fascinating real-world example of the desire for
increased dividend payout can be found in Kirk Kerkorian’s battle
with the management at Chrysler. In late 1994, Mr. Kerkorian
demanded that Chrysler use its cash hoard (about $6.6 billion at
the time) to increase the cash dividend on common stock and to
institute a stock repurchase program. The management of Chrysler
contended that, in the interest of prudent management, they were
amassing cash with which to ride out the next cyclical downturn.
Unhappy with Chrysler’s response, Mr. Kerkorian offered $55 per
share (nearly $23 billion total) to take over Chrysler. This bid
ultimately failed, but Chrysler’s management did raise the
dividend. Incidentally, Ford and GM subsequently found it
necessary to publicly defend their large cash positions in the
period after the Chrysler takeover bid.
.B Behavioral Finance
Investors could buy low-dividend stocks and sell shares as
necessary to create the desired cash flow, but buying a high-
dividend stock eliminates this need. “Behavioral financers” suggest
it is hard for most investors to exhibit the necessary self-control to
create the desired homemade dividend.
.C Agency Costs
As discussed in a prior chapter, excess free cash flow creates
agency costs, but paying a dividend forces managers to be more
disciplined.
.D Information Content of Dividends and Dividend Signaling
Dividend policy is irrelevant if future earnings are held constant. Increases in
dividend, however, are often viewed as an indication of an increase
in future earnings.
Changes in dividends may be important signals if the market
anticipates that the change will be maintained through time. If the
market believes that the change is just a rearrangement of
dividends through time, then the impact will be small. The reaction
to the information contained in dividend changes is called the
information content effect.
Lecture Tip: Selling stock to raise funds for dividends also creates
a “bird-in-the-hand” situation for the shareholder. Again, we are
back to “all else equal.” Can a higher dividend make a stock more
valuable? If a firm must sell more stock or borrow more money to
pay a higher dividend now, it must return less to the stockholder in
the future. The uncertainty over future income (the firm’s business
risk) is not affected by dividend policy.
19.6. The Clientele Effect: A Resolution of Real-World Factors?
Slide 19.21 Clientele Effect
The clientele effect says that dividend policy is irrelevant because investors
that prefer high payouts will invest in firms that have high payouts,
and investors that prefer low payouts will invest in
firms with low payouts. If a firm changes its payout policy, it will not affect
the stock value; it will just end up with a different set of investors.
This is true as long as the “market” for dividend policy is in
equilibrium. In other words, if there is excess demand for
companies with high dividend payouts, then a low payout company
may be able to increase its stock value by switching to a high
payout policy. This is only possible until the excess demand is met.
Lecture Tip: To put the clientele argument into a different light, consider the
case of opening a new restaurant. Even though a lot of people like
to eat hamburgers and fries, if McDonald’s already satisfies that
clientele, you will not make a fortune by opening a Burger King
next door. In the context of business finance, the moral is that for
dividend policy to be relevant, it must meet a currently unmet
demand if it is to create value.
Lecture Tip: The dividend clientele argument suggests that investors that do
not need current income will seek low dividend firms (and vice
versa). In a similar fashion, many theorists have argued that there
is also a clientele for various capital structure policies. Investors
in a low tax bracket will prefer highly leveraged firms because the
firms are better able to utilize the interest tax shield. While
investors in higher tax brackets will borrow on their own and buy
firms with less debt. Empirical evidence is mixed.
19.7. What We Know and Do Not Know about Dividend Policy
Slide 19.22 What We Know and Do Not Know
.A Corporate Dividends Are Substantial
.B Fewer Companies Pay Dividends
In practice, managers tend to have the following goals, in order of
importance:
-avoid cutting back on positive NPV projects to pay a dividend
-avoid dividend cuts
-avoid the need to sell equity
-maintain a target debt-to-equity ratio
-maintain a target dividend payout ratio
.C Corporations Smooth Dividends
Because of the information content of dividend changes, managers may prefer
to maintain a more stable dividend policy. This reduces the
uncertainty surrounding expected future dividends and should
decrease the risk attributed to the cash flows from the stock.
Lecture Tip: In July, 1995, Venture Corporation, a high-volume discount
retailer, announced the suspension of its quarterly dividend
following a period of poor earnings performance. The price of the
stock (which had already fallen over the preceding months) fell by
approximately one-third on the day of the announcement.
Subsequent quarterly earnings were “disappointing,” and the firm
filed for bankruptcy and was liquidated a few years later.
At about the same time, Edison Brothers, also a retailer,
announced that its dividend would be reduced in order to
“conserve cash for investment opportunities.” The price of the
stock fell dramatically, and the dividend was subsequently reduced
again about a year later. Eventually the dividend was eliminated,
and the firm filed for bankruptcy. In both cases, dividend
reductions followed periods of poor earnings performance and
were followed by more poor performance. One might say that the
“signal” being sent by the dividend cut was completely accurate.
