CHAPTER 8

D I V I D E N D S A N D PAY O U T P O L I C Y
 KEY CONCEPTS AND SKILLS

• Define dividend types and how dividends are paid

• Explain the issues surrounding dividend policy

decisions
• Describe the difference between cash and stock
dividends
• Explain why share repurchases are an alternative
to dividends
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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 will not 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 one business day (under NYSE rules) 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 7-4
FIGURE 14.2 – PRICE BEHAVIOR AROUND THE
EX-DIVIDEND DATE

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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 with one of two plans:
 Plan 1: can pay $10,000 per year for each of the next two years, or
 Plan 2: 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.

• Compare the market value of the two plans:

 Present value of Plan 1 dividends:
PV of constant dividends = $16,900.51
 Present value of Plan 2 dividends:
PV growing dividends 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 7-10
 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.

• For dividend policy to be relevant, it must meet a

currently unmet demand if it is to create value.
• Investors that do not need current income will seek low
dividend firms (and vice versa).
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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? no

• If a firm changes its policy, it will just have different

investors. Consequently, dividend policy won’t affect
the value of the stock.
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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

• 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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 INFORMATION CONTENT OF
STOCK REPURCHASES
• Stock repurchases send a positive signal that
management believes 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 REPURCHASES: RECENT GAIN IN POPULARITY
• FIGURE 14.3 Aggregate real (2012) dividends and stock repurchases by
publicly held U.S. industrial firms: 2004 to 2020

• Source: Redrawn by authors using Compustat data, following Farre-Mensa, Michaely, and Schmalz, Payout Policy,
2014, Annual Review of Financial Economics 6, 75–134. 7-15
TAX EFFECTS OF DIVIDENDS AND STOCK REPURCHASES

• Cash dividends:
• No investor control over timing or size.
• Taxed as ordinary income.

• Repurchase:
• Allows investors to decide if they want a current cash
flow.
 Taxed only if:
• They choose to sell AND.
• They reap a capital gain on the sale.
• Gain may qualify as lower taxed capital gains if shares owned more than
one year.

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 TAX EFFECTS OF DIVIDENDS
• FIGURE 14.5 Regular dividend initiations, 2001 to 2006

• Source: Alon Brav, John R. Graham, Campbell R. Harvey, and Roni Michaely, “Managerial Response to the May 2003
Dividend Tax Cut,” Financial Management 37, no. 4 (2008): 611–24. 7-17
 WHAT WE KNOW AND DO NOT KNOW

• Corporations “smooth” dividends.

• Dividends provide information to the market.

• Firms should follow a sensible dividend policy:

 Don’t forgo positive NPV projects just to pay a
dividend.
 Avoid issuing stock to pay dividends.
 Consider share repurchase when there are few
better uses for the cash.
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 PUTTING IT ALL TOGETHER (SUMMARY)
• Aggregate payouts and stock repurchases are
massive and have increased over time.

• Dividends are concentrated among a small number of

large, mature firms.

• Managers are reluctant to cut dividends.

• Managers smooth dividends.

• Stock prices react to unanticipated changes in

dividends. 7-19
 THE MANAGEMENT VIEW OF
DIVIDEND POLICY
• Agree or Strongly Agree
 93.8% Try to avoid reducing dividends per share
 89.6% Try to maintain a smooth dividend from year to year
 41.7% Pay dividends to attract investors subject to “prudent
man” restrictions

• Important or Very Important

 84.1% Maintaining consistency with historic dividend policy
 71.9% Stability of future earnings
 9.3% Flotation costs to issue new equity
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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 to 25%
 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 to 25%

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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 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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 COMPREHENSIVE PROBLEM

A company’s stock is priced at $50 per share, and

it plans to pay a $2 cash dividend.
 Assuming perfect capital markets, what will the per
share price be after the dividend payment?
 If the average tax rate on dividends is 25%, what will
the new share price be?

• In perfect market, new price = $48.

• In imperfect market, new price = 48 + 2 × .25 = $48.50

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 EXERCISE_1

• Bailey's decided on Friday, March 7, to pay a dividend of $.28 a share

on Monday, April 7. The ex-dividend date is Friday, March 22. What is
the date of record?

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 EXERCISE_2

• On July 9, you purchased 800 shares of Blue Water stock for $32 a
share. On August 4, you sold 200 shares of this stock for $33 a share.
You sold an additional 200 shares on August 15 at a price of $34.50 a
share. The company declared a dividend of $.76 per share on August 3
to holders of record as of Monday, August 17. This dividend is payable
on September 15. How much dividend income will you receive on
September 15?

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