Lecture 10: Corporate Equity, Earnings and DividendsThe CorporationFor-Profit vs. Non-ProfitCommon vs. Preferred StockLimited LiabilityOther Corporate ObligationsVoting of Common SharesBerle and MeansPayment of DividendsModigliani-Miller Dividend Irrelevance TheoryAdding Taxes to M&M WorldWhy Do Firms Pay Dividends?Dividend SignallingLintner Model of DividendsKahneman & Tversky Framing ExampleK&T Framing ContinuedGeneral Public Utilities CorpS&P D/E & D/P 1871-2004Share RepurchaseReasons for Share RepurchaseEmployee Options and Share RepurchaseReasons for Declining Dividend, Earnings Yield in New MillenniumLecture 10: Corporate Equity, Earnings and DividendsThe 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)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.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.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.Other Corporate Obligations•Convertible bonds: bondholder has option to convert the bond to stock•Employee incentive options•Tracking stock•Junk bonds•Warrants•Partnership contractsVoting 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 circusesBerle 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.Payment of Dividends•Purely discretionary•Young firms typically pay none•NASDAQ dividend yield virtually zero•Corporate culture influences dividends. Microsoft•Liquidity constraints on dividendsModigliani-Miller Dividend Irrelevance Theory•Journal of Business, 1961.•Assume no taxes or transactions costs•Consider purely financial transaction: selling shares to pay dividends•M&M Conclusion: Dividend policy has no effect on the value of the firm.•Purely nominal difference between dividend checks and repurchase checks.Adding Taxes to M&M 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.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 incomeDividend Signalling•By raising dividends, firm shows it can court bankruptcy.•Battacharya, Hakansson, Ross•Problem: alternative signalling methods are cheaper tax-wiseLintner Model of Dividends•DIVt-DIVt-1= ( × EPSt-DIVt-1) =adjustment rate, 0< <1=target ratio, 0< <1D I V E P Stkkt k   ( )10Kahneman & 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)K&T 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 1981General 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 reactionS&P D/E & D/P 1871-2004Share Repurchase•Once rare, now S&P 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.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.Employee Options and Share Repurchase•The “overhang,” percent of stock market promised to employees via options, stood at 6.2% in 144 of largest S&P 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.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