principles_of_corporate_finance_unit_f_lectures.pdf

Dividends and Repurchases Payout Policy A firm’s payout policy determines if and how its free cash flows are distributed to shareholders. 1 1 Source: Berk and DeMarzo Payout: Dividends • Cash dividend: The firm pays cash to shareholders on a pro-rata basis, eg, shareholders receive $0.50 in c...

Dividends and Repurchases Payout Policy A firm’s payout policy determines if and how its free cash flows are distributed to shareholders. 1 1 Source: Berk and DeMarzo Payout: Dividends • Cash dividend: The firm pays cash to shareholders on a pro-rata basis, eg, shareholders receive $0.50 in cash for each share held. • Regular cash dividend (quarterly, semi-annual) • Special cash dividend (one-off) • Stock dividend: The firm pays additional stock to shareholders on a pro-rata basis, eg, 10% stock dividend → shareholders receive 10 additional shares for every 100 currently held. • No actual transfer of cash to shareholders • Essentially a stock split with a much smaller split factor • For example, in a 2-for-1 split, every 100 shares receives 100 new shares How Do Firms Pay Dividends? • Declaration date: the board authorises payment of dividend and announces dividend amount • Record date: only people recorded as shareholders on this date receive a divided • Ex-dividend date: normally 1 to 2 days before record date; anyone purchasing shares on or after this date will not be eligible to receive the dividend. • Cum-dividend date: The day before the ex-dividend date • Payment date: the firm distributes dividend Example: Dividend Timeline Microsoft’s special dividend 2 2 Source: Berk and DeMarzo Payout: Share Repurchase Share repurchase: The firm uses cash to purchase its own stock from shareholders. • Open market repurchase (most common) • The firm purchases shares in the open (ie, secondary) market anonymously. • Open market repurchase programs usually last up to three years. • Tender offer • Firm pre-specifies the number of shares and the price which it will offer to repurchase shares. • The offer price is normally at a premium to the current market price (typically 10 to 20%). Payout: Share Repurchase (cont.) • Dutch auction • Firm provides a schedule of possible repurchase prices and invites stockholders to state the number of shares they are willing to sell at each price. • The firm selects the lowest price at which it can repurchase the desired number of shares. • Private negotiation • Firm offers to repurchase shares from a specific shareholder, normally at a significant premium to the market price. • By buying out a major shareholder, the firm can remove the threat of a takeover (“greenmail”). Payout Trends US Data: 1985 to 2017 3 3 Source: Brealey, Myers, and Allen The End MM Dividend Irrelevance Should Investors Care About Dividend Policy? Take two firms, A and B, both identical in all respects except the current dividend – Firm A plans to pay a larger dividend than Firm B. Suppose investors desperately need cash. Now consider the following argument: • The demand for cash will lead investors to want to buy Firm A stock (larger dividend) more than Firm B (smaller dividend) • → Excessive demand pushes up the price of Firm A • → Firm A value > Firm B value Franco Modigliani and Merton Miller (“MM”) showed that in perfect capital markets, this argument is incorrect. In such a world, payout policy is value-irrelevant (“dividend irrelevance”). MM Dividend Irrelevance: Perfect Capital Markets If the following assumptions hold: 1. Investment is held constant 2. No transactions costs 3. Efficient capital markets 4. Managers maximise shareholders’ wealth 5. No taxes (or, dividends and capital gains are taxed in the same way) Then dividend policy does not affect the value of the firm and the wealth of shareholders. MM Dividend Irrelevance: Example, Part I Firm A has assets with a market value of $500 million, surplus cash of $50 million, and 10 million shares outstanding. For simplicity, assume that the company has no debt. Its market value balance sheet today looks like this: Today Surplus cash ($m) 50 Assets ($m) 500 Firm value ($m) 550 Shares (millions) 10 $55 Share price MM Dividend Irrelevance: Example, Part II Suppose Firm A decides to pay out all of its excess cash