CHAPTER 4: DIVIDEND POLICY

1.1 DIVIDEND POLICY AND RETAINED EARNINGS

Operational Definitions

DIVIDEND
A taxable payment declared by a company's board of directors and given to its shareholders out
of the company's current or retained earnings, usually quarterly. Dividends are usually given as
cash (cash dividend), but they can also take the form of stock (stock dividend) or other property.
Dividends provide an incentive to own stock in stable companies even if they are not
experiencing much growth. Companies are not required to pay dividends. The companies that
offer dividends are most often companies that have progressed beyond the growth phase, and
no longer benefit sufficiently by reinvesting their profits, so they usually choose to pay them out
to their shareholders. also called payout.

ACCUMULATED DIVIDEND
A dividend due, but not yet paid, to a preferred stock holder.

ACCUMULATED EARNINGS TAX

An additional tax on earnings that a business retains in an attempt to avoid the higher income
taxes the owners would be subject to if the earnings were paid out to them as dividends. also
called accumulated profits tax.

CASH DIVIDEND
A dividend paid in the form of cash, usually by check.

CUMULATIVE DIVIDEND
A dividend paid on cumulative preference shares, that the company is liable for in the next
payment period if not satisfied in the current payment period (i.e. the dividends accumulate).
Unlike a dividend on common stock that the company can pay out to shareholders if they want,
dividends on cumulative preferred shares are an obligation regardless of the earnings of the
company. The unpaid accumulated preferred stock dividends must be paid before any common
stock dividends are.

RECORD DATE
Date, set by the issuing in order to be eligible to receive a declared dividend or capital gains
distribution. The date is also used by the NASD to set the ex- dividend date. also called date of
record.

PAYABLE DATE
The date a dividend will be paid to entitled shareholders. This date is set by the company on the
declaration date.
DECLARATION DATE
The date on which a company's directors meet to announce the date and amount of the next
dividend payment. Once the payment has been authorized, it is called a declared dividend. also
called announcement date.

DECLARE
Authorize payment of a dividend to shareholders.

DISBURSING AGENT
Individual or institution which handles dividend and interest payments for a corporation.

DISTRIBUTION
▪ The payment of a dividend or capital gain.
▪ A company's allocation of income and expenses among its various accounts.
▪ Handing out assets to beneficiaries of an estate.
▪ The sale of a large amount of stock by a single entity over a period of time rather than all at
once, to avoid adversely affecting its market price. opposite of accumulation.

EX-DIVIDEND
A security which no longer carries the right to the most recently declared dividend; or the period
of time between the announcement of the dividend and the payment. A security becomes ex-
dividend on the ex-dividend date (set by the NASD), which is usually two business days before
the record date (set by the company issuing the dividend). For transactions during the ex-
dividend period, the seller, not the buyer, will receive the dividend. Ex-dividend is usually
indicated in newspapers with an x next to the stock or mutual fund's name. In general, a stock’s
price drops the day the ex-dividend period starts, since the buyer will not receive the benefit of
the dividend payout till the next dividend date. As the stock gets closer to the next dividend date,
the price may gradually rise in anticipation of the dividend.

GUARANTEED STOCK
Preferred or common stock of one corporation whose dividends are guaranteed by another
corporation. Since the dividends are guaranteed, investors are generally willing to pay a higher
amount for the stock than if the stock was not backed up by a guarantee. How valuable the
actual guarantee is will depend on the guarantor's financial and credit history. The guaranteed
stock arrangement has frequently been used by railroads.

SHAREHOLDER OF RECORD
The name of an individual or entity that an issuer carries in its records as the registered holder
(not necessarily the beneficial owner) of the issuer's securities. Dividends and other distributions
are paid only to shareholders of record. also called stockholder of record or holder of record or
owner of record.

INCOME FUND
A mutual fund which emphasizes current income in the form of dividends or coupon payments
from bonds and/or preferred stocks, rather than emphasizing growth. Income funds are
considered to be conservative investments, since they avoid volatile growth stocks. Income
funds are popular with retirees and other investors who are looking for a steady cash flow
without assuming too much risk. Income Stock A stock with a history of paying consistently high
dividends.

