Chapter 19 Dividends and Other Payouts McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Key Concepts and Skills Understand dividend types and how they are paid  Understand the issues surrounding dividend policy decisions  Understand why share repurchases are an alternative to dividends  Understand the difference between cash and stock dividends  19-1 Chapter Outline 19.1 19.2 19.3 Different Types of Payouts Standard Method of Cash Dividend Payment The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy 19.4 Repurchase of Stock 19.5 Personal Taxes, Dividends, and Stock Repurchases 19.6 Real-World Factors Favoring a High Dividend Policy 19.7 The Clientele Effect: A Resolution of Real-World Factors? 19.8 What We Know and Do Not Know about Dividend Policy 19.9 Putting It All Together 19.10 Stock Dividends and Stock Splits 19-2 19.1 Different Types of Payouts  Many companies pay a regular cash dividend. ◼ ◼ ◼  Companies will often declare stock dividends. ◼ ◼  No cash leaves the firm. The firm increases the number of shares outstanding. Some companies declare a dividend in kind. ◼  Public companies often pay quarterly. Sometimes firms will pay an extra cash dividend. The extreme case would be a liquidating dividend. Wrigley’s Gum sends a box of chewing gum. Other companies use stock buybacks. 19-3 19.2 Standard Method of Cash Dividend Cash Dividend - Payment of cash by the firm to its shareholders. Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock immediately before this date is entitled to a dividend. Record Date – Date on which company determines existing shareholders. 19-4 Procedure for Cash Dividend 25 Oct. 1 Nov. 2 Nov. 5 Nov. 7 Dec. … Declaration Date ExCumdividend dividend Date Date Record Date Payment Date Declaration Date: The Board of Directors declares a payment of dividends. Cum-Dividend Date: Buyer of stock still receives the dividend. Ex-Dividend Date: Seller of the stock retains the dividend. Record Date: The corporation prepares a list of all individuals believed to be stockholders as of 5 November. 19-5 Price Behavior  In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date. -t … -2 -1 0 +1 +2 … $P $P - div The price drops Exby the amount of dividend Date the cash Taxes complicate things a bit. Empirically, the dividend. price drop is less than the dividend and occurs within the first few minutes of the ex-date. 19-6 19.3 The Irrelevance of Dividend Policy    A compelling case can be made that dividend policy is irrelevant. Since investors do not need dividends to convert shares to cash; they will not pay higher prices for firms with higher dividends. In other words, dividend policy will have no impact on the value of the firm because investors can create whatever income stream they prefer by using homemade dividends. 19-7 Homemade Dividends    Bianchi Inc. is a $42 stock about to pay a $2 cash dividend. Bob Investor owns 80 shares and prefers a $3 dividend. Bob’s homemade dividend strategy: ◼ Sell 2 shares ex-dividend homemade dividends Cash from dividend $160 Cash from selling stock $80 Total Cash $240 Value of Stock Holdings $40 × 78 = $3,120 $3 Dividend $240 $0 $240 $39 × 80 = $3,120 19-8 Dividend Policy Is Irrelevant  In the above example, Bob Investor began with a total wealth of $3,360: $42 $3,360 = 80 shares  share • After a $3 dividend, his total wealth is still $3,360: $39 $3,360 = 80 shares  + $240 share • After a $2 dividend and sale of 2 ex-dividend shares, his total wealth is still $3,360: $40 $3,360 = 78 shares  + $160 + $80 share 19-9 Dividends and Investment Policy   Firms should never forgo positive NPV projects to increase a dividend (or to pay a dividend for the first time). Recall that one of the assumptions underlying the dividend-irrelevance argument is: “The investment policy of the firm is set ahead of time and is not altered by changes in dividend policy.” 19-10 19.4 Repurchase of Stock   Instead of declaring cash dividends, firms can rid themselves of excess cash through buying shares of their own stock. Recently, share repurchase has become an important way of distributing earnings to shareholders. 