Transcript Dividend Decision and Stock Dividend-Repurchase

Dividend Decision
And
Stock
Repurchase/Dividend
and Split
Dividend Policy
• Determines the distribution of firm’s earnings
between retention and dividend payment
(Cash).
• Other Options:
– Stock Dividend
– Stock Split
– Stock Repurchase
Company’s
Earnings
Retained for
further
investment
Distributed to
Shareholders
Cash Dividend
Stock
Dividend
Stock
Repurchase
Stock Split
Retained
Earnings
Factors Affecting Dividend
Decisions
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Legal Rules
Liquidity Positions
Rate of Asset Expansion
Profit Rate
Stability of Earnings
Control
Need to Repay Debt
Restrictive Covenants
Cash Dividends and Dividend Payment
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Dividend: A payment made out of a firm’s earnings to its owners, in
the form of either cash or stock.
If a payment is made from other sources than current or
accumulated retained earnings, the term distribution is used.
Distribution from earnings is dividend while distribution from
capital as a liquidating dividend.
Basic types of cash dividends:
a) Regular Cash Dividends – paid regularly as a part of policy.
b) Extra Dividends- extra part may or may not be repeated in
future.
c) Special Dividends- truly unusual or one-time event
d) Liquidating Dividends- some or all of business has been
luqidated
Standard Method of Cash Dividend
Payment
1. Declaration Date: The BoD declares dividend
2. Ex-Dividend Date: The holder of the share certificate is entitled to
dividend before this date. On or after this date, even if you buy the
share, then the previous owner will get the dividend. Its two business
days before the date of record.
3. Record Date: The declared dividends are distributable to those people
who are shareholders of record as of this specific date.
4. Payment date: The dividends are paid to shareholders.
More on Ex-Dividend Date
• Before, ex-dividend date, the stock is said to trade “with dividend” and
afterwards the stock trades “ex dividend”
• The ex-dividend date convention removes any ambiguity about who is entitled
to the dividend.
• The stock price will be affected when the stock goes “ex”.
Illustration:
• A share is selling for $ 10
• BoD declares $ 1 dividend per share, and record date is Tuesday, June 12
(Sunday being off-day in market)
• Ex-Date – Friday (June 8)
• You buy stock on last hour of Thursday (June 7). You’ll get $ 1 dividend.
• You buy stock as the market opens on Friday (June 8). You wont get $ 1
dividend.
• What happens to the value of stock overnight ?
Price Behavior around Ex-Date
• Stock is worth about $ 1 less on Friday morning, so its price will
drop by that amount.
• In general, we expect that the value of the share of stock will go
down by about the dividend amount when the stock goes ex
dividend. (Remember – ABOUT)
Establishing Dividend Policy
• How do firms actually determine the level
of dividends they will pay at a particular
time ?
1. Residual Dividend Approach
2. Dividend Stability
3. A Compromise Dividend Policy
Residual Dividend Approach
• A policy under which a firm pays dividends only after
meeting its investment needs while maintaining a
desired debt-equity ratio.
• Firm generally doesn’t wish to sell new equity to pay
out dividend (expensive). (Firm wishes to minimize
the need to sell new equity)
• Then it will have to rely on internally generated
equity to finance new positive NPV projects.
• With a residual dividend policy, the firm’s objective
is to meet its investment needs and maintain its
desired debt-equity ratio before paying dividends.
Illustration:
Illustration:
• Imagine that a firm has $ 1,000 in earnings and
debt equity ratio of 1:2.
Steps in implementing residual dividend policy:
1. Determine the amount of funds that can be
generated without selling new equity.
– If the firm reinvests the entire $ 1,000 and pays no
dividend, then equity will increase by $ 1,000.
– But debt equity ratio should be maintained.
– So firm has to borrow additional amount of $ 500
– Total amount of funds that can be generated without
selling new equity is thus $ 1,000 + $ 500 = $ 1,500
Illustration (contd…)
2.
Decide whether or not a dividend will be paid.
•
