EF F E C T S O F DI V I D E N D PO L I C Y O N ks
The effects of dividend policy on ksmay be considered in terms of four factors:
(1) stockholders’ desire for current versus future income, (2) perceived riskiness of dividends versus capital gains, (3) the tax advantage of capital gains over div- idends, and (4) the information content of dividends (signaling). Since we dis- cussed each of these factors in detail earlier, we need only note here that the importance of each factor in terms of its effect on ksvaries from firm to firm depending on the makeup of its current and possible future stockholders.
It should be apparent from our discussion that dividend policy decisions are truly exercises in informed judgment, not decisions that can be quantified pre- cisely. Even so, to make rational dividend decisions, financial managers must take account of all the points discussed in the preceding sections.
S E L F - T E S T Q U E S T I O N S
Identify the four broad sets of factors that affect dividend policy.
What constraints affect dividend policy?
How do investment opportunities affect dividend policy?
How does the availability and cost of outside capital affect dividend policy?
O V E R V I E W O F T H E D I V I D E N D P O L I C Y D E C I S I O N
In many ways, our discussion of dividend policy parallels our discussion of cap- ital structure: We presented the relevant theories and issues, and we listed some additional factors that influence dividend policy, but we did not come up with any hard-and-fast guidelines that managers can follow. It should be apparent from our discussion that dividend policy decisions are exercises in informed judgment, not decisions that can be based on a precise mathematical model.
In practice, dividend policy is not an independent decision — the dividend decision is made jointly with capital structure and capital budgeting decisions.
The underlying reason for this joint decision process is asymmetric informa- tion, which influences managerial actions in two ways:
1. In general, managers do not want to issue new common stock. First, new common stock involves issuance costs — commissions, fees, and so on — and those costs can be avoided by using retained earnings to finance the
665 firm’s equity needs. Also, as we discussed in Chapter 13, asymmetric in- formation causes investors to view new common stock issues as negative signals and thus lowers expectations regarding the firm’s future prospects.
The end result is that the announcement of a new stock issue usually leads to a decrease in the stock price. Considering the total costs in- volved, including both issuance and asymmetric information costs, man- agers strongly prefer to use retained earnings as their primary source of new equity.
2. Dividend changes provide signals about managers’ beliefs as to their firms’ future prospects. Thus, dividend reductions, or worse yet, omis- sions, generally have a significant negative effect on a firm’s stock price.
Since managers recognize this, they try to set dollar dividends low enough so that there is only a remote chance that the dividend will have to be reduced in the future. Of course, unexpectedly large dividend in- creases can be used to provide positive signals.
The effects of asymmetric information suggest that, to the extent possible, managers should avoid both new common stock sales and dividend cuts, be- cause both actions tend to lower stock prices. Thus, in setting dividend pol- icy, managers should begin by considering the firm’s future investment oppor- tunities relative to its projected internal sources of funds. The firm’s target capital structure also plays a part, but because the optimal capital structure is a range, firms can vary their actual capital structures somewhat from year to year. Since it is best to avoid issuing new common stock, the target long-term payout ratio should be designed to permit the firm to meet all of its equity capital requirements with retained earnings. In effect, managers should use the residual dividend model to set dividends, but in a long-term framework.
Finally, the current dollar dividend should be set so that there is an extremely low probability that the dividend, once set, will ever have to be lowered or omitted.
Of course, the dividend decision is made during the planning process, so there is uncertainty about future investment opportunities and operating cash flows. Thus, the actual payout ratio in any year will probably be above or below the firm’s long-range target. However, the dollar dividend should be main- tained, or increased as planned, unless the firm’s financial condition deteriorates to the point where the planned policy simply cannot be maintained. A steady or increasing stream of dividends over the long run signals that the firm’s financial condition is under control. Further, investor uncertainty is decreased by stable dividends, so a steady dividend stream reduces the negative effect of a new stock issue, should one become absolutely necessary.
