Topic 8

Dividend Policy-Part I
I. Dividend Forms
A. Regular Cash Dividends
B. Dividend Reinvestment Plans (DRPs)
C. Special (Irregular) Dividends
D. Liquidating Dividends
E. Stock Dividends
II. Stock Splits
III. Dividend Payment Timeline
IV. Stock Repurchases
V. Repurchase Effect on Financial Statements
A. Changes in Earnings per Share (EPS)
B. Changes in Book Value per Share (BVPS)
VI. Valuation Equivalence of Cash Dividends and Share Repurchases
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Topic 8
Dividend Policy-Part I
“Dividends don’t lie.”
-Geraldine Weiss and Janet Lowe

A dividend is a distribution paid to shareholders based on the number of shares owned in a firm.

Unlike interest and principal repayment, the payment of dividend is discretionary rather than a legal

obligation and may be limited by legal status and debt contract provision.

Dividends are declared by corporation’s board of directors, whose action may require approval by

shareholders (e.g. U.S. and Saudi Arabia) or may not require such approval (e.g. most of Europe and China).

Dividend can take different forms such as regular cash payments, stock repurchases, stock

dividend, stock splits and others.

Dividend policy is the set of principles and guidelines that firms employ in the determination of an

appropriate dividend policy.

Of major concern is how much of the firm’s earnings should be distributed to the shareholders in

the form of cash dividends or stock repurchases. Retained earnings and dividends are alternative uses of

available net income. In evaluating potential dividend policies, managers must also consider its capital

budgeting decisions and its capital structure decisions. The interaction of these three decisions determines

the value of the firm.

Capital structure decision is concerned with creating value through altering the firm’s debt ratio.

The dividend policy, on the other hand, is concerned with creating value through cash dividend, stock

repurchase, or reinvesting in the firm to spur growth.

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I. Dividend Forms

• Companies can pay dividends in a number of ways. Cash dividends can be distributed to shareholders

through regular, special or irregular, or liquidating dividends.

• Other forms of dividends include stock dividend and stock splits.

A. Regular Cash Dividends

• Many companies pay cash to shareholders on a regular schedule. The frequency of payments varies

between companies (e.g. quarterly, semiannually, annually).

• Most companies that pay cash dividend strive to maintain or increase their dividends.

• A record of stable and increasing dividends is widely interpreted as evidence of consistent profitability.

B. Dividend Reinvestment Plans (DRPs)

• In some markets, companies are permitted to have a system that allows shareholders to automatically

reinvest all or a portion of their cash dividends. Such plans are referred to as DRPs, pronounced drips.

• There are two types of DRPs:

o Open-market DRPs: a company purchases shares in the open market to acquire the additional

shares credited to plan participants.

o New-issue DRPs: the company meets the need for additional shares by issuing them instead of

purchasing them.

o There are also plans that permit companies to obtain shares through open-market purchases or

new share issuance.

• For a company, there may be several advantages for offering DRPs:

o They may encourage a diverse shareholders base by providing small shareholders an easy way

to accumulate additional shares.

o They may encourage investors to invest in for the long-term.

o They allow the company to raise new equity without flotation costs.

• The advantages to shareholders include:

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o The accumulation of shares using cost averaging and that they are cost-effective means from

small shareholders to make additional investments in the company.

o Participating investors have no transaction costs.

C. Special (Irregular) Dividends

• A special dividend, also known as an irregular dividend, is a dividend paid by a company that does

not pay dividends on a regular schedule, or a dividend that supplements regular cash dividends with an

extra payment.

• Some companies in cyclical industries distribute special dividends in strong performance years.

D. Liquidating Dividends

• A dividend is referred to as liquidating dividend when a company:

o Goes out of business and the net asset of the company (after all liabilities have been paid) are

distributed to shareholders.

o Sells a portion of its business for cash and the proceeds are distributed to shareholders.

o Pays a dividend that exceeds its accumulated retained earnings.

E. Stock Dividends

• In many occasions companies declare stock dividends which means that they pay additional shares of

stock to common shareholders.

• Stock dividends are usually stated as a percentage of shares outstanding.

• Stock dividends increase the number of shares outstanding.