Firm must generate this $ 900 ($ 1,000 is already there, but the firm has to
maintain the current capital structure)
Firm will borrow 1/3 x $ 900 = $ 300
Rest $ 600 will be taken from available equity of $ 1,000
Residual fund available for dividend payment = $ 1,000 - $ 600 = $ 400
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– To do that, compare the total amount that can be
generated without selling new equity ( $ 1,500) to the
planned capital spending.
– If funds needed exceed funds available, then, no
dividends will be paid.
– In such case, dividends can only be paid by cutting out
on some capital spending or by selling new equity.
– If funds needed are less than funds generated, then a
dividend will be paid, and the amount of dividend will be
residual.
– Suppose the firm has $ 900 in planned capital spending.
– What will be residual fund available for dividend
payment ?
Sum up of the illustration
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Firm has after-tax earnings of $ 1,000.
Dividends paid are $ 400
Retained Earnings are $ 600
The firm’s debt equity ratio of 1:2 is unchanged.
The relationship between investment and
dividend payout for various levels of
investments :
The relationship
S.No
Aftertax
New
Additional Retained Additional Dividend
Earnings Investment
Debt
Earnings
Stock
1
$ 1,000
$ 3,000
?
?
?
?
2
1,000
2,000
?
?
?
?
3
1,000
1,500
?
?
?
?
4
1,000
1,000
?
?
?
?
5
1,000
500
?
?
?
?
6
1,000
0
?
?
?
?
The relationship
S.No
Aftertax
New
Additional Retained Additional Dividend
Earnings Investment
Debt
Earnings
Stock
1
$ 1,000
$ 3,000
$ 1,000
$1,000
$ 1,000
$0
2
1,000
2,000
667
1,000
333
0
3
1,000
1,500
500
1,000
0
0
4
1,000
1,000
333
667
0
333
5
1,000
500
167
333
0
667
6
1,000
0
0
0
0
1,000
The Relationship
A firm with many
investment
opportunities will pay
small amounts of
dividends and a firm
with few investment
opportunities will pay
relatively larger
amounts of dividends.
Younger, fast-growing firms commonly employ a low payout ratio, whereas
older, slower-growing firms in more mature industries use a higher payout
ratio.
Formula under Residual Dividend
Policy
Dividend = Net Income – [Capital Budget x Target equity ratio]
Where, target equity ratio is the proportion of equity
in the capital structure.
If the answer comes in negative, it means that the
firm has to raise that much amount from new
equity sale (external equity financing)
Example
• Malkor Instruments Company treats dividends
as a residual decision. It expects to generate
Rs 2 million in net earnings after taxes in the
coming year. The company has an all-equity
capital structure and its cost of equity capital
is 15%. The Company treats this cost as the
opportunity cost of retained earnings.
Because of floatation costs and under-pricing,
the cost of common stock financing is higher.
It is 16%.
(a) How much in dividends should be paid if the
company has Rs 1.5 million in projects whose
expected return exceeds 15%?
• Dividend = Net Income – [Capital Budget x Target equity ratio]
= Rs 2,000,00 – [1,500,000 x 1]
= Rs 500,000
Company can pay Rs 500,000 in dividends
(b) How much in dividends should be paid if the
company has Rs 2 million in projects whose
expected return exceeds 15%?
• Dividend = Net Income – [Capital Budget x Target equity ratio]
= Rs 2,000,00 – [2,000,000 x 1]
= Rs 0
Company can pay no dividend.
(c) How much in dividends should be paid if the
company has Rs 3 million in projects whose
expected return exceeds 16%? What else should
be done
• Dividend = Net Income – [Capital Budget x Target equity ratio]
= Rs 2,000,00 – [3,000,000 x 1]
= - Rs 1,000,000
Company can pay no dividend.
Company should raise Rs 1000,000 fund from
external equity to finance the project
Dividend Stability
• Strict residual dividend policy might lead to a very unstable
dividend policy.
• If investment opportunities in one period are quite high,
dividends will be low or zero.
• Conversely, dividends might be high in the next period of
investment opportunities are considered less promising.
• Consider a firm with seasonal sales pattern.
• Its annual earnings are forecasted to be equal year to year.
• But quarterly earnings vary greatly throughout the year.
