Chapter 16 The Dividend Controversy Principles of Corporate Finance Seventh Edition Richard A. Brealey Stewart C. Myers Chapter 16 The Dividend Controversy Slides by Matthew Will McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

Topics Covered How Dividends Are Paid Information in Dividends and Stock Repurchases How Do Companies Decide on Dividend Payments? The Dividend Controversy The Rightists Taxes and the Radical Left The Middle of the Roaders

Types of Dividends Cash Div Stock Div Stock Repurchase (3 methods) Regular Cash Div Special Cash Div Stock Div Stock Repurchase (3 methods) 1. Buy shares on the market 2. Tender Offer to Shareholders 3. Private Negotiation

Initial Notes Fama and French (2001) found that only about a fifth of public companies pay a dividend, down from 67% in 1978. Stock repurchases have boomed since 80s and was larger in value than dividend payments in late 90s. (Figure 16.1) Only Eregli Demir Çelik and Yazıcılar own their own shares in Turkey.

Some food for thought If investors prefer high dividend payout companies, > companies maybe reluctant to invest If a company is paying low dividend, it may be signalling that: It is optimistic about future growth opportunities It is pessimistic about keeping up its profitability in the future Is a high dividend paying company giving a bad signal? Usas, no! Technology co., yes!

Ülkemizde temettü esasları Halka açık anonim ortaklıkların temettü dağıtım yükümlülüğü ve temettü avansı dağıtımına ilişkin esaslar 13.11.2001 tarih ve 24582 sayılı Resmi Gazete’de yayınlanan Seri:IV, No:27 sayılı “Sermaye Piyasası Kanununa Tabi Olan Halka Açık Anonim Ortaklıkların Temettü ve Temettü Avansı Dağıtımında Uyacakları Esaslar Hakkında Tebliğ” ile düzenlenmiştir. Hisse senetleri borsada işlem gören ortaklıklarda birinci temettü oranı ve temettü dağıtımı Ortaklıkların birinci temettü tutarı, hesap dönemi kârından kanunlara göre ayrılması gereken yedek akçeler ile vergi, fon ve mali ödemeler ve varsa geçmiş yıl zararları düşüldükten sonra kalan dağıtılabilir kârın %20’sinden az olamaz. Temettü dağıtım zamanı Temettü dağıtımı, ortaklıklarca hesap dönemini izleyen 5 inci ayın sonuna kadar tamamlanmak zorundadır.

Temettü İlanı ARCLK Arçelik A.Ş.’nin 24.04.2003 tarihinde yapılan Olağan Genel Kurul Toplantısı’nda, 2002 yılı karından 72.720 milyar TL (%50) tutarında kar payının hisse senedi olarak, 72.720 milyar TL (%50 oranında, 1.000 TL nominal değerli beher hisseye 500 TL ve brüt=net) tutarında kar payının ise nakit olarak dağıtılmasına ve dağıtım tarihinin 28.05.2003 olarak belirlenmesine karar verildiği, bildirilmiştir.                

ARCLK Arçelik A.Ş.’nin çıkarılmış sermayesinin 181.800 milyar TL iç kaynaklardan, 72.720 milyar TL 2002 yılı kar payından karşılanmak suretiyle toplam 254.520 milyar TL (%175) bedelsiz artırılarak 145.440 milyar TL’den 399.960 milyar TL’ye yükseltilmesine ilişkin hisse senetlerinin ve %50 oranındaki nakit kar paylarının 28.05.2003-29.08.2003 tarihleri arasında aşağıdaki adreslerde, bu tarihten sonra ise sadece şirket merkezinde dağıtılacağı, iç kaynaklardan karşılanan hisse senetlerinin dağıtımının 11 nolu yeni pay alma kuponları, kar payından karşılanan hisse senetleriyle nakit kar paylarının dağıtımının ise 2002 yılı kar payı kuponları karşılığında yapılacağı bildirilmiştir. Ortaklara bedelsiz hisse senedi dağıtımı ve kar payı ödeme duyurusu ekte yayınlanmaktadır. Başvuru Yerleri: Şirket Merkezi, Tuzla, İstanbul Koç Yatırım Menkul Değerler A.Ş., Harbiye, İstanbul Bütün Koçbank Şubeleri                

Dividend Policy Define dividend policy as the choice between: 1) Retained earnings 2) Dividends and issuing new equity to pay for additional dividends. Notice that dividend policy holds firm's investment decisions and borrowing decisions as given.

Mature = high, growth = low The Dividend Decision Lintner’s Model (1956) Firms have long term target dividend payout ratios. Mature = high, growth = low 2. Managers focus more on dividend changes than on absolute levels. $2 div. is an important financial decision if last year’s was $1, but not so if it was $2. 18

3. Dividend changes follow shifts in sustainable levels of earnings. 4. Managers are reluctant to make dividend changes that might have to be reversed. (Managers smooth div.) Higher the conservativeness ....lower the adjustment factor Tested by Fama & Babiak (Dec 68): adj. factor= 0.33, target=0.5 18

However, accountants are creative! (Enron) This model implies that firms only increase dividends if earnings per share is expected to be higher. Consequently, changes in dividends provide information about next period's earnings per share. Div cuts => future earnings down => stock price goes down Div rise => future earnings up => stock price goes up However, accountants are creative! (Enron) Dividends provide information. If div is continuous and generous then earnings quality is good.