• When stock dividends are announced, the company debits retained earnings account and credits the

contributed capital account.

• Because each shareholder's proportionate claim on the firm's net worth and earnings is unchanged, the

market price of each share of stock should decline in proportion to the number of new shares issued.

Pre-stock Dividend Price

Post-Stock Dividend Price =
1+Percentage stock dividend rate

A 10% stock dividend would reduce the stock price by 9.09%.

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Table 8.1
Before Stock Dividend After Stock Dividend
Number of Shares Outstanding 1,000,000 1,100,000
Stock Price $40.0 $36.36
EPS $1.5 $1.36
P/E 26.67 26.67
Ownership Value $4,000,000 $4,000,000

• Stock dividend is a non-dilutive action.

• Even though the theoretical value of a stock dividend is zero, firms declare them for several reasons:

1. A stock dividend may broaden the ownership of the firm's shares since many stockholders sell the

stock from the dividend.

2. If the firm pays a cash dividend, a stock dividend results in an effective increase in cash dividends

if the level of the cash dividend is not reduced.

3. The reduction in share price may broaden the appeal of the stock to investors resulting in a real

increase in market value.

II. Stock Splits

• Stock splits are similar to stock dividends. They increase the number of shares and reduce the price of

each share by reducing the stock’s par value.

• Stock splits are expressed in terms of split ratios. For example, NMS company will split its stocks 3 to

1. This means that each investor will get 3 shares instead of 1. Thus the price of the stock will drop by

66.7%.

• For example, if the stock price is 75 and the company announced a 3 to 1 stock split, the new price is

P
Post − Stock Split Price =
Split Ratio
75
= 25
3
(1)

• A reverse stock split increases the share price and reduces the number of shares outstanding with no

effect on the market value a company’s equity.

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• If a company holds its DPO constant, then a stock split does not change the stock price or the dividend

yield.

• The following table shows the impact of two-for-one stock split on stock price, EPS, DPS, dividend

yield and P/E.

Table 8.2

Before Split After Split

Number of Shares Outstanding 5 million 10 million
Stock Price $40.0 $20.0
EPS $1.5 $0.8
DPS $1.0 $0.5
DPO 33% 33%
Div. Yld. 2.5% 2.5%
P/E 26.67 26.67
Market Value $200 million $200 million

III. Dividends Payment Timeline

• The board of directors holds quarterly, semi-annual or annual meetings to decide the amount of

dividends to be paid. The declaration and payment procedure follows the sequence given below:

1. Declaration date: The date board of directors approves payment of the dividend (for example,

February 1st)

2. Ex-dividend date: The first day a share of stock trades without the dividend (for example,

February 14th). The ex-dividend date is also the cutoff date for receiving the dividend and

occurs, usually, two business days before the record-date. If you buy the share on or after the

ex-dividend date, you will not receive the dividend.

3. Record date: The date on which the shareholders of record are designated to receive the

dividend (for example, February 16th)

4. Payment date: the date the dividend checks are paid. (for example, March 1st).

• Figure 8.1 displays the dividends payment timeline.

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Figure 8.1

IV. Stock Repurchases

• A stock repurchase (or buyback) is a transaction in which a company buys back its own shares.

• Stock repurchases are an alternative to dividends for transmitting cash to shareholders. Shares

repurchased by the issuing firm are called treasury stock. In some countries, the repurchased shares are

canceled.

• In either case, they are not considered for dividends, voting, or computing earnings per share.

• Stock repurchases can be done through four ways:

1. Open market repurchases. This method is the most common and the most flexible. In the open market

repurchase, the company is not legally obligated to undertake or complete the repurchase program. This

may occur for several reasons, such as unexpected need for cash, acquisitions, or capital expenditure.

Authorization to repurchase stocks can last for years. This gives the management the opportunity to

time its purchase to reduce the cost of the repurchase program.

2. Fixed price tender offer. In a tender offer the company offers to buy the stock at premium within a

certain time frame. An investor has the choice to sell or hold his shares. For example, a stock is selling

at $25. The management offers to buy a certain number of shares, 2 million shares for instance, at $28

per share. If shareholders are willing to sell more than the specified amount, the company will usually

buy back a pro rata amount from each shareholder. By setting a fixed date, a tender offer can be

accomplished quickly.