• 1st quarter- low, raises in 2nd and 3rd, and then 4th highest
• The firm can choose between at least two types of dividend
policies.
Dividend Stability (contd…)
1. Each quarter’s dividend can be fixed fraction of that
quarter’s earnings.
• Here, dividends will vary throughout the year.
• This is cyclical dividend policy, where dividends are
constant proportion of earnings at each pay date.
2. Each quarter’s dividend can be a fixed fraction of yearly
earnings.
• Here, all dividend payments will be equal.
• This is stable dividend policy, where dividends are a
constant proportion of earnings over an earnings cycle.
Stable policy seems to be in the best interest of the firm and
its stockholders, and stable policy would be more
common.
A Compromise Dividend Policy
1.
2.
3.
4.
5.
•
•
This policy is based on five main goals: (in the 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-equity ratio
Maintain a target dividend payout ratio.
Debt-Equity ratio is viewed as long-range goal, it is
allowed to vary in short run if necessary to avoid a
dividend cut or the need to sell the new equity.
One can minimize the problems of dividend instability by
creating two types of dividends : regular and extra.
Share Repurchase
• When the firm has funds in excess of present
and foreseeable future investment needs.
• It may distribute these funds either by cash
dividends or by the repurchase of the sock.
Stock Dividends
• Company distributes shares as dividends to
the shareholders
• Either from past retained earnings or from net
profit earned in the respective year.
• A company distributes stock dividend to raise
capital, to save tax to the stockholders etc.
Stock Split
• Company brakes shares through splitting the par
value of the share.
• A split takes place in two ways:
1. Straight split
•
Company increases he number of shares outstanding
through reducing the par value
2. Reverse split
•
•
Company reduces the number of shares outstanding
through merging the par value.
This takes place to increase the value of stock.
Stock
Dividend
Par Value per Share
Market Price per Share
Number of Shares
Common Stock
Additional Paid-in Capital
Retained Earnings
EPS
DPS (If not constant
dividend policy)
Straight
Stock Split
Reverse
Stock Split
Stock
Repurchase
Stock Repurchase (Share Buybacks)
• Another method used to pay out a firm’s earnings to its owners, which
provides more preferable tax treatment than dividends.
Illustration:
• Imagine all-equity firm with excess cash of $ 300,000.
• The firm pays no dividends, and its net income for the year just ended is $
49,000.
• The market value balance sheet at the end of the year is:
Market Value Balance Sheet
(before paying out excess cash)
Excess cash
$ 300,000
Debt
$0
Other assets
700,000
Equity
1,000,000
Total
$ 1,000,000
Total
$ 1,000,000
Contd….
• There are 100,000 shares outstanding
• Price per share = $ 10
• EPS = $ 49,000/100,000 = $ 0.49
• P/E Ratio = $ 10 / 0.49 = 20.4
• The firm is considering two options:
Option 1: $ 300,000/100,000 = $3 per share extra dividend
Market Value Balance Sheet
(After paying out excess cash)
Excess Cash
$0
Debt
$0
Other assets
700,000
Equity
700,000
Total
$ 700,000
Total
$ 700,000
Contd….
• There are still 100,000 shares outstanding. Hence
each share is worth = $ 700,000/100,000 = $ 7
• Value per share has fallen, but what happened to
shareholder’s wealth.
• A shareholder having 100 shares will have $700 + $
300 = $ 1000 in his wealth and that is same as before
(100x $10 = $ 1000)
• In this case, the stock price simply fell by $ 3 when
the stock went ex dividend.
• EPS is still the same = $ 0.49
• P/E ratio falls to $ 7/ 0.49 = 14.3
Contd…
Option 2: Company is thinking of using the money to repurchase $ 300,000 / 10
= 30,000 shares.
Market Value Balance Sheet
(After Share Repurchase)
Excess Cash
$0
Debt
$0
Other assets
700,000
Equity
700,000
Total
$ 700,000
Total
$ 700,000
• The worth of the company hasn’t changed ($700,000)
• Each share still worth $ 10
•EPS goes up to $ 49,000/70,000 = $ 0.70
•P/E ratio is same as that of option 1 = $ 10/0.70 = 14.3
If there are no imperfections, a cash dividend and a share repurchase are
essentially the same thing.
Equilibrium Repurchase Price
Equilibriu
m Repurchase
P
*
Price,
Pc  S

