Chapter 17
Dividends and Dividend Policy
Copyright © 2012 by McGraw-Hill Education. All rights reserved.
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?
Real-World Factors Favoring a Low Dividend Payout
Real-World Factors Favoring a High Dividend Payout
A Resolution of Real-World Factors
Stock Repurchase: An Alternative to Cash Dividends
What We Know and Do Not Know about Dividends
and Payout Policies
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 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 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 17.2
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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
Intheory, 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
Flotationcosts – 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
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
Given our tax structure, repurchases may
be more desirable due to the options
provided stockholders
The IRS recognizes this and will not allow a
stock repurchase for the sole purpose of
allowing investors to avoid taxes
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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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Example: Repurchase Announcement
“America West Airlines announced that its Board of Directors
has authorized the purchase of up to 2.5 million shares of its
Class B common stock on the open market as circumstances
warrant over the next two years …
“Following the approval of the stock repurchase program by
the company’s Board of Directors earlier today. W. A. Franke,
chairman and chief officer said ‘The stock repurchase program
reflects our belief that America West stock may be an
attractive investment opportunity for the Company, and it
underscores our commitment to enhancing long-term
shareholder value.’
“The shares will be repurchased with cash on hand, but only if
and to the extent the Company holds unrestricted cash in
excess of $200 million to ensure that an adequate level of cash
and cash equivalents is maintained.”
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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
Aggregate payouts 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
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Managements’ 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?
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END OF CHAPTER
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