as a dividend. Each share will receive a dividend of: $50m/10m = $5. Today PMT date 0 Surplus cash ($m) 50 Assets ($m) 500 500 Firm value ($m) 550 500 Shares (millions) 10 10 $50 Share price $55 Dividend per share $5 The share price drops by the amount of the dividend (technically, on the ex-dividend date). MM Dividend Irrelevance: Example, Part III Suppose you hold 1,000 shares of Firm A. Has the payment of the dividend affected your wealth? Before the dividend, your shareholder value was: • Stock: 1,000 shares @ $55 = $55,000 After the dividend payment: • Stock: 1,000 shares @ $50 = $50,000 • Cash: $5/share × 1,000 shares = $5,000 • Total: $55,000 MM Dividend Irrelevance: Example, Part IV What if Firm A only paid out $20m as a cash dividend? Surplus cash ($m) Assets ($m) Firm value ($m) Shares (millions) Share price Dividend per share Today 50 500 550 10 $55 Dividend: $50m 0 500 500 10 $50 $5 Shareholder value after the dividend payment: • Stock: 1,000 shares @ $53 = $53,000 • Cash: $2/share × 1,000 shares = $2,000 • Total: $55,000 Dividend: $20m 30 500 530 10 $53 $2 MM Dividend Irrelevance: Example, Part V So, no impact on shareholder value, but there are differences in how this value is distributed between shares and cash. Should this difference matter to investors? No! Shareholders can create any dividend they desire by selling or buying shares. Suppose Firm A opts to pay a $2 dividend per share but you wanted $5 per share. After receiving the dividend, you can: • Sell (3, 000/53) ≈ 56.60 shares @ $53 = $3,000 • Total cash: $2,000 + $3,000 = $5,000 • Shares: 1, 000 − 56.60 = 943.40 shares @ $53 = $50,000 By creating a “home-made dividend”, you have replicated the distribution you would have had under a $5 per share dividend. MM Dividend Irrelevance Since investors do not need dividends to convert shares to cash, they will not pay higher prices today for firms with higher dividend payouts. → In other words, dividend policy will have no impact on the value of the firm. → Dividend policy is irrelevant. But what about (open market) share repurchases? • The same reasoning applies, ending in the same result: the decision to repurchase shares does not affect firm value or shareholder wealth. The End Modelling 1: Dividend Irrelevance MM Dividend Irrelevance: Rational Demiconductor, Part I What if a company decides to pay a larger dividend today than it has available surplus cash? Consider the current balance sheet of Rational Demiconductor (RD): Cash Assets Total + New project NPV Firm value Shares Share price Today 1,000 9,000 10,000 2,000 12,000 1,000 $12 The company requires $1,000 cash to maintain investment but declares a $1,000 cash dividend anyway. Is the value of the firm altered assuming new shares are issued to fund that subsequent investment? Assume RD decides to pay the dividend and then issues shares to raise the required cash. MM Dividend Irrelevance: Rational Demiconductor, Part II Today Payment date 0 Cash 1,000 Assets 9,000 9,000 9,000 Total 10,000 + New Project NPV 2,000 2,000 11,000 Firm Value 12,000 1,000 Shares 1,000 Share price $12 $11 RD issues (1,000/11) ≈ 91 shares @ $11 = $1,000 Post-Issue 1,000 9,000 10,000 2,000 12,000 1,091 $11 MM Dividend Irrelevance: Rational Demiconductor, Part III Initial shareholder value: • Stock: 1,000 shares @ $12 = $12,000 Value to old shareholders after dividend payment: • Cash: $1,000 • Stock: 1,000 shares @ $11 = $11,000 • Total: $12,000 Dividend irrelevance is easily seen if the old stockholders just purchase the new issue themselves with the proceeds from the dividend: • Buy $1,000/$11 = 91 shares • plus 1,000 shares already owned • equals to 1,091 shares @ $11 = $12,000 MM Dividend Irrelevance: Rational Demiconductor, Part IV Again, shareholders do not actually need RD to pay the $1,000 dividend to get their hands on an equivalent amount of cash. Even if RD chooses not to pay the dividend, shareholders can always create home-made dividends by selling 83.33 shares (@ $12 = $1,000). Initial shareholder value: • Stock = 1,000 shares @ $12 = $12,000 Shareholder value after home-made dividends: • Stock: 916.66 shares @ $12 = $11,000 • Cash: $1,000 • Total: $12,000 MM Dividend Irrelevance: What Just Happened? Old shareholders: • Receive cash dividend • Their