Stock Distributions and the Market Reaction How can we tell what the motivation is behind stock dividends, stock
Stock Distributions and the Market Reaction How can we tell what the motivation is behind stock dividends, stock
splits, and reverse splits? We can’t. But we can get a general idea of how investors interpret these actions by looking at what happens to the firm’s share price when a corporation announces its decision to pay a stock dividend, split its stock, or reverse split. If the share price tends to go up when the announcement is made, the decision is probably good news; if the price goes down, the stock dividend is probably bad news. This is supported by evidence that indicates firms’ earnings tend to increase following stock splits and dividends. 11
The share price of companies announcing stock distributions and stock splits generally increase at the time of the announcement. 12 The most likely explanation is that this distribution is interpreted as good news—that management believes that the future prospects of the firm are favorable or that the share price is more attractive to investors.
The stock price of companies announcing a reverse stock split usu- ally decreases at the time of the announcement. 13 The most likely expla- nation for this decrease is that the firm is unable to increase the share price in any way other than through a reverse split. That is, the pros- pects of the firm are so bleak that this is the only way to increase the share price.
11 See, for example, Maureen McNichols and Ajay Dravid, “Stock Dividends, Stock Splits, and Signaling,” Journal of Finance (July 1990) pp. 857–879.
12 The stock price typically increases by 1 to 2% when the split or stock dividend is announced. When the stock dividend is distributed or the split is effected (on the
“ex” date), the share’s price typically declines according to the amount of the distri- bution. Suppose a firm announces a 2:1 split. Its share price may increase by 1 to 2% when this is announced, but when the shares are split, the share price will go down to approximately half of its pre-split value. See, for example, Mark Grinblatt, Ronald Masulis, and Sheridan Titman, “The Valuation Effects of Stock Splits and Stock Dividends,” Journal of Financial Economics (December 1984), pp. 461–490.
13 See, for example, David Peterson and Pamela Peterson, “A Further Evidence of Stock Distributions: The Case of Reverse Stock Splits,” Journal of Financial Re-
search (Fall 1992), pp. 189–206.
Common Stock
EXHIBIT 16.2 Dividends per Share and Dividend Payout for the Cooper Tire &
Rubber Company, 1980–2001
Source: Value Line Investment Survey Dividend Policy
A dividend policy is a firm’s decision about the payment of cash divi- dends to shareholders. Looking at the dividends per share and the divi- dend payout at a point in time doesn’t tell us much about the firm’s dividend policy. We generally need somewhat more information than one quarter’s or one year’s dividend. If we look at dividends over a longer period, we can begin to get a better picture of the firm’s dividend policy.
There are several basic ways of describing a firm’s dividend policy: ■ No dividends
■ Constant growth in dividends per share ■ Constant payout ratio ■ Low regular dividends with periodic extra dividends
The firms that typically do not pay dividends are those that are gener- ally viewed as younger, faster growing firms. For example, as of 2002, firms such as Microsoft Corporation (computer software), Amgen (bio- technology), and Amazon.com (internet retailer) had never paid dividends.
A common pattern of cash dividends tends to be the constant growth of dividends per share. As we see for Cooper Tire and Rubber in Exhibit
16.2, dividends per share grew at a constant rate after 1986 and until 1999.
FINANCING DECISIONS
EXHIBIT 16.3 Dividends per Share and Dividend Payout for the Sara Lee
Corporation, 1980–2001
Source: Value Line Investment Survey Another pattern is the constant payout ratio, as exhibited in Exhibit
16.3 by the Sara Lee Corporation. Sara Lee’s dividend payout is around 40% each year, with the most noticeable deviation occurring when it paid a special dividend in 1992. Many other companies in the food pro- cessing industry, such as Kellogg and Tootsie Roll Industries, pay divi- dends that are a relatively constant percentage of earnings.
Some companies display both a constant dividend payout and a con- stant growth in dividends. The dividends per share and dividend payout of General Electric common stock over the years 1980 through 2001 are graphed in Exhibit 16.4. Dividends per share grew steadily throughout much of this period. Looking at the dividend payout in this same figure, we see that it has been relatively constant throughout the period as well. This type of dividend pattern is characteristic of large, mature companies that have predictable earnings growth—the dividends growth tends to mimic the earnings growth, resulting in a constant payout.
U.S. corporations that pay dividends tend to pay either constant or increasing dividends per share. Dividends tend to be lower in industries that have many profitable opportunities to invest their earnings. But as
a company matures and finds fewer and fewer profitable investment opportunities, a greater portion of its earnings are paid out in dividends.
Common Stock
EXHIBIT 16.4 Dividends per Share and Dividend Payout for the General Electric
Corporation, 1980–2001
Source: Value Line Investment Survey Many firms are reluctant to cut dividends because the firm’s share
price usually falls when a dividend reduction is announced. 14 For exam- ple, the U.S. auto manufacturers cut dividends during the recession in the early 1990s, as illustrated in Exhibit 16.5 by General Motors (Panel
A) and Ford Motor Company (Panel B). As you can see in these graphs, as earnings per share declined the auto makers did not cut dividends until EPS were negative—and in the case of GM, not until it had experi- enced two consecutive loss years. But as earnings recovered in the mid- 1990s, dividends were increased. Firms tend to only raise their regular quarterly dividend when they are sure they can keep it up in the future. By giving a special or extra dividend, the firm is able to provide more cash to the shareholders without committing itself to paying an increased dividend each period into the future. Let’s look at an example. The fortunes of Longview Fibre, a timber growing and harvesting firm,
14 A number of studies have documented the fall in share price that accompanies a cut in dividends. See, for example, Richardson Pettit, “Dividends Announcements,
Security Performance, and Capital Market Efficiency,” Journal of Finance (Decem- ber 1972), pp. 86–96; and Joseph Aharony and Itzhak Swary, “Quarterly Dividend and Earnings Announcements and Stockholders’ Returns: An Empirical Analysis,” Journal of Finance (March 1980), pp. 1–12]. But just how much the share price falls depends on the reasons for the cut; see J. Randall Woolridge and Chinmoy Gosh, “Dividend Cuts: Do They Always Signal Bad News?” Midland Journal of Corporate Finance (Summer 1985), pp. 20–32.
FINANCING DECISIONS
vary depending on construction demand and timber cutting availability on public land, both of which are quite uncertain. Longview Fibre pays
a regular quarterly dividend around $0.10 a share, but also may pay special dividends that vary according to its earnings.
EXHIBIT 16.5 Dividends and Earnings per Share for General Motors and Ford
Motor Company, 1980–2001 Panel A: General Motors
Panel B: Ford Motor Company
Source: Value Line Investment Survey
Common Stock
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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