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RWJordan Chap18MBA

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Information about RWJordan Chap18MBA
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Published on January 10, 2008

Author: Rebecca

Source: authorstream.com

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T18.4 The Ex-Date Price Drop (Figure 18.2):  T18.4 The Ex-Date Price Drop (Figure 18.2) The stock price will fall by the amount of the after-tax dividend on the ex date (time 0). Without taxes, if the dividend is $1 per share, the price will be equal to $10 - $1 = $9 on the ex date. (With a personal tax rate of 0.28, the price will be equal to $10 – $0.72 = $9.28): Before ex date (time -1) dividend = 0 Price = $10 On ex date (time 0) dividend = $1 Price = $9 (or $9.28) Price of stock if no dividends paid Price of stock after dividends paid Time Ex dividend date ln Price T18.5 Dividend Policy is the time pattern of dividend payout Does Dividend Policy Matter?:  T18.5 Dividend Policy is the time pattern of dividend payout Does Dividend Policy Matter? Dividend policy versus cash dividends An illustration of dividend irrelevance (to the value of the firm’s equity) Original dividends if RE = 20%: P0(total) = $1000/1.2 + $1000/1.22 = $ _______ 0 1 2 $1,000 $1,000 T18.5 Does Dividend Policy Matter? (concluded):  T18.5 Does Dividend Policy Matter? (concluded) Dividend policy versus cash dividends An illustration of dividend irrelevance Original dividends 0 1 2 $1000 $1000 if RE = 20%: P0 (total) = $1000/1.2 + $1000/1.22 = $1,527.78 T18.5 Does Dividend Policy Matter? (concluded):  T18.5 Does Dividend Policy Matter? (concluded) New dividend plan 0 1 2 $1000 $1000 +200 -240 $1200 $760 P0 (total) = $1200/1.2 + $760/1.22 = $________ T18.5 Does Dividend Policy Matter? (concluded):  T18.5 Does Dividend Policy Matter? (concluded) New dividend plan 0 1 2 $1000 $1000 +200 -240 $1200 $760 P0 (total) = $1200/1.2 + $760/1.22 = $1,527.78 T18.5 Homemade Dividends (i.e. dividend irrelevance to investor’s desired consumption pattern):  T18.5 Homemade Dividends (i.e. dividend irrelevance to investor’s desired consumption pattern) An illustration of “homemade” dividends Original dividends if you own 10% of the stock (= your preferred dividend payout) Dividends under new plan 0 1 2 $100 $100 0 1 2 $120 $76 T18.5 Homemade Dividends (i.e. dividend irrelevance to investor’s desired consumption pattern - continued):  T18.5 Homemade Dividends (i.e. dividend irrelevance to investor’s desired consumption pattern - continued) An illustration of “homemade” dividends Undo the new plan by buying shares Analogous to homemade leverage argument in Chapter 16 (also attributable to M&M) Note: ADRs (DRIPs) Automatic reinvestment of some or all of cash dividends in shares of stock, in some cases at a discounted price.  Corporation helps shareholders in creating homemade dividend policies (e.g., reinvestment of dividends ↓ “effective” payout) 0 1 2 $100 $100 - 20 - 24 $100 $100 T18.6 Dividends and the Real World: Why dividend payout may not be Irrelevant:  T18.6 Dividends and the Real World: Why dividend payout may not be Irrelevant Factors favoring a low payout 1. Company has more positive NPV projects than can be financed with earnings. 2. Internal financing out of retained earnings cheaper than external financing via bond or equity issues. Reasons: a. Lower info costs (See Section 16.6: Pecking order theory.) b. No flotation costs 3. Taxes Shareholders prefer to receive earnings as capital gains, rather than dividends. Reasons: a. Generally lower tax rates on capital gains than dividends b. Deferral of taxes on capital gains until realized. 4. Indenture restrictions Bondholders may prohibit dividend payout above some level. (See Section 16.3, Protective Covenants.) T18.6 Dividends and the Real World: Why dividend payout may not be Irrelevant (continued):  T18.6 Dividends and the Real World: Why dividend payout may not be Irrelevant (continued) Factors Favoring a high payout 1. Company has more earnings than can be used to finance positive NPV projects (i.e., free cash flow). High payout decreases agency costs between managers and shareholders. 2. Taxes again If TP (on dividends) < TC, individuals have more after-tax returns if they make their financial investments for themselves, rather than through the corporation. (See example, 2 slides below.) Note: assuming 1 above, only question is when corporation should pay out dividends, not whether it should. Possible exceptions: a. Exclusion of at least 70% of dividends from taxable income, if dividends paid to corp. b. Tax-exempt or tax-deferred investors (Exs: pension, endowment, trust funds). Slide10:  3. Legal reasons (most applicable to large financial institutions). a. Fiduciary responsibility To invest clients’ money in companies with established record of (high) dividend payout b. Prohibition against clients “dipping into principal.” 