Topic 8 Dividends and Dividend Policy

MFA 8033
FINANCIAL
MANAGEMENT
1
TOPIC 8
DIVIDENDS AND
DIVIDEND POLICY
2
TOPIC LEARNING OUTCOME
 Display the understanding on the issues

surrounding dividend policy decision.
 Distinguish the difference between cash
and stock dividends and why share
repurchases are an alternative to
dividends.
3
CHAPTER 17
DIVIDENDS AND PAYOUT POLICY
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
KEY CONCEPTS AND SKILLS
• Define dividend types and how dividends are paid
• Explain the issues surrounding dividend policy

decisions
• Describe the difference between cash and stock

dividends
• Explain why share repurchases are an alternative to

dividends
17-5
CASH DIVIDENDS
• Regular cash dividend – cash payments made

directly to stockholders, usually each quarter
• Extra cash dividend – indication that the “extra”

amount may not be repeated in the future
• Special cash dividend – similar to extra dividend,

but definitely will not be repeated
• Liquidating dividend – some or all of the business

has been sold
17-6
DIVIDEND PAYMENTS
August 31 August 28 August 30 October 1
The date on Shares start to Shareholders The date on

which the firm trade without registered on which dividend
announces it the dividend, this date will checks are
intends to pay a thus “ex- receive the mailed to the
dividend dividend” dividend shareholders
Declaration Ex-dividend Record Payment

Date Date Date Date
17-7
DIVIDEND PAYMENTS
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
before this date is entitled to a dividend
Record Date - Person who owns stock on this

date received the dividend
17-8
DIVIDEND PAYMENT
• Declaration Date – Board declares the dividend,

and it becomes a liability of the firm
• Ex-dividend Date
 Occurs two business days before date of record
 If you buy stock on or after this date, you will not
receive the dividend.
 Stock price generally drops by about the amount of
the dividend.
• Date of Record – holders of record are determined,

and they will receive the dividend payment
• Date of Payment – checks are mailed

17-9
DIVIDEND PAYMENTS
Stock Dividend - Distribution of additional
shares to a firm’s stockholders
Stock Splits - Issue of additional shares to

firm’s stockholders
Stock Repurchase - Firm distributes cash

to stockholders by repurchasing shares
17-10
STOCK DIVIDEND
Example
Amoeba Products has 2 million shares currently
outstanding at a price of $15 per share. The
company declares a 50% stock dividend. How
many shares will be outstanding after the dividend
is paid?
Answer
2 mil × .50 = 1 mil + 2 mil = 3 mil shares
17-11
STOCK DIVIDEND
Example – continued
After the stock dividend, what is the new
price per share and what is the new value
of the firm?
Answer
• The value of the firm was 2 mil × $15 per
share, or $30 mil. After the dividend, the
value will remain the same.
• Price per share = $30 mil/3 mil shares =
$10 per share 17-12
FIGURE 17.2 – PRICE BEHAVIOR
AROUND THE EX-DIVIDEND DATE
17-13
DOES DIVIDEND POLICY MATTER?
• Dividends matter – the value of the stock is

based on the present value of expected
future dividends.
• Dividend policy may not matter

 Dividend policy is the decision to pay dividends
versus retaining funds to reinvest in the firm.
 In theory, if the firm reinvests capital now, it will
grow and can pay higher dividends in the future.
17-14
ILLUSTRATION OF IRRELEVANCE
• Consider a firm that can either pay out dividends with one of
two plans:
 Plan 1: can pay $10,000 per year for each of the next two years,
or
 Plan 2: can pay $9,000 this year, reinvest the other $1,000 into the
firm and then pay $11,120 next year.
 Investors require a 12% return.
• Compare the market value of the two plans:

 Present value of Plan 1 dividends:
PV of constant dividends = $16,900.51
 Present value of Plan 2 dividends:
PV growing dividends with reinvestment = $16,900.51
• If the company will earn the required return, then it doesn’t

matter when it pays the dividends.
17-15
Payout Information
Information content of dividends

 Dividend increases convey managers’
confidence about future cash flow and
earnings
 Dividend cuts convey lack of confidence
and therefore are bad news
17- 16
Stock Repurchase
Stock Repurchase (4 methods)

1. Open market repurchase
2. Tender offer to shareholders
3. Auction (Dutch auction)
4. Direct negotiation (Green mail)
17- 17
Dividend Decision Survey
Dividend Decision Survey (2005)
The cost of external capital is lower than the cost
of a dividend cut
Rather than reducing dividends we would raise
new funds to undertake a profitable project
We consider the change in the dividend
We are reluctant to make a change that may have

to be reversed
We look at the current dividend level
We try to maintain a smooth dividend stream
We try to avoid reducing the dividend
0 20 40 60 80 100
Executives who agree or strongly agree (%)
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 17- 18
Stock Repurchase (1 of 3)
Example — Cash dividend versus share repurchase