ownership of the company is diluted (less valuable) New shareholders: • Contribute cash • In return, they receive shares of the company If capital markets are efficient, the above transactions are fair, so the net gain/loss to everyone is 0. The size of the company is unchanged. Thus dividend policy is irrelevant. MM Dividend Irrelevance: What Just Happened? (cont.) Another example: one-third of firm value paid as dividend, raised via new share issue → capital loss to old shareholders offsets dividend 1 1 Source: Brealey, Myers, and Allen The End Empirical Facts Dividends in the Real World Lintner’s (1956) stylised facts • Firms have long-term target dividend payout ratios. • Managers focus more on dividend changes than on absolute levels. • Managers are reluctant to make dividend changes that might have to be reversed. • Dividend changes follow shifts in long-run, sustainable levels of earnings rather than short-run changes in earnings. • Firms repurchase stock when they have accumulated a large amount of unwanted cash or wish to change their capital structure by replacing equity with debt. Dividend Smoothing GM’s dividend and earnings per share (1985 to 2008) 1 1 Source: Berk and DeMarzo Event Study Evidence Stock prices rise when firms start paying dividends (Asquith and Mullins, 1983). Abnormal returns (%) 6 5 4 3 2 1 0 -1 -12 -10 -8 -6 -4 -2 0 2 4 6 Day relative to announcement 8 10 12 Dividend Relevance? • Lintner suggests that managers act as though dividend policy is relevant. • Event study evidence suggests market responds. • So who is wrong? • Managers? • Modigliani and Miller? • Use MM to understand by relaxing the five assumptions in turn. The End Dividend Policy in the Real World Relax MM Assumptions, Part I 1. Investment may not be held constant. • If investment decisions (positive or negative NPV) are affected by dividend policy, then firm value can change • If surplus cash will be wasted by managers, then paying out dividends increases firm value. • Or, if paying dividends means sacrificing valuable investment, then it decreases firm value. 2. There are transaction costs. • There are costs to mailing dividends (small nowadays) and buying/selling stocks, eg, brokerage fees, bid-ask spread, flotation costs (also smaller nowadays). Relax MM Assumptions, Part II 3. Capital markets are not efficient. Two possibilities: I Information asymmetry – eg, managers know more about the firm than outsiders II “Irrationality” – markets predictably make mistakes when pricing stocks Result: Capital market transactions are not always conducted at fair prices. Let’s consider each possibility in turn . . . Relax MM Assumptions, Part III 3. Capital markets are not efficient (cont.) I There is information asymmetry. • Dividend changes can and do change the market’s perception of the firm’s value. What type of signals may dividends convey? Information in Dividends: Some Empirical Evidence The market responds to dividend change announcements. • Dividend increases are followed by a stock price increase of approximately 0.36%. • Dividend decreases are followed by a stock price decline of −1.1% to −1.4%. How big is the magnitude of the stock price response? • An annual equity rate of return of 12% implies a daily average return of around 0.05%. Information in Dividends: Dividends Increase Value! Thus, dividends can serve as signals. • Dividend increases send good news about managers’ confidence in future cash flows and earnings. • A signal is not credible if everyone can send it. • “Bad” firms do not mimic, because they do not have the cash flow to support a high dividend payout policy. Relax MM Assumptions 3. Capital markets are not efficient. II Stocks are mispriced. • Then the stock sale is no longer a zero NPV transaction • Repurchase stocks when undervalued • A practice often called “market timing” Relax MM Assumptions (cont.) 4. Managers’ preferences differ from shareholders’ preferences. • Managers may have short-term objectives (eg, if they retire, change jobs, get replaced, etc). • If they are not around tomorrow, they may prefer to underinvest and inflate dividends to (temporarily) increase the current stock price and their pay (eg, bonus). • Solution: Link managers’ compensation to the firm’s future stock