18

Dividends and Dividend Policy

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 Key Concepts and Skills
 Understand dividend types and how they
are paid
 Understand the issues surrounding
dividend policy decisions
 Understand the difference between cash
and stock dividends
 Understand why share repurchases are an
alternative to dividends

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 Chapter Outline
 Cash Dividends and Dividend Payment
 Does Dividend Policy Matter?
 Some Real-World Factors Favoring a Low Payout
 Some Real-World Factors Favoring a High Payout
 A Resolution of Real-World Factors
 Establishing a Dividend Policy
 Stock Repurchase: An Alternative to Cash Dividends
 Stock Dividends and Stock Splits

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 Cash Dividends
 Regular cash dividend – cash payments made
directly to stockholders, usually each quarter
 Extra cash dividend – indication that the “extra”
amount may not be repeated in the future
 Special cash dividend – similar to extra
dividend, but definitely won’t be repeated
 Liquidating dividend – some or all of the
business has been sold

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 Dividend Payment
 Declaration Date – Board declares the dividend and it
becomes a liability of the firm
 Ex-dividend Date
 Occurs two business days before date of record
 If you buy stock on or after this date, you will not receive
the dividend
 Stock price generally drops by about the amount of the
dividend
 Date of Record – Holders of record are determined and
they will receive the dividend payment
 Date of Payment – checks are mailed

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Figure 18.2

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Does Dividend Policy Matter?
 Dividends matter – the value of the stock is
based on the present value of expected future
dividends
 Dividend policy may not matter
 Dividend policy is the decision to pay dividends
versus retaining funds to reinvest in the firm
 In theory, if the firm reinvests capital now, it will grow
and can pay higher dividends in the future

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 Illustration of Irrelevance
 Consider a firm that can either pay out dividends of
$10,000 per year for each of the next two years or can
pay $9,000 this year, reinvest the other $1,000 into the
firm and then pay $11,120 next year. Investors require
a 12% return.
 Market Value with constant dividend = $16,900.51
 Market Value with reinvestment = $16,900.51
 If the company will earn the required return, then it
doesn’t matter when it pays the dividends

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 Low Payout Please
 Why might a low payout be desirable?
 Individuals in upper income tax brackets might
prefer lower dividend payouts, given the immediate
tax liability, in favor of higher capital gains with the
deferred tax liability
 Flotation costs – low payouts can decrease the
amount of capital that needs to be raised, thereby
lowering flotation costs
 Dividend restrictions – debt contracts might limit the
percentage of income that can be paid out as
dividends

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 High Payout Please
 Why might a high payout be desirable?
 Desire for current income
• Individuals that need current income, i.e. retirees
• Groups that are prohibited from spending principal
(trusts and endowments)
 Uncertainty resolution – no guarantee that the higher
future dividends will materialize
 Taxes
• Dividend exclusion for corporations
• Tax-exempt investors don’t have to worry about
differential treatment between dividends and capital
gains

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 Dividends and Signals
 Asymmetric information – managers have more
information about the health of the company than
investors
 Changes in dividends convey information
 Dividend increases
• Management believes it can be sustained
• Expectation of higher future dividends, increasing present value
• Signal of a healthy, growing firm
 Dividend decreases
• Management believes it can no longer sustain the current level
of dividends
• Expectation of lower dividends indefinitely; decreasing present
value
• Signal of a firm that is having financial difficulties

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 Clientele Effect
 Some investors prefer low dividend
payouts and will buy stock in those
companies that offer low dividend payouts
 Some investors prefer high dividend
payouts and will buy stock in those
companies that offer high dividend
payouts

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 Implications of the Clientele
Effect
 What do you think will happen if a firm
changes its policy from a high payout to a
low payout?
 What do you think will happen if a firm
changes its policy from a low payout to a
high payout?
 If this is the case, does dividend POLICY
matter?

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 Stock Repurchase
 Company buys back its own shares of stock
 Tender offer – company states a purchase price and a desired
number of shares
 Open market – buys stock in the open market
 Targeted repurchase- purchases shares from specific
individual shareholders.
 Similar to a cash dividend in that it returns cash from
the firm to the stockholders
 This is another argument for dividend policy irrelevance
in the absence of taxes or other imperfections

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 Real-World Considerations
 Stock repurchase allows investors to decide if
they want the current cash flow and associated
tax consequences
 In our current tax structure, repurchases may
be more desirable due to the options provided
stockholders

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 Information Content of Stock
Repurchases
 Stock repurchases send a positive signal that
management believes that the current price is
low
 Tender offers send a more positive signal than
open market repurchases because the
company is stating a specific price
 The stock price often increases when
repurchases are announced

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 Stock Dividends
 Pay additional shares of stock instead of cash
 Increases the number of outstanding shares
 Small stock dividend
 Less than 20
 If you own 100 shares and the company declared a
10% stock dividend, you would receive an additional
10 shares
 Large stock dividend – more than 20

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 Stock Splits
 Stock splits – essentially the same as a stock dividend
except expressed as a ratio
 For example, a 2 for 1 stock split is the same as a 100% stock
dividend
 Stock price is reduced when the stock splits
 Common explanation for split is to return price to a
“more desirable trading range”

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 Quick Quiz
 What are the different types of dividends and how is a
dividend paid?
 What is the clientele effect and how does it affect dividend
policy relevance?
 What is the information content of dividend changes?
 What is the difference between a residual dividend policy and
a compromise dividend policy?
 What are stock dividends and how do they differ from cash
dividends?
 How are share repurchases an alternative to dividends and
why might investors prefer them?

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 18

End of Chapter

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 Comprehensive Problem
 Compute the dividends under a residual
dividend policy, given
 A need of $12 million for new investments
 Target capital structure is D/E = 1/2
 Net Income = $9 million
 Finding dividend
 1/3 financed with debt (4 million)
 2/3 financed with equity (8 million)
 NI – equity financing = $1 million, paid out as
dividends

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