S n
where,
S  number of shares outstandin g prior to repurchase
P c  current market price per share prior to repurchase
n  number of shares to be repurchase
Alternativ ely,
P
*

Total Market Value prior to repurchase
Number of shares after repurchase
Alternativ ely,
P
*

Pre Repurchase
1  Percentage
Share Price
of Stock Repurchase
Alternativ ely,
P *  P c - Cash Dividend
Per Share
Rate in fraction
Example
• Company A has enjoyed considerable recent
success because they placed a huge order of
their product. The business is not expected to
be repeated, and Company has Rs 6 million in
excess funds. The company wishes to distribute
these funds via the repurchase of stock.
Presently it has 2,400,000 shares outstanding,
and the market price per share is Rs 25. It
wishes to repurchase 10 percent of its stocks, or,
240,000 shares.
(a) Assuming no signaling effect, at what share
price should the company offer to repurchase?
Equilibriu
P
*
m Repurchase
Price,
Pc  S
25  2 , 400 , 000


 Rs 27.78
S n
2 , 400 , 000  240 , 000
Alternativ ely,
P
*

Pre repurchase price
1 - Percentage
of stock repurchase rate

25
1 - 0.10
 Rs 27.78
(b) In total, how much will the company be
distributing through share repurchase ?
Amount distributed through share repurchase
= P* x n
= Rs 27.78 x 240,000
= Rs 6,667,200
(c) What is the total amount used from
retained earnings to repurchase the stocks
?
Rs 6,667,200
(d) If the company were to pay out funds
through cash dividends instead, what would be
the market price per share after distribution ?
• Cash dividend per share = P* - PC
= Rs 27.78 – Rs 25 = Rs 2.78
• Price per share after cash dividend = PC - DPS
= Rs 25 – Rs 2.78 = Rs 22.22
Real world considerations in repurchase
• In the real world, there exists transaction costs and tax.
• Generally a repurchase has a significant tax advantage
over a cash dividend.
• A dividend is fully taxed as ordinary income, and a
shareholder has no choice about whether or not to
receive the dividend.
• In a repurchase, a shareholder pays taxes only if:
– The shareholder actually chooses to sell
– The shareholder has a capital gain on the sale (only on profit)
• But there has to be some business-related reason for
repurchasing.
• “ The stock is a good investment”, “investing in the stock is
a good use of money” , “the stock is undervalued”
Stock Dividends and Stock Splits
• Stock Dividend: Dividend paid out in shares of stock.
• The effect of a stock dividend is to increase the number of
shares that each owner holds. (thus diluting the value of
each shares outstanding)
• A stock dividend is commonly expressed as a percentage.
• Stock Split: Essentially the same thing as stock dividend,
but in this case, there’s no change in the owner’s equity.
• It is expressed as a ratio instead of percentage.
• When a split is declared, each share is split-up to create
additional shares.
• For eg. In a 3 for 1 stock split, each old share is split into
three new shares.
Illustration Stock Dividend
• Co. A has 10,000 shares outstanding, each selling for $ 66
• Stock dividend announced = 10 %
• Total no of shares outstanding after the dividend = 11,000
Equity position of Co. A before stock dividend:
Common Stock ( $1 par, 10,000 shares )
$ 10,000
Capital in excess of par value (Add. Paid in capital)
200,000
Retained earnings
290,000
Total owner’s equity
500,000
•After stock dividend, common stock a/c increases by $ 1,000
•But market price of each stock is more by $ 65.
•Excess of $ 65 x 1000 = $ 65,000 is added to Capital in excess of par
value.
Illustration
• Total owner’s equity is unaffected by the stock dividend because, no cash
has come in or gone out.
• Equity position of Co A after stock dividend
Common Stock ( $1 par, 11,000 shares )
$ 11,000
Capital in excess of par value (Additional paid in capital)
265,000
Retained earnings
224,000
Total owner’s equity
500,000
Market price per share after stock dividend
P
*

Pre stock dividend price
1  Percentage stock dividend rate
Alternativ ely,
P
*

Total Market Value prior to Stock Dividend
Number of shares after Stock Dividend
Alternativ ely,
P
*
S x Pc

