Please enable JavaScript.
Coggle requires JavaScript to display documents.
Corporate Finance - Coggle Diagram
Corporate Finance
4 Payout policy & cash holdings
4.1 Preliminaries
Companies distribute cash to shareholders mainly through:
Cash dividends (regular, special, bonus)
Share repurchases (number of outstanding shares decreases
Stock dividends (scrip issue or scrip dividend)
An offer of shares 'free of charge' to existing shareholders
An 'alternative' to increase of dividend payout.
'Special' cash flows to shareholders are associated with M&A (Sabbatucci, 2015)
Share issue can be thought as negative payout
Why do corporations pay dividends, and why do investors care?
List is long:
Signaling
Tax preference
Agency costs
Behavioral explanations (prospect theory)
Aggregate cash flows received by US shareholders:
There has been steady but minimal growth in ordinary dividends but a significant increase in share repurchases
Dividends are sticky and tend to follow earnings (Damodaran 2011)
International variation in dividend payout ratios (G-7 countries)
Dividend taxes might matter.
Dividend payout ratio:
US: More of less stable around 38%
Japan: Has been increasing, in 2008-2009 around 32%
Germany: Reduced in 1989-91 but increased in 2008-09 to 50%
France: Reduced in 1989-91 but increase in 2008-09 to 38%
Italy: increasing, 2008-09 to 35%
UK: increasing substantially, 2008-09 52%
Canada: Increased to 49% in 1989-91 but reduced to 40% in 2008-09
Aggregate payout behavior (Ferris et al. 2009)
Diminishing difference between countries with common law legal regime and others
4.2 Payout policy in perfect markets
Payout policy in perfect markets (Miller & Rock 1985)
Sources and uses of funds = EAR + mP + ∆B = I + DIV
Net cash flows from operations (EAR - I) = Net payout (DIV - mP - ∆B):
EAR - I = DIV - mP - ∆B
Value of the firm and equity
Value of the firm = current cum dividend value + discounted expected cash flows using appropriate risk-adjusted rate k.
Original shareholders' wealth is the value of the firm minus the market value of debt and new equity issued:
Using the sources and uses of funds constraint, we obtain:
Note S1 can be expressed without dividends, DIV
Earning shocks revise expected future earnings
Evolution of firm's earnings stream, EAR, depends on past investments, I and random earnings shock, e
where unconditional, period 0 expectation of each shock of earnings is zero, i.e. E0(e1) = E0(e2) = 0
Dividend announcement effect
Under full information assumptions, a firm, operating in the best of its shareholders, will choose values of DIV, I, ∆B and mP to maximize S1 subject to sources and uses of funds constraint.
Thus there is no room for dividend announcement effect
Dividend surprise does not convey nothing new to market since earnigns surprise and dividend surprise convey the same information
Without any information asymmetry or other market imperfections dividends are irrelevant (i.e. Modigliani-Miller's (1961) proposition
Value of equity depends only on net cash flows from operations
Illustration of irrelevance of dividend policy in the MM world
Assume all-equity firm has yearly total cash flow of $10,000. There are 100 shares outstanding. Assume a 10% required return. Firm will be dissolved in two years.
Current policy: Dividend set equal to cash flow:
P_0=D_1/1+r +D_2/(1+r)^2=100/1.1+100/1.1^2=173.55
Alternative policy: Initial dividends lower than cash flow. Year 1 dividends 90 per stock. Firm can earn 10 return for retained $10 cash flow (=$11)
Value of share today:
P_0=D_1/1+r +D_2/(1+r)^2=90/1.1+110/1.1^2=173.55
This is the same value as before---> irrelevance of dividend policy
4.3 Signaling by payouts
Miller & Rock 1985
So is there any room for dividend announcement effect?
When payout surprise and earnings surprise convey the same information, dividends have no signaling effect.
However, if managers are better informed about generation of future earnings stream than outside shareholders (asymmetric information) market responses only partially to earnings release and wait whether dividend release provides a clue from the managers to unobserved future earnings, then dividend release has announcement effect.
However, managers may be tempted to rise share price by paying out higher dividends even that means cutting back on investments (sending a false signal)
Are there vehicles (e.g. dissipative costs) that penalize ex post if managers depart from optimal policy?
Introducing information asymmetry
When information asymmetry exists, formation of earnings expectations must be clarified.
Assume that the 2nd period shock (e2) of earnings given the 1st shock (e1) is not necessary zero, then E(e2|e1) = ye1, where y is a earnings persistence coefficient, 0<y<§
The persistence y measures the effect of earnings revision on the present value of the expected future earnings.
The shock can be entirely permanent y=1 (e.g. by improved productivity) or y=0 the shock is entirely transitory or something between 1 and 0.