In general, firms with superior investment opportunities should set lower payouts, hence retain more earnings, than firms with poor investment opportu- nities. The degree of uncertainty also influences the decision. If there is a great deal of uncertainty in the forecasts of free cash flows, which are defined here as the firm’s operating cash flows minus mandatory equity investments, then it is best to be conservative and to set a lower current dollar dividend. Also, firms with postponable investment opportunities can afford to set a higher dollar div- idend, because in times of stress investments can be postponed for a year or two, thus increasing the cash available for dividends. Finally, firms whose cost of capital is largely unaffected by changes in the debt ratio can also afford to set a higher payout ratio, because they can, in times of stress, more easily issue
O V E R V I E W O F T H E D I V I D E N D P O L I C Y D E C I S I O N
additional debt to maintain the capital budgeting program without having to cut dividends or issue stock.
Firms have only one opportunity to set the dividend payment from scratch.
Therefore, today’s dividend decisions are constrained by policies that were set in the past, hence setting a policy for the next five years necessarily begins with a review of the current situation.
Although we have outlined a rational process for managers to use when set- ting their firms’ dividend policies, dividend policy still remains one of the most judgmental decisions that firms must make. For this reason, dividend policy is always set by the board of directors — the financial staff analyzes the situation and makes a recommendation, but the board makes the final decision.
S E L F - T E S T Q U E S T I O N
Describe the dividend policy decision process. Be sure to discuss all the fac- tors that influence the decision.
S T O C K D I V I D E N D S A N D S T O C K S P L I T S
Stock dividends and stock splits are related to the firm’s cash dividend policy.
The rationale for stock dividends and splits can best be explained through an example. We will use Porter Electronic Controls Inc., a $700 million electronic components manufacturer, for this purpose. Since its inception, Porter’s mar- kets have been expanding, and the company has enjoyed growth in sales and earnings. Some of its earnings have been paid out in dividends, but some are also retained each year, causing its earnings per share and stock price to grow.
The company began its life with only a few thousand shares outstanding, and, after some years of growth, each of Porter’s shares had a very high EPS and DPS. When a “normal” P/E ratio was applied, the derived market price was so high that few people could afford to buy a “round lot” of 100 shares. This lim- ited the demand for the stock and thus kept the total market value of the firm below what it would have been if more shares, at a lower price, had been out- standing. To correct this situation, Porter “split its stock,” as described in the next section.
ST O C K SP L I T S
Although there is little empirical evidence to support the contention, there is nevertheless a widespread belief in financial circles that an optimal price range exists for stocks. “Optimal” means that if the price is within this range, the price/earnings ratio, hence the firm’s value, will be maximized. Many observers, including Porter’s management, believe that the best range for most stocks is from $20 to $80 per share. Accordingly, if the price of Porter’s stock rose to
$80, management would probably declare a two-for-one stock split,thus dou- bling the number of shares outstanding, halving the earnings and dividends per share, and thereby lowering the stock price. Each stockholder would have more Stock Split
An action taken by a firm to increase the number of shares outstanding, such as doubling the number of shares outstanding by giving each stockholder two new shares for each one formerly held.
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S T O C K D I V I D E N D S A N D S T O C K S P L I T S
L O O K I N G O N L I N E F O R I N F O R M AT I O N O N S TO C K S P L I T S A N D S TO C K R E P U R C H A S E S
Up-to-date information about changes in stock splits and stock repurchases is now just a few clicks away. While this information is reported on several web sites, a good place to get started is the Online Investor at http://www.
investhelp.com. Online Investor’s home page includes recent stock repurchase and stock split announcements at “Buybacks”
and “Splits Center.”
shares, but each share would be worth less. If the post-split price were $40, Porter’s stockholders would be exactly as well off as they were before the split.