19-11 Stock Repurchase versus Dividend Consider a firm that wishes to distribute $100,000 to its shareholders. Assets A.Original balance sheet Liabilities & Equity Cash $150,000 Debt 0 Other Assets 850,000 Equity 1,000,000 Value of Firm 1,000,000 Value of Firm 1,000,000 Shares outstanding = 100,000 Price per share= $1,000,000 /100,000 = $10 19-12 Stock Repurchase versus Dividend If they distribute the $100,000 as a cash dividend, the balance sheet will look like this: Assets Liabilities & Equity B. After $1 per share cash dividend Cash $50,000 Debt Other Assets 850,000 Equity Value of Firm 900,000 0 900,000 Value of Firm 900,000 Shares outstanding = 100,000 Price per share = $900,000/100,000 = $9 19-13 Stock Repurchase versus Dividend If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this: Assets C. After stock repurchase Liabilities& Equity Cash $50,000 Debt 0 Other Assets 850,000 Equity 900,000 Value of Firm 900,000 Value of Firm 900,000 Shares outstanding= 90,000 Price pershare = $900,000 / 90,000 = $10 19-14 Share Repurchase   Flexibility for shareholders Keeps stock price higher ◼   Good for insiders who hold stock options As an investment of the firm (undervaluation) Tax benefits 19-15 19.5 Personal Taxes, Dividends, and Stock Repurchases  To get the result that dividend policy is irrelevant, we needed three assumptions: ◼ ◼ ◼   No taxes No transactions costs No uncertainty In the United States, both cash dividends and capital gains are (currently) taxed at a maximum rate of 15 percent. Since capital gains can be deferred, the tax rate on dividends is greater than the effective rate on capital gains. 19-16 Firms without Sufficient Cash Investment Bankers Cash: stock issue Firm The direct costs of stock issuance will add to this effect. Stock Holders Cash: dividends Taxes Gov. In a world of personal taxes, firms should not issue stock to pay a dividend. 19-17 Firms with Sufficient Cash   The above argument does not necessarily apply to firms with excess cash. Consider a firm that has $1 million in cash after selecting all available positive NPV projects. ◼ ◼ ◼ ◼ Select additional capital budgeting projects (by assumption, these are negative NPV). Acquire other companies Purchase financial assets Repurchase shares 19-18 Taxes and Dividends  In the presence of personal taxes: 1. 2. 3. A firm should not issue stock to pay a dividend. Managers have an incentive to seek alternative uses for funds to reduce dividends. Though personal taxes mitigate against the payment of dividends, these taxes are not sufficient to lead firms to eliminate all dividends. 19-19 19.6 Real-World Factors Favoring High Dividends   Desire for Current Income Behavioral Finance ◼  Tax Arbitrage ◼  It forces investors to be disciplined. Investors can create positions in high dividend yield securities that avoid tax liabilities. Agency Costs ◼ High dividends reduce free cash flow. 19-20 19.7 The Clientele Effect  Clienteles for various dividend payout policies are likely to form in the following way: Group Stock Type High Tax Bracket Individuals Low Tax Bracket Individuals Tax-Free Institutions Zero-to-Low payout Low-to-Medium payout Medium payout Corporations High payout Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy. 19-21 19.8 What We Know and Do Not Know     Corporations “smooth” dividends. Fewer companies are paying dividends. Dividends provide information to the market. Firms should follow a sensible policy: ◼ ◼ ◼ Do not forgo positive NPV projects just to pay a dividend. Avoid issuing stock to pay dividends. Consider share repurchase when there are few better uses for the cash. 19-22 19.9 Putting It All Together      Aggregate payouts are massive and have increased over time. Dividends are concentrated among a small number of large, mature firms. Managers are reluctant to cut dividends. Managers smooth dividends. Stock prices react to unanticipated changes in dividends. 19-23 19.10 Stock Dividends Pay additional shares of stock instead of cash  Increases the number of outstanding shares  Small stock dividend  Less than 20 to 25% ◼ If you own 100 shares and the company declared a 10% stock dividend, you would receive an additional 10 shares. ◼  Large stock dividend – more than 20 to 25% 19-24 Stock Splits  Stock splits – essentially the same as a stock dividend except it is expressed as a ratio ◼ For example, a 2 for 1 stock split is the same as a 100% stock dividend. Stock price is reduced when the stock splits.  Common explanation for split is to return price to a “more desirable trading range.”  19-25 Quick Quiz What are the different types of dividends, and how is a dividend paid?  What is the clientele effect, and how does it affect dividend policy irrelevance?  What is the information content of dividend changes?  What are stock dividends, and how do they differ from cash dividends?  