Titman CH 16 - Dividend Policy

Financial Management:
Principles & Applications

Thirteenth Edition
Chapter 16
Dividend Policy
Copyright © 2018, 2014, 2011 Pearson

Copyright Education, Inc. Education,
© 2018, 2014, 2011 Pearson All Rights
Inc. All Reserved
Rights Reserved
Learning Objectives
1. Distinguish between the use of cash dividends
and share repurchases.
2. Understand the tax treatments of dividends and
capital gains, and the conditions under which
dividend policy is an important determinant of
stock value.
3. Describe corporate dividend policies that are
commonly used in practice.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Principles Applied in This Chapter
• Principle 1: Money Has a Time Value.
• Principle 3: Cash Flows Are the Source of Value.
• Principle 4: Market Prices Reflect Information.
Introduction (1 of 2)
When a firm generates cash from operations, what
can the firm do with the cash?
1. Use the cash to fund new investments,
2. Use the cash to pay off some of the firm’s
debt, and/or
3. Distribute the cash back to the firm’s
shareholders either as a cash dividend or as
stock repurchases.
Introduction (2 of 2)
This chapter provides answers to three questions
regarding a firm’s dividend policy:
1. What are the pros and cons of the methods
the firm can use to distribute cash?
2. Why should the firm’s shareholders care
about the firm’s dividend policy given that they
can generate cash when they need it by
selling some of their shares?
3. What cash distribution policies do most firms
use in practice?
16.1 HOW DO FIRMS DISTRIBUTE
CASH TO THEIR SHAREHOLDERS?
How Do Firms Distribute Cash to their
Shareholders? (1 of 2)
Cash distributions by a firm to its stockholders can
take one of two basic forms:
1. Cash dividend - firm pays cash directly to the
shareholders.
2. Share repurchase - firm uses cash to buy back
its own shares from the market place, thereby
reducing the number of outstanding shares.
How Do Firms Distribute Cash to their
Shareholders? (2 of 2)
The impact on the balance sheet will be as follows:
– Assets side - cash will be reduced due to cash
dividends or share repurchase.
– Equity side - there will be a corresponding decrease.
Figure 16.1 Historical Distributions to Shareholders Through
Dividends and Share Repurchases
(Panel A) Cash
Distributions to
Shareholders:
Dividends and
Repurchases
(Panel B) Relative
Importance of
Sources:
Dividends and http://www.reuters.com/
Share investigates/special-rep
ort/usa-buybacks-canni
Repurchases
balized;
http://www.yardeni.com
/Pub/buybackdiv.pdf;
and
http://www.factset.com/
websitefiles/PDFs/buyb
ack/buyback_12.15.15.
Cash Dividends
A firm’s dividend policy determines how much
cash it will distribute to its shareholders and when
these distributions will be made. Dividend policy has
two fundamental attributes:
– The fraction of firm earnings paid in dividends
(dividend payout ratio), and
– the pattern of payments followed by the firm over time.
Dividend Payment Procedures
Date Explanation Calendar Date
Declaration Date Dividend is declared. March 15
Ex-Dividend Date Shares begin trading ex-dividend. May 17
Date of Record Dividend will be paid to shareholders who own the May 19
stock on this date.
Payment Date Dividends are distributed to the shareholders of May 27

record on the record date.
Stock Repurchases
A company engages in a share or Stock repurchase
(stock buyback) when it uses the firm’s cash to
repurchase some of its own stock. This results in a
reduction in the firm’s cash balance as well as the
number of shares of stock outstanding.
How do Firms Repurchase Their Shares?
(1 of 2)
• Open Market Repurchase - Here the firm

acquires the stock on the market, often buying a
relatively small number of shares everyday, at the
going market price.
• Tender Offer - Here the company makes a formal
offer to buy a specified number of its shares at a
stated price. The tender price is set above the
market price to attract sellers.
How do Firms Repurchase Their Shares?
(2 of 2)
Direct Purchase from a large investor - Here the

