Transcript Chapter 18

Chapter 18: Dividends and other
payouts
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Dividend irrelevance in a world of perfect
financial markets (Modigliani and Miller)
Dividend policy in the real world where
asymmetric information exists
More on dividend policy decisions
Stock repurchases
Stock splits
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Methods used to pay out cash
(excess capital) to shareholders
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Dividends
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Stock repurchases
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Paid on a per share basis, e.g., $0.80 per share
Repurchases have grown substantially since 1982.
Each payout method transfers cash from the firm to the
markets.
A dividend change (increase) is likely to be interpreted
as a stronger management signal since managers are
averse to decreasing dividends.
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How dividends are paid out; an
example using Kodak
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Dividend payments have four associated dates: announcement,
record, ex dividend, and payment dates.
Kodak Board Declares Semi-Annual Cash Dividend
ROCHESTER, N.Y.--(BUSINESS WIRE)--April 11, 2002--Eastman
Kodak Company's board of directors today declared a semi-annual cash
dividend of 90 cents per share on the outstanding common stock of the
company.
The 90 cent per share dividend declared today will be payable July 16,
2002, to shareholders of record at the close of business on June 3, 2002.
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April 11 is the announcement date, June 3 is the record date,
July 16 is the payment date, and the ex date will be two
business days before the record date. If you purchase the stock
on or after the ex date, you will not receive the dividend.
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Dividend irrelevance in a
Modigliani and Miller world
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Under perfect financial markets, there is no asymmetric
information.
Dividend policy decisions would just pay already publicly
known amounts of cash to the shareholders. There would be no
signaling. However, this is a good place to start in
understanding dividend implications.
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Sources of cash = uses of cash, better expressed as:
Operating cash flow + new capital raised = dividends + investments
The value of the firm is determined by its investment policy (its
assets) and not by its dividend policy.
Refer to example of dividend irrelevance on Chapter 18 Lecture
Notes, pages 1 and 2.
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Dividend policy in the real world,
i.e., asymmetric information exists
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Announcements of increased cash payouts, i.e.,
dividend initiations and increases and also share
repurchases, are usually associated with an
immediate increase in stock prices.
Announcements of decreased cash payments,
i.e., dividend decreases and omissions, are
usually associated with an immediate decrease
in stock prices.
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Dividend policy in the real world
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We assume that managers possess superior
information concerning the firm's value (the
firm’s future cash flows and risk).
Why do these dividend and repurchase
announcements change stock prices?
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These announcements constitute selective
management actions that communicate or signal
important private information regarding
management’s perception of the firm.
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Lintner (1956) observations on dividend
policy
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Lintner observed the following in interviews with
executives:
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Managers perceive dividends as a proportion of earnings. A
target payout ratio preferred by managers.
Managers will not make changes in the level of dividend
payments if they perceive that the new level of payments
cannot be sustained.
Dividend changes follow or lag behind changes in the long
run (perceived permanent) earnings potential of firms.
Investments or capital spending had little effect on
modifying the pattern of dividend behavior.
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Lintner’s theories on dividend policy
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Partial Adjustment Hypothesis:
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Dividend(t=1) = Dividend(t=0) + s[pEPS(t=1) –
Dividend(t=0)]
p is the target proportion of earnings to be paid out, and s is
the speed of adjustment to the new target dividend payout.
Let s=0.35, p=0.40, and this year's Earnings per Share is
$6.00. Last year's dividend was $2.00 per share.
This year's dividend is 2.00 + [0.35][(0.40)(6.00) – 2.00] =
$2.14.
The dividend does not immediately move to 40% of the new
earnings or (0.4)($6.00) = $2.40.
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Lintner’s theories on dividend policy
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Permanent Earnings Hypothesis:
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Dividend(t=1) = (p)(Permanent Earnings for period t=1)
Managers examine the current level of earnings and
ascertain what portion is permanent (sustainable) and
what portion is temporary.
Dividend payments are then based on the permanent
portion of earnings – a sustainable dividend.
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If permanent earnings ↑, then dividends ↑ and vice versa.
Temporary or transitory (whether high or low) changes in
earnings should not affect the level of dividends.
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Observations concerning
dividends
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When firms increase dividends, future earnings
generally do not fall below the new earnings level.
