finance
Advanced Managerial Finance
In Ji Jang
Payouts to Shareholders
Ch.19
Two Methods of Returning Cash to Shareholders • Cash Dividends
Usually paid quarterly
Tend to be ‘sticky’ – companies reluctant to eliminate dividends
Lagged adjustments to changes in earnings
Individual investors taxed at current rate
Company has option to declare ‘special’ dividends
• Share Repurchases
Can be implemented through tender offer or open market repurchases
No presumption of regularities
Capital gains taxable only to selling shareholders
Stock Price and Dividend • Stock price as discounted future dividend (constant growth
model): Assume the company retains ‘b’ and the earnings grow at ‘g’ every year
• Where does the growth come from? ROE and growth
1 1 0
(1 )
S S
DIV b EPS P
R g R g
− = =
− −
g b ROE=
Procedure for Cash Dividend 28 Oct. 2 Nov. 3 Nov. 4 Nov. 7 Dec.
Declaration
Date
Cum-
dividend
Date
Ex-
dividend
Date
Record
Date
Payment
Date
…
Declaration Date: The Board of Directors declares a payment
of dividends.
Cum-Dividend Date: Buyer of stock still receives the dividend.
Ex-Dividend Date: Date that determines whether a stockholder is
entitled to a dividend payment; anyone holding stock immediately
before this date is entitled to a dividend Record Date: The corporation prepares a list of all individuals
believed to be stockholders as of 4 November.
Stock Price Should Fall on Ex- Dividend Date • At cum-dividend date (a day prior to ex-dividend date), the next dividend will
be received (almost) immediately: Cum-dividend price
• At year 0, the next dividend is one year away (DIV1): Ex-dividend price
• Stock price falls by the amount of dividend (ignoring taxes) on the ex- dividend date
Year 0 1
DIV0 DIV1
Pcum-div.= DIV0 + DIV1/(RS-g) P0(ex-div.) = DIV1/(RS-g) P1 = DIV2/(RS-g)
Ex-dividend date
Cum-dividend
date
Dividends and Financing (with no market frictions) • Firm decides to issue enough new shares to pay a dividend of $5 per share on
each of its 20 million shares
• New shareholders will not receive the dividend
• Need to raise 5*20 = $100 mil. : Issue Δn new shares at price P* such that ΔnP* = $100mil
Initial Mkt. Value Balance Sheet
ATOCF/RS = $100mil/.1 nP = 20mil($50)
________ _________
$1000mil $1000mil
Dividend has NO effect on Shareholder Wealth
• (20+Δn)P* = $1000mil; ΔnP*=100mil; 20mil.×P*=$900mil ; P*=$45
• Initial shareholders get $5 in dividends but lose $5 in market value, leaving them equally well off
Post-Issue Mkt. Value Balance Sheet
ATOCF/RS = $100mil/.1 (n + Δn)P* = (20mil + Δn)P*
________ _________
$1000mil $1000mil
Dividends vs. Repurchase (with no market frictions)
• Firm has extra cash $100mil. It evaluates between dividends and repurchases
• If it choose dividends, it pays $5 dividend to each share; DPS=100/20=5
• If it choose repurchase, it buys 2 million shares : Δn = $-100mil/$50 =-2mil.
Mkt. Value Balance Sheet
Cash $100mil
Other Asset $900mil nP = 20mil.($50)
________ _________
$1000mil $1000 mil
Dividend vs. Repurchase choice: No effect on shareholder wealth
• Ex-dividend price: P*=900/20=$45
• Shareholder wealth per share (dividend):DPS + P* =$5+$45=$50
• Shareholder wealth per share (repurchase): P=$50
• No effect on shareholder wealth
Post-Dividend Mkt. Value Balance Sheet
Other Assets $900mil nP* = 20milP* = 20mil.×$45 ________ _________
$900mil $900mil
Post-Repurchase Mkt. Value Balance Sheet
Other Assets $900mil (n + Δn)$50 = (20mil – 2mil)$50 ________ _________
$900mil $900mil
Effect of Capital Market Frictions on Payout Policy • Taxes
Tax advantage to repurchases for individual investors
Corporate investors can exclude 50-100% of dividends received from taxable income
• Transaction costs Shareholder preference for dividend (consumption)
Corporation preference for retention (avoid new security issue)
• Agency Costs Dividends and repurchases remove funds from the grasp of both bondholders
and managers (“free cash flow hypothesis”)
Earnings, Dividends and Net Repurchases for Large U.S. firms
Dividend vs. Repurchases • Flexibility
Dividends are commitment to shareholders
• Executive compensation
Executive stock options
• Offset to Dilution
Reduce number of shares to offset dilution
• Undervaluation
Buy back shares when managers think it is undervalued
Practice Problems • Question 1
• Question 2
• Question 3