Increasing Shareholder Value: Distribution Policy, A Corporate Finance Challenge

148 Pages·2001·8.304 MB·English

by  Harold Bierman Jr. (auth.)

INCREASING
SHAREHOLDER VALUE
Distribution Policy, A Corporate
Finance Challenge
INCREASING
SHAREHOLDER V ALUE
Distribution Policy, A Corporate
Finance Challenge
by
Harold Bierman, Jr.
The Nicholas H Noyes Professor ofB usiness Administration
The Johnson Graduate School ofM anagement
Cornell University
Ithaca, New York
SPRINGER SCIENCE+BUSINESS MEDIA, LLC
Library of Congress Cataloging-in-Publication Data
Bierman, Harold.
Inereasing shareholder value:distribution poliey, a eorporate finanee ehallenge Iby
Harold Bierman, Jr.
p.em.
Includes bibliographieal referenees and index.
ISBN 978-1-4613-5587-8 ISBN 978-1-4615-1505-0 (eBook)
DOI 10.1007/978-1-4615-1505-0
1. Corporate profits. 2. Ineome distribution. 3. Investments--Valuation. 4.
Corporations--Finanee. 5. Stoekholders. I.Title
HG4028.P7 B54 2001
658.15'5--de21
2001038524
Copyright @) 2001 Springer Science+Business Media New York
Originally published by Kluwer Academic Publishers in 2001
Softcover reprint of the hardcover 1s t edition 2001
AII rights reserved. No part of this publication may be reproduced, stored in a
retrieval system or transmitted in any form or by any means, mechanical, photo
copying, record ing, or otherwise, without the prior written permission of the
publisher, Springer Science+Business Media, LLC.
Printed on acid-free paper.
TABLE OF CONTENTS
Preface vii
1. An Overview ofCorporate Distribution Policy .
2. Dividends Versus Retained Earnings 3
3. Dividends Versus Share Repurchase 21
4. Share Repurchase and Stock Price 43
5. Choosing Between Real Investments and Share Repurchase 67
6. The Return Earned by Share Repurchase 77
7. Share Repurchase and Earnings Per Share Buyback Parity 85
8. A Dividend Reduction Strategy 97
9. The Investor's Viewpoint.. III
10. Dividend Reinvestment Plans (DRIP's) 123
11. RepurchaseofShares Accompanied bythe SellingofPuts 131
12. A Ranking ofAlternatives 137
Index 149
Increasing Shareholder Value
Distribution Policy, a Corporate Finance Challenge
Preface
Corporations earn incomes and amass wealth. There are many
books offering advice how to increase the profitability ofcorporations
by achieving excellence in operations and choosing the correct strategic
path. This book is concerned with how the corporation should reward
its shareholders after the incomes are earned.
Chapters where there are potentially complex mathematical
relationships are divided into two parts. The body of the chapter has
the relevant basic conclusions and numerical examples. The appen-
dices to the chapter contains the derivation of the formulas that are
used, ifthe derivations are not relatively intuitive. The appendices can
be skipped if you are willing to accept the formulas used in the
chapters.
Harold Bierman, Jr.
Cornell University
Ithaca, New York
Chapter 1
An Overview ofCorporate Distribution Policy
The managing director (MD) of one ofthe world's five largest
investment banks was teaching a real live case in my finance case
course. He concluded that the healthy firm being discussed should
reduce or eliminate its dividend on its stock. A visiting professor who
was subject to pontification raised his hand and when called on asked,
in a supercilious tone, the MD whether or not he was aware that all the
empirical academic research indicated that on the average the stock
price offirms that reduced dividends suffered declines compared to the
market and that he (the MD) mistakenly advocated a dividend decrease.
Ifyou agree with the visiting professor that on the average divi
dend decreases are accompanied by negative stock price effects, you
are on solid ground. However, if you conclude that therefore any
specific firm should not reduce its dividend, then you should continue
reading this book. Empirical studies of the effects of dividend
decreases on stockprices tell us nothing about what a board ofdirectors
should decide on reviewing a specific firm's dividend policy.
The Choices
Business corporations attempt to make profits and increase the
value of the stockholder's position. Management makes capital
structure, working capital, investment, marketing, operations and
personnel decisions with that objective in mind. But there is one
important element missing in the above listing. How should the equity
investors be rewarded?
This book focuses on the distribution policy decisions of
corporations as they affect shareholders. After a corporation makes a
profit what is the best way to transmit the benefits to the shareholders?
What is the economic importance to investors of this distribution
decision?
In choosing a distribution policy a corporation has a wide range
ofchoices. This book will considerthe following alternatives:
2 Increasing Shareholder Value
1. Retained earnings
2. Cash dividends
3. Share repurchase
4. Dividend reinvestment plan (DRIP)
5. Stock dividends
6. Sale ofbusiness (combined with retained earnings)
7. Bond interest
8. Preferred stock dividends
It probably is not obvious why all of the above items are
included. The above list has to be explained. We will, at times, shift
the firm's objective from maximizing the value of the stockholder's
position to increasing the firm's value to all its capital investors.
This latter objective will be consistent with maximizing the
value ofthe stockholders, but will be somewhat broader.
Chapter 2
Dividends Versus Retained Earnings
This chapter assumes a corporation has excess cash and retained
earnings. We will only consider two alternatives:
a. the corporation pays a cash dividend
b. the corporation adds to its retained earnings.
The term "excess cash" means the corporation has cash in
excess of maintenance capital expenditures and high priority other
capital expenditures. Should it pay a cash dividend? Black (1976)
defined the puzzle that exists since corporations pay dividends when
logic seems to indicate that they should not.
A corporation is not legally obligated to declare a dividend of
any specific amount. Thus, a firm's board of directors actually has
