Dividends and Other Payouts c19

Chapter Nineteen
Dividends and Other

Payouts
19
Prepared by
Professor Wei Wang
Queens University
2011 McGrawHill Ryerson Limited
19-2
Chapter Outline
19.1 Different Types of Dividends
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, Issuance Costs, and Dividends
19.6 Expected Return, Dividends, and Personal Taxes
19.7 Real-World Factors Favouring a High-Dividend Policy
19.8 The Clientele Effect: A Resolution of Real-World
Factors
19.9 What We Know and Do Not Know About Dividend
Policy
19.10 Summary and Conclusions
19-3
Different Types of Dividends
LO19.1
Many companies pay a regular cash dividend.

Public companies often pay quarterly.
Sometimes firms will throw in an extra cash dividend.
The extreme case would be a liquidating dividend.
Often companies will declare stock dividends.

No cash leaves the firm.
The firm increases the number of shares outstanding.
Some companies declare a dividend in kind.

Wrigleys Gum sends around a box of chewing gum.
Dundee Crematorium offers shareholders discounted
cremations.
19-4
Standard Method of Cash Dividend Payment

LO19.2
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.
19-5
Procedure for Cash Dividend Payment

25 Oct.
1 Nov.
2 Nov.
6 Nov.
LO19.2
7 Dec.
Declaration
Date
ExCumdividend dividend
Date
Date
Record
Date
Payment
Date
Declaration Date: The board of directors declares a payment

of dividends.
Cum-Dividend Date: The last day that the buyer of a stock is
entitled to the dividend.
Ex-Dividend Date: The first day that the seller of a stock is
entitled to the dividend.
Record Date: The corporation prepares a list of all individuals
believed to be stockholders as of 6 November.
19-6
Price Behaviour around the Ex-Dividend Date LO19.2
In a perfect world, the stock price will fall by

the amount of the dividend on the exdividend
date.
-t -2 -1 0 +1 +2
$P
$P - div
The price drops
Exby the amount of
dividend
Date
the cash
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.
19-7
The Benchmark Case: An Illustration of the

Irrelevance of Dividend Policy
LO19.3
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 dividend payouts.
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.
19-8
The Benchmark Case: An Illustration of the

Irrelevance of Dividend Policy
LO19.3
Example: York Corporation , an all-equity firm
At date 0, the managers are able to forecast
cash flows perfectly.
The firm will receive a cashflow of $10,000
at date 0 and $10,000 at date 1
The firm will dissolve at date 1.
The firm has no additional positive NPV
projects
19-9
An Illustration of the Irrelevance of Dividend

Policy (continued)
LO19.3
I ) Current Policy:Dividends set equal to
cashflow
Dividends (Div.) at each date = $10000
The firm value will be :
DIV 1
V 0 DIV 0
1 rs
$10000
V 0 $10000
$19090.91
1.1
19-10

Policy (continued)
LO19.3
Assume 1,000 shares are outstanding, then:
$10
P 0 $10
$19.09
1.1
After the imminent dividend is paid, the

stock price will fall to $9.09 (19.09-10)
19-11

Policy (continued)
LO19.3
I I)
Alternative Policy: Initial dividend > cash

flow
Pay $11 per share immediately i.e., $11 X 1000 shares =

$11,000 as total dividend.
The extra $1,000 must be raised by issuing new stock.
Date 0 Date1
Total dividends to old shareholders $11,000 $8,900
Dividends per share
$11
$8.9
Note: at date1, the new shareholders will get $1,100 of
the total cash flow leaving only $8,900 to old
shareholders.
19-12

Policy (continued)
LO19.3
The PV of dividends per share with the
alternative policy:
$8.9
P 0 $11
$19.09
1.1
The indifference proposition:
-The PV of the stock in both scenarios is the same.
-The change in dividend policy did not affect the value of a
share.
19-13
Modigliani and Miller (MM) proposition
LO19.3
MM proposition: Investors are indifferent to

dividend policy
Assumptions:
1) No taxes, brokerage fees, etc.
2) Homogeneous expectations
3) The investment policy of the firm is set
ahead of time
19-14
Homemade Dividends
LO19.3
ABC Inc. is a $42 stock about to pay a $2 cash

dividend.
Bob Investor owns 80 shares and prefers $3 cash
dividend.
Bobs homemade dividend strategy:
Sell two shares ex-dividend
$3 Dividend
homemade dividends
Cash from dividend
$240 $160
Cash from selling
$0 stock $80
Total Cash $240
$240
Value of Stock
$39
Holdings
80 =
$40 78 =
$3,120$3,120
19-15
Dividend Policy is Irrelevant
LO19.3
Since investors do not need dividends to convert shares to

cash, dividend policy will have no impact on the value of the
firm.
In the above example, Bob Investor began with 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 two ex-dividend shares,his
total wealth is still $3,360:
$3,360 78 shares
$40
$160 $80
share
19-16
Irrelevance of Stock Dividends: Example
LO19.3
XYZ Inc. has two million shares currently outstanding at $15

per share. The company declares a 50% stock dividend. How
many shares will be outstanding after the dividend is paid?
A 50% stock dividend will increase the number of shares by
50%:
2 million1.5 = 3 million shares
After the stock dividend what is the new price per share and
what is the new value of the firm?
The value of the firm was $2m $15 per share = $30 m. After
the dividend, the value will remain the same.
Price per share = $30m/ 3m shares = $10 per share
19-17
Dividends and Investment Policy
LO19.3
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 arguments was The
investment policy of the firm is set ahead of time
and is not altered by changes in dividend policy.
A final note:
-Dividends are relevant
-Dividend policy is irrelevant
19-18
Repurchase of Stock
LO19.4
Instead of declaring cash dividends, firms

can rid itself of excess cash through buying
shares of their own stock.
Recently share repurchase has become an
important way of distributing earnings to
shareholders.
When tax avoidance is important, share
repurchase is a potentially useful adjunct to
dividend policy.
19-19
Stock Repurchase versus Dividend
LO19.4
Consider a firm that wishes to distribute $100,000 to

its shareholders.
Assets
A.Original balance sheet
Liabilities & Equity
Cash
$150,000 Debt
0
Otherassets
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
19-20
LO19.4
If they distribute the $100,000 as cash dividend, the

balance sheet will look like this:
Assets
B. After $1 per share cash dividend

Cash
$50,000
Debt
Other assets
850,000
Equity
Value of Firm 900,000
0
900,000
Value of Firm 900,000
Shares outstanding = 100,000

Price per share = $900,000/100,000 = $9
19-21
LO19.4
If they distribute the $100,000 through a stock repurchase, the

balance sheet will look like this:
Assets
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
19-22
Share Repurchase (Real-World Considerations)
LO19.4
Lower tax
Tender offers
If offer price is set wrong, some stockholders lose.
Open-market repurchase
Targeted repurchase
Greenmail
Gadflies
Repurchase as investment
Recent studies have shown that the long-term stock price
performance of securities after a buyback is significantly
better than the stock price performance of comparable
companies that do not repurchase.
19-23
Personal Taxes, Issuance Costs, and Dividends
LO19.5
To get the result that dividend policy is irrelevant,

we needed three assumptions:
No taxes
No transactions costs
No uncertainty
In Canada, individual investors face a lower

dividend tax rate due to the dividend tax credit.
Capital gains for individuals are taxed at 50% of the
marginal tax rate, and the effective tax rate on
dividend income is higher than the tax rate on
capital gains.
19-24
Firms Without Sufficient Cash to Pay a Dividend

LO19.5
Investment Bankers
Cash: stock issue

Firm
The direct costs of

stock issuance will
add to this effect.
Stock
Holders
Cash: dividends
Taxes
Gov.
In a world of personal taxes,

firms should not issue stock
to pay a dividend.
19-25
Firms With Sufficient Cash to Pay a Dividend

LO19.5
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.
The firm has several options:
Select additional capital budgeting projects (by
assumption, these are negative NPV).
Acquire other companies
Purchase financial assets
Repurchase shares
19-26
Personal Taxes, Issuance Costs, and Dividends

LO19.5
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.
19-27
Expected Return, Dividends, and Personal Taxes

LO19.6
What is the relationship between the expected

return on the stock and its dividend yield?
The expected pretax return on a security with a
high dividend yield is greater than the expected
pretax return on an otherwise-identical security
with a low dividend yield.
After tax is a different story; otherwise-identical
securities should have the same return.
19-28
Evidence on Dividends and Taxes in Canada
LO19.6
Prior to 1972, capital gains were untaxed in Canada

In 1985, a life-time exemption on capital gains was
introduced.
Anticipation of the tax break on capital gains caused
investors to bid up prices of low-dividend yield
stocks.
Firms responded by lowering their dividend
payouts.
The dividend tax credit works to reduce taxes on
dividends received from Canadian firms.
19-29
Real World Factors Favouring a High Dividend

Policy
LO19.7
Desire for Current Income

Behavioral Finance
Agency Costs
Dividends Signalling
19-30
LO19.7
The homemade dividend argument relies on

no transactions costs.
To put this in perspective, mutual funds can
repackage securities for individuals at very
low cost: they could buy low-dividend stocks
and with a controlled policy of realizing
gains, pay their investors at a specified rate.
19-31
Behavioral Finance
LO19.7
Investors deal with self-control in investing and

consumption.
Selling stocks to realize cash for consumption:
may sell off too much.
Holding high dividend paying stocks: sticking to
a firm personal rule of never dipping into
principal.
19-32
Agency Costs
LO19.7
Agency Cost of Debt

Firms in financial distress are reluctant to cut
dividends. To protect themselves, bondholders
frequently create loan agreements stating
dividends can only be paid if the firm has
earnings, cash flow, and working capital above
pre-specified levels.
Agency Costs of Equity

Managers will find it easier to squander funds if
they have a low dividend payout.
19-33
Dividends Signalling
LO19.7
Stock price rises when a firm stats or resumes

dividends, and falls following announcements of
dividend omissions.
Firms will raise the dividend only when future
earnings and cash flows are expected to rise enough
so that the dividend is not likely to be reduced later.
The rise in the stock price following the dividend
signal is called the information content effect of
dividend.
19-34
The Clientele Effect: A Resolution of Real-World

Factors?
LO19.8
Reasons for Low Dividend
Personal Taxes
High Issuing Costs
Reasons for High Dividend

Information Asymmetry
Dividends as a signal about firms future performance
Lower Agency Costs

capital market as a monitoring device
reduce free cash flow, and hence wasteful spending
Bird-in-the-hand: Theory or Fallacy?

Uncertainty resolution
Clientele Effect
19-35
The Clientele Effect: A Resolution of Real-World

Factors?
LO19.8
Clienteles for various dividend payout policies are
likely to form in the following way:
Group
High Tax Bracket Individuals
Low Tax Bracket Individuals
Tax-Free Institutions
Corporations
Stock
Zero to Low payout stocks
Low-to-Medium payout
Medium Payout Stocks
High Payout Stocks
Once the clienteles have been satisfied, a corporation is

unlikely to create value by changing its dividend policy.
19-36
What We Know and Do Not Know About

Dividend Policy
LO19.9
Corporations Smooth Dividends.
Dividends Provide Information to the
Market.
Firms should follow a sensible dividend
policy:
Dont 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.
19-37
Summary and Conclusions
LO19.10
The optimal payout ratio cannot be determined

quantitatively.
In a perfect capital market, dividend policy is
irrelevant due to the homemade dividend concept.
A firm should not reject positive NPV projects to
pay a dividend.
Personal taxes and issue costs are real-world
considerations that favour low dividend payouts.
Many firms appear to have a long-run target
dividend-payout policy. There appears to be some
value to dividend stability and smoothing.
There appears to be some information content in
dividend payments.
19-38
Quick Quiz
What are the different types of dividends, and
how is a dividend paid?
What is the clientele effect, and how does it
affect dividend policy irrelevance?
What is the information content of dividend
changes?
What are stock dividends, and how do they
differ from cash dividends?
How are share repurchases an alternative to
dividends, and why might investors prefer
them?

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Chapter Nineteen

Dividends and Other

Different Types of Dividends

Many companies pay a regular cash dividend.

Often companies will declare stock dividends.

Some companies declare a dividend in kind.

Standard Method of Cash Dividend Payment

Cash Dividend - Payment of cash by the firm

Procedure for Cash Dividend Payment

Declaration Date: The board of directors declares a payment

Price Behaviour around the Ex-Dividend Date LO19.2

In a perfect world, the stock price will fall by

The Benchmark Case: An Illustration of the

The Benchmark Case: An Illustration of the

An Illustration of the Irrelevance of Dividend

An Illustration of the Irrelevance of Dividend

After the imminent dividend is paid, the

2011 McGrawHill Ryerson Limited

An Illustration of the Irrelevance of Dividend

Alternative Policy: Initial dividend > cash

Pay $11 per share immediately i.e., $11 X 1000 shares =

An Illustration of the Irrelevance of Dividend

2011 McGrawHill Ryerson Limited

Modigliani and Miller (MM) proposition

MM proposition: Investors are indifferent to

ABC Inc. is a $42 stock about to pay a $2 cash

Dividend Policy is Irrelevant

Since investors do not need dividends to convert shares to

After a $3 dividend, his total wealth is still $3,360:

total wealth is still $3,360:

Irrelevance of Stock Dividends: Example

XYZ Inc. has two million shares currently outstanding at $15

Dividends and Investment Policy

Firms should never forgo positive NPV projects to

2011 McGrawHill Ryerson Limited

Instead of declaring cash dividends, firms

Stock Repurchase versus Dividend

Consider a firm that wishes to distribute $100,000 to

Liabilities & Equity

2011 McGrawHill Ryerson Limited

Stock Repurchase versus Dividend

If they distribute the $100,000 as cash dividend, the

Liabilities & Equity

B. After $1 per share cash dividend

Value of Firm 900,000

Value of Firm 900,000

Shares outstanding = 100,000

2011 McGrawHill Ryerson Limited

Stock Repurchase versus Dividend

If they distribute the $100,000 through a stock repurchase, the

Liabilities & Equity

2011 McGrawHill Ryerson Limited

Share Repurchase (Real-World Considerations)

Personal Taxes, Issuance Costs, and Dividends

To get the result that dividend policy is irrelevant,

In Canada, individual investors face a lower

Firms Without Sufficient Cash to Pay a Dividend

Cash: stock issue

The direct costs of

In a world of personal taxes,

Firms With Sufficient Cash to Pay a Dividend

The above argument does not necessarily apply to

2011 McGrawHill Ryerson Limited

Personal Taxes, Issuance Costs, and Dividends