ADJUSTABLE-RATE PREFERRED STOCK

Preferred stock whose dividend changes, usually quarterly, according to changes in the
Treasury Bill rate or a similar benchmark. The changes in the dividend are determined by a pre-
set formula. Like floating rate debt, adjustable-rate preferred stock tends to have stable prices,
since the dividend amount can be can changed to offset price changes.

INDICATED DIVIDEND
The total amount of dividends that would be paid on a share of stock over the next 12 months if
each dividend were the same amount as the most recent dividend.

PARTICIPATING DIVIDEND
Dividend paid on participating preferred stock. This is an unusual dividend structure, since it
allows holders of preferred stock to receive payouts in addition to the stated dividend rate under
certain circumstances. The additional payouts could be a result of either specific events (such
as a takeover), or increases in payout to common stockholders. In some cases, there is a
formula established that relates additional preferred stockholder payouts to increases in
common stockholder payouts.

INTERIM DIVIDEND
A dividend which is declared and distributed before the company's annual earnings have been
calculated; often distributed quarterly.

OMITTED DIVIDEND
A dividend which was expected, but which was not declared, usually due to financial difficulties.
also called passed dividend.

OPTIONAL DIVIDEND
Dividend which the shareholder can choose to take as either cash or stock.

PATRONAGE DIVIDEND
A taxable distribution made by a cooperative to its members or patrons.

PAYMENT DATE
The date on which a dividend, mutual fund distribution, or bond interest payment is made or
scheduled to be made. also called distribution date.

PEACE DIVIDEND
The reallocation of spending from military purposes to peacetime purposes, such as housing,
education, and social projects.

REINVESTMENT
Using the dividends, interest, or profits from an investment to buy more of that investment,
rather than receiving a cash payout. Reinvestment can sometimes delay or reduce capital gains
taxes.
RESTRICTED SURPLUS
A portion of a company's retained earnings not legally available for dividend payment.

RETAINED EARNINGS
When a company generates a profit, management has one of two choices: they can either pay it
out to shareholders as a cash dividend, or retain the earnings and reinvest them in the
business.

When the executives decide that earnings should be retained, they have to account for them on
the balance sheet under Shareholder Equity. This allows investors to see how much money has
been put into the business over theyears. Once you learn to read the income statement, you
can use the retained earnings figure to make a decision on how wisely management is
deploying and investing the shareholder's money. If you notice a company is plowing all of its
earnings back into itself and isn't experiencing exceptionally high growth, you canbe sure that
the stock holders would be better served if the board of directors declared a dividend.

Ultimately, the goal for any successful management is to create $1 in market value for every $1
of retained earnings.

STOCK
An instrument that signifies an ownership position (called equity) in a corporation, and
represents a claim on its proportional share in the corporation's assets and profits. Ownership in
the company is determined by the number of shares a person owns divided by the total number
of shares outstanding. For example, if a company has 1000 shares of stock outstanding and a
person owns 50 of them, then he/she owns 5% of the company. Most stock also provides voting
rights, which give shareholders a proportional vote in certain corporate decisions. Only a certain
type of company called a corporation has stock; other types of companies such as sole
proprietorships and limited partnerships do not issue stock. also called equity or equity
securities or corporate stock.

TRADING DIVIDENDS
The practice by some corporations of buying and selling other corporations' stock to maximize
collected dividends, for tax benefits (since corporations pay very little tax on dividend income).
also called dividend capture.

UNPAID DIVIDEND
A dividend that has been declared but not yet paid.

ACCRUED DIVIDEND
A regular dividend that is considered to be earned but not declared or payable.

SPECIAL DIVIDEND
A nonrecurring dividend that is exceptional in terms of either size or date issued.

1.2 THE DIVIDEND PAYMENT PROCEDURE

Dividends are generally paid quarterly.
1. DECLARATION DATE: The board of directors announces the forthcoming payment of
dividends.

