DIVIDEND POLICY Chapter 17

Alex Tajirian

1997 Alex Tajirian . OUTLINE # # # # What to do with excess cash? Types of dividends Theories of optimal dividend policy: dividend puzzle Some practical considerations © morevalue.com.Dividend Policy 17-2 1.

Dividend Policy 17-3 Graphics: WHAT TO DO WITH EXCESS CASH © morevalue.com. 1997 Alex Tajirian .

borrowing) constant. it is a trade-off between retained earnings on one hand. © morevalue. Dividend Policy: What happens to the value of the firm as dividend is increased. holding everything else (capital budgets.com. 1997 Alex Tajirian . Thus.Dividend Policy 17-4 2. and distributing cash or securities on the other. OBJECTIVE & DEFINITION Definition: Dividend is the distribution of value to shareholders.

Dividend Policy 17-5 3. © morevalue. regular + "extra" . 1997 Alex Tajirian . TYPES 3.com.5 for every share you hold Regular. special Dates: |_____________|______________|___________|____ 1/15 1/26 1/30 2/15 Declaration Ex-dividend Record Payment Date Date Date Date Only investors who hold the security prior to the ex-dividend date receive the dividend.1 CASH DIVIDEND1 Example: $.

com. Q If management re-purchases stocks. thus value of firm increases !? 3. ! Firm has no obligation to make future repurchases. As an obstacle to takeovers. Q ! Greenmail EPS increases. © morevalue.3 STOCK REPURCHASE2 3.Dividend Policy 17-6 3.2 STOCK DIVIDEND Example: 1 new stock for each 10 you hold 3.2 Reasons ! Alternative to "extra" or special dividend. Example. ! ! If management believes the stock is under-valued. 1997 Alex Tajirian .1 Method in the open market tender offer direct negotiation with major shareholders 3. then the price increases. thus prevents raiders from acquiring company at an attractive price. A company just sold a division and cannot use the proceeds for favorable investments.3 Advantages( ! Shareholders have a choice: sell shares or keep.

(2-1 split).4 STOCK SPLIT Example. ! ! Argument for splits: To make stock "more attractive" to investors?! Value of firm is not expected to change. © morevalue..4 Disadvantages.3. for every share you own. ! May signal to investors that the firm's investment opportunities are limited.e. Example: Greenmail 2. 1997 Alex Tajirian . i.Dividend Policy 17-7 2. ! The firm may pay too high a price for the repurchase.com. now you own two.

© morevalue. rightists (high dividend). 1997 Alex Tajirian . leftists (low payoff). Firm and investors have identical opportunities.1 IRRELEVANT M & M in the case of perfect markets. Reasoning: There is nothing the firm can do that investors cannot duplicate.com. DIVIDEND CONTROVERSY THEORIES Irrelevant. Middle of the Road k = capital gains + dividend yield 4.Dividend Policy 17-8 4.

What about return? ! Grand Ma's argument: "I need the regular cash dividend to live on!" 4..2 RIGHTISTS ! Bird in the hand fallacy.... 1997 Alex Tajirian .com. But tax on dividends must be paid now.. CFT 100 60 .Dividend Policy 17-9 4. © morevalue.. .. "Paying out some cash today reduces risk of future payoff uncertainty" Alternatives 1 2 CF1 0 20 CF2 0 20 CF .3 LEFTISTS Tax argument: Tax on dividends = tax on income $ tax on capital gains. while on capital gains would be in the future. ..

T)]20 = 100 [ 1 + . T = 40% Case 1.75 ..75 .75 after tax FV20 = final value . Investor takes money and buys back stock FV20 = $100 (1 + After tax rate of return )20 = 100 [1 + ks (1 .(.Dividend Policy 17-10 Illustration.1)20 = 672. 1997 Alex Tajirian .100) = 443. Invest $100. © morevalue.7 ˆ Case 1 is better.4)]20 = 320. Optimal dividend policy is zero/very low. ks = 10% . Assume that all earnings are paid as dividends. Stock held for 20 years.65 Case 2. FV20 = $100(1+.1(1 .75 .4)(672. Thus.tax paid = 672.(T)(capital gains) = 672.com.

