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Lakehead University

Winter 2005

Types of Dividend

Dividends are usually paid in cash, and this four times a year. A company may also pay a stock dividend: • A 2% stock dividend, for instance, is such that shareholders receive 1 share for each 50 shares they own. • A 2-for-1 stock split is a 100% stock dividend.

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**Dividend Payment Procedure
**

Dividends are normally paid quarterly and, if conditions permit, the dividend is increased once a year. Suppose for example that a corporation paid $0.50 per quarter in 2003. Its annual dividend is then $2.00. If the corporation decided to increase the annual dividend to $2.08, say, then the quarterly dividend would be $0.52.

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**Dividend Payment Procedure
**

The procedure for paying dividends is as follows:

Declaration Date: On January 15, say, corporation XYZ announces that it will pay a dividend on February 16 of the same year. Holder-of-Record Date: At the close of business on the holder-of-record date, January 30, say, XYZ clsoes its stock transfer book and makes a list of shareholders to that date. If XYZ is not notiﬁed of the purchase of its stock by an individual before 5 PM on the record date, the individual does not get the dividend.

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Whoever buys the stock on or after the ex-dividend date does not receive the dividend. the ex-dividend date would be January 28.Dividend Payment Procedure Ex-Dividend Date: To avoid conﬂict. 5 Dividend Payment Procedure Jan 15 Jan 27 Jan 28 Jan 30 Feb 16 Declaration date Dividend goes with the stock Ex-dividend date Holder-of-record date Payment date 6 . the convention is that the right to the dividend remains with the stock until two days before the holder-of-record date. In the present example.

shareholders expect to receive (1 − td )d0 and tcg ( p0 − p0 ) if capital losses are tax ˜ deductible. the stock price should fall by d0 on the ex-dividend date. and suppose capital gains are taxed at the rate tcg . ˜ ˜ and thus p0 − p0 = ˜ 1 − td × d0 . The day prior to the ex-dividend date. Then p0 = p0 + (1 − td )d0 + tcg ( p0 − p0 ).Fall in Stock Price on the Ex-Dividend Date d0 ≡ dividend announced p0 ≡ stock price one day before the ex-dividend date ˜ p0 ≡ stock price on ex-dividend date p0 = p0 = p0 + d0 ˜ dt ∑ t t=1 (1 + rs ) ⇒ p0 − p0 = d0 . 1 − tcg 8 . 7 Fall in Stock Price on the Ex-Dividend Date (Taxes) Suppose dividends are taxed at the rate td . ˜ ∞ Without taxes.

XYZ has to either raise debt or equity.55 1 + rs (1 + rs )2 1.Dividend Irrelevance Theory XYZ. 9 Dividend Irrelevance Theory Suppose that XYZ wants to change its dividend policy.10 (1. which gives a stock price P0 = D1 D2 100 100 + = + = $173. an all-equity ﬁrm has 100 shares outstanding and a cash ﬂow of $10. 10 .10)2 where rs = 10% is the return required by shareholders (XYZ’s cost of capital when an all-equity ﬁrm). Instead of paying $100 per year to each shareholder. The ﬁrm can then pay a dividend of $100 per shares in each of these two periods. To ﬁnance the greater dividend.000 (including liquidation) over the next two years. it will pay $120 per share the ﬁrst year and whatever remains after liquidation of the ﬁrm on the second year.

11 Dividend Irrelevance Theory Equity Is Issued The new stock price is then P0 = 120 78 + 1.10)2 = = = = = = 120 1.10 $173. i.10 120 1.10 100 1. This means that there will be 10.55 12 . 200 = $7.10)2 100 − (1.10 120 1.10)2 20 × 1. a payment of $2.10)2 22 (1.10 (1.10 120 1.10)2 20 1. There is no increase in leverage and thus the new shareholders will also require a return of 10%. 000 − 2.e.10 + + + + + 100 − 22 (1.200 at the end of the second year.Dividend Irrelevance Theory Equity Is Issued If equity is issued new shares have to be issued in exchange of 100 × 20 = $2.10)2 100 (1.10 (1. 800 available to the old shareholders at time 2.10)2 100 − (1. 000 after one year.10)2 100 − (1.

1 + rs (1 + rs )2 14 . What happens if. 13 Dividend Irrelevance Theory Debt Is Issued The argument is more complex here but the increase in debt will increase the return required by shareholders.Dividend Irrelevance Theory Debt Is Issued Note that the price did not change when equity was issued to ﬁnance the dividend.e. 120 100 − 20(1 + rd ) + . i. the ﬁrm issues debt to pay the extra $20 dividend per share? Suppose the ﬁrm borrows $2. instead. 000 × (1 + rd ) at the end of year 2. It can be shown that P0 = P0 .000 in year 1 and repay $2. P0 = where rs > 10%.