3. Dutch auction. A Dutch auction is also a tender offer to existing shareholders, but instead of specifying

a fixed price for a specific number of shares, the company stipulates a range of acceptable prices. For

example, if the stock price is $25, the company would offer to buy back 2 million shares in the range

of $28 to $30. Each shareholder would then indicate the number of shares and the lowest price at which
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he would be willing to sell. The company would then begin to qualify bids at higher prices at $29 and

continue to qualify bids at higher prices until the 2 million share are exhausted.

4. Repurchase by direct negotiation. In some market, a company may negotiate with a major shareholder

to buy back its shares often at a premium to the market price. The company may do this to reduce the

number of block shareholders and to prevent activist shareholders from gaining representation on the

board of directors.

• Stock repurchases are financed by using idle cash or using borrowed funds.

V. Repurchases Effect on Financial Statements

A. Changes in Earnings per Share (EPS)

• The effect of repurchases on EPS depends on the method to finance the repurchase.

• In the absence of investment opportunities, management may decide to use cash surplus on its balance

sheet to repurchase shares.

• The following example shows the effect of share repurchase using idle cash.

Example: The Effect of Share Repurchase Using Idle Cash

Either Services has been accumulating cash in recent years with a plan to expand in new geographic areas. The
company has 10 million shares outstanding and its net income is $100 million. Either share price is $240. The
accumulated cash that is not needed for operations is $240 million. The management believes that the stock can
be bought at $140.

Calculate the impact of the repurchase on Either’s EPS.

Solution

The current EPS is $10 ($100 million/10 million).

If Either uses the $240 million to repurchase shares, it can buy around 1.7 million shares ($240 million/$140) so
that there are 8.3 million shares outstanding.

Thus, after the repurchase, the new EPS is $12 ($100 million/8.3 million).

• If the company has no idle cash, it may use long-term debt to repurchase shares.
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• The effect of share repurchases using borrowed funds on EPS depends on the company’s after-tax

borrowing rate on the funds used to repurchase stocks.

Example: Share Repurchase Using Borrowed Funds

Munger Industries, Inc. plans to borrow $12 million to repurchase shares. The following information is given:

• Share price at time of share repurchase is $60

• EAT is $6.6 million
• EPS before share repurchase is $3
• P/E is 20x ($60/$3)
• Earnings yield (E/P) is 5% ($3/$60).
• Shares outstanding is 2.2 million
• Planned share repurchase is 200,000 shares.
a) Calculate the EPS after the share repurchase, assuming 5% after-tax cost of debt.
b) Calculate the EPS after the share repurchase assuming the company’s after-tax borrowing rate increases to
6%.

Solution

a) EPS after buyback=(Earnings - After-tax cost of funds)/Shares outstanding after buyback

=[6.6 million-($12 million×0.05)]/2 million shares
= [6.6 million-($0.6 million)]/2 million shares=$6 million/2 million shares=$3

Note that the after-tax cost of borrowing is equal to the earnings yield.

b) EPS after buyback=(Earnings - After-tax cost of funds)/Shares outstanding after buyback

=[6.6 million-($12 million×0.06)]/2 million shares
= [6.6 million-($0.72 million)]/2 million shares=$5.88 million/2 million shares=$2.94

Note that the after-tax cost of debt is greater than the earnings yield.

What if the earnings yield is greater than the cost of borrowing?

• A share repurchase may increase, decrease, or have no effect on EPS. The effect depends on whether

the repurchase is financed internally or externally.

• In the case of internal financing, a repurchase increases EPS only if the funds used for the repurchase

would not earn the internal cost of capital.

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• In the case of external financing, the effect of a repurchase on EPS is positive if the earnings yield (E/P)

is greater than the cost to finance the repurchase.

B. Changes in the Book Value per Share (BVPS)

• The BVPS is used to calculate the P/B ratio, which is often used to value equity. Thus, it is important

to understand the effect of repurchases on the calculation of BVPS.