How are share repurchases an alternative to dividends, and why might investors prefer them?  19-26 Chapter 20 Raising Capital McGraw-Hill/Irwin Copyright © 2013 by the McGraw-Hill Companies, Inc. All rights reserved. Key Concepts and Skills Understand the venture capital market and its role in financing new businesses  Understand how securities are sold to the public and the role of investment bankers  Understand initial public offerings and the costs of going public  Understand the process of secondary offerings and the impact of dilution  20-1 Chapter Outline 20.1 20.2 20.3 20.4 20.5 20.6 20.7 20.8 20.9 20.10 20.11 Early-Stage Financing and Venture Capital The Public Issue Alternative Issue Methods The Cash Offer The Announcement of New Equity and the Value of the Firm The Cost of New Issues Rights The Rights Puzzle Dilution Shelf Registration Issuing Long-Term Debt 20-2 Venture Capitalists (VCs)    Financial intermediaries that are typically set up as limited partnerships Play an active role in overseeing, advising, and monitoring companies in which they invest Generally do not want to own the investment forever 20-3 Stages of Financing 1. 2. 3. 4. 5. 6. Seed-Money Stage Start-Up First-Round Financing Second-Round Financing Third-Round Financing Fourth-Round Financing 20-4 20.2 The Public Issue  The Basic Procedure ◼ ◼ ◼ ◼ ◼ Management gets the approval of the Board. The firm prepares and files a registration statement with the SEC. The SEC studies the registration statement during the waiting period. The firm prepares and files an amended registration statement with the SEC. If everything is copasetic with the SEC, a price is set and a full-fledged selling effort gets underway. 20-5 The Process of a Public Offering Steps in Public Offering Time 1. Pre-underwriting conferences Several months 2. Registration statements 20-day waiting period 3. Pricing the issue Usually on the 20th day 4. Public offering and sale After the 20th day 5. Market stabilization 30 days after offering 20-6 An Example of a Tombstone 20-7 20.3 Alternative Issue Methods  There are two kinds of public issues: The general cash offer ◼ The rights offer ◼  Almost all debt is sold in general cash offerings. 20-8 Table 20.1 - I 20-9 Table 20.1 - II 20-10 20.4 The Cash Offer  There are three methods for issuing securities for cash: Firm Commitment ◼ Best Efforts ◼ Dutch Auction ◼  There are two methods for selecting an underwriter Competitive ◼ Negotiated ◼ 20-11 Firm Commitment Underwriting      The issuing firm sells the entire issue to the underwriting syndicate. The syndicate then resells the issue to the public. The underwriter makes money on the spread between the price paid to the issuer and the price received from investors when the stock is sold. The syndicate bears the risk of not being able to sell the entire issue for more than the cost. This is the most common type of underwriting in the United States. 20-12 Best Efforts Underwriting     Underwriter must make their “best effort” to sell the securities at an agreed-upon offering price. The company bears the risk of the issue not being sold. The offer may be pulled if there is not enough interest at the offer price. The company does not get the capital, and they have still incurred substantial flotation costs. This type of underwriting is not as common as it used to be. 20-13 Dutch Auction Underwriting      Underwriter accepts a series of bids that include number of shares and price per share. The price that everyone pays is the highest price that will result in all shares being sold. There is an incentive to bid high to make sure you get in on the auction but knowing that you will probably pay a lower price than you bid. The Treasury has used Dutch auctions for years. Google was the first large Dutch auction IPO. 20-14 Investment Banks Also called underwriters  Perform critical functions:  ◼ ◼ Help determine type of security, method of sale, and offering price Sell the securities   ◼ Typically using a syndicate to limit risk For compensation – the spread Stabilize IPO prices in the aftermarket 20-15 IPO Underpricing May be difficult to price an IPO because there is not a current market price available.  Private companies tend to have more asymmetric information than companies that are already publicly traded.  Underwriters want to ensure that, on average, their clients earn a good return on IPOs.  Underpricing causes the issuer to “leave money on the table.”  