Lecture 10: Corporate Equity, Earnings and Dividends

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Lecture 10 Corporate Equity, Earnings and
Dividends
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The Corporation

• 1611 A body corporate legally authorized to act
  as a single individual, an artificial person
  created by royal charter, prescription, or act of
  legislature, and having authority to preserve
  certain rights in perpetual succession. (OED)
• Compare publicani of ancient Rome, essentially
  corporations (though the most prominent were
  private collecting agencies for taxes)

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For-Profit vs. Non-Profit

• For-profit corporation is owned by shareholders,
  equal claim after debts paid, subject to
  corporate profits tax.
• Non-profit is not owned, self-perpetuating
  directors. Not subject to corporate profits tax.

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Common vs. Preferred Stock

• Common stock dividend is at discretion of firm,
  subject to legal restrictions
• Preferred stock Specified dividend does not have
  to be paid, but firm cannot pay dividend on
  common stock unless all past preferred stock
  dividends are paid.
• Corporate bonds Firm is contractually obligated
  to pay coupons and there is a maturity date when
  principal must be paid.

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Limited Liability

• Even publicani had some form of limited liability
  sometimes
• New York State legislature made limited liability
  standard for all corporations, 1811
• Standard copied by other states, finally
  California, 1931.

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Other Corporate Obligations

• Convertible bonds bondholder has option to
  convert the bond to stock
• Employee incentive options
• Tracking stock
• Junk bonds
• Warrants
• Partnership contracts

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Voting of Common Shares

• Usually one share one vote, in person or by
  proxy, for board of directors and some other
  essential matters
• Shareholders meetings usually annual event, and
  required by law for big events such as merging
  corporation
• Shareholder meeting circuses

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Berle and Means

• Adolf A. Berle Jr., and Gardiner C. Means, The
  Modern Corporation and Private Property, 1933
• Separation of ownership and control
• ownership is so widely scattered that working
  control can be maintained with but a minority
  interest.
• The quasi-public corporation is constrained by
  law to serve other interests.

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Payment of Dividends

• Purely discretionary
• Young firms typically pay none
• NASDAQ dividend yield virtually zero
• Corporate culture influences dividends. Microsoft
• Liquidity constraints on dividends

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Modigliani-Miller Dividend Irrelevance Theory

• Journal of Business, 1961.
• Assume no taxes or transactions costs
• Consider purely financial transaction selling
  shares to pay dividends
• MM Conclusion Dividend policy has no effect on
  the value of the firm.
• Purely nominal difference between dividend checks
  and repurchase checks.

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Adding Taxes to MM World

• Dividends are taxable as personal income, share
  repurchases are capital gains, lower rate.
• Announcing payment of new dividends should lower
  value of firm by present value of taxes.

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Why Do Firms Pay Dividends?

• Hersch Shefrin and Meir Statman Self-control
  theory of dividends. (analogy to Christmas clubs,
  overwithholding) Rule of thumb spending rule.
• Prospect theory interpretation framing matters.
  Dividends framed as income.
• University endowments once required high-yield
  investments to provide income

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Dividend Signalling

• By raising dividends, firm shows it can court
  bankruptcy.
• Battacharya, Hakansson, Ross
• Problem alternative signalling methods are
  cheaper tax-wise

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Lintner Model of Dividends

• DIVt-DIVt-1 ?(? EPSt-DIVt-1)
• ?adjustment rate, 0lt ?lt1
• ?target ratio, 0lt ?lt1

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Kahneman Tversky Framing Example

• US is preparing for a rare Asian disease which
  is expected to kill 600 people.
• If Program A is adopted, 200 people will be
  saved. If program B is adopted, there is a 1/3
  probability that 600 people will be saved and a
  2/3 probability that no people will be saved.
  (Majority A)

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KT Framing Continued

• Other respondents given a different choice
• If program C is adopted, 400 people will die If
  Program D is adopted, there is a 1/3 probability
  that no one will die, and a 2/3 probability tha
  600 people will die. (Majority D) Scientific
  American 1981

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General Public Utilities Corp

• President Kuhn proposed to substitute stock
  dividends for cash dividends, and offered to sell
  the stock dividend for any stockholder for
  minimal transaction cost. (ca. 1968)
• Direct saving to shareholder 4 million a year.
• Intense negative shareholder reaction

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SP D/E D/P 1871-2004
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Share Repurchase

• Once rare, now SP 500 firms repurchase approx.
  2 of shares per year. They issue about 1 of
  shares per year in employee option exercise, so
  net repurchase is about 1 per year.
• Repurchase now almost as high as dividends paid,
  but firms still pay dividends. A puzzle.

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Reasons for Share Repurchase

• Tax break for investors
• Firms unwillingness to cut dividends,
  uncertainty that current earnings will continue
• Price pop after a repurchase. Buybacks taken as a
  signal. But price pops are fading.
• Now investors sometimes view repurchase as a sign
  that firm is old economy. NASDAQ firms less
  likely to repurchase shares, as if they think
  value is too high.

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Employee Options and Share Repurchase

• The overhang, percent of stock market promised
  to employees via options, stood at 6.2 in 144 of
  largest SP 500 firms in 1998.
• Option holders have an interest in repurchasing
  shares rather than paying dividends.
• Lambert Lanen Larker JFQA 1985 dividend
  payouts reduced after option plans introduced.

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Reasons for Declining Dividend, Earnings Yield in
New Millennium

• Perception of great growth opportunities with new
  technology
• First-mover advantage prized
• Dividends, Earnings are for losers
• Problem in valuing firms