Dividend Policy 17-11 hg. dividend and tax © morevalue.com. 1997 Alex Tajirian .

Market Reaction to Dividend `: Price usually `.Dividend Policy 17-12 4. 1997 Alex Tajirian . in that the firm's future opportunities are not good. In practice. ! ! © morevalue. Institutional Restrictions: Many trust portfolios are required to protect the investment principle and can only spend investment income. Regular dividend can be used by managers to provide information/signal about future prospects. Investors interpret it as a negative signal.4 MIDDLE OF THE ROAD Signaling. 5. they tend to invest in companies with high dividends. They have to distribute them as dividends. Thus.com. it is too expensive to signal with dividends. PRACTICAL ISSUES ! Legal Requirements: Companies cannot keep "excess" cash as retained earnings if no investment opportunities exist.

Dividend Policy 17-13 6.com. DIVIDEND POLICY IN PRACTICE ! ! ! Constant $ pay-off Constant payoff: fixed % of earnings Residual Theory: Pay out $ that cannot be re-invested in the firm at the required rate of return ks. 1997 Alex Tajirian . © morevalue.

© morevalue.com. On recent trends. E56. See LAT 6/12/92 p. On Dividend Reinvestment Plans (DRIPs) see LAT 2/16/93 p. 2. 1997 Alex Tajirian . E164. E158.Dividend Policy 17-14 7. ENDNOTES 1. see LAT 1/27/93 p.

com. then it should acquire another. the optimal dividend policy should be zero dividends. would be 3 times the original price. 9. tax laws.Dividend Policy 17-15 8. then you can conclude that investors prefer dividend income over capital gains. 5. 1997 Alex Tajirian .S. 8. QUESTIONS True\False-Explain 1. after the split. A 3-to-1 stock split means that for every 3 shares you currently own you end up with one. announces an increase in its dividends and the price of the stock increases on the same day. If splitting a stock increases its liquidity. If a company has excess cash. 2. Stock repurchase is a form of dividend. 3. the new price. Given U. Stock splits should have no effect on the value of a company. © morevalue. 4. Moreover. 7. SPDRs can have no disadvantages over an S&P500 mutual fund. If XYZ Inc. The 1993 tax changes (tax on dividend $ tax on capital gains) make high dividend paying stocks more attractive to the average investor. then the firm necessarily benefits. 6.

1997 Alex Tajirian . Thus. A possible explanation for the price increase might be than investors interpret the increase as a strength in the company's future earnings prospects. True. they buy the stock.Dividend Policy 9. If the company does not have any positive NPV projects to invest in. False. 4. True. then it should pay shareholders dividend (either extra dividends or repurchase stock). 2. and thus its price goes up. An alternative explanation. Since dividends are defined as a distribution of wealth. Thus. which has nothing to do with dividends. False.com. Value of Firm ' Price× (# of Shares) Value After Split: Price × (# of shares × 2) 2 Y Value unchanged 5. might be that the general stock © morevalue. additional value has to be distributed to shareholders. acquiring another company in the same line of business is also considered a project. 3. Note. Stocks have to be repurchased at a price higher than then market price.0 ANSWERS TO QUESTIONS 17-16 True\False-Explain 1. See notes for explanation True. this increases the demand for the stock.

9. With a 3-to-1 split you end up with 3 shares for each that you held. Remember the secondary market is for the exchange of ownership. 8. the new price ought to be a third of the original price. It is the primary market that is more of a concern to the firm. The new lax laws make high paying dividend stocks even less attractive to the average investor. from the underlying stocks.Dividend Policy market went up. 1997 Alex Tajirian . False. can devise a dividend reinvestment plan to reduce the dividend tax effect. Liquidity in the secondary market benefits the investors not the company. One disadvantage of SPDRs is that dividends. are distributed to shareholders. and so did XYZ Inc! 6. False. 7. False. on the other hand. Moreover. An index fund. 17-17 False.com. Actually the opposite is true. © morevalue.

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