However, if the stock price were to stabilize above $40, stockholders would be better off. Stock splits can be of any size — for example, the stock could be split two-for-one, three-for-one, one-and-a-half-for-one, or in any other way.11
ST O C K DI V I D E N D S
Stock dividends are similar to stock splits in that they “divide the pie into smaller slices” without affecting the fundamental position of the current stock- holders. On a 5 percent stock dividend, the holder of 100 shares would receive an additional 5 shares (without cost); on a 20 percent stock dividend, the same holder would receive 20 new shares; and so on. Again, the total number of shares is increased, so earnings, dividends, and price per share all decline.
If a firm wants to reduce the price of its stock, should it use a stock split or a stock dividend? Stock splits are generally used after a sharp price run-up to produce a large price reduction. Stock dividends used on a regular annual basis will keep the stock price more or less constrained. For example, if a firm’s earn- ings and dividends were growing at about 10 percent per year, its stock price would tend to go up at about that same rate, and it would soon be outside the desired trading range. A 10 percent annual stock dividend would maintain the stock price within the optimal trading range. Note, though, that small stock dividends create bookkeeping problems and unnecessary expenses, so firms today use stock splits far more often than stock dividends.12
EF F E C T O N ST O C K PR I C E S
If a company splits its stock or declares a stock dividend, will this increase the market value of its stock? Several empirical studies have sought to answer this question. Here is a summary of their findings.13
11Reverse splits,which reduce the shares outstanding, can even be used. For example, a company whose stock sells for $5 might employ a one-for-five reverse split, exchanging one new share for five old ones and raising the value of the shares to about $25, which is within the optimal price range. LTV Corporation did this after several years of losses had driven its stock price below the optimal range.
12Accountants treat stock splits and stock dividends somewhat differently. For example, in a two- for-one stock split, the number of shares outstanding is doubled and the par value is halved, and that is about all there is to it. With a stock dividend, a bookkeeping entry is made transferring “re- tained earnings” to “common stock.” For example, if a firm had 1,000,000 shares outstanding, if the stock price was $10, and if it wanted to pay a 10 percent stock dividend, then (1) each stockholder would be given one new share of stock for each 10 shares held, and (2) the accounting entries would involve showing 100,000 more shares outstanding and transferring 100,000($10) ⫽ $1,000,000 from “retained earnings” to “common stock.” The retained earnings transfer limits the size of stock dividends, but that is not important because companies can always split their stock in any way they choose.
13See Eugene F. Fama, Lawrence Fisher, Michael C. Jensen, and Richard Roll, “The Adjustment of Stock Prices to New Information,”International Economic Review,February 1969, 1–21; Mark S.
Grinblatt, Ronald M. Masulis, and Sheridan Titman, “The Valuation Effects of Stock Splits and Stock Dividends,”Journal of Financial Economics, December 1984, 461–490; C. Austin Barker, “Eval- uation of Stock Dividends,”Harvard Business Review, July–August 1958, 99–114; and Thomas E.
Copeland, “Liquidity Changes Following Stock Splits,”Journal of Finance,March 1979, 115–141.
Stock Dividend
A dividend paid in the form of additional shares of stock rather than in cash.
669 1. On average, the price of a company’s stock rises shortly after it announces
a stock split or dividend.
2. However, these price increases are more the result of the fact that in- vestors take stock splits/dividends as signals of higher future earnings and dividends than of a desire for stock dividends/splits per se. Since only companies whose managements think things look good tend to split their stocks, the announcement of a stock split is taken as a signal that earnings and cash dividends are likely to rise. Thus, the price increases associated with stock splits/dividends are probably the result of signals of favorable prospects for earnings and dividends, not a desire for stock splits/dividends per se.
3. If a company announces a stock split or dividend, its price will tend to rise. However, if during the next few months it does not announce an in- crease in earnings and dividends, then its stock price will drop back to the earlier level.
4. As we noted earlier, brokerage commissions are generally higher in per- centage terms on lower-priced stocks. This means that it is more expen- sive to trade low-priced than high-priced stocks, and this, in turn, means that stock splits may reduce the liquidity of a company’s shares. This par- ticular piece of evidence suggests that stock splits/dividends might actu- ally be harmful, although a lower price does mean that more investors can afford to trade in round lots (100 shares), which carry lower commis- sions than do odd lots (less than 100 shares).