Rightists claim dividends are good - Bird-in-the-Hand Fallacy Are dividends good or bad? More specifically, what should be the dividend policy of the firm? Rightists claim dividends are good - Bird-in-the-Hand Fallacy Argue that dividends are worth more than capital gains, since high and constant dividends will reduce the risk to the shareholders. - Market discipline - Information effect => Higher dividends higher firm value.

Leftists: Dividends are bad - Taxes Since capital gains are taxed at a lower rate than dividend income, companies should pay the lowest dividend possible. - Transaction costs => Higher dividends lower firm value.

Middle of the roaders Modigliani & Miller Black & Scholes - If companies should increase their share price by distributing more or less cash dividends, why have they not already done so? - Supply effect, there are enough firms meeting demands of high and low dividend seeking clientele - Whatever effects there are these are small - Perfect cap. markets Black & Scholes Imperfections

DIVIDEND IRRELEVANCY Does the dividend policy affect shareholders' wealth? In (perfect) efficient capital markets share price falls dollar for dollar with dividends, however the shareholders' wealth is unchanged. The fall in the share price is exactly offset by the dividend check the shareholder receives. Remember that dividends are financed by issue of new shares. In an (perfect) efficient capital market, the new shareholders acquire claims on the firm exactly equal to what they paid for. Consequently, the old shareholders given up claims on the firm (to the new shareholders) exactly equal to the value of the dividends they receive. Thus, assuming no taxes or transaction costs (and no info. costs), the only necessary condition for dividend irrelevancy proposition is that capital markets must be efficient (i.e., information efficient). We will consider additional complications such as taxes and transactions costs later on.

On ex-dividend day, stock price must fall exactly by the dividend paid. P(ON) = P(EX) + DIV Q: What if P(ON) < P(EX) + DIV A: Buy a share before the record day, get the dividend and sell the share on the ex-dividend day Cost = P(ON) Revenue = P(EX) + DIV Profit = Revenue - Cost = P(EX) + DIV – P(ON) > 0 by assumption. Since everyone would do the same, P(ON) < P(EX) + DIV cannot be true. Similarly P(ON) > P(EX) + DIV cannot be true!

Example 1 ABC wants to pay $2 a share dividends Example 1 ABC wants to pay $2 a share dividends. Stock price of ABC is $10.00, and ABC has 1,000,000 shares outstanding. - Find shareholders' wealth before and after dividends. - Find share price after dividends - How much new equity must be issued to finance the dividends? Sol'n: At $2 a share for 1,000,000 shares, ABC needs $2 million today for dividends. Notice that new shareholders are not entitled to dividends thus they will pay the ex-dividend price for each new share. P(EX) = $10 - $2 = $8. To raise $2 million 2,000,000/8 = 250,000 new shares must be sold.

Old shareholders’ wealth before dividends: = $10 x 1,000,000 = $10M. After dividends: = ($8) (1,000,000) + $2,000,000 = $10M. Old shareholders’ wealth is unchanged. Firm value after dividends: = ($8) (1,250,000) = $10M Firm value is unchanged. New shrholders’ wealth = ($8) (250,000) = $2M New shrholders’ wealth is unchanged. This is what is meant by dividend irrelevancy proposition.

Example 2 Now suppose that the firm has a positive net present value project worth $2 million. The project requires an investment of $2 million. A) Assume that the firm takes the project and then pays dividends. B) Assume that the firm foregoes the project to pay dividends. How does your answer change?

(A). Stock price with investment will increase by NPV per share (A) Stock price with investment will increase by NPV per share! After the investment, stock price will be $12. To raise $2M, 2,000,000/12 = 166,666 new shares have to be sold Firm value = (12) (1,166,666) = $14M Firm value increases by $4M $2M due to positive NPV of project $2M due to additional shares sold to finance the investment

(1) Old shareholders’ wealth = 12 (1M) = $12M Old shareholders’ wealth goes up by $2M. Old shareholders capture the entire NPV of project. (2) New shareholders’ wealth = 166,000 (12) = $2M Same as before. Now pay dividends by selling new shares to 3rd group of shareholders. Dividends = $2 per share for 1,166,666 shares = $2,333,332 needed.

The (3) group is not entitled to dividends The (3) group is not entitled to dividends. Thus they will only pay ex-dividend price  Ex-dividend price = 12 - 2 = $10  233,333 new shares must be sold Wealth of 2nd group SH: = 166,666 (10 + 2) = $2M Wealth of 1st group SH: = 1,000,000 (10 + 2) = $12M Paying dividends does not change the wealth of ‘old’ shareholders. (B) If we forego the project, we go to Example (1). Old shareholders will suffer a loss of wealth of $2M, equal to the NPV of project.