firm purchases the stock from one or more major
stockholders on a negotiated basis. This method is
seldom used.
Personal Tax Considerations—Dividend
Versus Capital Gains Income
Historically, the U.S. tax code has had a built-in
preference for capital gains income over dividend
income. However, one of the important recent changes
to the tax code established the same tax rate for
corporate dividends and capital gains.
Specifically, the maximum tax rate on qualifying
dividends and long-term capital gains is now 15% for
those in the 25 and 35 percent tax brackets, and 20%
for those whose income surpasses the 35 percent
bracket. For those in the 10 and 15 percent tax
brackets, they are tax-free.
Noncash Distributions: Stock Dividends
and Stock Splits (1 of 2)
• A stock dividend is a pro-rata distribution of
additional shares of stock to the firm’s current
stockholders.
• For example, a firm might pay a stock dividend of
.20 shares of stock per share or 2 shares for every
10 held.
Noncash Distributions: Stock Dividends
and Stock Splits (2 of 2)
• Stock split is essentially a very large stock
dividend.
• For example, a 2-for-1 split would entail receiving
two new shares for every old share currently held
and the share price will drop in half.
Rationale for a Stock Dividend or Split
One rationale for splits and stock dividends is that
financial executives believe there is an optimal
trading price range for the firm’s stock. If the price
exceeds that optimal range, it can be brought back
to the optimal range by doing a stock split or paying
stock dividend.
16.2 DOES DIVIDEND POLICY
MATTER?
Does Dividend Policy Matter?
Modigiliani and Miller proposition states that, without
taxes and transaction costs, cash dividends and
share repurchases are equivalent and the timing of
the distribution is unimportant.
The Irrelevance of the Distribution Choice
(1 of 2)
The distribution choice is matter of irrelevance

under the following conditions (or assumptions):
1. There are no taxes.
2. No transaction costs are incurred in either
buying or selling shares of stock.
3. The firm’s operating and investment policies
are fixed.
The Irrelevance of the Distribution Choice
(2 of 2)
The dividend irrelevancy proposition can be

illustrated in two ways:
1. Timing of dividend distributions does not affect
firm value.
2. In the absence of taxes and transaction costs,
a cash dividend is equivalent to a share
repurchase.
Figure 16.2 Dividend Policy Choices Faced by Clinton
Enterprises (1 of 2)
(Panel A) Dividend Policy Alternative 1: Dividends = 100 percent of Year

0 and Year 1 Cash Flows
Figure 16.2 Dividend Policy Choices Faced by Clinton
Enterprises (2 of 2)
(Panel B) Dividend Policy Alternative 2: Dividends = 150 percent of Year

0 Cash Flows and Remainder in Year 1
The Timing of Dividend is Irrelevant
Figure 16-2 considers two alternatives:
1. Pay $35M now and $135M in one year
2. Pay $52.5M now and $114.875M in one year
• In both cases, the value of share remains the
same at $15.24 per share.
CHECKPOINT 16.1: CHECK YOURSELF
Stock Price and the Timing of Dividend Payments
The Problem
Consider Alternative #3 in which Northwest Wire
and Cable decides to increase its current period
dividend to only $8 million. Show that the firm’s
equity under this scenario would be $30.79 million.
Step 1: Picture the Problem
The firm is considering two alternatives:
– Pay $4 million today and $30 in year 1 as liquidating
dividend; or
– Pay $8 million today and pay $25.52 in year 1 ($30
million - $4million*1.12 paid to new shareholders)
Step 2: Decide on a Solution Strategy
The value of Northwest Wire and Cable company’s
equity is equal to the present value of the firm’s
expected cash dividends. We can estimate the
value using equation 16-1.
Step 3: Solve (1 of 2)
Value – Alternative 1
Value = $4 million + $25.52 million /(1.12)1

Value = $30.79 million
Step 3: Solve (2 of 2)
Value – Alternative 2
Value = $8 million + $30 million /(1.12)1

Value = $30.79 million
Step 4: Analyze
• This example illustrates that the timing of dividend
payment does not affect the value of the firm.
• This was true because we held constant the firm’s
investment cash flows. We also assumed that the
new shares could be issued under the same terms
as the existing shares.
The form of Payment (Cash Dividend
Versus Share Repurchase) is Irrelevant
Table 16.1 illustrates two possibilities for the use of
$1,000,000 in cash flows:
1. A $1,000,000 cash dividend.
2. A $1,000,000 stock repurchase.
• It is observed that the value is the same so an
investor will be indifferent between the two
options.
Table 16.1 Wealth Effects of Cash Distributions: Dividends
and Share Repurchases (1 of 2)
(Panel A) Firm Setting