2. RECORD DATE: Designates when the stock transfer books are to be closed. The declared
dividends are payable to the shareholders of record on a specific date.

3. EX-DIVIDEND DATE: Brokerage firms terminate the right of ownership to the dividend four
working days prior to the date of record. (Buy before this date if you want the dividend)

4. PAYMENT DATE: The dividend checks are mailed to the shareholders of record.

Example of a Cash Dividend Payment Process

The custodian and the depositary work with the issuer to ensure prompt notification and
payment of dividends to the holders of depositary receipts. The dividend payment process
involves:
• setting and announcing dividend record date and payment date to DR holders
• receipt and processing of record and payment date information from issuers and custodians
• reconciling the accuracy of positions between custodians, registrars, the depositary, brokers,
and the DTC
• arranging for funds transfers and currency conversions necessary to disburse payments
• calculating the US$ dividend rate and paying the dividend.

The following flowchart depicts a sample dividend payment process and delineates the
responsibilities of the various parties involved.

1.2.1 FACTORS AFFECTING THE DIVIDEND DECISION

LEGAL RESTRICTIONS
A corporation may not pay a dividend
▪ If the firm's liabilities exceed its assets.
▪ If the amount of the dividend exceeds the accumulated profits (retained earnings).
▪ If the dividend is being paid from capital invested in the firm.

Debtholders and Preferred stockholders may impose restrictive provisions on management,

such as common dividends not being paid from earnings prior to the payment of interest or
preferred dividends.

LIQUIDITY POSITION
The amount of a firm's retained earnings and its cash position are seldom the same. Thus, the
company must have adequate cash available as well as retained earnings to pay dividends.

ABSENCE OR LACK OF OTHER SOURCES OF FINANCING

All firms do not have equal access to the capital markets. Consequently, companies with limited
financial resources may rely more heavily on internally generated funds.
EARNING PREDICTABILITY
A firm that has a stable earnings trend will generally pay a larger portion of its earnings in
dividends. If earnings fluctuate significantly, a larger amount of the profits may be retained to
ensure that enough money is available for investment projects when needed.

OWNERSHIP CONTROL
For many small firms, and certain large ones, maintaining the controlling vote is very important.
These owners would prefer the use of debt and retained profits to finance new investments
rather than issue new stock.

INFLATION
Because of inflation, the cost of replacing equipment has increased substantially. Depreciation
funds tend to become insufficient. Hence, greater profit retention may be required.

1.2.2 THE FIRM’S DIVIDEND POLICY

The Company's Board of Directors establishes its dividend policy pursuant to which the pay-out
ratio over a business cycle should be at least one-third (or any percentage decided by the board
of directors) of the Group's profit for the period. In its annual dividend proposal, the Board of
Directors will, in addition to financial results, take into consideration the Group's investment and
development needs.

The dividends that are distributed from the current year earnings have a direct impact on the
capital structure, the future growth of the firm, and the value of the company to outside investors
and owners. From the available theoretical research and from writings of professional
practitioners, there does not seem to be one optimal dividend distribution strategy (which would
be similar to the optimal capital structure theory seen in the previous chapter). Instead, there are
two or three guiding rules relating to dividend distribution which are presented below. However,
some dividend policies may be detrimental to a firm, and for those, a financial analyst ought to
be on the alert.

Interpretation of Dividend Data

Dividends can be of different types. Ordinary dividends are cash payments which must come
from current or prior year earnings (i.e. not from capital or paid-in capital because it is prohibited
in most countries), which are decided by the board of directors, which are paid (usually
quarterly) to holders of common shares, and which come as a reduction of the earnings to be
retained. Special or extraordinary dividends are also cash payments which are added to
ordinary dividends in the years when earnings are unusually large. There are also preferred
shares dividends which are cash payments, but only for the holders of preferred shares: they
are most often fixed (although a few are "participating" in earnings), and cumulative (i.e. if one
year payment is missed it accrues for next year).

