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Dividends and Other Payouts Distributions -Firms make distributions to their shareholders in 2 ways: -Cash distributions -cash dividends -share repurchases -Share distributions -stock dividends -stock splits Why Distribute? -Paying dividends reduces agency cost of equity -Dividends reduce free cash flow and so reduce managerial waste -Forces management to run tight ship -Forces managers to face scrutiny of capital markets when new project financing needed Dividend Policy – The Debate -Academics look at dividend policy as a cash flow issue in an M&M perfect world -Practioners look at dividend policy as a leverage and investment decision -Corporate growth potential -Shareholder reinvestment opportunities -In the absence of taxes, the firm should pay out internally generated funds as a dividends if investors have access to higher positive NPV projects than does the firm M&M on Dividends -In the absence of transactions costs and taxes, dividend policy is irrelevant and does not affect shareholder wealth -Investors do not need dividends to convert shares to cash therefore, they will not pay higher prices for firms with higher dividend payouts -Dividend policy will have no impact on the value of the firm because investors can: -Sell shares off a small part of the stock that has appreciated in value to create dividends -Reinvest dividends in company by purchasing more shares to create capital gains Dividend Policy is Irrelevant -Since investors do not need dividends to convert shares to cash, dividend policy will have no impact on the value of the firm -Dividend policy establishes the trade-off between paying a dividend now or paying a dividend in the future Ex. Wise Holdings has the following market value based balance sheet: In millions Current assets $25 Long term $75 assets Total assets $10 Equit $100 0 y The company has 5 million shares of common stock outstanding, an EPS of $4 and it has declared a cash dividend of $1 per share. -What are the firm’s stock price and P/E ratio before the ex-dividend date? -What are the stock price, P/E ratio and total market value of equity after the ex-dividend date? -Suppose Joe owned 50 shares of Wise Holdings. Show that, in the absence of taxes, his wealth is unaffected by the dividend issue Fundamental Concept -In perfect capital markets, without taxes, dividend policy is irrelevant Taxes and Dividends -In a tax free world, cash dividends are a wash between the firm and its shareholder -In a world with taxes, the government gets a cut What are Practical Issues? -Dividend policy is a decision to give money back to shareholders and NOT invest in a new project -Affects the firm’s capital budgeting decision: -Paying dividends means less internal cash available for other uses -Paying dividends means borrowing money to invest in new projects -Historically firms pa out dividends in both good times and bad times -Firms should never give up a positive NPV project to pay dividends Real World Relevance – Factors Favouring a Low Payout -Taxes, imposing an immediate tax burden on investors -Firm has unusually good investment prospects -Cost if have to issue new equity in the future -Why pay dividends and incur costs to issue securities in the future? -Bond covenants and other restrictions -Growth and control issues -Short term cash position -Inherent firm risk -Restrictions on foreign transfers Real World Relevance – Factors Favouring a High Payout -Desire of current income: -Cost of home-made dividends -Uncertainty resolution: -“Bird-in-the-hand” argument – Investors prefer cash dividend now to uncertain capital gain in future -Tax: -Tax exempt owners -Signalling arguments (Asymmetric information) -Free cash flow issues The Clientele Effect: A Resolution of Real-World Factors? -Clienteles for various dividend payout policies are likely to form in the following way: Clientele Group Stock High tax bracket Zero to low payout individuals stocks Low tax bracket Low-to-medium payout individuals Tax-free institutions Medium payout stocks Canadian corporations High payout stocks -Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy Fundamental Concept -Many factors in the real world make dividend policy relevant Guiding Principles and Practical Implementation of a Dividend Policy -Guiding principles: 1. Avoid padding on positive NPV projects to pay dividends 2. Avoid cutting or reducing dividends 3. Avoid the need to sell equity 4. Maintain the target debt/equity ratio -These suggest keeping the payout set low in the first place -Implement: -Set a low per share constant dollar dividend -Set a target payout consistent with long term profitability and long term capital needs -Increase dividends only when the long term profitability supports the new payout level -Reduces dividends reluctantly, but do not risk the viability of the firm Residual Dividend Policy A Theory of Leftovers -Firms may follow a residual dividend policy -Use internally generated funds to finance capital projects an
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