.D Some Survey Evidence about Dividends
-Almost 94% of the managers that responded to the survey indicated that they
try to avoid reducing the dividends per share.
-About 84% of the managers indicate that they try to maintain consistency
with historic dividends.
-Less than 10% of managers worry about flotation costs.
19.8. Putting It All Together
Slide 19.23 Putting It All Together
This section can be summarized by five primary observations:
1. Aggregate payouts (dividends and repurchases) are massive
and have increased in absolute terms over the years.
2. Dividends are concentrated among a small number of large,
mature firms.
3. Managers are reluctant to cut dividends, normally doing so
only due to firm-specific problems.
4. Managers smooth dividends, raising them slowly and
incrementally as earnings grow.
5. Stock prices react to unanticipated changes in dividends.
Slide 19.24 General Dividend Guidelines
Further, we can provide some general guidelines on the
characteristics of a sensible payout policy:
1. Over time pay out all free cash flows
2. Avoid cutting positive NPV projects to pay dividends or buy
back shares
3. Do not initiate dividends until the firm is generating substantial
free cash flows
4. Set the current regular dividend consistent with a long-run
target payout ratio
5. Set the level of dividends low enough to avoid expensive future
external financing
6. Use repurchases to distribute transitory cash flow increases
19.10. Stock Dividends and Stock Splits
Slide 19.25 Stock Dividends
Stock dividend – dividend paid in shares of stock rather than in
cash. Commonly expressed as a percentage, e.g., a 25% stock
dividend means you will receive 1 share for every 4 that you own.
As with a cash dividend, the stock price declines proportionally.
Stock split – new outstanding shares issued to existing
stockholders, expressed as a ratio, e.g., a 2-for-1 split means you
will receive 2 shares for every one that you own. Again, the price
drops proportionally. Splits are usually, but not always, larger than
dividends and are treated differently for accounting purposes.
Lecture Tip: Some investors believe that it is desirable to purchase
a company’s stock prior to the announcement of the stock split.
Discuss the accounting treatment of stock splits and show that
there is no difference between the stock before and after the split.
The cash flows to stockholders do not change, and the risk of the
stock is unaffected by a stock split, so a stock split should not add
value to the firm. However, empirical evidence has indicated that
there is unusual stock price behavior around the ex-dividend date
for non-taxable stock dividends and stock splits. Grinblatt, Masulis
and Titman (Journal of Financial Economics, 1984) documented a
5-day average abnormal return of about two percent surrounding
the ex-date. The rationale for this is not fully understood, but it is
too large to be due solely to the tax impact.
.A Some Details about Stock Splits and Stock Dividends
Slide 19.26 Stock Splits Click on the web surfer icon to go to
www.stocksplits.net to get information on stock dividends and stock splits.
Stock dividend – retained earnings transferred to par value and capital
accounts
Stock split – par value adjusted to reflect the split with no effect on retained
earnings
.B Value of Stock Splits and Stock Dividends
Benchmark case – no change in shareholder wealth
Lecture Tip: In theory, stock dividends and stock splits are accounting issues
and should not impact the value of the firm. Yet, empirical
research has documented large stock price gains at the
announcement of a company’s decision to issue a stock dividend.
Why the apparent discrepancy?
A plausible argument is that there exists a signaling effect. Students should
recognize that the value of the stock dividend is transferred from
retained earnings into the common stock and capital in excess of
par accounts. Remind students that many bond covenants restrict
cash dividend payments when retained earnings fall below a
minimum level. Only those companies confident of future earnings
will be willing to reduce retained earnings through a stock
dividend.
Popular trading range – more investors can afford cheaper stocks, so it will
increase the value – or so the argument goes.
.C Reverse Splits
Three popular reasons:
1. reduced transaction costs (higher priced stocks have lower commissions on
a percentage basis)
2. popular trading range – the price has gotten too low and it affects the stocks
liquidity and marketability
3. respectability – many people are leery about investing in “penny stocks”
Two technical reasons:
1. stock exchanges have minimum listing requirements
2. may combine a reverse split and a stock repurchase where the company
offers to buy out shareholders that end owning shares below some
minimum number
Lecture Tip: Anecdotal evidence indicates that the number of reverse splits
generally increases in market downturns. The reasoning is that
managers of firms whose share price had suffered are more likely
to attempt to inflate the price via a reverse split. It is important to
note that this is not consistent with an informationally efficient
market – by itself, a reverse split is purely cosmetic. It remains to
be demonstrated whether the existence of market imperfections
and institutional requirements provide an economic rationale for
reverse splits.
Slide 19.27 Quick Quiz