price. Potential problem: Managers may then want to overinvest to keep stock prices (temporarily) high, so such a link should be to long-term stock prices. (Feasible?) The End Payout Policy and Taxes Relax MM Assumptions 5. Taxes are not equivalent. • Dividends are taxed similar to ordinary income. • Pay when you receive dividend. • In the UK, the first £2K in dividends is tax-free, then 7.5%, 32.5%, or 38.1% depending on your income. • Capital gain is usually taxed separately. • Pay when you sell your investment. • In the UK, the first £12.3K capital gain is tax-free, then 10 to 20% depending on the size of gain and your income. • These rates vary a lot over time, across countries, and between investor types. Tax Argument: Dividends Reduce Value • Dividends are tax-inefficient. • Taxes for dividends are usually higher. • They cannot be deferred. • As a result, dividend-paying firms should be less valuable than non-dividend-paying firms. • Empirical problem: It’s hard to observe the counterfactual, ie, the firm value of a dividend-paying firm if it had not paid the dividend. • Dividend policy should adjust to changes in the tax code. Tax Argument: Dividends Reduce Value (cont.) Next year's price Firm A Firm B (no dividend) 112.50 (high dividend) 102.50 Dividend 0 10 Total pretax payoff 112.50 112.50 Today' s stock price 100 97.78 Capital gain 12.50 Pretax rate of return (%) 12.5 ´ 100 100 Tax on div @ 40% Tax on Cap Gain @ 20% Total After Tax income (div + cap gain - taxes) After tax rate of return (%) = 12.5 0 .20 ´ 12.50 = 2.50 (0 + 12.50) - 2.50 = 10 10 ´ 100 100 = 10.0 4.72 14.72 ´ 100 97.78 = 15.05 .40 ´ 10 = 4.00 .20 ´ 4.72 = 0.94 (10 + 4.72) - (4 + 0.94) = 9.78 9.78 ´ 100 97.78 = 10.0 Taxes: Some Evidence for 1 1 Source: Berk and DeMarzo Taxes: Some Evidence for (cont.) Conjecture: Investors may form clienteles based upon their tax brackets. • Investors in high tax brackets may invest in stocks which do not pay dividends and those in low tax brackets may invest in dividend-paying stocks. Evidence: Investors’ portfolio positions were affected by their tax brackets. • Older investors were more likely to hold high-dividend stocks. • Poorer investors tended to hold high-dividend stocks. Taxes: Some Evidence Against In the presence of taxes, how much should the price drop on the ex-dividend date? Imagine you are a long-term investor who bought a stock for P0 . Should you sell it on the cum-dividend date or ex-dividend date? • Your after-tax pay-off if you sell the stock cum-divided: Pcum − τcg (Pcum − P0 ) {z } | capital gains tax • Your after-tax pay-off if you sell it ex-dividend: Pex − τcg (Pex − P0 ) + d (1 − τd ) | {z } | {z } capital gains tax after-tax div. where Pcum = cum-dividend price, Pcum = ex-dividend price, τcg = capital gains tax rate, τd = personal tax rate, and d = dividend. Taxes: Some Evidence Against (cont.) In the absence of arbitrage, the after-tax pay-off should be the same whether you sell it cum-dividend or ex-dividend, so: Pcum − τcg (Pcum − P0 ) = Pex − τcg (Pex − P0 ) + d (1 − τd ) Rearranging, we get: Pcum − Pex 1 − τd =d× 1 − τcg ! Prediction: If τd and τcg are different, then the fall in price on the ex-dividend date should be some multiple (̸= 1) of the dividend. Evidence: Price tends to drop by the full amount of the dividend. Taxes: Example In 2003, Microsoft announced that they would begin paying a quarterly dividend of $0.16 per share. • Assume the tax rate on capital gains is 20%. • Assume dividend tax is zero. • Closing price on cum-dividend day is $49.32. What is the expected ex-dividend opening price?  1 − τd 1 − τcg   1−0 = 49.32 − 0.16 1 − 0.2 = 49.12  Pex = Pcum − d That is, the stock is expected to fall by more than the dividend. Taxes: Example (cont.) Suppose you are a fund manager at a pension fund which does not pay tax on income. The fund owns Microsoft stock and plans to hold it for the long term. Suppose Microsoft’s stock price will react the way you predicted previously. Recommend an investment based on Microsoft stock which the fund could use to increase their risk-adjusted returns. Trading strategy: • Sell the stock cum-dividend (high price). • Buy the stock ex-dividend (low price). This strategy trades a 16-cent dividend for a 20-cent capital gain. The End