What do we conclude from all this? From a pure economic standpoint, stock dividends and splits are just additional pieces of paper. However, they provide management with a relatively low-cost way of signaling that the firm’s prospects look good. Further, we should note that since few large, publicly owned stocks sell at prices above several hundred dollars, we simply do not know what the effect would be if Microsoft, Xerox, Hewlett-Packard, and other highly success- ful firms had never split their stocks, and consequently sold at prices in the thou- sands or even tens of thousands of dollars. All in all, it probably makes sense to employ stock dividends/splits when a firm’s prospects are favorable, especially if the price of its stock has gone beyond the normal trading range.14
S T O C K D I V I D E N D S A N D S T O C K S P L I T S
14It is interesting to note that Berkshire Hathaway, which is controlled by billionaire Warren Buf- fett, one of the most successful financiers of the twentieth century, has never had a stock split, and its stock sold on the NYSE for $65,000 per share in December 2000. But, in response to invest- ment trusts that were being formed to sell fractional units of the stock, and thus, in effect, split it, Buffett himself created a new class of Berkshire Hathaway stock (Class B) worth about 1⁄30of a Class A (regular) share.
S E L F - T E S T Q U E S T I O N S
What are stock dividends and stock splits?
How do stock dividends and splits affect stock prices?
In what situations should managers consider the use of stock dividends?
In what situations should they consider the use of stock splits?
S T O C K R E P U R C H A S E S
Several years ago, aFortunearticle entitled “Beating the Market by Buying Back Stock” discussed the fact that during a one-year period, more than 600 major corporations repurchased significant amounts of their own stock. It also gave il- lustrations of some specific companies’ repurchase programs and the effects of these programs on stock prices. The article’s conclusion was that “buybacks have made a mint for shareholders who stay with the companies carrying them out.”
In addition, we noted earlier that several years ago FPL cut its dividends but simultaneously instituted a program to repurchase shares of its stock. Thus, it substituted share repurchases for cash dividends as a way to distribute funds to stockholders. FPL is not alone — in recent years Philip Morris, GE, Disney, Citigroup, Merck, and more than 800 other companies took similar actions, and the dollars used to repurchase shares approximately matched the amount paid out as dividends.
Why are stock repurchase programs becoming so popular? The short an- swer is that they enhance shareholder value: A more complete answer is given in the remainder of this section, where we explain what a stock repurchaseis, how it is carried out, and how the financial manager should analyze a possible repurchase program.
There are three principal types of repurchases: (1) situations where the firm has cash available for distribution to its stockholders, and it distributes this cash by repurchasing shares rather than by paying cash dividends; (2) situations where the firm concludes that its capital structure is too heavily weighted with equity, and then it sells debt and uses the proceeds to buy back its stock; and (3) situations where a firm has issued options to employees and then uses open market repurchases to obtain stock for use when the options are exercised.
Stock that has been repurchased by a firm is called treasury stock.If some of the outstanding stock is repurchased, fewer shares will remain outstanding. As- suming that the repurchase does not adversely affect the firm’s future earnings, the earnings per share on the remaining shares will increase, resulting in a higher market price per share. As a result, capital gains will have been substi- tuted for dividends.
TH E EF F E C T S O F ST O C K RE P U R C H A S E S
Many companies have been repurchasing their stock in recent years. Until the 1980s, most repurchases amounted to a few million dollars, but in 1985, Phillips Petroleum announced plans for the largest repurchase on record — 81 million of its shares with a market value of $4.1 billion. Other large repurchases have been made by Texaco, IBM, CBS, Coca-Cola, Teledyne, Atlantic Richfield, Goodyear, and Xerox. Indeed, since 1985, more shares have been repurchased than issued.