Notice that as long as taxes and transactions costs are ignored, dividend policy doesn’t change [firm value] (or shareholders’ wealth) this is called M&M dividend irrelevancy proposition after Modigliani and Miller.

Transactions costs, taxes, and dividends: Investors who desire a steady income may prefer dividends to capital gains, since dividends relieve them from having to sell some shares. For individuals, dividends are taxed at ordinary tax rates whereas capital gains are taxed at 40% of the ordinary tax rate. (Long term (> 1 year) realized capital gains. No taxes are paid on unrealized capital gains). Thus taxable individuals would prefer capital gains income over dividend income. Greater the tax rate, greater the preference for capital gains. Miller & Scholes suggest a way individuals can avoid paying taxes on dividends. Tax-laws allow interest expense as tax deductions. The idea is to borrow and establish interest deductions. Invest your borrowed amount in stocks.

Example: Value of portfolio = $10,000 5% dividend yield = $500 in dividends 5% capital gains = $500 in cap. gains Borrow $20,000 and buy more stock Interest rate is 7.5% Dividend income = 30,000 (0.05) = 1,500 Capital gains = 30,000 (0.05) = 1,500 Interest expense = 20,000 (0.075) = 1,500 Hence interest expense exactly offsets dividend income  no tax liability on dividends.

Corporations on the other hand would prefer dividend income Corporations on the other hand would prefer dividend income. For corporations 85% of dividends are excluded from taxation (80% after 1986). Realized capital gains are taxed at 30% (34% after 1986). However, tax-exempt institutions such as universities, pension funds do not care about dividends versus cap. gains. Black & Scholes argue that while there may be demand for high and low dividend policies, it is possible that firms will cater to these needs so that there is no unsatisfied clientele. Any given firm would not find it beneficial to switch dividend policy if there are no unsatisfied clienteles.

Black and Scholes test this idea: What would you expect  to be if investors did not like dividends. Why? Black & Scholes (1974) find that on average   0 Consequently, the market capitalization rate is unrelated to the dividend yield. Investors are indifferent to dividends.

When dividends are taxed more heavily than capital gains, high dividend paying stock must sell at a lower price in order to provide the same after-tax return.

TAM MÜKELLEF KURUM TAM MÜKELLEF GERÇEK KİŞİ HİSSE SENEDİ TEMETTÜ GELİRİ -Tam mükellef kurumlardan elde edilenler kurumlar vergisinden istisna. - Kar payı stopajına tabi değil . -Tam mükellef kurumlardan elde edilenlerin 1/2 si gelir vergisinden istisna. (GVK’nun Geçici 62 nci maddesinde belirtilenler hariç) (16) -Stopaja tabi tutulmuş, beyana tabi diğer menkul sermaye iratları, gayrimenkul sermaye iratları ve birden fazla işverenden alınmış ücretlerle birlikte (2003 yılı için) 12.000.000.000 TL’yi aşarsa gelirin tamamı beyan edilir. (1) HİSSE SENEDİ ALIM SATIM KAZANCI -Kurumlar Vergisi (fon payı dahil, % 33) (2) -İvazsız olarak iktisap edilenler ile İMKB’de işlem gören ve 3 aydan fazla elde tutulanlar vergiye tabi değil. (5) - IMKB de işlem görmeyenlerden tam mükellef kurumlara ait olup (1) yıldan fazla elde tutulanlar vergiye tabi değil. -İktisap bedeli, sadece, elden çıkarılan ay hariç olmak üzere TEFE artış oranıyla endekslenebilir. -Enflasyon indirimi uygulanmaz. - Alım satım zararları, alım satım karlarına mahsup edilir. (17) -Diğer menkul kıymet alım satım kazançlarıyla birlikte 10 milyar TL’yi aşarsa, aşan kısım beyan edilir. (1)

Policy implications 1) The evidence shows that investors do not like sudden changes in dividends. Clientele effect implies that you attract investors who most prefer your dividend policy. Thus, sudden changes in dividends will disturb your shareholders who will have to readjust their portfolio. 2) Reduce dividends to minimize reliance on external capital. This will minimize situations where you pay dividends and at the same time issue new equity. Remember that retained earnings do not involve any issue costs. 3) Evidence also shows that the discount rate is independent of the dividend yield. As a manager, you can ignore the effect of dividend yield on your investment projects. 4) As a shareholder, you would be best off by ignoring dividend yield. Concentrating on low dividend stocks also implies that you concentrate your holdings on high risk stocks only. This prevents you from holding a well-diversified portfolio, which may be more costly. Use Miller-Scholes suggestion to offset any potential tax liability on dividends.

ISE Listed Companies Net Gross Payout TL Bn Profit / Loss Dividend Ratio 1996 382,083 31,561 28,765 8% 1997 857,055 35,599 29,894 4% 1998 1,338,027 611,327 431,955 46% 1999 1,625,761 610,599 590,221 38% 2000 2,033,555 669,256 650,013 33% 2001 -4,014,863 681,589 667,024 n.m. 2002 4,138,000 931,170 900,704 23%

Reading Why is dividend yield so low?