4. Need for current income Probably fallacious: can create homemade dividends by selling low-dividend shares, if transactions costs are low enough 5. Uncertainty resolution. The “bird-in-the-hand” argument. Also probably fallacious: in long run, uncertainty of dividend payments is a reflection of uncertainty of underlying earnings. (Recall:  in current dividends still => later  equal to future value of those dividends.) Example: Factors Favoring a High Payout, #2: Taxes Again (c.f. RW Jaffe, Chapter 18, Page 505):  Example: Factors Favoring a High Payout, #2: Taxes Again (c.f. RW Jaffe, Chapter 18, Page 505) Given that there is excess cash after financing all positive NPV investments, the dividends should be paid out. The question is only when to pay them out, not if. The answer depends on the relative magnitudes of TP versus TC. Assume TP = 0.28, TC = 0.34, and free cash flow (excess cash after financing all positive NPV projects) = $1000. Alternative financial investment is T-bonds with maturity of 5 yrs. and yield to maturity of 10%. If free cash flow paid out as dividends, FV = [1,000(1 - 0.28)][1 + 0.10(1 - 0.28)]5 = 1,019.31 (18.3) If free cash flow is retained by corp., which invests in the same T-bonds, then pays out earnings as dividends, FV = [1,0001 + 0.10(1 – 0.34)5](1 - 0.28) = 991.10 (18.4) Comparing the 2 expressions for FV, you can see that, when TP < TC, as it is here, FV is higher when FCF is paid out as dividends. This gives the firm an incentive to pay out any excess cash as dividends. T18.6 Dividends and the Real World: Why dividend payout may not be Irrelevant (continued):  T18.6 Dividends and the Real World: Why dividend payout may not be Irrelevant (continued) Empirical Evidence 1. Increase in dividends usually followed by increase in stock price. But this doesn’t necessarily => investors prefer higher dividends, due the information effect: Increase in dividends is a signal to investors of increased expected future dividends, and therefore increased value of shares. 2. Clientele effects (See reasons 2 and 4 above for high payout). Investors facing high taxes on dividends prefer low dividend payout; investors facing low taxes on dividends (or who need current income and face high transactions costs of selling shares) prefer high dividend payout. This latter reason suggests that different dividend payout rates among firms provide low-cost alternatives to homemade dividends. Companies adjust dividend policy to satisfy one or the other of these groups until the market for dividends is in equilibrium. T18.8 Establishing a Compromise Dividend Policy :  T18.8 Establishing a Compromise Dividend Policy Ranked in order of importance, the objectives of dividend policy are: - Avoid rejecting +NPV projects to pay a dividend - Avoid cutting dividends - Avoid issuing new equity (to finance high dividend payout) - Maintain target debt/equity ratio (to max. firm value) - Maintain target dividend payout ratio (i.e. a long-run proportion of earnings that is paid out in dividends) Note: A type of dividend stability may be maintained in spite of earnings instability. Define permanent earnings as long-run average earnings. Make regular dividend payout a small enough fraction of permanent earnings so that payout can be met almost all the time. Make extra dividend payout a bonus to be paid when actual earnings are > permanent earnings. T18.10 Example: The Effects of a Cash Dividend Versus a Share Repurchase (a.k.a. Share Buy-Back):  T18.10 Example: The Effects of a Cash Dividend Versus a Share Repurchase (a.k.a. Share Buy-Back) Assume no taxes, commissions, or other market imperfections Consider a firm with 50,000 shares outstanding and the following market value balance sheet Cash $ 100,000 $ 0 Debt Other Assets 900,000 1,000,000 Equity Total $1,000,000 $1,000,000 Total Price per share is $20 ($1,000,000/50,000) Net income is $100,000, so EPS = $2.00 The P/E ratio is 10 The firm is considering; 1) paying a $1 per share cash dividend or 2) repurchasing 2,500 shares at $20 a share T18.10 Example: The Effects of a Cash Dividend versus a Share Repurchase (continued):  T18.10 Example: The Effects of a Cash Dividend versus a Share Repurchase (continued) 1. Choose the cash dividend (all stockholders get $1 per share) Cash $ 50,000 Debt $ 0 Other Assets 900,000 Equity 950,000 Total $950,000 Total $950,000 Price/share  to $19 (=$950,000/50,000 share) (since  A =  E with no  shares). Net income is still $100,000, so EPS still =$2.00 (= $100,000/50,000 sh) => P/E ratio  to 9.5 (=$19/$2) (since P  with no  in EPS). Conclusion:  Div =  V (reflected in  P, given no  no. of shares, as co. goes ex-dividend) Note: taxes paid on entire dividend payout T18.10 Example: The Effects of a Cash Dividend versus a Share Repurchase (continued):  T18.10 Example: The Effects of a Cash Dividend versus a Share Repurchase (continued) 2. Choose the repurchase (2,500 shares are repurchased at $20 a share) Note: market value balance sheet is the same as with cash dividends. Cash $ 50,000 Debt $ 0 Other Assets 900,000 Equity 950,000 Total $950,000 Total $950,000 Price/share remains at $20 (= 950,000 / 47,500 share) (since firm has shrunk proportionately) Net income is still $100,000, so EPS  to $2.10 (= $100,000/47,500 shares) (since no. of sh ) => P/E ratio  to 9.5 (= $20/$2.10) (since EPS  with no  P) Note: P/E same as with cash dividend T18.9 Cash Dividend Versus Repurchase (Concluded):  T18.9 Cash Dividend Versus Repurchase (Concluded) Conclusion: Share repurchase =  V, same as with dividend payout (but no  P, since %  V = %  sh = 5%). Implication: We have a third irrelevance result, this time between cash dividends and repurchase. Recall that the other two irrelevance results, both due to M&M, were 1) capital structure (debt v. equity) and 2) dividend policy (dividend payout v. capital gains). Note that all of these irrelevance results hold only in a world without taxes. Capital gains taxes negate the two irrelevance results related to dividends, since these taxes paid only on that portion of share repurchase that is capital gain. Since the capital gains tax rate is also usually lower than tax rate on ordinary income, share repurchase is generally preferred to dividend payout for tax reasons.

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