20-16 20.5 The Announcement of New Equity and the Value of the Firm   The market value of existing equity drops on the announcement of a new issue of common stock. Reasons include ◼ Managerial Information Since the managers are the insiders, perhaps they are selling new stock because they think it is overpriced. ◼ Debt Capacity If the market infers that the managers are issuing new equity to reduce their debt-equity ratio due to the specter of financial distress, the stock price will fall. ◼ Issue Costs 20-17 20.6 The Cost of New Issues 1. 2. 3. 4. 5. 6. Gross spread, or underwriting discount Other direct expenses Indirect expenses Abnormal returns Underpricing Green Shoe Option 20-18 The Costs of Equity Public Offerings Proceeds (in millions) 2 - 9.99 10 - 19.99 20 - 39.99 40 - 59.99 60 - 79.99 80 - 99.99 100 - 199.99 200 - 499.99 500 and up Direct Costs SEOs IPOs 35.11% 25.22% 13.86% 14.69% 9.54% 14.03% 13.96% 9.77% 6.85% 8.94% 6.72% 8.55% 5.23% 7.96% 4.94% 6.84% 3.37% 5.50% Underpricing IPOs 20.42% 10.33% 17.03% 28.26% 28.36% 32.92% 21.55% 6.19% 6.64%` 20-19 20.7 Rights If a preemptive right is contained in the firm’s articles of incorporation, the firm must offer any new issue of common stock first to existing shareholders.  This allows shareholders to maintain their percentage ownership if they so desire.  20-20 Mechanics of Rights Offerings  The management of the firm must decide: The exercise price (the price existing shareholders must pay for new shares). ◼ How many rights will be required to purchase one new share of stock. ◼  These rights have value: ◼ Shareholders can either exercise their rights or sell their rights. 20-21 Rights Offering Example Popular Delusions, Inc. is proposing a rights offering. There are 200,000 shares outstanding trading at $25 each. There will be 10,000 new shares issued at a $20 subscription price.  What is the new market value of the firm?  What is the ex-rights price?  What is the value of a right?  20-22 What is the new market value of the firm? $25 $20 $5,200,000 = 200,000 shares  + 10,000 shares  share shares There are 200,000 outstanding shares at $25 each. There will be 10,000 new shares issued at a $20 subscription price. 20-23 What Is the Ex-Rights Price? There are 110,000 outstanding shares of a firm with a market value of $5,200,000.  Thus the value of an ex-rights share is:  $5,200,000 = $24.7619 210,000 shares 20-24 What Is the Ex-Rights Price?  Thus, the value of a right is: $0.2381 = $25 – $24.7619 20-25 20.8 The Rights Puzzle   The vast majority of new issues in the U.S. are underwritten, even though rights offerings are much cheaper. A few explanations: ◼ ◼ ◼ ◼ Underwriters increase the stock price. There is not much evidence for this, but it sounds good. The underwriter provides a form of insurance to the issuing firm in a firm-commitment underwriting. Underwriters “certify” the price to the market. The proceeds from underwriting may be available sooner than the proceeds from a rights offering. 20-26 20.9 Dilution  Dilution is a loss in value for existing shareholders: ◼ ◼ ◼ ◼ Percentage ownership – shares sold to the general public without a rights offering Market value – firm accepts negative NPV projects Earnings per share – may decline even with positive NPV projects (at least in short run) Book value– occurs when market-to-book value is less than one 20-27 20.10 Shelf Registration Permits a corporation to register an offering that it reasonably expects to sell within the next two years.  Not all companies are allowed shelf registration.  Qualifications include:  ◼ ◼ ◼ ◼ The firm must be rated investment grade. They cannot have recently defaulted on debt. The market capitalization must be > $150 m. No recent SEC violations. 20-28 20.11 Issuing Long-Term Debt Public issuance follows the same general process as stocks  Direct financing  ◼ ◼  Term loans Private placements Direct financing may have more restrictive covenants and higher rates, but is less costly to issue and easier to negotiate. 20-29 Quick Quiz         What is venture capital, and what types of firms receive it? What are some of the important services provided by underwriters? What type of underwriting is the most common in the United States, and how does it work? What is IPO underpricing, and why might it persist? What are some of the costs associated with issuing securities? What is a rights offering, and how do you value a right? What is shelf registration? What are the advantages of direct financing as opposed to public issuance of long-term debt? 20-30
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