.

-12 -b 0 24 $ +A2 +16 328 Part I11 F i n a n c i n g a n d D i v i d e n d Policies era1 days surrounding the announcement, there is a run-up in the cumulative abnormal return, after which the higher level of security price persists owing to the favorable information effect. The larger the announced stock split, in relation to that which was anticipated, the greater the abnormal return.

The empirical evidence is consistent with an information or signaling effect;

namely, that the stock is undemalued and should be priced higher. Of course, the company must eventually deliver improved earnings if the stock is to remain higher. The underlying cause for the increase in market price is perceived future earnings, not the stock dividend or split itself.

Reverse Stock Splits Rather than increase the number of shares of stock outstanding, a company may want to reduce the number. It can accomplish this with a reverse split. In our stock split example before, had there been a 1-to-4 reverse split instead of the 2-to-1 straight stock split, for each four shares held the stockholder would have received one share in exchange. The par value per share would become $20, and there would be 100,000 shares outstanding rather than 400,000. Reverse stock splits are employed to increase the market price per share when the stock is considered to be selling at too low a price. Many companies have an aversion to seeing their stock fall below $10 per share. If financial difficulty or some other depressant lowers the price into this range, it can be increased with a reverse split.

As with stock dividends and straight stock splits, there is likely to be an information or signaling effect associated with the announcement. Usually the signal is negative, such as would accompany the admission by a company that it is in financial difficulty. A healthy company simply wanting to place its stock in a higher trading range should think twice before undertaking a reverse stock split. There are too many bad apples in the barrel not to be tainted by association.

MANAGERIAL CONSIDERATIONS AS TO DIVIDEND/SHARE REPURCHASE POLICY Many p r a c t i c a l A number of things come into play when a company is trying to detennine the apthings influence propxiate amount of cash to distribute to stockholders and whether it should be the dividendishare dividends or share repurchase. These considerations should be related back to the repurchase decision.

theory we have discussed pertaining to the valuation of a company. In what follows, we take up various factors that financial managers in practice should analyze.

Funds Needs of the Firm Perhaps the place to begin is with an assessment of the funds needs of the firm.

In this regard, cash budgets and projected source and use of funds statements

(topics taken up in Chapter 13) are of particular use. The key is to determine the likely cash flows and cash position of the company in the absence of a change in dividend/share repurchase. In addition to looking at expected outcomes, we should factor in business risk, so that we may obtain a range of possible cashflow outcomes. The procedure is spelled out in Chapter 13, so we need not dwell on it here.

In keeping with our earlier discussion of the theory of dividend payout, the firm wishes to determine if anythmg is left over after servicing its funds needs, including profitable investment projects. In this regard, a company should look at its situation over a reasonable number of future years to iron out fluctuations. On the basis of this analysis, a company can determine its likely future residual funds that are available for distribution to stockholders.

~ Chapter 11 Dividend Policy: Theory and Practice 329 With respect to dividends, we would expect no dividends to be paid in the early life of a company. As it matures and begins to generate excess cash, dividends may be paid-a token dividend at first, but bigger ones as relatively fewer productive investment opportunities are found. The dividend may be supplemented or supplanted by share repurchase. In the late stages of a company's life cycle, "hamesting"

may occur. Here a company self-liquidates by paying substantial dividends to its stockholders or, more usually, engaging in substantial stock repurchase. For dividend payout, the life-cycle notion is illustrated in Fig. 11-2.

Ability to Borrow A liquid position is not the only way to provide for flexibility and thereby protect against uncertainty. If a firm has the ability to borrow on comparatively short notice, it may be relatively flexible. This ability to borrow can be in thc form of a line of credit or a revolving credit from a bank or simply the informal willingness of a financial institution to extend credit. In addition, flexibility can come from the ability of a company to go to the capital markets with a bond issue. The larger and more established a company, the better its access to capital markets. The greater the ability of the firm to borrow, the greater its flexibility and the greater its ability to pay a cash dividend or engage in share repurchase.

Assessment of Any Valuation Information To the extent that there are insights into the effect of a dividend on valuation, they should be gathered. Most companies look at the dividend-payout ratios of other companies in the industry, particularly those having about the same growth. It may not matter that a company is out of line with similar companies, but it will be conspicuous;

and usually a company will want to jusbfy its position. Also, a company should judge the informational effect of a dividend or share repurchase. What do investors expect? Here security analysts and security reports are useful. The company should ask itself what information it is conveying with its present dividend and/or share repurchase program and what it would convey with a possible change.