16 .Dividend Irrelevance Theory Note that we have assumed • No taxes. no brokerage fees • Individuals have homogeneous beliefs • Investment policy is not affected by the dividend policy 15 Homemade Dividends Another argument in favour of the dividend irrelevance theory is that an investor not satisﬁed with the proposed stream of dividends can always create her own personalized stream of income by borrowing or lending.

˜ ˜ (1 + r)d0 + d1 .e. 1 + rs but the investor wants to receive all her dividends in period 1. d0 = 0. this gives p0 = 0 + ˜ If r = rs . 1 + rs 18 . then p0 = p0 . p0 = d0 + ˜ 17 Homemade Dividends If d0 can be saved at the rate r. i.Homemade Dividends Suppose that d1 .

That is. 19 Bird-in-the-Hand Theory M&M called this theory the bird-in-the-hand fallacy since investors tend to reinvest their dividends in securities that have the same risk characteristics as the stock paying the dividend. P0 D1 /P0 being more certain than g.Bird-in-the-Hand Theory Myron Gordon and John Lintner have argued that rs decreases as the dividend payout increases because investors are less certain of receiving the capital gains supposed to result from retaining earnings than they are of receiving dividend payments. 20 . take D1 rs = + g. rs will decrease as D1 increases.

to dividends. and thus a low payout ratio. Investors in high tax brackets may prefer capital gains. which means that they can be deferred indeﬁnitely. 22 .Taxes Preference Theory Dividends have greater tax consequences than capital gains. 21 Optimal Dividend Policy On the board. taxes on capital gains are paid only when the stock is sold. Also.

however. which is not possible. one must have a sample of ﬁrms that differ in their dividend policy only. More speciﬁcally.Empirical Evidence on Dividend Policy Empirical tests of dividend policy theories have not been too conclusive because of two reasons: • For a valid statistical test. • We must also be able to measure with a high degree of accuracy each ﬁrm’s cost of equity. different investors have different beliefs and some individuals have more information than others. 23 Other Dividend Policy Issues Signaling Hypothesis The M&M dividend irrelevance theory assumes that all investors have the same information regarding the ﬁrm’s future earnings. the ﬁrm managers have better information about future earnings than outside investors. things other than dividend policy must be held constant across the ﬁrms in the sample. In reality.e. 24 . another difﬁculty. i.

This may be due to the tax treatment of dividends or because some investors are seeking cash income while others want growth. These facts can be interpreted in two different ways: • Investors prefer dividends to capital gains. • Unexpected dividend increases can be seen as signals of the quality of future earnings (signaling theory). Changing the dividend policy may force some stockholders to sell their shares.Other Dividend Policy Issues Signaling Hypothesis It has been observed that dividend increases are often accompanied by an increase in the stock price and dividend decreases are often accompanied by stock price declines. 25 Other Dividend Policy Issues Clientele Effect Different groups (clienteles) of stockholders prefer different dividend policies. 26 .

28 . 27 Dividend Stability Since proﬁts vary over time. dividends should also vary. Many stockholders. • the likelihood that the shareholders who sell pay capital gains taxes. Cutting dividends may also send the wrong signal to investors who would then bid the stock price down. Maximizing the stock price requires a ﬁrm to balance internal needs of funds with stockholders’ needs.Other Dividend Policy Issues Clientele Effect This is not a problem if stockholders can switch without costs but there are • brokerage costs. rely on dividends to meet expenses. • a possible shortage of investors who like the ﬁrm’s newly adopted dividend policy. however.

30 . “stable dividend” means approximately the same dollar amount each year. – How the last dividend can help predict the next one. Dividends are paid only if more earnings are available than what is needed. “stable dividend” means a dividend that grows in line with inﬂation. The ﬁrm determines the amount of equity needed given the target capital structure. • There are two components to dividend stability: – The dividend growth rate. The ﬁrm determines its optimal capital budget. 3.Dividend Stability • Public company usually make ﬁve. dividends are determined as follows: 1. With inﬂation. 29 Dividend Policy in Practice The Residual Dividend Model Under this model. Retained earnings are used to meet equity requirements to the extent possible. 4. 2. • When inﬂation is not persistent.to ten-year ﬁnancial forecast of earnings.