A. Original balance sheet
Assets Liabilities & Equity

A. Original balance sheet
Cash $150,000 Debt $0
Other assets 950,000 Equity 1,100,000
Value of firm 1,100,000 Value of firm 1,100,000
Shares outstanding = 100,000
Price per share = $1,100,000/100,000 = $11

B. After cash dividend of $1 per share

B. After cash dividend
Cash $50,000 Debt $0
Price per share = $1,000,000/100,000 = $10

C. After $100,000 stock repurchase program

C. After stock repurchase
Cash $50,000 Debt $0
Price per share = $1,000,000/90,909 = $11
Dividends and Signals
 Asymmetric information – managers have more
information about the health of the company than
investors
 Changes in dividends convey information
 Dividend increases
• Management believes it can be sustained
• Expectation of higher future dividends, increasing present value
• Signal of a healthy, growing firm
 Dividend decreases
• Management believes it can no longer sustain the current level
of dividends
• Expectation of lower dividends indefinitely; decreasing present
value
• Signal of a firm that is having financial difficulties 17-22
17- 22
The Dividend Decision
Senior Executive Dividend Policy Features
(How Dividends are Determined)
1. Managers are reluctant to make dividend changes
that might have to be reversed.
2. Managers “smooth” dividends and hate to cut
them. Dividends changes follow shifts in long-run,
sustainable levels of earnings.
3. Managers focus more on dividend changes than
on absolute levels
17- 23
The Dividend Decision
Factors in the Dividend Decision Process

1. Target payout ratios
2. Repurchase decisions
3. Information content of dividends and repurchases
17- 24
What We Know and Do Not Know
 Corporations “smooth” dividends
 Dividends provide information to the
market
 Firms should follow a sensible dividend
policy:
 Don’t 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
17-25
17- 25
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 dividend
payouts
 In other words, dividend policy will have no
impact on the value of the firm
17- 26
Dividends Increase Value
 Market Imperfections
– There are natural clients for high-payout
stocks, but it does not follow that any
particular firm can benefit by increasing its
dividends
– The high dividend clientele already have plenty
of high dividend stock to choose from
– These clients increase the price of the stock
through their demand for a dividend paying
stock
17- 27
Dividends Increase Value
 Dividends as Signals
– Dividend increases send good news about cash
flows and earnings
– Dividend cuts send bad news
– Because a high dividend payout policy will be
costly to firms that do not have the cash flow
to support it, dividend increases signal a
company’s good fortune and its manager’s
confidence in future cash flows
17- 28
Dividends Decrease Value
Tax Consequences
 Companies can convert dividends into capital
gains by shifting their dividend policies
 If dividends are taxed more heavily than capital
gains, taxpaying investors should welcome such a
move and value the firm more favorably
 In such a tax environment, the total cash flow
retained by the firm and/or held by shareholders
will be higher than if dividends are paid
17- 29
DIVIDENDS AND SIGNALS
• Asymmetric information – managers have more

information about the health of the company than
investors
• Changes in dividends convey information
 Dividend increases
• Management believes it can be sustained
• Expectation of higher future dividends, increasing present
value
• Signal of a healthy, growing firm
 Dividend decreases
• Management believes it can no longer sustain the current level
of dividends
• Expectation of lower dividends indefinitely; decreasing present
value
• Signal of a firm that is having financial difficulties 17-30
CLIENTELE EFFECT
• Some investors prefer low dividend payouts and will

buy stock in those companies that offer low
dividend payouts.
• Some investors prefer high dividend payouts and

will buy stock in those companies that offer high
dividend payouts.
17-31
IMPLICATIONS OF THE
CLIENTELE EFFECT
• What do you think will happen if a firm changes its
policy from a high payout to a low payout?
• What do you think will happen if a firm changes its

policy from a low payout to a high payout?
• If this is the case, does dividend policy matter?
17-32
STOCK REPURCHASE
• Company buys back its own shares of stock

