Recall: Stock Returns

Return =

P1 - Po + D1 Po

Recall: Stock Returns

Return =

P1 - Po + D1 Po D1 + Po

=

P1 - Po Po

Recall: Stock Returns

Return =

P1 - Po + D1 Po D1 + Po

=

P1 - Po Po

Capital Gain

Recall: Stock Returns

Return =

P1 - Po + D1 Po D1 + Po Dividend Yield

=

P1 - Po Po

Capital Gain

Dilemma: Should the firm use retained earnings for: a) Financing profitable capital investments? b) Paying dividends to stockholders? .

Po Po + D1 Po we retain earnings for profitable investments.Return =  If P1 . .

. dividend yield will be zero.Po Po + D1 Po we retain earnings for profitable investments.Return =  If P1 .

dividend yield will be zero. resulting in a higher capital gain.Return =  If P1 .Po Po + D1 Po we retain earnings for profitable investments. . but the stock price will increase.

Return =  If P1 . .Po Po + D1 Po we pay dividends.

Return =  If P1 . stockholders receive an immediate cash reward for investing. .Po Po + D1 Po we pay dividends.

since this cash is not invested in the firm.Return =  If P1 .Po Po + D1 Po we pay dividends. but the capital gain will decrease. stockholders receive an immediate cash reward for investing. .

dividend policy really involves 2 decisions:  How much of the firm’s earnings should be distributed to shareholders as dividends.So. . and  How much should be retained for capital investment.

If we pay a dividend.Is Dividend Policy Important? Three viewpoints: 1) Dividends are Irrelevant. shareholders’ dividend yield rises. but capital gains decrease. If we assume perfect markets (no taxes. etc. .) dividends do not matter. no transactions costs.

an increase in dividends .g  Dividend irrelevance: In perfect markets.D1 Po = kc .

g  Dividend irrelevance: In perfect markets.D1 Po = kc . an increase in dividends .

. an increase in dividends means less money will be invested. so the growth rate declines.D1 Po = kc .g  Dividend irrelevance: In perfect markets.

an increase in dividends means less money will be invested. so the growth rate declines.D1 Po = kc . .g  Dividend irrelevance: In perfect markets.

an increase in dividends means less money will be invested.  The increase in D1 is offset by the decrease in g. .D1 Po = kc .g  Dividend irrelevance: In perfect markets. so the growth rate declines.

an increase in dividends means less money will be invested.g  Dividend irrelevance: In perfect markets. so the growth rate declines. .  The increase in D1 is offset by the decrease in g.  Consequently. dividend policy does not affect stock price.D1 Po = kc .

Return = P1 .Po Po + D1 Po  Dividend irrelevance: In perfect markets. . investors do not care if returns come in the form of dividend yields or capital gains.

.Po Po + D1 Po  Dividend irrelevance: In perfect markets.Return = P1 . investors do not care if returns come in the form of dividend yields or capital gains.

.Po Po + D1 Po  Dividend irrelevance: In perfect markets. investors do not care if returns come in the form of dividend yields or capital gains.Return = P1 .

2) High Dividends are Best  Some investors may prefer a certain dividend now over a risky expected capital gain in the future. .

Po Po + D1 Po .2) High Dividends are Best  Some investors may prefer a certain dividend now over a risky expected capital gain in the future. Return = P1 .

.3) Low Dividends are Best  Dividends are taxed immediately.  Therefore. taxes on capital gains can be deferred indefinitely. Capital gains are not taxed until the stock is sold.

Do Dividends Matter? Other Considerations: 1) Residual Dividend Theory:  The firm pays a dividend only if it has retained earnings left after financing all profitable investment opportunities. .  This would maximize capital gains for stockholders and minimize flotation costs of issuing new common stock.

.Do Dividends Matter? 2) Clientele Effects:  Different investor clienteles prefer different dividend payout levels. These attract a clientele that prefers high dividends.  Some firms. such as utilities. pay out over 70% of their earnings as dividends.  Growth-oriented firms which pay low (or no) dividends attract a clientele that prefers price appreciation to dividends.

.  Dividend changes convey information to the market concerning the firm’s future prospects.Do Dividends Matter? 3) Information Effects:  Raising a firm’s dividend usually causes the stock price to rise and decreasing the dividend causes the stock price to fall.

 Raising external equity subjects the firm to scrutiny of regulators (SEC) and investors and therefore helps monitor the performance of managers. .  Paying dividends reduces retained earnings and forces the firm to raise external equity financing.Do Dividends Matter? 4) Agency Costs:  Paying dividends may reduce agency costs between managers and shareholders.

 Expectations are based on past dividends. investment and financing decisions.Do Dividends Matter? 5) Expectations Theory:  Investors form expectations concerning the amount of a firm’s upcoming dividend. expected earnings.  The stock price will likely react if the actual dividend is different from the expected dividend. the economy. etc. .

for example. .Dividend Policies 1) Constant Payout Ratio Policy: if directors declare a constant payout ratio of. 30%. 30 cents would be paid out as dividends. then for every dollar of earnings available to stockholders. the ratio remains constant over time. but the dollar value of dividends changes as earnings change.

Decreasing the dividend sends a negative signal! .Dividend Policies 2) Stable Dollar Dividend Policy: the firm tries to pay a fixed dollar dividend each quarter.  firms and stockholders prefer stable dividends.

