14.
Chapter
14
Dividends and
Dividend
Policy
McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved
14.1
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
McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved
14.2
Chapter Outline
Cash Dividends and Dividend Payment
Does Dividend Policy Matter?
Establishing a Dividend Policy
Stock Repurchase: An Alternative to Cash
Dividends
Stock Dividends and Stock Splits
McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved
14.3
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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14.4
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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14.5
Figure 14.2 The Ex-Day Price Drop
-t -2 -1 0 +1 +2 t
Price= $10
$1 is the ex-dividend price drop
Price= $9
The stock price will fall by the amount of the dividend on the ex date
(Time 0). If the dividend is $1 per share, the price will be equal to
$10 – 1 = $9 on the ex date.
Before ex date (Time –1) Dividend = $0 Price = $10
On ex date (Time 0) Dividend = $1 Price = $9
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14.6
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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14.7
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 $9000 this year, reinvest the other $1000 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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14.8
Low Payout Please
Why might a low payout be desirable?
Individuals in upper income tax brackets might prefer
lower dividend payouts, with the 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 contracts might limit the
percentage of income that can be paid out as
dividends
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14.9
High Payout Please
Why might a high payout be desirable?
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
Tax-exempt investors don’t have to worry about
differential treatment between dividends and capital gains
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14.10
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
McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved
14.11
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?
McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved
14.12
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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14.13
Dividend Policy in Practice
Residual dividend policy
Constant growth dividend policy – dividends
increased at a constant rate each year
Constant payout ratio – pay a constant percent
of earnings each year
Compromise dividend policy
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14.14
Residual Dividend Policy
Determine capital budget
Determine target capital structure
Finance investments with a combination of
debt and equity in line with the target capital
structure
Remember that retained earnings are equity
If additional equity is needed, issue new shares
If
there are excess earnings, then pay the
remainder out in dividends
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14.15
Example – Residual Dividend
Policy
Given
Need $5 million for new investments
Target capital structure: D/E = 2/3
Net Income = $4 million
Finding dividend
40% financed with debt (2 million)
60% financed with equity (3 million)
NI – equity financing = $1 million, paid out as
dividends
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14.16
Compromise Dividend Policy
Goals, ranked in order of importance
Avoid cutting back on positive NPV projects to pay a
dividend
Avoid dividend cuts
Avoid the need to sell equity
Maintain a target debt/equity ratio
Maintain a target dividend payout ratio
Companies want to accept positive NPV
projects, while avoiding negative signals
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14.17
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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14.18
Real-World Considerations
Stock repurchase allows investors to decide if they
want the current cash flow and associated tax
consequences
Investors face capital gains taxes instead of ordinary
income taxes (lower rate)
In our current 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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14.19
Information Content of Stock
Repurchases
Stock repurchases sends 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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14.20
Stock 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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14.21
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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14.22
Stock Splits
Stocksplits – 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”
McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved
14.23
Chapter 14 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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