CORPORATE FINANCIALTHEORY

Lecture 6

Review

Goal: Maximize Value of the Firm

Past Topics Investment Decision (spending money) Financing Decision (raising money)

Future Topics “Variations on a Theme”

Today’s Topics

Dividends (today)• Define (Capital Budgeting & Investment

variation)• Dividends & Value of the Firm

Capital Structure• Define (financing variation)• Capital Structure & Value of the Firm

Dividends

A payment made by a company to the shareholders of the company.

Dividend Payments

Cash Dividend - Payment of cash by the firm to its shareholders.

- Regular

- Special

Stock Dividend - Distribution of additional shares to a firm’s stockholders.

Stock Splits - Issue of additional shares to firm’s stockholders.

Dividend Payments

Stock Repurchase - Firm buys back stock from its shareholders.

Stock Repurchase (4 methods)1. Buy shares on the market2. Tender Offer to Shareholders3. Dutch Auction4. Private Negotiation (Green

Mail)

Dividend Terms

Record Date

Announcement Date

Payment Date

Ex-Dividend

Dividend Payments

Aug 14 Aug 25 Aug26 Sept 1 Sept 15

Declaration With- Ex-dividend Record Paymentdate dividend date date date

date

Share price falls

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 dividend payouts. In other words, dividend policy will have no impact on the value of the firm.

Dividend Policy is IrrelevantExample - Assume Rational Demiconductor has no extra cash, but

declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.

Record DateCash 1,000Asset Value 9,000Total Value 10,000 +New Proj NPV 2,000# of Shares 1,000price/share $12

Dividend Policy is IrrelevantExample - Assume Rational Demiconductor has no extra cash, but

declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.

Record Date Pmt DateCash 1,000 0Asset Value 9,000 9,000Total Value 10,000+ 9,000New Proj NPV 2,000 2,000# of Shares 1,000 1,000price/share $12 $11

Dividend Policy is IrrelevantExample - Assume Rational Demiconductor has no extra cash, but

declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.

Record Date Pmt Date Post PmtCash 1,000 0 1,000 (91 sh @

$11)Asset Value 9,000 9,000 9,000Total Value 10,000+ 9,000 10,000New Proj NPV 2,000 2,000 2,000# of Shares 1,000 1,000 1,091price/share $12 $11 $11

NEW SHARES ARE ISSUED

Example - continued - Shareholder Value

Record

Stock 12,000

Cash 0

Total Value 12,000

Stock = 1,000 sh @ $12 = 12,000

Dividend Policy is Irrelevant

Dividend Policy is Irrelevant

Example - continued - Shareholder Value

Record Pmt

Stock 12,000 11,000

Cash 0 1,000

Total Value 12,000 12,000

Stock = 1,000sh @ $11 = 11,000

Dividend Policy is Irrelevant

Example - continued - Shareholder Value

Record Pmt Post

Stock 12,000 11,000 12,000

Cash 0 1,000 0

Total Value 12,000 12,000 12,000

Stock = 1,091sh @ $11 = 12,000

Assume stockholders purchase the new issue with the cash dividend proceeds.

Payout Policies

Dividend & Stock Repurchases$

Bil

lion

s

U.S. Data 1995 - 2013

Dividend Theories

Leftists (M&M) - Div does not effect value

Rightists - Dividends increase value

Middle of the roaders - Leftist theory with some reality thrown in.

Residual Dividend Policy

Dividend Theories

MRI = IRR

COC12 %

r

QTY $$$

Dividends Increase Value

Market Imperfections and Clientele EffectThere are natural clients for high-

payout stocks, but it does not follow that any particular firm can benefit by increasing its dividends. The high dividend clientele already have plenty of high dividend stock to choose from.

These clients increase the price of the stock through their demand for a dividend paying stock.

Dividends Increase Value

Dividends as SignalsDividend increases send good news

about cash flows and earnings. Dividend cuts send bad news.

Because a high dividend payout policy will be costly to firms that do not have the cash flow to support it, dividend increases signal a company’s good fortune and its manager’s confidence in future cash flows.

Dividends Decrease Value

Tax ConsequencesCompanies can convert dividends into

capital gains by shifting their dividend policies. If dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move and value the firm more favorably.

In such a tax environment, the total cash flow retained by the firm and/or held by shareholders will be higher than if dividends are paid.

Taxes and Dividend Policy

Companies can convert dividends into capital gains by shifting their dividend policies. If dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move and value the firm more favorably.

In such a tax environment, the total cash flow retained by the firm and/or held by shareholders will be higher than if dividends are paid.

Since capital gains are taxed at a lower rate than dividend income, companies should pay the lowest dividend possible.

Dividend policy should adjust to changes in the tax code.

Taxes and Dividend Policy

Rate of Income tax

0% 39.60%Operating Income 100 100Corporate tax (Tc=.35) 35 35After Tax income (paid as div) 65 65Income tax 0 25.7Cash to Shareholder 65 39.3

In U.S., shareholders are taxed twice (figures in dollars)

Taxes and Dividend Policy

Rate of Income tax

15% 30% 47%Operating Income 100 100 100Corporate tax (Tc=.30) 30 30 30After Tax income 70 70 70

Grossed up Dividend 100 100 100Income tax 15 30 47Tax credit for Corp Pmt -30 -30 -30Tax due from shareholder -15 0 17Cash to Shareholder 85 70 53

Under imputed tax systems, such as that in Australia, Shareholders receive a tax credit for the corporate tax the firm pays (figures in Australian dollars)

Capital Structure

Read Chapter 17 on your own

Overlap with Lecture 3

Exam Review