Pre- and post-announcement expected value of shareholder's wealth
Shareholder's expected wealth based on information before earnings announcement
Shareholder's wealth based on information after earnings announcement
Earnings announcement effect
Earnings announcement results stock price change driven by
i) earnings surprise
ii) earnings persistent coefficient, y
if y>0 market only partially adjusts to new information (error in 1st period), since uninformed investors underestimate the information content of y and the post-earnings announcement drift (PEAD) in stock returns can be observed (e.g. Bernard & Thomas 1989)
Stock prices move many days after the earnings announcement to same direction as the earnings surprise
Dividends as signals
Dividends (or stock repurchases) do not affect the fundamental value of the company, but makes the market value better informed about managers' inside information of firm value (i.e. signaling)
i) An unexpected increase in dividends provide a clue to unobserved future earnings E(e1|DIV0)
ii) The cost of signaling by increasing (net) dividends is the forgone use of the funds in productive investment
iii) Assumes that sending a wrong signal cause dissipative costs (only good firms can signal with dividend increase)
iv) Dividends make sense as signals for good-news firms, not for bad-news firms
Persistence factor is related to the ability to forecast earnings
Dividend announcement effects should be larger when future earnings are hard to predict, they are managed and when dividends precede earnings
Empirical evidence by Pettit (1972): Dividend announcement effect
The signaling hypothesis predicts positive stock price response to the announcement of dividends that are larger than expected.
Empirical model by Pettit (1972) is standard market model assuming linear relationship between the stock return and return on the market
R_it=total return (dividends and capital gains on the stock)
alpha = constant term of stock i
beta = beta of stock i (sensitivity to the return on market index)
R_mt = return on the market index
e_it = error term
First two terms (alpha and beta) serve as a conditional expected return and the difference between actual return and expected return measures departures from the risk-adjusted rate of return.
Empirical evidence by Pettit (1972): Dividend announcement effect 135 firms
The cumulative abnormal performance is averaged over all firms in each dividend class (changes of -1% to -99%, 1% to 10%, 10% to 25% and over 25% by compounding the average abnormal daily returns)
Especially dividend cuts and omissions are interpreted as bad news
Most of the price adjustment takes place very quickly
Wansley, Sirmans, Shilling, Lee (1991)
They test whether a relation exists between timing of dividend announcements vis-a-vis earnings announcements, the level od information contained in the earnings announcement, and the volatility of earnings because of possible interaction among variables.
3,262 dividend change obs with available earnings (1973-86)
They used regular quarterly dividend change announcements
They find that dividend announcement effect is somewhat larger when current earnings are unknown, but dividend announcement effect is not related to the predictability of the firm's earnings nor to the percentage change announcements
They find that dividend announcement effect is somewhat larger when current earnings are unknown, but dividend announcement is not related to the predictability of the firm's earnings nor to the percentage change in earnings
Dividend decrease results larger absolute price adjustment than dividend increase (-4.4% versus 0.7%
Aharony & Swary (JF, 1980)
Evidence that changes in quarterly cash dividends do change stock price
Dividend increases may be good for stock but bad for bonds
(The wealth transfer hypothesis)
Excess returns on straight bonds around dividend changes (Damodaran)
Bondholders view dividend increases as bad news. It makes the bonds much riskier. To the extent that the dividend increase was unanticipated and was not built into interest rate, this transfers wealth from bondholders to stockholders.
Koch & Sun (2004)
Whether market interprets the dividend changes as signals about
i) persistence of past earnings changes, or
ii) information about future earnings changes
Persistence of earnings = extent to which an unexpected change in earnings revises expectation of future earnings (for one or more periods) in the same direction as the unexpected change. The higher (less) the persistence, the unexpected change in earnings result higher (lower) change is share price (Miller & Rock 1985)
Prior evidence suggests that stock price responses to earnings vary with persistence of earnings (Basu 1997)
Ex ante, negative (positive) earnings changes are less (more) persistent (due to accounting conservatism)
Persistence of earnings change and dividends (Koch and Sun 2004)
Investors assumed to have difficulties to immedietly know the persistence and valuation implications of past earnings changes, but subsequent change in dividends help resolve this uncertainty.
Dividend change, therefore, provides a previously missing piece of information needed to evaluate the implications that recent past earnings have for future earnings.
So, a dividend change with the same sign as a past earnings change is interpreted as the past earnings change is persistent
Koch & Sun (2004) Hypothesis 2
H2: The positive relation between the market reaction to dividend change announcement and the preceding change in earnings is larger for a dividend decrease that confirms a prior earnings decrease than that for a dividend increase that confirms a prior increase
If earnings decreases are, ex ante, likely to be less persistent than earnings increases (due to accounting conservatism) then a subsequent dividend cut (that indicates the persistence of a past earnings decrease) is expected to cause a larger belief variation that would be expected for a dividend increase that indicates the persistence of a past earnings increase
Koch & Sun's (2004) findings
Consistent with Hypothesis 1 that the market interprets changes in dividends as information about the persistence of past earnings changes
Positive relation between stock returns around dividend announcement that confirms past earnings changes
Partially the dividend announcement effect is a delayed response to past earnings news (resolution of uncertainty about the persistency of past earnings news) as well as anticipation of future earnings changes
Consistent with Hypothesis 2 that past earnings decrease (increase) with a subsequent dividends cut (increase) cause higher (lower) market response
In line with accounting conservatism (which require quicker recognition for negative news than positive news, see Basu 1997)
4.4 Optimal dividend policy
4.5 Dividend clientele effects and ex date effects
4.6 Behavioral aspects to dividends
4.7 Stock repurchases
4.8 Corporate cash holdings