Control If a company pays substantial dividends or engages in substantial share repwchase, it may need to raise capital at a later time through the sale of stock. Under such circumstances, the controlling interest of the company may be diluted if controlling stockholders do not or cannot subscribe for additional shares. These stock-

F I G U R E 1 1 - 2 I I Start up Growth Maturity TIME 330 Part I11 Financing and Dividend Policies holders may prefer a low dividend payout/share repurchase program and the financing of investment needs with retained earnings. Control can work two ways, however. When a company is being sought by another company or by individuals, a low dividend payout may work to the advantage of the "outsiders" seeking control.

The outsiders may be able to convince stockholders that the company is not maximizing shareholder wealth and that they (the outsiders) can do a better job.

Consequently, companies in danger of being acquired may establish a high dividend payout in order to please stoclolders.

Nature of Stockholders When a company is closely held, management usually knows the dividend desires of its stockholders in relation to their share repurchase desires and may act accordingly If most stockholders are in high tax brackets and prefer capital gains to current income, the firm can establish a low, or even zero, dividend payout and use share repurchase as a way to distribute excess cash. The corporation with a large number of stockholders can judge their desires for dividends only in a market context.

Liquidity The liquidity of a company is a consideration in many dividend/share repurchase decisions. As they represent a cash outflow, the greater the cash position and overall liquidity of a company, the greater its ability to pay a dividend or engage in a share repurchase program. A company that is growing and profitable may not be liquid, for its funds may go into fixed assets and permanent additions to current assets. Because the management of such a company usually desires to maintain some liquidity cushion, it may be reluctant to jeopardize this position in order to pay a large dividend or engage in a substantial share buyback.

Restrictions in Bond Indenture or Loan Agreement The protective covenants in a bond indenture or loan agreement often include a restriction on payment of dividends and share repurchase. The restriction is employed by the lenders to preserve the company's ability to service debt. Usually, it is expressed as a maximum percentage of cumulative earnings. When such a restriction is in force, it naturally influences dividends and share repurchases.

Dividend Stability The financial manager must be concerned with the stability of dividends to investors.

By stability, we mean maintaining a position in relation to a dividend trend line, preferably one that is upward sloping. It would appear that investors value stability.

As we have said, dividends may serve to resolve uncertainty. When earnings drop and a company does not cut its dividend, the market may have more confidence in the stock than it would have if the dividend were cut. The stable dividend may convey management's view that the future of the company is better than the drop in earnings suggests. Thus, management may be able to influence the expectatiom of investors through the informational content of dividends. Management will not be able to fool the market permanently. If there is a downward trend in earnings, a stable dividend will not convey forever an impression of a rosy future.

Investors who desire a specific periodic income will prefer a company with stable dividends to one with unstable dividends, even though both companies may have the same pattern of earnings and long-run dividend payout. Although investors can always sell portions of their stock for income when the dividend is not sufficient to meet their current needs, many investors have an aversion to dipping into principal and to transaction and inconvenience costs.

Chapter 11 Dividend Policy: Theory and Practice 331 Finally, dividend stability may be important from the standpoint of permitting certain institutional investors to buy the stock. Various governmental bodies prepare lists of securities in which pension funds, trustees, insurance companies, and certain others may invest. To qualify, a company often must have an uninterrupted pattern of dividends. A cut in dividends or their omission may result in the removal of a company from these lists.

Target-Payout Ratios A number of companies appear to follow the policy of a target dividend-payout ratio over the long run. Lintner contends that dividends are adjusted to changes in earnings, but only with a lag.19 When earnings increase to a new level, a company increases dividends only when it feels it can maintain the increase in earnings.

Companies are also reluctant to cut the absolute amount of their cash dividend.

Both of these factors explain the lag in dividend changes behind changes in earnings.

In an economic upturn, the lag relationship becomes visible when retained earnings increase in relation to dividends. In a contraction, retained earnings grow at a slower rate than dividends.

However, a company cannot pay dividends indefinitely unless there is pmfitability.

In an empirical test, DeAngelo, DeAngelo, and Skinner find that 51 percent of companies experiencing losses reduce their dividend in the initial loss yeatzOT hey claim that a loss is a necessary condition for dividend reductions, but not a sufficient reason. Income adjusted for unusual items is a critical determinant of dividend changes. The authors view the evidence as supporting Lintner's target-payout notion.

Rather than omit dividends in the face of financial distress, the majority of companies reduce them, indicating managerial reluctance to do away with a dividend.

Some Final Observations In determining a dividend payout and/or share repurchase program, the typical company will analyze a number of factors already described. These factors largely dictate the boundaries within which a dividend can be paid or shares repurchased.

When a company pays a dividend in excess of its residual funds, it implies that management and the board of directors believe the payment has a favorable effect on shareholder wealth. The frustrating thing is that we have so little in the way of clear generalizations from the empirical evidence. The lack of firm footing for predicting the long-run effect of a specific dividend policy on valuation makes the dividend decision more difficult in many ways than either the investment or financing decisions.