Common shareholders also may occasionally receive stock dividends which consist of the
distribution of one new share of the corporation for a given number of existing outstanding
shares. If the proportion is more than one new share for four existing shares, the distribution is
said to be a stock split rather than a stock dividend. From an accounting point of view, a stock
dividend requires assigning a portion of retained earnings to capital (and possibly paid-in
capital), whereas a stock split does not change capital, only the number and unit value of the
shares outstanding. Instead of a stock dividend, shareholders may receive pre-emptive rights to
acquire new shares at a reduced price. These rights have a value equal to the difference
between the market price and the subscription price. A right provides additional cash for the
shareholder if sold, or the ability to preserve the fractional ownership in the corporation.
Occasionally, there may be a dividend distributed in kind to shareholders, that is, a physical
asset given to each shareholder, but this is only found in closely-held corporations. Finally, there
are also liquidating dividends in cash or in kind, which are distributed when a firm is closing
down.

What constitutes a dividend policy is primarily determined by the proportion of ordinary cash
dividends paid from current year earnings. This proportion is known as the payout ratio. The
portion that goes to retained earnings is known as the retention rate.

Steady Dividend or Payout Ratio

Maintaining an image of stability is important to a company in order to keep the perceived risk
premium low. The discounted dividend model of share value explicitly makes dividends the
essential determinant of stock prices. Instability in dividends would create instability in stock
price, cause a higher BETA (i.e. a higher risk premium), and result, consequently, in a lower
stock price. This all- important stability of dividends can be accomplished by distributing the
same ordinary dividend year after year. In exceptionally good years, some extraordinary
dividends may be paid out. The dividends are designated as extraordinary to inform
shareholders that these added dividends are not to be expected every year in the future.
However, the ordinary dividends should grow in step with earnings. Thus, the board of directors
sets the dividend at some target proportion of long run average earnings.

Stock dividends and stock splits do not, in theory, add any wealth to shareholders: each
shareholder keeps exactly the same fraction of a combined net worth that does not change as a
result of the stock distribution. The only effect is that there are more shares, with each having a
lesser value. In practice however, there are benefits to existing shareholders. First, the reason
for a stock split is to make it easier to sell shares that have risen in price to over one hundred
dollars which would make it harder for buyer and sellers of the stock. Remember that share lots
are normally 100, and buying 100 shares at $500 each, is a $50,000 transaction; this is a large
transaction which limits the appeal of this stock to investors holding well diversified portfolios. In
today's electronic trading world, round lots do not have the same importance as in the past. Yet,
stock prices of several hundred dollars are still looked upon as impediment to trade. Prices in
the range of $30 to $80 are most common.

Second, a stock split conveys a message to investors that the company has grown. The
combined market price of the new shares is often higher than earlier quotations of the
corresponding number of shares before the stock split. Stock dividends may have a similar
message, but not always. Instead, they give the shareholder the opportunity to sell some shares
and derive current income without having to disturb shareholder's investment portfolio. On
occasion, the stock dividend is used in lieu of an extraordinary cash dividend. In other cases,
however, the stock dividend is distributed in lieu of ordinary dividend, which is not a healthy sign
because it suggests that current year earnings are not sufficient to distribute an ordinary
dividend.

In countries where capital gains receive a beneficial tax treatment (which was the case of the
United States until 1986), stock dividends and stock splits may be more appealing to
shareholders than cash dividends. Capital gains are calculated as the excess of the selling price
over the purchase price if the share has been held usually for more than 6 or 12 months
depending on tax provisions of the country. The tax is often half of the ordinary income tax rate.
Thus a considerable benefit is derived by shareholders.

IRRELEVANCE OF DIVIDEND POLICY

Numerous studies have shown that it does not make any difference to the wealth of
shareholders whether
1. A company pays a large proportion of its earnings, or
2. A company pays little of no dividends, but achieves a higher growth rate by reinvesting the
earnings it does not distribute.

