Chapter 4

DIVIDENDS AND OTHER PAYOUTS

Dr. Nguyen Quynh Tho

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Can the dividend policy bankrupt a firm?

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On December 3, 2014, Clothing Retail Company
H&M announced a broad plan to reward
stockholders for the recent success of the firm’s
business.
Under the plan, Corning would:
(1) boost its annual dividend by 20 percent, from
10 cents per share to 12 cents per share;
(2) repurchase $1.5 billion of the company’s
common stock.
Investors cheered, bidding up the stock price by
about 2.5 percent on the day of the
announcement. Why were investors so pleased?

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 Key Concepts and Skills

● Understand dividend types and how they are paid

● Understand the issues surrounding dividend policy
decisions
● Understand why share repurchases are an
alternative to dividends
● Understand the difference between cash and stock
dividends

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 Chapter Outline
1. Different Types of Payouts

2. Standard Method of Cash Dividend Payment

3. The Irrelevance of Dividend Policy

4. Repurchase of Stock

5. Personal Taxes, Dividends, and Stock Repurchases

6. Stock Dividends and Stock Splits

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 Part 1.
Different types of Payouts

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 Different Types of Payouts

● Dividend usually refers to a cash distribution of earnings.

o Dividend refers to a distribution from earnings
o Liquidating dividend refers to a distribution from capital
● The decision to pay a dividend is made by the board of
directors of the corporation.
● The most common type of dividend is in the form of cash.

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 Different Types of Payouts

1. Regular cash dividend

○ Public companies often pay quarterly.
○ Sometimes firms will pay an extra cash dividend.
○ Sometimes firms will pay an special dividend.

2. Stock dividends
○ No cash leaves the firm.
○ The firm increases the number of shares outstanding.
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 Different Types of Payouts

3. Stock split
○ Example: three for one stock spilt

○ The firm increases the number of shares outstanding.

4. Stock buybacks
○ Company use cash to buy back shares

○ The shares are accounted for as treasury stock

5. Dividend in kind
○ pay owners using products or services of the firm
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 Part 2.
Standard Method of Cash Dividend

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 2. Standard Method of Cash Dividend

● A dividend is distributable to shareholders of record on a

specific date.

● When a dividend has been declared, it becomes a

liability of the firm and cannot be easily rescinded by the
corporation.

● Expressed as Dividend per share, dividend yield,

dividend payout
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 2. Standard Method of Cash Dividend

Cash Dividend - Payment of cash by the firm to its

shareholders.

Ex-Dividend Date - Date that determines whether a

stockholder is entitled to a dividend payment; anyone
holding stock immediately before this date is entitled to a
dividend.

Record Date – Date on which company determines

existing shareholders.

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 Procedure for Cash Dividend

25 Oct. 2 Nov. 3 Nov. 5 Nov. 7 Dec.

…
Declaration Date Cum-dividend Ex-dividend Record Date Payment
Date Date Date

Declaration Date: The Board of Directors declares a payment of dividends.

Cum-Dividend Date: Buyer of stock still receives the dividend.
Ex-Dividend Date: Seller of the stock retains the dividend.
Record Date: The corporation prepares a list of all individuals believed to be
stockholders as of 5 November.
Payment Date: The dividend checks are mailed to the stockholders.

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 Price Behavior

●In a perfect world, the stock price will fall by the amount of the dividend on the ex-
dividend date.
-t … -2 -1 0 +1 +2 …

$P

$P - div
The price drops by the Ex-dividend
amount of the cash Date
dividend.

Taxes complicate things a bit. Empirically, the price drop is less

than the dividend and occurs within the first few minutes of the
ex-date.
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 Part 3.
The Irrelevance of Dividend Policy

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 The Irrelevance of Dividend Policy

● A compelling case can be made that dividend policy is

irrelevant.
● Since investors do not need dividends to convert shares
to cash; they will not pay higher prices for firms with higher
dividends.
 Dividend policy will have no impact on the value of the
firm because investors can create whatever income stream
they prefer by using homemade dividends.

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 Homemade Dividends

● Bianchi Inc. is a $42 stock about to pay a $2 cash dividend.

● Bob - Investor owns 80 shares and prefers a $3 dividend.
● Bob’s homemade dividend strategy:
○ Sell 2 shares ex-dividend

homemade dividends $3 Dividend

Cash from dividend $160 $240
Cash from selling stock $80 $0
Total Cash $240 $240
Value of Stock Holdings $40 × 78 $39 × 80
= $3,120 = $3,120
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 Dividends and Investment Policy

● Firms should never forgo positive NPV projects to

increase a dividend (or to pay a dividend for the first time).

● Recall that one of the assumptions underlying the

dividend-irrelevance argument is: “The investment policy of
the firm is set ahead of time and is not altered by changes
in dividend policy.”

