Practical financial management lasher 7th ed chapter 015

Chapter 15 Dividends Background Dividends as a Basis for Value – Dividends are important in determining stock value Individual investors buy stocks expecting dividends and price appreciation » Dn Pn D1 D2 P0 = + + + + n (1 + k ) (1 + k ) (1 + k ) (1 + k ) n – From the whole market view, today’s stock price is the present value of an infinite stream of dividends Focus on the individual view Understanding the Dividend Decision The Discretionary Nature of Dividends – Board of Directors determines the dividend Can be more than earnings or nothing The Dividend Decision – Whether to pay cash dividends or retain earnings for growth Current income Deferred income The Dividend Controversy Does paying or not paying dividends affect stock price? Do stockholders prefer current or deferred income? Three arguments regarding investors’ preferences for or against dividends Dividend Irrelevance Dividend Preference Dividend Aversion Dividend Irrelevance Most theorists say dividends matter very little to stock price – Value of eliminated early dividends is offset by growth-created value in the future Dequation DD21, D2 … is made up byDgains valuation loss of =n 1, 2,…n) and n in later Di (i P –P In = + + + + 0Pn (1 + k ) (1 + k ) (1 + k ) n (1 + k ) n Concept Connection Example 15-3 Tailoring the Income Stream The Winters are retirees with most of their savings invested in 10,000 shares of Ajax Corporation (AJAX) AJAX sells for $10 per share and pays an annual dividend of $0.50 per share This year AJAX eliminated the dividend, but began to grow at 5% a year due to the reinvested earnings How can the Winters maintain their income and their position in AJAX? Concept Connection Example 15-3 Tailoring the Income Stream Original value of the Winters’ AJAX shares $10 × 10,000 shares = $100,000 Eliminated dividend 10,000 shares × $0.50 = $5,000 After one year of 5% growth, AJAX should sell for $10 × 1.05 = $10.50 To maintain their income the Winters must sell $5,000 ÷ $10.50 = 476 shares After which they would have 10,000 – 476 = 9,524 shares Worth $10.50 x 9,524 = $100,002 Dividend Irrelevance Transaction costs – The more significant the transactions costs, the less valid the irrelevance theory becomes Income taxes – Dividends are taxed as ordinary income – Appreciation is taxed as a capital gain The View from Within the Company – Dividends represent a cash outflow – Firms prefer not paying dividends if it avoids selling new stock Dividend Preference Investors prefer immediate cash to uncertain future benefits – Poor management may waste the funds rather than using effectively for growth Inconsistency in theory: – If investors are worried about management not using resources effectively, why did they invest in the firm in the first place? Dividend Aversion Investors prefer future capital gains to current dividends because of tax rates – – Price appreciation taxed as capital gain Dividends taxed as ordinary income Argument hinges on current tax rates on dividend income vs capital gains income – Capital gains taxes are not paid until stock is sold so taxes are deferred 10 Alternate Policies Target Payout Ratio – Firm selects a long-run target payout ratio Stable Dividends Per Share – A constant dividend is paid regardless of earnings Small Regular Dividend with a Year-End Extra if Earnings Permit – An effort to avoid the signaling effect 14 The Mechanics of Dividend Payments Each quarterly dividend has key dates: – – – – Declaration Date: Date the board authorizes the dividend Date of Record: Date by which you must be an owner to receive the dividend Payment Date: Date on which the dividend will actually be paid – check in the mail Ex-Dividend Date: Date from which new stock buyers no longer receive the dividend 15 Figure 15.1 The Dividend Declaration and Payment Process 16 Dividend Reinvestment Plans Large companies offer automatic dividend reinvestment plans (DRIPs) to stockholders – – – Instead of receiving cash dividends, the stockholder receives additional shares The payment is taxable Don’t confuse with stock dividend 17 Stock Splits and Dividends Stock Split – Stockholders issued new shares in proportion to current holdings – – Stock Dividend – – Similar to stock split Called a stock dividend if the number of No change in proportionate new shares is less than or equal to ownership of company 20% of previously outstanding shares Reverse splits also possible 18 Rationale for Stock Splits and Stock Dividends Stock Split Trading Range Argument for splits – Splits keep stock prices in a trading range: accessible to small investors Stock usually split when prices are increasing – May give false impression that price increase is from split Stock Dividend Giving Something that Doesn’t Cost Anything – – – Stock dividends are an attempt at signaling