The effects of a repurchase can be illustrated with data on American Devel- opment Corporation (ADC). The company expects to earn $4.4 million in 2002, and 50 percent of this amount, or $2.2 million, has been allocated for dis- tribution to common shareholders. There are 1.1 million shares outstanding, and the market price is $20 a share. ADC believes that it can either use the $2.2 Stock Repurchase
A transaction in which a firm buys back shares of its own stock, thereby decreasing shares outstanding, increasing EPS, and, often, increasing the stock price.
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S T O C K R E P U R C H A S E S
15Stock repurchases are generally made in one of three ways: (1) A publicly owned firm can sim- ply buy its own stock through a broker on the open market. (2) It can make a tender offer,under which it permits stockholders to send in (that is, “tender”) their shares to the firm in exchange for a specified price per share. In this case, it generally indicates that it will buy up to a specified num- ber of shares within a particular time period (usually about two weeks); if more shares are tendered than the company wishes to purchase, purchases are made on a pro rata basis. (3) The firm can pur- chase a block of shares from one large holder on a negotiated basis. If a negotiated purchase is em- ployed, care must be taken to ensure that this one stockholder does not receive preferential treat- ment over other stockholders or that any preference given can be justified by “sound business reasons.” Texaco’s management was sued by stockholders who were unhappy over the company’s repurchase of about $600 million of stock from the Bass Brothers’ interests at a substantial pre- mium over the market price. The suit charged that Texaco’s management, afraid the Bass Brothers would attempt a takeover, used the buyback to get them off its back. Such payments have been dubbed “greenmail.”
S TO C K R E P U R C H A S E S : A N E A SY WAY TO B O O S T S TO C K P R I C E S ?
Looking for a way to boost your company’s stock price? Why not buy back some of your company’s shares? That reflects the thinking of an increasing number of financial managers.
The buyback rage is in some ways surprising. Given the re- cent performance of the stock market, it has become quite ex- pensive to buy back shares. Nevertheless, the market’s response to a buyback announcement is usually positive. For example, in mid-1996 Reebok announced that it would buy back one-third of its outstanding shares, and on the announcement day, the stock price rose 10 percent. Reebok’s experience is not unique.
A recent study found (1) that the average company’s stock rose 3.5 percent the day a buyback was announced and (2) that companies that repurchase shares outperform the market over a four-year period following the announcement.a
Why are buybacks so popular with investors? The general view is that financial managers are signaling to the investment community a belief that the stock is undervalued, hence that the company thinks its own stock is an attractive investment.
In this respect, stock repurchases have the opposite effect of stock issuances, which are thought to signal that the firm’s stock is overvalued. Buybacks also help assure investors that the company is not wasting its shareholders’ money by invest-
ing in sub-par investments. Michael O’Neill, the CFO of BankAmerica, puts it this way: “We look very hard internally, but if we don’t have a profitable use for capital, we think we should return it to shareholders.”
Despite all the recent hoopla surrounding buybacks, many analysts stress that in some instances repurchases have a downside: If a firm’s stock is actually overvalued, buying back shares at the inflated price will harm the remaining stockhold- ers. In this regard, buybacks should not be viewed as a gimmick to boost stock prices in the short run, but should be used only if they are part of a well-thought-out strategy for investment and for distributing cash to stockholders. Indeed, buybacks do not always succeed — Disney, for example, announced a buy- back in April 1996, and its stock price fell more than 10 per- cent in the next six months.
aDavid Ikenberry, Josef Lakonishok, and Theo Vermaelen, “Market Under-Reaction to Open Market Share Repurchases,” Journal of Financial Economics,1995, Vol. 39, 181–208.
SOURCE: Adapted from “Buybacks Make News, But Do They Make Sense?” Busi- nessWeek,August 12, 1996, 76.
million to repurchase 100,000 of its shares through a tender offer at $22 a share or else pay a cash dividend of $2 a share.15
The effect of the repurchase on the EPS and market price per share of the remaining stock can be analyzed in the following way:
1.
2. P/E ratio⫽ $20
$4 ⫽5⫻.
Current EPS⫽ Total earnings
Number of shares⫽ $4.4 million
1.1 million ⫽$4 per share.