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Evidence supports the Permanent Earnings Hypothesis
When earnings are temporarily higher, firms often
issue a special dividend or a stock repurchase.
After dividend initiations or increases, future risk
generally falls (and also the discount rate rE). The
opposite risk effect is observed for dividend decreases
or omissions.
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Strong operating performance usually precedes initiations.
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More on dividend policy
decisions
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Reasons stated for low dividends:
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Reasons stated for high dividends:
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Taxes (usually higher on dividends)
Transactions costs or reinvesting dividends
Lower agency costs of free cash flow: firm is committed to paying out
excess cash, rather than wasting it on negative NPV projects. Relatively
high levels of debt can also mitigate this agency problem by forcing or
binding the firm to pay out cash as interest rather than as dividends.
Bird-in-the-hand (theory or fallacy)
Desire for current income
Clientele effect
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Really just affects who owns what type of stocks
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Stock repurchases: PepsiCo
announcement of Nov. 21, 2000
PepsiCo Board Clears New Stock Buyback
PURCHASE, N.Y. (Reuters) - PepsiCo Inc. (NYSE:PEP - news) said on Tuesday its board has
authorized a new share repurchase program under which the soft drink and snack company plans
to buy back $4 billion worth of stock over the next three years.
The new program will go into effect once the current $3 billion program is complete. PepsiCo
expects the current program, which was authorized in March 1999, to be completed by early
2001.
“This new share repurchase program is a reflection of the strength of our businesses and our
confidence in the consistent growth of PepsiCo's already powerful cash flow,” Chairman and
Chief Executive Officer Roger Enrico said in a statement. “We are fortunate in being able to
invest in growth opportunities, pay a healthy dividend and buy back a substantial number of
shares all at the same time.”
Just last week, Chief Financial Officer Indra Nooyi said the current buyback program is on track
to be completed a year ahead of the original schedule. Since the beginning of 1996, PepsiCo
has invested about $9 billion in share repurchases, including $1.3 billion so far this year.
Shares of Purchase, N.Y.-based PepsiCo were up $1-1/4, or 2.78 percent, at $46-1/4 in late
Tuesday morning trading.
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Stock repurchases
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Traditionally, shareholders pay lower effective taxes on
capital gains versus dividend income.
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Repurchases are often used to signal the market that
the stock price is too low (often cited by managers).
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Most shareholders are better off with repurchase
An equity repurchase is the opposite of an equity issue
(Pecking Order Theory from Chapter 16)
Types of repurchases:
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Open market (by far most common)
Tender offer (fixed price or Dutch auction)
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Stock splits (and reverse splits)
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HiTek has a total stock market value of $1 billion and
10 million shares of stock. HiTek’s stock price is thus
($1 billion)/(10 million shares) = $100/share.
HiTek issues a 5 for 1 stock split. Effectively, each
existing share of stock is now five shares. The firm
now has 50 million shares outstanding.
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New stock price is ($1 billion)/(50 million shares) = $20 per
share.
Ignoring any signaling or information effect, receiving
a stock split appears analogous to exchanging a $100
bill for five $20 bills.
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Stock splits and asymmetric
information
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In reality, stock prices usually increase by around 3% at the
announcement of a stock split. Managers must be trying to
signal or convey something positive about the firm.
Stock splits are typically issued by firms that have experienced
strong increases in both stock price and operating performance
in the year prior to the split – these are not ordinary firms.
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Splits produce a lower post-split stock price. Evidence suggests that
managers are signaling that there will be no disappointing future new that
will send the price down even further, and thus managers are attempting
to signal the quality of the firm. Managers are attempting to signal that
the prior good performance is permanent in nature.
Dividend increases often follow splits (for those firms that pay
dividends).
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Stock splits
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Some executives feel differently about stock splits.
Berkshire Hathaway (run by Warren Buffett) has never
issued a stock split. The firm has performed very well
the last 40 years, hence the nearly $90,000 stock price!
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BH’s 1983 annual report has very interesting opinions
concerning stock splits!
Reverse stock splits do the opposite of a stock split.
The post-split stock price will be higher since the
number of outstanding shares is decreases.
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Reverse splits are viewed as negative events
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