If capital requirements were $200m.Dividend Policy in Practice The Residual Dividend Model Under the residual dividend model. the ﬁrm would not pay any dividend. 32 . The ﬁrm needs . its dividend will be 100 − 30 = $70m. dividends are determined as follows: Dividends = Net Income − Target Equity Ratio × Capital Needed 31 Dividend Policy in Practice The Residual Dividend Model Suppose a ﬁrm has a target equity ratio of 60% and needs to spend $50m on new projects. If its net income is $100m.6 × 50 = $30m in equity.

the lower the dividend paid. 3. the better the ﬁrm’s investment opportunities. Following the residual dividend policy rigidly would lead to ﬂuctuating dividends. something investors don’t like. 34 . ﬁrms should 1. Set a target payout ratio. Estimate earnings and investment opportunities. 33 Dividend Policy in Practice The Residual Dividend Model To satisfy shareholders’ taste for stable dividends. Use this information to ﬁnd out the average residual payout ratio.Dividend Policy in Practice The Residual Dividend Model Under the residual dividend model. on average over the next ﬁve to ten years. 2.

on new investments. on average.Dividend Policy in Practice Note that one way to maintain a regular dividend payment is to set a payment sufﬁciently low to never exceed the expected payment given by the target payout ratio. Note that r can be approximated by the return on equity (ROE). Let It denote investment at time t and let Et denote earnings at time t. and let r denote the rate of return the ﬁrm will earn. 36 . There are other factors inﬂuencing the dividend policy: • Bond indentures • Preferred stock restrictions • Availability of cash 35 Dividend Policy and Growth Rate Let b denote the ﬁrm’s retention ratio.

= That is. the expected growth rate in dividends can be approximated by Return on Equity (ROE) × Retention Ratio.Dividend Policy and Growth Rate Then Et = Et−1 + rIt−1 = Et−1 + rbEt−1 = (1 + rb)Et−1 . 37 Dividend Policy and Growth Rate The growth in dividends is then g = Dt − Dt−1 Dt−1 (1 − b)Et − (1 − b)Et−1 (1 − b)Et−1 Et − Et−1 = Et−1 = rb. 38 .

40 . Extra cash may then be distributed through stock repurchases. • Stockholders have a choice when a ﬁrm repurchases stocks: They can sell or not sell.Repurchases of Shares Advantages of Stock Repurchases • Repurchase announcements are viewed as positive signals by investors. • Dividends are sticky in the short-run because reducing them may negatively affect the stock price. 39 Repurchases of Shares Disadvantages of Stock Repurchases • Stockholders may not be indifferent between dividends and capital gains. • The selling stockholders may not be fully aware of all the implications of a repurchase. • The corporation may pay too much for the repurchased stocks. • The target payout ratio may be achieved with the help of repurchases.

the ﬁrm decides to repurchase n shares.Repurchases of Shares (vs Dividend Payment) The day before a dividend payment. and thus n is such that n p0 = n0 d0 ˜ ∞ 42 . the price of a stock is dt p0 = d0 + ∑ ˜ = d0 + (1 + rs )t t=1 ∞ CFt /n0 ∑ t t=1 (1 + rs ) ∞ where CFt is the cash ﬂow net of debt payments at time t and n0 is the initial number of shares. 41 Repurchases of Shares (vs Dividend Payment) Anybody left with a share will receive CFt /(n0 − n ) ˜ ∑ (1 + rs)t = p0 t=1 The ﬁrm uses dividend money to repurchase the shares. Suppose that instead of paying d0 .

Repurchases of Shares (vs Dividend Payment) This gives us p0 = ˜ CFt /(n0 − n ) (1 + rs )t t=1 ∑ ∞ ∞ CFt /n0 n0 ×∑ = n0 − n t=1 (1 + rs )t ∞ n0 CFt /n0 = ×∑ n0 − n0 d0 / p0 t=1 (1 + rs )t ˜ ∞ 1 CFt /n0 = ×∑ 1 − d0 / p0 t=1 (1 + rs )t ˜ 43 Repurchases of Shares (vs Dividend Payment) p0 ˜ ∞ CFt /n0 1 = ×∑ 1 − d0 / p0 t=1 (1 + rs )t ˜ d0 p0 − p0 × ˜ ˜ = p0 ˜ t=1 ∑ (1 + rs)t t=1 ∞ CFt /n0 ∞ p0 = d0 + ˜ ∑ (1 + rs)t CFt /n0 = p0 . ˜ 44 .

for example. A two-for-one split. 45 . In efﬁcient markets. means that each outstanding shares now becomes two separate shares. the two-for-one split of a $80 stock would create two $40 stocks.Stock Splits A stock split takes place when a ﬁrm declares that each outstanding share now becomes more than one share.

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