S  Stock Dividend
Example
• The Kleidon King Company has the following
shareholder’s equity account:
Common Stock ( Rs 8 par value)
Additional paid-in capital
Retained Earnings
Shareholder’s equity
Rs 2,000,000
Rs 1,600,000
Rs 8,400,000
Rs 12,000,000
The current market price of the stock is Rs 60 per share.
(a) What will happen to this account
and to the number of shares
outstanding with
(i) 20% stock dividend ?
(ii) a 2 for 1 stock split ?
(iii) a 1 for 2 reverse stock split ?
(i) 20 % Stock Dividend
• Number of shares outstanding before stock
dividend= Rs 2000,000/8 = 250,000
• Stock dividend = 20% of 250,000 = 50,000 shares
• Rs 8 x 50000 = Rs 400,000 added in common stock.
• Rs 52 premium x 50000 = Rs 2,600,000 added in
additional paid in capital
• Rs (8+ 52) x 50,000 = Rs 3,000,000 deducted from
retained earnings
• No of shares outstanding after stock dividend = Rs
3,000,000
After stock dividend
Common Stock ( Rs 8 par value)
Additional paid-in capital
Retained Earnings
Shareholder’s equity
Rs 2,400,000
Rs 4,200,000
Rs 5,400,000
Rs 12,000,000
Number of shares outstanding = 3,000,000
(ii) a 2 for 1 stock split ?
• Par value after split = 8 x ½ = Rs 4
• Number of shares after split = 250,000 x 2/1 =
500,000 shares
Common Stock ( Rs 4 par value)
Additional paid-in capital
Retained Earnings
Shareholder’s equity
Rs 2,000,000
Rs 1,600,000
Rs 8,400,000
Rs 12,000,000
(iii) a 1 for 2 reverse stock split ?
• Par value after split = 8 x 2/1 = Rs 16
• Number of shares after split = 250,000 x 1/2 =
125,000 shares
Common Stock ( Rs 16 par value) Rs 2,000,000
Additional paid-in capital
Rs 1,600,000
Retained Earnings
Rs 8,400,000
Shareholder’s equity
Rs 12,000,000
(b) In the absence of an informational or signaling
effect, at what share price should be common stock sell
after the 20% stock dividend ?
Market price per share after stock dividend
P
*

Rs 60
1  0.20
 Rs 50
Alternativ ely,
P
*

Rs 60 x 250,000
2 50 , 000  5 0 , 000
 Rs 50
(b) What would have happened if
there were signaling effect ?
• If there were a signaling or informational
effect, the stock price per share might be
somewhat higher than Rs 50
Exercise
Common stock ($8 par value)
Additional paid-in capital
Retained earnings
Total shareholders’ equity
$2,000,000
1,600,000
8,400,000
12,000,000
• The current market price of the stock is $ 60 per share.
• What will happen to this account and to the number of
shares outstanding with
– A 10 percent stock dividend
– A 2-for-1 stock split
– A 1-for-2 reverse stock split
• In the absence of an informational or signaling effect, at
what share price should the common stock sell after the 10
percent stock dividend? What might happen to stock price
if there were signaling effect?
• Present number of shares outstanding = 2,000,000 /
8 = 250,000
Stock
dividend
Common stock
275,000 @ 8 =
2,200,000
Additional paid in capital
2,900,000
Retained earnings
6,900,000
Total shareholders’
equity
12 million
• Present number of shares outstanding = 2,000,000 /
8 = 250,000
Stock
dividend
Stock split
Common stock
275,000 @ 8 = 500,000 @ 4 =
2,200,000
2,000,000
Additional paid in capital
2,900,000
1,600,000
Retained earnings
6,900,000
8,400,000
Total shareholders’
equity
12 million
12 million
• Present number of shares outstanding = 2,000,000 /
8 = 250,000
Stock
dividend
Stock split
Reverse split
Common stock
275,000 @ 8 = 500,000 @ 4 =
2,200,000
2,000,000
125,000 @ 16
= 2,000,000
Additional paid in capital
2,900,000
1,600,000
1,600,000
Retained earnings
6,900,000
8,400,000
8,400,000
Total shareholders’
equity
12 million
12 million
12 million
• Present number of shares outstanding = 2,000,000 /
8 = 250,000
Stock
dividend
Stock split
Reverse split
Common stock
275,000 @ 8 = 500,000 @ 4 =
2,200,000
2,000,000
125,000 @ 16
= 2,000,000
Additional paid in capital
2,900,000
1,600,000
1,600,000
Retained earnings
6,900,000
8,400,000
8,400,000
Total shareholders’
equity
12 million
12 million
12 million
The total market value of the firm before the stock dividend is
$60x250,000 = $ 15 million. With no change in the total value of the
firm the market price of share after stock dividend should be = $ 15
million / 275,000 = 54.55 per share. However, if there is signaling
effect, the total value of the firm might rise and share price be
somewhat higher than 54.55 per share.