In fact, companies that need to grow fast would need to access the capital market to issue new
shares more often if they did distribute dividends. Issuing shares can be costly, as will discussed
in next section. It does not make sense to distribute dividends and issue new shares at the
same time, unless flotation costs are manageable such as in dividend reinvestment plans. For
instance, AT&T sends a dividend reinvestment offer together with their mailing of cash dividend
payments. This strategy satisfies both corporate and individual shareholder's needs.

CLIENTELE EFFECT
The dividend policy, while affecting the financing strategy of the firm, is more justified by
investors' attitudes than corporate needs. Investors who rely on cash dividends for living will put
a premium on stocks that have a steady dividend policy. Such investors will prefer these shares,
and will expect from the board of directors that it will continue its policy of regular dividends. The
companies that fall in this category, are those which have reached the standardization phase in
their product life cycle, such as for instance, utilities. Their market and earnings are steady. The
need for new growth is moderate.

At the other extreme are investors who seek capital gains from growth stocks. For this group of
investors, dividends are not only undesirable because they cut into company growth, but they
can also be inconvenient because of the tax liability they create for recipients. Companies in this
category come from new consumer product or advanced technology sectors. In the early
1990's, biogenetics may be an example of a field with high potential growth, in late 1990's
internet companies. All through the 1980's, Apple Computers did not distribute any dividend.

In between, lies a large group of investors that want stocks with growth potential (preferably
from internal financing), but also a reassurance of steady dividends (which signal healthy
earnings). The majority of corporations in the United States and many other countries fall in this
category. The average payout ratio in the United States has been around 50% over the past half
century.

ASSESSING DIVIDEND POLICIES

This 50% payout rate is an average, many firms distribute more. If a firm is a growth one, a
large distribution will jeopardize its growth potential, and the payout rate should be much less
than 50%. The financial analyst should also be weary of firms with excessively conservative
attitudes: if a company has very moderate growth in sales of standardized products, but
sufficient and secure profits, no dividend distribution does not make sense. The conclusion is
that the dividend policy appropriate for a firm must be in line with its marketing and investment
strategies on the one hand, and the needs and expectations of shareholders, on the other.

INTERNATIONAL COMPARISON
The 50% payout rate in the United States is higher than in most countries. In European
countries, the payout rate is lower. There are legal and institutional reasons for this. As
mentioned earlier, many countries require that a portion of earnings be set aside, sometimes
5%, 10% or even higher, (these are the previously discussed legal and statutory reserves).
Difficult access to capital markets or poorly organized capital markets are additional reasons for
companies outside the United States to pay less dividends. For all these reason, internal
reinvestment of earnings is prevalent. But, as emerging capital markets become more active
and efficient, this is likely to change in the future.

In Russia, internal reinvestment of earnings would seem to be warranted because of the growth
needs of all firms, the precarious state of emerging stock markets and high taxes. But there
seems to be a clientele effect: shareholders who feel insecure and want a rapid return on their
investment. Thus, some Russian firms pay out large dividends, or promise to do so.

1.3 DIVIDEND REINVESTMENT AND OTHER BENEFIT PLAN

Investing in stocks is not hard. While most investors elect to purchase shares directly from a
stockbroker, an interesting alternative exists - Dividend Reinvestment Plans. In this introductory
tutorial we will explain:
• What Are Dividend Reinvestment Plans (DRIPs)?
• Two Types of Dividend Reinvestment Plans
• Benefits of Dividend Reinvestment Plans

What is a Dividend Reinvestment Plan?

Some corporations offer their shareholders the option of reinvesting their dividends in additional
shares of stock. This allows shareholders to purchase additional shares of stock directly from
the company without having to use a brokerage service. This is known as a dividend
reinvestment plan (DRIP).

However, to be eligible for a dividend reinvestment plan, most corporations require that you
purchase your original shares from a brokerage house. Once you own some of the company's
stock, you then may be eligible to participate in a dividend reinvestment plan. Nonetheless,
many brokerage services can be very helpful in pointing out to investors (who ask) what
companies offer dividend reinvestment plans.