made a specific distribution decision every time a dividend is declared.
However, once the board declares a dividend, the corporation is legally
obligated to make the payments. Therefore, a dividend should not be
declared unless a corporation is in a financial position to make the
payment.
The expectation ofreceiving dividends (broadly defined as any
distribution of value) ultimately determines the market value of the
common stock. By declaring a dividend, the board of directors is not
only turning over some of the assets of the corporation to its
stockholders, but it may be influencing the expectations that
stockholders have about the future dividends they can expect from the
corporation. Ifexpectations are affected, the dividend decision and the
underlying dividend policy will have an impact on the value that the
market places on the common stock ofthe corporation.
Many financial experts believe that a stable dividend results in a
higher stock price. A common reason for this beliefis that some stock
holders prefer a steady cash flow stream from their investments. There
is at least one other reason for thinking that a variable dividend rate
may not be in the best interest ofa company. In the long run, the value
of a share of stock tends to be determined by the discounted value of
4 Increasing Shareholder Value
the expected dividends or other cash flows. Insofar as this is the case, a
fluctuating dividend rate will tend to make it difficult for the pro
spective stockholders to determine the value ofthe stock and the stock
is likely to sell at a lower price than comparable stocks paying the same
average dividend through time but making the payments at a steady
rate. This conclusion assumes that investors are risk averse and have
incomplete information about the company.
Factors Affecting Investor Reaction to Dividends
Traditional concepts about the distinction between income and
capital, some of which have been embodied into laws that control the
behavior of certain financial institutions, are important considerations
in understanding how these investors react to corporate dividend
decisions and policies. The more recent and sophisticated thinking
about financial matters tends to emphasize the total return received
from an asset and to ignore distinction between capital gains and other
forms of income except insofar as they affect taxes. Thus, we will
focus on the tax consequences ofalternative strategies.
Suppose that an investor held shares ofCompany A and shares
ofCompany B. At the beginning ofthe year, the shares in both ofthe
companies were selling for $50. During the year, Company A paid a
dividend of $3 per share, and the stock was selling for $52 a share at
the end ofthe year. Company B paid no dividend but the stock in that
company was selling for $56 per share at the end ofthe year. The total
return approach considers that the stockholders had received a return of
$5 per share from Company A and $6 a share from Company B. The
next step is to consider the after-tax returns from the two investments.
The total return approach treats the market value of the
securities held and dividends received as one pool of liquid assets that
can be divided up at each decision point into consumption and further
investment. The fact that some ofthe liquid assets available have come
from dividends and others from a change in the value ofthe investment
would be of secondary importance if there were no taxes and no
transaction costs.
Chapter 2 5
There are some investors who approach these same events with
a very different point of view and conclude that there is an important
distinction between income and capital gains. Stockholder return is
typically defined as the sum of dividends and interest. Investors who
think of only dividends as the return often are quite comfortable in
consuming part or all of their dividend but are very uncomfortable
about having to dispose ofsome oftheir securities in orderto consume.
Ifdividends are considered to be the only income from common
stock, and if this concept is embodied in legal concepts, then the
amount of cash dividends will tend to influence the likelihood of a
company's shares being purchased by this segment ofthe market.
Suppose that a wealthy man specifies in his will that the income
from his estate is to go to his wife during her lifetime but that the
capital is to be preserved and applied for the benefit of their children
after his wife passes away. If the estate is large, a bank trust
department will frequently be appointed as trustee to carry out the
intentions ofthe person creating the will. There are billions ofdollars
of assets managed by bank trust departments under the terms of trust
agreements that are basically similar to the one described. In many of
these cases, only dividends and interest are considered to be income.
The distinction between dividends and capital gains is also
reinforced by tax laws that define the receipt ofdividends or interest as
a taxable event. By contrast, changes in the value ofcommon stock are
not taxable events unless, and until, the securities are actually sold.
One further institutional factor that should be mentioned in
connection with dividends is the so-called trust legal list. Banks,
insurance companies, and other financial institutions, as well as
individual trustees, often manage substantial sums for the benefit of
others. Over the years, many states have passed laws designed to
ensure that the beneficiaries ofthese assets do not incur losses because
trustees have purchased excessively risky investments for the trust.
Various controls have been designed to accomplish this end. One is to
restrict the kinds of assets that are eligible for considerations
investments by a particular kind oftrustee or financial institution. Such
a list of eligible assets is called a trust legal list. The laws do not
specify the particular securities that are eligible for inclusion on the
legal list but rather the characteristics that a security must possess in
order to be eligible. A state official is responsible for determining