Example: The Effect of Repurchases on BVPS

Lynch Inc. and Miller Com. are two companies traded in the stock market. Both companies common stock is
traded at $20. Each company has 10 million shares outstanding. Both companies have announced a $5 million
buyback at the current market price.

• Lynch’s has a book value of equity of $100 million and BVPS of $10 ($100 million/10 million shares). Note
that the market price is higher than the BVPS ($20>$10).
• Miller’s has a book value of equity of $300 million and BVPS of $30 ($300 million/10 million shares). Note
that the market price is lower than the BVPS ($20<$30).

Calculate the BVPS for both companies after the buyback.

Solution

Both companies will buyback 250,000 shares ($5 million/$20)

Both companies are left with 9.75 million shares outstanding (10 million-250,000)

• Lynch Inc.

Lynch’s BV of equity falls to $95 million ($100 million-$5 million).

Lynch’s BVPS decreases from $10 to $9.74 ($95 million/9.75 million).

• Miller Com.

Miller’s BV of equity falls to $295 million ($300 million-$5 million).

Miller’s BVPS increases from $30 to $30.26 ($295 million/9.75 million)

• From the previous example, we can see that stock repurchases:

o Decreases BVPS if the repurchase price is higher than the BVPS (Price>BVPS)

o Increases BVPS if the repurchase price is lower than the BVPS (Price<BVPS)
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VI. Valuation Equivalence of Cash Dividends and Share Repurchases

• Holding everything else equal, share repurchases, and cash dividend have the same impact on

shareholders’ wealth.

• Understanding this idea will help us to analyze dividend policy in the next topic.

• The following example illustrates the equivalence of cash dividends and stock repurchases.

Dividend and Stock Repurchases

NMS company has announced that the earnings available to common shareholders are $ 1 million. The number
of common shares outstanding is 400,000. The EPS of NMS is $2.5 (1,000/400). The market price per share is
$50 and the P/E is 20.

The firm is considering to distribute $800,000 as cash dividends or repurchase shares.

A. Cash Dividends

If cash dividends are paid, the amount will be $2 per share ($800,000/400,000)

B. Repurchase Shares

If the company pays $52 per share to repurchase stocks, it could repurchase 15,385 shares ($800,000/$52).
Because of the repurchase, outstanding shares reduce to 384,615 and EPS to rise to $2.6 ($1 million/384,615).

If the stock still sold at 20× earnings, its market price would rise to $52.

Result: In both cases stockholders receive $2 per share.

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Practice Problems
Q1: Bikers Financial Firm (BFF) currently pays a semi-annual dividend of $0.5 per share. This quarter’s
dividend will be paid to stockholders of record on Friday February 21st, 20X8. BFF has 200,000 common
shares outstanding. The retained earnings account has a balance of $15 million before the dividend, and
BFF holds $2.5 million in cash.
a) What is the ex-dividend date for this half year?
b) BFF traded for $22 per share the day prior to the ex-dividend date. What would you expect the stock
price to open at on the ex-dividend date? Give some reasons why this might not occur.
c) What is the effect of the dividend payment on BFF’s cash, retained earnings, and total assets.
Q2: Heath Brothers, Inc., has just announced a 100% stock dividend. The annual cash dividend per share
was $2.40 before the stock dividend. Heath Brothers intends to pay $1.40 per share on each of the new
shares. Compute the percentage increase in the cash dividend rate that will accompany the stock dividend.
Q3: Stiglitz Groceries, Inc. (50,000 common shares outstanding) currently has annual earnings before
interest and taxes of $1,000,000. Its interest expense is $200,000 a year, and it pays $100,000 in annual
dividend. The company’s tax rate is 40%, and its common stock’s current dividend yield is 2.0%.
a) Calculate the company’s earnings pers share (EPS).
b) Calculate the company’s dividend payout ratio (DPO).
c) Calculate the company’s current stock price.
d) If the company declares and pays a 100% stock dividend and then pays an annual cash dividend of
$1.10 per share, what is the effective rate by which the dividend has been increased?
Answer to selected problems:

Q2: 16.7%

Q3: a) EPS= $9.60, b) DPO= 20.8%, c) Price= $100, d) Dividend increase= 10%.