9/23/2019

Principles of Finance
with Excel, 2nd edition

Instructor materials

Chapter 19
Dividend Policy

What’s a dividend?
 A dividendis cash paid by a firm to its
shareholders

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 Chronology

 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 upcoming dividend
Stock price generally drops by approximately 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

Tax Effects of Dividends

Cash dividends:
No investor control over timing or size
Taxed as ordinary income

Factors Favoring a Low Payout

 Taxes:
Individuals in upper income tax brackets might
prefer lower dividend payouts, with their immediate
tax consequences, in favor of higher capital gains
 Flotation costs:
Low payouts can decrease the amount of capital
that needs to be raised, thereby lowering flotation
costs
 Dividend restrictions:
Debt covenants may limit the percentage of income
that can be paid out as dividends

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Factors Favoring a High Payout

 Desire for current income:
Individuals in low tax brackets
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
Dividends versus capital gains irrelevant to tax-
exempt investors

Clientele Effects
Investor preference:
Some investors prefer low dividend payouts
Some investors prefer high payouts
Investors will buy stock in companies that
meet their dividend preferences
What do you think will happen if a firm
changes its policy from a high payout to
a low payout? … or vice versa?

Time Warner
has not paid a
dividend since
1992.
Does it
matter?

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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

Illustration of Irrelevance
Wharton Corporation
 Allequity firm with 100 shares outstanding
 Investors require a 10% return.
 Expected cash flow = $10,000 each year
 Plans to dissolve firm in 2 years
 Firm can either:
A. Pay out dividends of $10,000 per year for each of
the next two years ($100 per share), or
B. Pay $11,000 this year, raising the other $1,000 by
issuing stock (or bonds), then pay an amount in
year 2 sufficient to provide new shareholders with
a 10% return

Illustration of Irrelevance
Wharton Corporation

PLAN A: PLAN B:
Year 1 Year 2 Year 1 Year 2
Cash Flow $10,000 $10,000 $10,000 $10,000
New stock $0 $0 $1,000 $0
CF available to S/H: $10,000 $10,000 $11,000
To New S/H:
Dividends $0 $0 $1,100
DPS $0 $0 $110
To Old S/H:
Dividends $10,000 $10,000 $11,000 $8,900
DPS $100 $100 $110 $89

Stock Price $ 173.55 $ 173.55

E(R ) 10% 10%

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Coca-Cola raises
its dividend from
$1.00/year to
$1.12/year. The
company cites
“confidence in its
long-term cash
flow.”
DIVIDENDS CAN
BE A SIGNAL.

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Information Content of Dividends

Stock prices generally rise with
unexpected increases in dividends and
fall with unexpected decreases in
dividends
Does this mean that the average
investor prefers a high dividend payout
ratio?
No – changes in the dividend send a
signal about management’s view
concerning future prospects
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Information Content of Dividends

Thesignalling theory of dividends
makes two assertions:
All other things being equal, higher
dividends are signal of more financial
strength than lower dividends
Changes in dividends are indicative of the
future financial health of the company. An
increase in dividends is indicative that the
future prospects of the firm are improved
and vice versa.

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Stock Repurchase
 Company buys back shares of its own stock
Open market = company buys its own stock in the
open market
Tender offer = company states a purchase price
and a desired number of shares to be bought
Targeted repurchase = firm repurchases shares
from specific individual shareholders
 Repurchase vs. cash dividend:
Repurchase returns cash from the firm to the
stockholders
Same as cash dividend in the absence of taxes and
transactions costs

Information Content of Repurchases

 Stock repurchases signal that management

believes the current stock price is low
 Tender offers send a more positive signal than
open market repurchases because the
company is stating a specific stock price
 Stock prices often increase when repurchases
are announced

Tax Effects of Stock Repurchases

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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Dividend Summary
1. Aggregate dividend and stock
repurchases are massive and have
increased steadily.
2. Dividends heavily concentrated among a
small number of large firms
3. Managers very reluctant to cut dividends
4. Managers smooth dividends, raising them
slowly as earnings grow.
5. Stock prices react to unanticipated
changes in dividends

Factors that Affect Dividend Decisions

Survey Results

Managers:
1. Try to avoid reducing dividends per share
2. Try to maintain a smooth dividend from
year to year
3. Consider the level of dividends per share
paid in recent quarters
4. Reluctant to make dividend changes that
might have to be reversed in the future

Federated Department Stores

Federated both pays dividends and repurchases stock. Both are ways of
paying out cash to shareholders.