 Tender offer – company states a purchase price and a
desired number of shares
 Open market – buys stock in the open market
• Similar to a cash dividend in that it returns cash

from the firm to the stockholders
• This is another argument for dividend policy

irrelevance in the absence of taxes or other
imperfections.
17-33
INFORMATION CONTENT OF
STOCK REPURCHASES
• Stock repurchases send a positive signal
that management believes the current
price is low.
• Tender offers send a more positive signal

than open market repurchases because
the company is stating a specific price.
• The stock price often increases when

repurchases are announced.
17-34
EXAMPLE: REPURCHASE
ANNOUNCEMENT
“America West Airlines announced that its Board of Directors
has authorized the purchase of up to 2.5 million shares of its
Class B common stock on the open market as circumstances
warrant over the next two years …”
“Following the approval of the stock repurchase program by

the company’s Board of Directors earlier today. W. A. Franke,
chairman and chief officer said ‘The stock repurchase
program reflects our belief that America West stock may be
an attractive investment opportunity for the Company, and it
underscores our commitment to enhancing long-term
shareholder value.”
“The shares will be repurchased with cash on hand, but only if

and to the extent the Company holds unrestricted cash in
excess of $200 million to ensure that an adequate level of
cash and cash equivalents is maintained.”
17-35
WHAT WE KNOW AND DO NOT
KNOW
• Corporations “smooth” dividends.
• Dividends provide information to the market.
• Firms should follow a sensible dividend policy:

 Don’t 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.
17-36
PUTTING IT ALL TOGETHER
• Aggregate payouts are massive and have

increased over time.
• Dividends are concentrated among a small

number of large, mature firms.
• Managers are reluctant to cut dividends.
• Managers smooth dividends.
• Stock prices react to unanticipated changes in

dividends.
17-37
THE MANAGEMENT VIEW OF
DIVIDEND POLICY
• Agree or Strongly Agree
 93.8% Try to avoid reducing dividends per share
 89.6% Try to maintain a smooth dividend from year to year
 41.7% Pay dividends to attract investors subject to “prudent
man” restrictions
• Important or Very Important

 84.1% Maintaining consistency with historic dividend policy
 71.9% Stability of future earnings
 9.3% Flotation costs to issue new equity
17-38
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%

17-39
STOCK SPLITS
• Stock splits – essentially the same as a stock

dividend except 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.”
17-40
COMPREHENSIVE PROBLEM
• A company’s stock is priced at $50 per

share, and it plans to pay a $2 cash
dividend.
 Assuming perfect capital markets, what will the

per share price be after the dividend payment?
 If the average tax rate on dividends is 25%, what

will the new share price be?
17-41
END OF CHAPTER
CHAPTER 17
17-42

Topic 8 Dividends and Dividend Policy

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MFA 8033

 Display the understanding on the issues

• Define dividend types and how dividends are paid

• Explain the issues surrounding dividend policy

• Describe the difference between cash and stock

• Explain why share repurchases are an alternative to

• Regular cash dividend – cash payments made

• Extra cash dividend – indication that the “extra”

• Special cash dividend – similar to extra dividend,

• Liquidating dividend – some or all of the business

August 31 August 28 August 30 October 1

The date on Shares start to Shareholders The date on

Declaration Ex-dividend Record Payment

Ex-Dividend Date - Date that determines

Record Date - Person who owns stock on this

• Declaration Date – Board declares the dividend,

• Date of Record – holders of record are determined,

• Date of Payment – checks are mailed

Stock Splits - Issue of additional shares to

Stock Repurchase - Firm distributes cash

• Dividends matter – the value of the stock is

• Dividend policy may not matter

• Compare the market value of the two plans:

• If the company will earn the required return, then it doesn’t

Information content of dividends

Stock Repurchase (4 methods)

We are reluctant to make a change that may have

We try to maintain a smooth dividend stream

We try to avoid reducing the dividend

Example — Cash dividend versus share repurchase

Assets Liabilities & Equity

Example — Cash dividend versus share repurchase

Assets Liabilities & Equity

Example — Cash dividend versus share repurchase

Assets Liabilities & Equity

 Changes in dividends convey information

Factors in the Dividend Decision Process

 Since investors do not need dividends to

• Asymmetric information – managers have more

• Some investors prefer low dividend payouts and will

• Some investors prefer high dividend payouts and

• What do you think will happen if a firm changes its

• If this is the case, does dividend policy matter?

• Company buys back its own shares of stock

• Similar to a cash dividend in that it returns cash

• This is another argument for dividend policy

• Tender offers send a more positive signal

• The stock price often increases when

“Following the approval of the stock repurchase program by

“The shares will be repurchased with cash on hand, but only if

• Dividends provide information to the market.

• Firms should follow a sensible dividend policy:

• Aggregate payouts are massive and have

• Dividends are concentrated among a small

• Managers are reluctant to cut dividends.

• Managers smooth dividends.

• Stock prices react to unanticipated changes in

• Important or Very Important

• Pay additional shares of stock instead of cash

• Increases the number of outstanding shares

• Small stock dividend

• Large stock dividend – more than 20 to 25%

• Stock splits – essentially the same as a stock

• Stock price is reduced when the stock splits.