Employed to send a positive message Doesn’t really give shareholders anything Effect On Price And Value Splits and stock dividends increase shares outstanding without changing economic value of the underlying company – Have no real economic effect 20 Accounting for a Stock Split Accounting for a Stock Dividend Stock Repurchases Alternative to Dividend – Firms with cash on hand can pay dividends or repurchase their own stock Repurchase reduces the number of shares outstanding and increases EPS Remaining shares will increase in value if the market maintains the P/E ratio after the repurchase 23 Concept Connection Example 15-6 Stock Repurchases The Johnson Company has 2,500,000 shares of common stock outstanding, net income of $5 million, and a P/E ratio of 10 EPS = $5,000,000 / 2,500,000 = $2.00 per share; Market price = $2.00 x 10 = $20 Johnson has $1 million in cash to distribute to stockholders Per share dividend $1,000,000 / 2,500,000 = $0.40 per share If Johnson repurchases shares instead it will retire $1,000,000 / $20 = 50,000 shares leaving 2,450,000 shares outstanding 24 Stock Repurchases The new EPS will be $5,000,000 / 2,450,000 = $2.04 per share If the P/E ratio remains unchanged, the stock price will be $2.04 x 10 = $20.40 A price appreciation equal to the dividend 25 Stock Repurchases Methods of Repurchasing Shares – – – Buy on open market – easiest method Tender offer – buy shares at a set price offered to interested stockholders Negotiated deal – buy from a large investor who owns a block of stock 26 Other Repurchase Issues Opportunistic Repurchase – Stock is temporarily undervalued Repurchase to Dispose of Excess Cash – Distributes cash without a signaling effect 27 Other Repurchase Issues Taxes – Occasional stock repurchases can benefit stockholders because capital gains tax rates may be lower than ordinary rates Repurchases to Restructure Capital – Borrowing money to repurchase stock raises leverage level and debt ratio 28 [...]... Legal Restrictions Contractual Restrictions Dividends can’t be paid out of Loan indentures and covenants may limit contributed capital – must come from dividend payments to protect creditors’ retained earnings interests Insolvent firms can’t pay dividends Cumulative feature of preferred stock limits dividend payments 12 Dividend Policy Dividend policy: Rationale for determining dividend payouts Payout... $5,000,000 / 2,450,000 = $2.04 per share If the P/E ratio remains unchanged, the stock price will be $2.04 x 10 = $20.40 A price appreciation equal to the dividend 25 Stock Repurchases Methods of Repurchasing Shares – – – Buy on open market – easiest method Tender offer – buy shares at a set price offered to interested stockholders Negotiated deal – buy from a large investor who owns a block of stock 26 Other... stockholder receives additional shares The payment is taxable Don’t confuse with stock dividend 17 Stock Splits and Dividends Stock Split – Stockholders issued new shares in proportion to current holdings – – Stock Dividend – – Similar to stock split Called a stock dividend if the number of No change in proportionate new shares is less than or equal to ownership of company 20% of previously outstanding shares... when prices are increasing – May give false impression that price increase is from split Stock Dividend Giving Something that Doesn’t Cost Anything – – – Stock dividends are an attempt at signaling Employed to send a positive message Doesn’t really give shareholders anything Effect On Price And Value Splits and stock dividends increase shares outstanding without changing economic value of the underlying... economic effect 20 Accounting for a Stock Split Accounting for a Stock Dividend Stock Repurchases Alternative to Dividend – Firms with cash on hand can pay dividends or repurchase their own stock Repurchase reduces the number of shares outstanding and increases EPS Remaining shares will increase in value if the market maintains the P/E ratio after the repurchase 23 Concept Connection Example 15-6 Stock Repurchases... Clientele Effect – Investors choose stocks for dividend policy so any change in payments policy is disruptive The Residual Dividend Theory – Dividends are paid from earnings only after viable projects are funded The Signaling Effect of Dividends – Cash dividends signal management’s confidence The Expectations Theory – – A refinement of the signaling effect Dividends that fail to fulfill stockholders’ expectations... a set price offered to interested stockholders Negotiated deal – buy from a large investor who owns a block of stock 26 Other Repurchase Issues Opportunistic Repurchase – Stock is temporarily undervalued Repurchase to Dispose of Excess Cash – Distributes cash without a signaling effect 27 Other Repurchase Issues Taxes – Occasional stock repurchases can benefit stockholders because capital gains tax