The obvious advantage to dividend reinvestment plans is the potential to save on brokerage
commissions through direct purchases. Nonetheless, there are other attractive features of these
plans that we will explore.
But before we look at all the potential benefits, let's begin by looking at the two dividend-
reinvestment plans available.

Types of Dividend Reinvestment Plans

There are two types of dividend reinvestment plans:
1. Plans that offers a shareholder stock that already exists, "old stock"
2. Plans that offers a shareholder “new stock”.

The first type of DRIP has an outside trustee repurchase shares on the secondary market.
These shares are purchased to re-issue them to shareholders in the dividend reinvestment plan.
The shareholder will get the shares at market price. However, the corporation will often offer to
cover the commission and fees to encourage shareholders to participate in the plan.
In the second type of DRIP the shareholders receive newly issued shares directly from the
company. This implies that the company has the control on whether to provide an additional
discount or not. Some corporations will go as far as offering their stock at three to five percent
below the market price. Companies offer these discounts because they save the costs of going
through an investment banker to issue the new shares. The goal is usually to have shareholders
continuing to invest.

Read below to see how everyone benefits from these DRIPs.

Benefits of Dividend Reinvestment Plans

Dividend reinvestment plans benefit both the investors and the corporations.

For investors: An investor will usually save brokerage fees or will be offered other discounts
that a corporation will provide in order to keep the investor. Furthermore, some investors may
also enjoy the benefits of the option to purchase more shares in a company they already know
and trust, rather than searching through the thousands of options available to them in the free
market.

For the corporation: By offering the DRIP a corporation raises capital inexpensively. DRIPs
can also help provide stability for a company's stock price by offering perpetual demand for the
company's shares as new dividends are declared. Furthermore, the corporation may decrease
or increase the availability and the benefits of their dividend reinvestment plans based on how
much capital they need to raise.

Conclusion
Today, about a thousand corporations (mainly the large ones) offer DRIPs. Only about 25% of
the shareholders actually choose to take advantage of them. Yet, corporations will continue to
offer discounts because DRIPS have proven themselves to be a good way to raise capital.
Furthermore, as more investors learn about the benefits of DRIPs, one might expect that more
investors will be drawn to the advantages offered by these programs.

1.4 STOCK DIVIDEND AND STOCK SPLITS

Rules for determining your basis and holding period for stock received in stock dividends and
splits.

This will explain how to determine your basis when you receive stock as a result of a non-
taxable stock dividend or a stock split. The explanation covers your initial basis in the new
shares you receive, and your adjustment in basis to the shares you already owned. This
discussion does not cover the following:
• Stock you received from dividend reinvestment. Dividend reinvestment is not the same as
stock dividends.
• Stock you received in a taxable stock dividend. This is a relatively rare event. If the company
or your broker notifies you that you received a taxable stock dividend, you should rely on
information from the company or from a tax professional to determine your basis.

Background
Companies sometimes increase the number of shares outstanding (and at the same time
reduce the value of each share) by issuing stock dividends or stock splits. These events are
usually non-taxable, but change the number of shares you own and the basis of those shares.

A stock dividend is generally declared in terms of a percentage. For example, in a 5% stock

dividend, you will receive one additional share for every 20 shares you already own. A stock split
is usually declared as a fraction. In a 2-for-1 split, you receive one additional share for every
share you own (so that you end up owning two shares for every one you owned before the
split). Stock splits can occur at odd fractions. For example, if your stock splits 3-for-2, you
receive one additional share for every two you owned before the split (and end up owning three
for every two you had before). A 3-for-2 stock split is the same as a 50% stock dividend.

Determining Your Basis

When you receive additional shares as a result of a non-taxable stock dividend or split, your
total basis in your stock remains the same. The basis is divided among the shares you already
owned and the new shares in proportion to the value of the shares. In the usual case, where the
new shares are exactly the same as the old ones, the value is the same, and basis is allocated
equally to each share.