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 Part 4.
Repurchase of Stock

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 Repurchase of Stock

● Instead of declaring cash dividends, firms can rid

themselves of excess cash through buying shares of their
own stock.

● Recently, share repurchase has become an important

way of distributing earnings to shareholders.

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 Stock Repurchase versus Dividend

Consider a firm that wishes to distribute $100,000 to its shareholders.

Assets Liabilities & Equity

A. Original balance sheet
Cash $150,000 Debt 0
Other Assets 850,000 Equity 1,000,000
Value of Firm 1,000,000 Value of Firm 1,000,000
Shares outstanding = 100,000
Price per share = $1,000,000 /100,000 = $10

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 Stock Repurchase versus Dividend

If they distribute the $100,000 as a cash dividend, the balance sheet will
look like this:
Assets Liabilities & Equity
B. After $1 per share cash dividend
Cash $50,000 Debt 0
Other Assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding = 100,000
Price per share = $900,000/100,000 = $9

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 Stock Repurchase versus Dividend

If they distribute the $100,000 through a stock repurchase, the balance

sheet will look like this:
Assets Liabilities & Equity
C. After stock repurchase
Cash $50,000 Debt 0
Other Assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding = 90,000
Price per share = $900,000 / 90,000 = $10

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 Why Share Repurchase?

● Flexibility for shareholders

● Keeps stock price higher

● Offset to Dilution

● Stock undervaluation

● Tax benefits
 Part 5.
Personal Taxes, Dividends,
and Stock Repurchases

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 Personal Taxes, Dividends, and Stock Repurchases

●To get the result that dividend policy is irrelevant, we needed three
assumptions:
○No taxes
○No transactions costs
○No uncertainty

●In the United States, both cash dividends and capital gains are
(currently) taxed at a maximum rate of 15 percent.
●Since capital gains can be deferred, the tax rate on dividends is
greater than the effective rate on capital gains.

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 Firms without Sufficient Cash

The direct costs of stock

Investment Bankers issuance will add to this
effect.

Cash: stock issue

Stock
Firm
Holders
Cash: dividends

Taxes
In a world of personal taxes, firms
Gov.
should not issue stock to pay a dividend.

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 Firms with Sufficient Cash

● The above argument does not necessarily apply to firms with

excess cash.
● Consider a firm that has $1 million in cash after selecting all
available positive NPV projects.
○ Select additional capital budgeting projects (by assumption, these are
negative NPV).

○ Acquire other companies

○ Purchase financial assets

○ Repurchase shares
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 Taxes and Dividends

● In the presence of personal taxes:

1. A firm should not issue stock to pay a dividend.

2. Managers have an incentive to seek alternative uses for funds

to reduce dividends.

3. Though personal taxes mitigate against the payment of

dividends, these taxes are not sufficient to lead firms to
eliminate all dividends.

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Real-World Factors Favoring High Dividends

●Desire for Current Income

●Behavioral Finance

○ It forces investors to be disciplined.

●Tax Arbitrage

○ Investors can create positions in high dividend yield securities that avoid tax liabilities.

●Agency Costs

○High dividends reduce free cash flow.

 Part 6.
Stock Dividends and Stock Splits

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 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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 Stock Splits

● Stock splits – essentially the same as a stock dividend

except it is 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.”

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 The Clientele Effect

●Clienteles for various dividend payout policies are likely to form in the
following way:

Group Stock Type

High Tax Bracket Individuals Zero-to-Low payout

Low Tax Bracket Individuals Low-to-Medium payout
Tax-Free Institutions Medium payout
Corporations High payout
Once the clienteles have been satisfied, a corporation is
unlikely to create value by changing its dividend policy.

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 What We Know and Do Not Know

● Corporations “smooth” dividends.

● Fewer companies are paying dividends.

● Dividends provide information to the market.

● Firms should follow a sensible policy:

○ Do not forgo positive NPV projects just to pay a dividend.

○ Avoid issuing stock to pay dividends.

○ Consider share repurchase when there are few better uses for the cash.

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 General Dividend Guidelines

● Over time pay out all free cash flows

● Avoid cutting positive NPV projects to pay dividends or buy back shares

● Do not initiate dividends until the firm is generating substantial free cash
flows

● Set the current regular dividend consistent with a long-run target payout ratio

● Set the level of dividends low enough to avoid expensive future external
financing

● Use repurchases to distribute transitory cash flow increases

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 1. What are the different types of dividends, and
how is a dividend paid?
2. What is the clientele effect, and how does it
affect dividend policy irrelevance?
Quick Quiz 3. What is the information content of dividend
changes?
4. What are stock dividends, and how do they
differ from cash dividends?
5. How are share repurchases an alternative to
dividends, and why might investors prefer
them?

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