Dividend Policies 3) Small Regular Dividend plus Year-End Extras  the firm pays a stable quarterly dividend and includes an extra year-end dividend in prosperous years. .  By identifying the year-end dividend as “extra.” directors hope to avoid signaling that this is a permanent dividend.

and decides on the payment date. 11 Payment date Dividend Payments 1) Declaration Date: the board of directors declares the dividend.Jan. .1 Ex-div. determines the amount of the dividend. Record date date Mar.28 Feb.4 Declare dividend Jan.

Record date date Mar.1 Ex-div. 11 Payment date Dividend Payments 2) Ex-Dividend Date: .4 Declare dividend Jan.28 Feb.Jan.

Record date date Mar. 11 Payment date Dividend Payments 2) Ex-Dividend Date: To receive the dividend.28 Feb. On this date. you have to buy the stock before the ex-dividend date. the stock begins trading “exdividend” and the stock price falls approximately by the amount of the dividend. .Jan.1 Ex-div.4 Declare dividend Jan.

Jan. 11 Payment date Dividend Payments 3) Date of Record: .1 Ex-div. Record date date Mar.28 Feb.4 Declare dividend Jan.

11 Payment date Dividend Payments 3) Date of Record: 4 days after the exdividend date.  often.Jan.4 Declare dividend Jan. Record date date Mar. . the firm receives the list of stockholders eligible for the dividend.1 Ex-div.28 Feb. a bank trust department acts as registrar and maintains this list for the firm.

Jan. 11 Payment date Dividend Payments 4) Payment Date: date on which the firm mails the dividend checks to the shareholders of record.1 Ex-div. .28 Feb.4 Declare dividend Jan. Record date date Mar.

 Did the shareholders’ wealth increase? . For each 100 shares held.Stock Dividends and Stock Splits  Stock dividend: payment of additional shares of stock to common stockholders. 1987.  Example: Citizens Bancorporation of Maryland announced a 5% stock dividend to all shareholders of record on March 27. shareholders received another 5 shares.

 Does this increase shareholder wealth?  Are a stock dividend and a stock split the same? . shareholders received another 50 shares.Stock Dividends and Stock Splits  Stock Split: the firm increases the number of shares outstanding and reduces the price of each share. For each 100 shares held.  Example: Joule. announced a 3-for-2 stock split. Inc.

For each 100 shares held.Stock Dividends and Stock Splits  Stock Splits and Stock Dividends are economically the same: the number of shares outstanding increases and the price of each share drops. The value of the firm does not change.  Example: A 3-for-2 stock split is the same as a 50% stock dividend. shareholders receive another 50 shares. .

Stock Dividends and Stock Splits  Effects on Shareholder Wealth: .

Stock Dividends and Stock Splits  Effects on Shareholder Wealth: these will cut the company “pie” into more pieces but will not create wealth. A 100% stock dividend (or a 2-for-1 stock split) gives shareholders 2 half-sized pieces for each full-sized piece they previously owned. .

Stock Dividends and Stock Splits  Effects on Shareholder Wealth: these will cut the company “pie” into more pieces but will not create wealth. but would cause a $60 stock price to fall to $30. A 100% stock dividend (or a 2-for-1 stock split) gives shareholders 2 half-sized pieces for each full-sized piece they previously owned.  For example. this would double the number of shares. .

Stock Dividends and Stock Splits  Why bother?  Proponents argue that these are used to reduce high stock prices to a “more popular” trading range (generally $15 to $70 per share). Plus.  Opponents argue that most stocks are purchased by institutional investors who have $millions to invest and are indifferent to price levels. stock splits and stock dividends are expensive! .

Stock Dividend Example  shares outstanding: 1. P/E = 10  25% stock dividend.000.  An investor has 120 shares.000  net income = $6. Does the value of the investor’s shares change? .000.000.

25 = 1.200 After the 25% stock dividend:  # shares = 1.000.25 = 150 shares.000.000/1. so P = $48 per share.  EPS = 6.Before the 25% stock dividend:  EPS = 6.200 .000/1.000.250.000 = $6  P/E = P/6 = 10. so P = $60 per share.  Investor now has 120 x 1.000 = $4.000.000.250.  Value = $48 x 150 = $7.  Value = $60 x 120 shares = $7.80  P/E = P/4.000 x 1.80 = 10.

Stock Repurchases  Stock Repurchases may be a good substitute for cash dividends. why not buy back common stock? .  If the firm has excess cash.

 If the firm has excess cash. why not buy back common stock? .Stock Repurchases  Stock Repurchases may be a good substitute for cash dividends.

which increases stock price.  Repurchases increase leverage.Stock Repurchases  Repurchases drive up the stock price. and can be used to move toward the optimal capital structure.  Repurchases signal positive information to the market . producing capital gains for shareholders. .

Both were unsuccessful because the target firms undertook stock repurchases.Stock Repurchases  Repurchases may be used to avoid a hostile takeover. Boone Pickens attempted raids on Phillips Petroleum and Unocal in 1985. . Example: T.

(targeted stock repurchase)  Tender offer: offer to pay a specific price to all current stockholders.  Buy a large block by negotiating the purchase with a large block holder. .Stock Repurchases Methods:  Buy shares in the open market through a broker. usually an institution.

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