Blank Current Alternative Alternative Alternative
Situation 1—Pay 2-a—Repurchase/P 2-b—Repurchase/P
Dividend ettys Sell Shares ettys Retain Shares
Earnings $1,000,000 Blank Blank Blank
Shares 500,000 500,000 450,000 450,000
Earnings per share $ 2.00 $ 2.00 $ 2.22 $ 2.22
Cost of equity 11.11% Blank Blank Blank
Share price (predistribution) $ 18.00 $ 20.00 $ 20.00 $ 20.00
Share price (postdistribution) Blank $ 18.00 $ 20.00 $ 20.00
Equity value (market cap) $9,000,000 $9,000,000 $9,000,000 $9,000,000
Table 16.1 Wealth Effects of Cash Distributions: Dividends
and Share Repurchases (2 of 2)
(Panel B) Wealth Effects on the Petty Family’s 10% Holdings (No
Taxes)
Cash distribution proceeds Blank $ 100,000 $ 100,000 $ —
% share ownership of the 10% 10% 10.00% 11.11%
Petty family
Shares held by the Petty 50,000 50,000 45,000 50,000
family
Value of equity holdings $ 900,000 $ 900,000 $ 900,000 $1,000,000
Blank Blank Blank Share Repurchase Blank
Wealth Effects of the Alternative 1— Alternative 2-a— Alternative 2-b—
Alternatives Pay Dividend Repurchase/Pettys Repurchase/Pettys
Sell Shares Retain Shares
Cash distribution Blank $ 100,000 $ 100,000 $ —
(dividends or sale of
shares)
Total value of shares held Blank $ 900,000 $ 900,000 $1,000,000
by the Petty family
Total cash plus value of Blank $1,000,000 $1,000,000 $1,000,000
shares
Individual Wealth Effects: Personal Taxes
(1 of 2)
Here are some tax facts concerning dividends and stock

repurchases:
1. All cash dividends received by individuals are
taxable in they year in which they are received.
2. When individuals sell shares of stock, tax is
assessed only on the capital gain.
3. If an individual investor decides not sell his or her
shares to the company making stock repurchase,
he or she will not incur a taxable gain.
Individual Wealth Effects: Personal Taxes
(2 of 2)
• Table 16.2 shows the cash flow consequences of

the alternative methods for distributing cash to the
shareholders that were introduced in Table 16-1.
• It is assumed that both dividends and capital gains
are taxed at 15%.
Table 16.2 Dividends Versus Share Repurchases with
Personal Taxes (1 of 2)
(Panel A) Tax Rates Equal 15% for Dividends and Capital Gains:
Basis in Shares Sold Is $0
Tax basis in shares $0 Blank Blank
Tax rate on dividends and capital 15% Blank Blank

gains
Alternative Alternative Alternative
After-Tax Wealth Effects of the 1—100% 2-a—Repurchase/P 2-b—Repurchase/P
Alternatives Dividend ettys Sell Shares ettys Retain Shares
Cash distribution (dividends or
$100,000 $ 100,000 $ —
sale of shares)
Less: Taxes (15,000) (15,000) —
After-tax cash distribution $ 85,000 $ 85,000 $ —
Total value of shares held by the
900,000 900,000 1,000,000
Petty family
Total cash plus value of shares $985,000 $ 985,000 $1,000,000
Table 16.2 Dividends Versus Share Repurchases with
Personal Taxes (2 of 2)
(Panel B) Tax Rates Equal 15% for Dividends and Capital Gains:
Basis in Shares Sold Is $20
Tax basis in shares $ 20.00 Blank Blank
Tax rate on dividends and 15% Blank Blank

capital gains
Alternative Alternative Alternative

After-tax wealth effects of the 1—100% 2-a—Repurchase/P 2-b—Repurchase/P
alternatives Dividend ettys Sell Shares ettys Retain Shares
Cash distribution $100,000 $ 100,000 $ —
Less: Taxes (15,000) — —
After-tax cash distribution $ 85,000 $ 100,000 $ —
Total value of shares held by the 900,000 900,000 1,000,000