Example: You own 400 shares of XYZ with a basis of $33 per share (total basis of $13,200).
XYZ declares a 10% stock dividend. You receive 40 additional shares and now own a total of
440 shares. Your total basis is unchanged, so your basis per share is now $13,200 divided by
440, or $30.

Example: You own 150 shares of ABC with a basis of $24 per share, and another 100 shares of
ABC with a basis of $28 per share. The stock splits 2-for-1. After the split, you own 300 shares
with a basis of $12 per share, and 200 shares with a basis of $14 per share. (This is true even if
you receive a single certificate representing your 250 new shares.)

Holding Period
You are treated as if you held the new shares as long as you held the old shares. For example,
if you bought 400 XYZ on June 10, 2000 and received 40 new shares in a non-taxable stock
dividend on November 10, 2003, any gain or losson a sale of the 40 new shares will be treated
as a long-term capital gain even if you sold them immediately after you acquired them.

What are Stock Splits?

A stock split is a simple re-organization of a company's share structure. A company issues a
new number of shares for all its existing shares outstanding. The terms two-for-one, three-for-
one and five-for-four all describe a different type of stock split.
If a stock has made large gains, the company may want to lower the price of the shares to make
the purchase of a board lot (usually 100 shares) more reasonably priced for the average
investor. It also tends to make the shares more liquid, which is always a desirable property.
Stock splits come in two varieties: one that creates a certain number of whole new shares for
the old shares (e.g., two-for-one, three-for-one) and one that creates a fraction of a new share
for each old share (e.g., three-for-two, four-for-three).

What essentially happens is that the company cancels its existing shares and issues new
shares in their place. In a two-for-one split, each issued share is replaced by two new shares. In
a three-for-two split, two issued shares are replaced by three new shares (so, in effect, each old
share has been replaced by one-and-a-half new shares).

It is important to note that stock splits by themselves do not create any value to shareholders.
The split is simply a cosmetic change intended mainly to reduce the market price of a
company's shares. The immediate effect of a stock split on a company's share price is to reduce
it by the proportionate amount of the split. For example, suppose XYZ Corp. declares a two-for-
one stock split of its common shares, which are trading prior to the split at $50 per share. You
own 100 shares of XYZ, which are worth $5,000.

Once the stock split happens, the market, knowing that there are now twice as many shares of
XYZ outstanding, will immediately cut XYZ's stock price in half to $25 per share. You now own
200 shares worth $25 each. The net effect is that your investment in XYZ did not change.

After a Stock Split

Trading Commissions
Depending on the type of brokerage account you have, the commission charge may change.

If your broker charges a fee per share, your costs may go up after a stock split, but if you pay a
flat fee, a split doesn't affect the cost of trading.

Dividends
When a stock splits two-for-one, the number of shares outstanding doubles and each share is
now worth half of the pre-split price. On the same day of the split, the cash dividend the
company regularly pays also gets cut in half so the dividend yield remains constant.

Tax Consequences
When an investor receives additional stock from a stock split, there is no tax consequence until
the investor decides to liquidate his/her position.
Reverse Stock Splits
Reverse splits occur most frequently among lower-priced junior mining and oil exploration
companies.

A reverse split raises the market price of the new shares and can put the company in a better
position to raise capital.
The company substitutes one share of stock for a predetermined amount of shares but, again,
the value of investor holdings remains the same.

Example: ABC Corporation has shares selling at $1.00 per share and declares a one-for-four
reverse stock split. After the reverse split, there will be 1/4 as many shares outstanding and the
stock will now have a market price of $4.00 per share. If an investor owned 1,000 shares of ABC
Corporation before the split at $1.00 per share, he will now own 250 shares at $4.00 per share.

Tip - Hold on!

The benefits of long-term investing often comes into play when it comes to stock splits.

When a company splits its stock, it often reflects solid growth and earnings potential.

If the company continues to grow rapidly, the additional shares increase the value of an
investor's portfolio.

