Professional Documents
Culture Documents
Concepts
◼ 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
Outline
Different Types of Dividends
Standard Method of Cash Dividend Payment
The Benchmark Case: An Illustration of the Irrelevance of
Dividend Policy
Repurchase of Stock
Personal Taxes and Dividends
Real-World Factors Favoring a High Dividend Policy
The Clientele Effect: A Resolution of Real-World Factors?
What We Know and Do Not Know about Dividend Policy
Stock Dividends and Stock Splits
Different Types of Dividends
◼ Many companies pay a regular cash dividend.
◼ Public companies often pay quarterly.
◼ Sometimes firms will pay an extra cash dividend.
◼ The extreme case would be a liquidating dividend.
◼ Companies will often declare stock dividends.
◼ No cash leaves the firm.
◼ The firm increases the number of shares outstanding.
◼ Some companies declare a dividend in kind.
◼ Wrigley’s Gum sends a box of chewing gum.
◼ Dundee Crematoria offers shareholders discounted cremations.
Standard Method of Cash Dividend
Cash Dividend - Payment of cash by the firm
to its shareholders.
₹P
₹P - div
The price drops Ex-
by the amount of dividend
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.
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.
◼ In other words, 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.
Homemade Dividends
$ 42
$ 3,360 = 80 shares
share
• After a ₹3 dividend, his total wealth is still ₹3,360:
$ 39
$ 3,360 = 80 shares + $ 240
share
• After a ₹2 dividend and sale of 2 ex-dividend shares, his
total wealth is still ₹3,360:
$ 40
$ 3,360 = 78 shares + $ 160 + $ 80
share
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.”
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.
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
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
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 pershare = ₹900,000 / 90,000 = ₹10
Share Repurchase
◼ Flexibility for shareholders
◼ Keeps stock price higher
◼ Good for insiders who hold stock options
◼ As an investment of the firm (undervaluation)
◼ Tax benefits
Personal Taxes and Dividends
◼ 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 taxed at a maximum rate of 15 percent.
◼ In India companies pay a corporate dividend tax
rate of 12.5% ( Previously shareholders used to pay
tax based on their tax bracket)
◼ Since capital gains can be deferred, the tax rate on
dividends is greater than the effective rate on
capital gains.
Firms without Sufficient Cash
Taxes
In a world of personal taxes,
firms should not issue stock to
Gov. pay a dividend.
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
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.
Real-World Factors Favoring High
Dividends
◼ Desire for Current Income
◼ Behavioral Finance
◼ It forces investors to be disciplined.
◼ Agency Costs
◼ High dividends reduce free cash flow.
The Clientele Effect
◼ Clienteles for various dividend payout policies are
likely to form in the following way: