03-Aug-21

UNIVERSITY OF ECONOMICS – HO CHI MINH CITY

DIVIDENDS AND OTHER PAYOUTS

Chapter Outline

19.1 Different Types of Payouts

19.2 Standard Method of Cash Dividend Payment
19.3 The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy
19.4 Repurchase of Stock
19.5 Personal Taxes, Dividends, and Stock Repurchases
19.6 Real-World Factors Favoring a High Dividend Policy
19.7 The Clientele Effect: A Resolution of Real-World Factors?
19.8 What We Know and Do Not Know about Dividend Policy
19.9 Putting It All Together

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19.1 Different Types of Payouts

• 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.
• Other companies use stock buybacks.

19.2 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. 1 Nov. 2 Nov. 5 Nov. 7 Dec.
…

Declaration Cum- Ex- Record Payment

Date dividend dividend Date 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.

Price Behavior

• Ina 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
Ex-
the amount of the
dividend
cash dividend.
Date
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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19.3 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
• 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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Dividend Policy Is Irrelevant

• In the above example, Bob Investor began with a total wealth of $3,360:
$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.”

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19.4 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 Liabilitie s & 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 outstandin g = 100,000
Price per share = $900,000/1 00,000 = $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 Li abilities & 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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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

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19.5 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

Investment Bankers stock issuance will add
to this effect.

Cash: stock
issue Stock
Firm
Holders
Cash: dividends

Taxes In a world of personal taxes, firms

should not issue stock to pay a
dividend.
Gov.

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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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19.6 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.

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19.7 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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19.8 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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19.9 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.

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