Petty family
Total cash plus value of shares $985,000 $1,000,000 $1,000,000
Why Dividend Policy is Important?
There are reasons why a firm might want to
continue paying a cash dividend. Some of the
important reasons follow.
Transactions are Costly
Since taxes are incurred when dividends are
received and transactions costs are incurred when
buying and selling shares, investors will prefer to
select companies whose dividend policy match up
with their own preferences. Because firms with
different dividends attract different dividend
clienteles, it is important that dividend policy
remain somewhat stable.
The Information Conveyed by Dividend
and Share Repurchase Announcements
• Information can affect future valuation. Firms tend
to increase their dividends when dividends can be
sustained in the future. In such cases, dividend
increase is clearly good news and stock prices
tend to increase.
• When firms announce that they are initiating a
repurchase program, their stock prices tend to rise
as it reveals that the firm has generated more
money than it currently needs, and/or the equity is
currently underpriced.
The Information Conveyed by Stock
Dividend and Stock Split Announcement
Announcements of stock dividends and stock splits
tend to generate positive stock returns. Some have
suggested that firms have a preferred trading range
and stock splits help bring stock prices to that
trading range. Another possibility is that stock splits
and stock dividends tend to attract attention. CEOs
will not like to attract attention if have something
bad to hide.
16.3 CASH DISTRIBUTION POLICIES IN PRACTICE
Stable Dividend Payout Policy
• In a survey of CEOs, most CEOs recognized the
importance of maintaining consistency and
stability in dividend policy (see figure 16.3)
• Table16.3 summarizes the views of financial
executives about payout policy.
Figure 16.3 Survey of CFO Opinions Regarding Dividend
Policy Issues (1 of 2)
(Panel A) Agreement with Dividend Policy Statements
Figure 16.3 Survey of CFO Opinions Regarding Dividend
Policy Issues (2 of 2)
(Panel B) Importance of Dividend Policy Statements
Source: A. Brav, J. R. Graham, C. R. Harvey, and R. Michaely, “Payout Policy in the 21st Century,” Journal of Financial
Economics, 77 (2005), 483–527.
Table 16.3 Summary of Financial Executives’ Views about
Payout Policy
Dividends Blank Repurchases
Very important. Do not cut dividends except in Historical Level Historical level is not important.
extreme circumstances.
Sticky. Inflexible. Smooth through time. Flexibility Very flexible. No need to smooth out.
Little reward for increasing. Consequence If Stock price increases when repurchase plan
Increased announced.
Big market penalty for reducing or omitting. Consequence If Little consequence to reducing from one
Reduced year to the next, although firms try to
complete plans.
Most common target is the level of dividend, Target Most common target is dollar amount of
followed by payout ratio and growth in dividends. repurchases, a very flexible target.
Target is viewed as rather flexible.
External funds would be raised before cutting Relation to Repurchases would be reduced before
dividends. External Funds raising external funds.
First maintain historical dividend level; then Relation to First make investment decisions; then make
make incremental investment decisions. Investment repurchase decisions.
Dividend increases tied to permanent, stable Earnings Quality Repurchases increase with permanent
earnings. earnings but also with temporary earnings.
Economics 77 (September 2005): 483–527.
Stock Repurchase Decision
Figure 16-4 reveals that stock repurchase decisions
are driven by executive’s feeling that, first, the stock
is a good investment relative to its true value and,
second, that there are a lack of good investment
opportunities to pursue.
Figure 16.4 Factors Important to Your Company’s
Repurchase Decision
Economics 77 (September 2005): 483–527.
Residual Dividend Policy
Under the residual dividend policy, dividends are
paid out of the residual earnings that are not
needed to finance new investment opportunities.
Other Factors Playing a Role in How Much
to Distribute
• Liquidity Position
• Lack of Other Sources of Financing
• Earnings Predictability
Key Terms (1 of 2)
• Cash dividend
• Date of record
• Declaration date
• Dividend clienteles
• Dividend payout ratio
• Dividend policy
• Ex-dividend date
Key Terms (2 of 2)
• Open market repurchases
• Payment date
• Residual dividend payout policy
• Stock dividend
• Share or stock repurchase
• Stock split
• Tender offer
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Financial Management:

Principles & Applications

Copyright © 2018, 2014, 2011 Pearson

Declaration Date Dividend is declared. March 15

Ex-Dividend Date Shares begin trading ex-dividend. May 17

Payment Date Dividends are distributed to the shareholders of May 27

• Open Market Repurchase - Here the firm

Direct Purchase from a large investor - Here the

The distribution choice is matter of irrelevance

The dividend irrelevancy proposition can be

(Panel A) Dividend Policy Alternative 1: Dividends = 100 percent of Year

(Panel B) Dividend Policy Alternative 2: Dividends = 150 percent of Year

Value = $4 million + $25.52 million /(1.12)1

Value = $8 million + $30 million /(1.12)1

(Panel A) Firm Setting

Shares 500,000 500,000 450,000 450,000

Earnings per share $ 2.00 $ 2.00 $ 2.22 $ 2.22

Cost of equity 11.11% Blank Blank Blank

Share price (predistribution) $ 18.00 $ 20.00 $ 20.00 $ 20.00

Share price (postdistribution) Blank $ 18.00 $ 20.00 $ 20.00

Equity value (market cap) $9,000,000 $9,000,000 $9,000,000 $9,000,000

Here are some tax facts concerning dividends and stock

• Table 16.2 shows the cash flow consequences of

Tax rate on dividends and capital 15% Blank Blank

Tax rate on dividends and 15% Blank Blank

Alternative Alternative Alternative

Less: Taxes (15,000) — —

After-tax cash distribution $ 85,000 $ 100,000 $ —

Total value of shares held by the 900,000 900,000 1,000,000

(Panel A) Agreement with Dividend Policy Statements

(Panel B) Importance of Dividend Policy Statements

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