In order to fully understand the implications of stock splits on your long-term portfolio, it is
important to discuss the tax implications and treatment of capital gains with your financial
planner or accountant.

1.5 REPURCHASING STOCK

Can be done in Three Ways

1. Open market repurchase: Firms permitted to purchase stock anonymously through broker
2. Tender offer to shareholders: Offer to sell a certain number of shares a fixed price (single-
price tender) or over a range of prices (Dutch auction)
3. Private negotiations

Stock Repurchases Benefits

▪ To provide an internal investment opportunity.
▪ To modify the firm's capital structure.
▪ To impact earnings per share, thus increasing stock price.

Stock Repurchases
▪ Share repurchase as a dividend decision:
▪ A firm may repurchase its shares, increasing the earnings per share which should be reflected
in a higher stock price.
▪ For tax purposes the investor may prefer the firm to repurchase stock in lieu of a dividend.
Dividends are taxed as ordinary income, whereas any price appreciation resulting from the
stock repurchase would be taxed as a capital gain.
▪ The investor may still prefer dividend payment because
 • Dividends are viewed more dependable than stock repurchases.
• The price the firm must pay for its stock may be too high.
• Riskiness of the firm's capital structure may increase, lowering the P/E ratio and thus the
stock price.
▪ Financing or investment decision
• A stock repurchase effectively increases the debt-equity ratio towards higher debt, thus
repurchase is viewed as a financing decision.
• Buying its own stock at depressed prices, a firm may consider the repurchase as an
investment decision. However, this action is not a true investment opportunity, as the extreme
result would mean the company would consume itself.
▪ The Stock Repurchase Procedure
• A public announcement should be made detailing the amount, purpose and procedure for
the stock repurchase.
• Open market purchase - at the current market price.
• Tender offer - more formal and at a specified price.
• Negotiated Block Purchase - repurchasing from specific large shareholders.

Stock Repurchase Procedure

▪ Dutch Auctions: There is the possibility of “under / over” subscriptions, if the firm sets a
repurchase price, and the subsequent release of information about availability of shares at
particular prices. This procedure deals with that, and shifts the “wealth-transfer” effects
responsibility back to shareholders.
▪ The firm announces a range of prices within which it will re-purchase shares and invites
shareholders to tender their shares – indicating amounts and prices.
▪ Starting from the bottom price, the firm works up, till the repurchase share target is met –
offering everyone the same (highest) price.
▪ What is the “no-regrets” strategy for shareholders?

Reason to Repurchase Stock

▪ Tax advantaged way to distribute cash to shareholders (at least for individuals)
▪ Signal under-valuation
▪ Distribute excess cash
▪ Adjust capital structure of firm
▪ Acquire shares to fund a stock options program

Comparing Dividends and Repurchases

▪ Suppose firm has 100 shares of stock valued at $9 per share at beginning of year.
▪ During the year, the firm has profits of $100, or $1 per share. Thus, stock price rises to $10 per
share.
▪ Suppose firm wishes to distribute the $100 to shareholders via a dividend. Every shareholder
receives $1 dividend and stock price would fall back to $9. Investors receive $0 in capital gains
and $1 of dividend income per share.
▪ Now suppose the firm wishes to distribute its $100 to shareholders via a share repurchase.
▪ With the $100, the firm can buy 10 shares @ $10 per share.
▪ For those shareholders that do not tender their shares, they will enjoy a $1 capital gain per
share, and no dividend income.
▪ When pay a dividend, assets (cash) declines. Shares outstanding fixed. So price per share
falls.
▪ When repurchase stock, assets (cash) declines. Shares outstanding also declines, holding
stock price unchanged.
▪ Dividends → investors pay dividend taxes
▪ Repurchases → investors pay capital gains

Final Thoughts
▪ Repurchases fluctuate more than dividends. Repurchases used to distribute transitory income,
while dividends are used to distribute permanent income.
▪ Stock-repurchases, additional stock issues etc., do indeed potentially change the percentage
ownership, and the price at which these are done, can have “wealth transfer” effects.