Considerations taken up in the section above allow a company to determine with reasonable accuracy what would be an appropriate passive dividend strategy.

An active dividend policy involves an act of faith, because it demands that a portion of the cumulative dividends ultimately be replaced with common stock financing.

Such a strategy is undertaken in a fog& area, but one in which most academics have difficulty believing shareholder wealth will be enhanced. Notwithstanding, many companies profesi a belief that dividend payout affects share price and behave in a manner consistent with dividends mattering.

When a company has a sizable amount of excess funds to transmit to shareholders, a strong case can be made for the repurchase of stock as opposed to cash dividends.

This alternative results in capital gains income as opposed to dividend income.

'%e John Lintner, "Di~hibutiono f Income of Corporations among Dividends, Retained Earnings, and Taxes,"

American Economic Rruim, 46 (May 1956), 97-113.

Warry DeAngelo, Linda DeAngelo, and Douglas J. Skinner, "Dividends and Losses," Jouml of Finance, 48

(December 1992). 183743. See also DeAngelo and DeAngelo, "Dividend Policy and Financial Distress: An Empirical Investigation of Troubled NYSE Finns," Journni of Finnnce, 45 (December 1990). 141M1.

332 Part 111 F i n a n c i n g a n d Dividend Policies The distribution of excess cash to shareholders can take two forms: dividends and/or share repurchase.

In recent years the latter has become increasingly more important, though in the aggregate dividends are larger.

The critical question in dividend policy is whether dividends have an influence on the value of the firm, given its investment decision.

If dividends are irrelevant, as Modigliani and Miller believe, the firm should retain earnings only in keeping with its investment opportunities.

If there are not sufficient investment opportunities providing expected returns in excess of the required return, the unused funds should be paid out as dividends.

The key issue is whether dividends are more than just a means of distributing unused funds. With perfect capital markets and an absence of taxes, stockholders can manufacture homemade dividends and make dividend payout irrelevant. Only market imperfections will result in relevancy. With imperfections, there are three possibilities: (1) dividends have a negative effect on value, (2) dividends are neutral in effect, and (3) dividends have a positive effect.

With differential taxes on dividends and capital gains, there seemingly is a bias in favor of retention. This is a negative dividend effect where dividend-paying companies must provide a higher before-tax expected return, resulting in a yield tilt. However, different investors are affected differently by taxes, and a clientele theory would suggest that corporations alter the supply of dividends in keeping with the tax situation of investor clienteles.

This could well result in dividend neutrality.

For behavioral reasons, certain investors may prefer dividends to the retention of earnings and capital gains. Though not necessarily rational, this could result in a positive dividend effect.

Financial signaling implies that dividends may be used to convey information. That information, rather than the dividend itself, affects valuation.

Empirical testing of dividend policy has focused on whether there is a tax effect and whether dividends serve as signals in conveying information. The evidence is conflicting with respect to the former, but the preponderance of recent evidence is consistent with dividend neutrality. There seems to be agreement that dividends provide financial signals. In final analysis, we are unable to state whether the dividend payout of the firm should be more than a passive decision variable. Most academics think not.

Instead of dividends, a company can repurchase its own stock. Employees with stock options have a decided preference for share repurchase.

There are three methods of share repwchase:

(1) fixed-price tender offers; (2) dutchauction tender offers, the most widely used method; and (3) open-market purchases. In the absence of a tax differential between dividends and capital gains, the monetary value of share repurchase or cash dividends should be the same. A formula for determining the equilibrium fixed-price tender offer was presented.

Tender offer repurchases appear to have a positive and significant signaling effect, though more so for fixed-price tender offers than for dutch-auction repurchases.

A stock dividend pays additional stock to stockholders. Theoretically, it is not a thing of value to the stockholder unless cash dividends per share remain unchanged or are increased.

Stock dividends may serve to keep the market price per share in a popular trading range. A more effective device for reducing market price per share is a stock split. Both stock dividends and stock splits appear to have an informational or signaling effect. When other things are held constant, share price tends to rise around the time of the announcement, consistent with a positive signal. In a reverse stock split, the number of shares outstanding is reduced and the signal to the market usually is negative.

In the preceding section we examined various managerial considerations when a company is faced with a dividend and/or share repurchase decision. These factors include the funds needs of the firm, liquidity, ability to borrow, assessment of any valuation 1 Chapter 11 Dividend P o l i c y : Theory and Practice 333 control and the nature of stock- companies appear to follow the policy of a tarrestrictions in bond indenture or get dividend-payout ratio, increasing divi-

Dividend stability is thought dends only when they feel that an increase in important to investors. Many eamings can be sustained.