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Share repurchases affect capital

gains
Share repurchases
Raise the price of stock (fewer shares
outstanding)
Raise the per share future earnings per
share of shares remaining in the company
So share repurchases raise future
anticipated capital gains

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Finance theory
Dividends and capital gains tend to
cancel out
More dividends  less future capital
gains
Taxes are important!
No taxes: Dividends/capital
gains/repurchases – doesn’t matter
Capital gains taxes < ordinary income
taxes – repurchases better than dividends

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When don’t dividends matter?

John and Mary’s taxi companies
JOHN'S TAXI COMPANY, MARY'S TAXI COMPANY
Assets Liabilities and equity
Cash 5,000 Debt 10,000

Taxis 20,000 Equity

Stock 5,000
Accumulated retained earnings 10,000

Total assets 25,000 Total liabilities and equity 25,000

John and Mary each own an identical taxi company.

The companies only differ in their dividend policies.
Each company owns the same number of taxis and
has the same income and expenses.
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John pays himself a $3,000

dividend

JOHN'S TAXI COMPANY--after dividend John pays

Assets Liabilities and equity himself a
Cash 2,000 Debt 10,000 dividend, but
Taxis 20,000 Equity Mary doesn’t.
Stock 5,000 John’s balance
Accumulated retained earnings 7,000
sheet goes down
Total assets 22,000 22,000 to $22,000,
Mary’s stays at
MARY'S TAXI COMPANY
$25,000.
Assets Liabilities and equity
Cash 5,000 Debt 10,000 But did anything
Taxis 20,000 Equity really happen?
Stock 5,000
Accumulated retained earnings 10,000

Total assets 25,000 25,000

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To dividend or not?
Question 1: Valuation effects?
Write the balance sheet in terms of net
debt (debt-cash)
Question 2: Capital structure effects?
The dividends changed the capital
structure of companies.
Dividends might matter if capital structure
matters
 If companies with higher debt to equity ratio
have higher values then companies should pay
dividends
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Balance sheet with net debt

(net debt = debt – cash)

JOHN'S or MARY'S TAXI COMPANY--net debt

Assets Liabilities and equity
Net debt = Debt - cash 5,000

Taxis 20,000 Equity

Stock 5,000
Accumulated retained earnings 10,000

Total assets 20,000 20,000

Net debt is the Debt minus Cash of the business.

Here are John & Mary’s balance sheets in terms of net debt, before John
pays himself a dividend.
The left hand side of the balance sheet represents the company’s
Operating Assets. 27

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To dividend or not?
As long as there are no tax effects, it
doesn’t make any difference
Both Mary (no dividends) & John
(dividend) are equally well off
One has left the money in the
company, the other has taken the
money out.

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Taxes can make a difference

 Both John and Mary sell their taxi
companies for $40,000
 Before handing over their companies, each
has access to the cash and pays off the
debts.
 John will get the dividend before sale.
 Tax rates:
Capital gains: 15% . This is the tax on gains
over book value.
Ordinary income tax: 30%. This is the tax on
dividends.

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Mary makes more than John!

Because dividends are more highly
taxed than capital gains
With equal tax on income and capital
gains, this wouldn’t happen!

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What If John Really Needs the

Money?
Pay a Bonus
Tax deductible expense for the company
Repurchase Stock
Company buys back $3,000 of stocks
from John
After this repurchse suppose John sells
the company
All of $3,000 repurchase of stock is taxed
to John as a capital gain

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