Dividends and Other Payouts

Key Concepts and Skills

• Understand dividend types and how they are
paid
• Understand the issues surrounding dividend
policy decisions
• Understand why share repurchases are an
alternative to dividends
• Understand the difference between cash and
stock dividends
 Chapter Outline
18.1 Different Types of Dividends
18.2 Standard Method of Cash Dividend Payment
18.3 The Benchmark Case: An Illustration of the Irrelevance
of Dividend Policy
18.4 Repurchase of Stock
18.5 Personal Taxes and Dividends
18.6 Real-World Factors Favoring a High Dividend Policy
18.7 The Clientele Effect: A Resolution of Real-World Factors?
18.8 What We Know and Do Not Know about Dividend Policy
18.9 Stock Dividends and Stock Splits
18.1 Different Types of Dividends
• 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 (called
“Bonus” in India).
– 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.
– Dundee Crematoria offers shareholders discounted cremations.
18.2 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.
 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
• In a 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 Ex-
by the amount of dividend
the cash Date
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.
 18.3 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
 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.”
 18.4 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.
 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
 Stock Repurchase versus Dividend
If they distribute the $100,000 as a cash dividend, the balance
sheet will look like this:
Assets Liabilities & 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 outstanding = 100,000
Price per share = $900,000/100,000 = $9
 Stock Repurchase versus Dividend

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

balance sheet will look like this:
Assets Liabilities & 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 pershare = $900,000 / 90,000 = $10
 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
 18.5 Personal Taxes and Dividends

• 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 taxed at a maximum rate of 15 percent.
• In India companies pay a corporate dividend tax rate of
12.5% ( Previously shareholders used to pay tax based on
their tax bracket)
• Since capital gains can be deferred, the tax rate on
dividends is greater than the effective rate on capital gains.
 Firms without Sufficient Cash

Investment Bankers The direct costs of

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
Gov. pay a dividend.
 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
 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.
 18.6 Real-World Factors Favoring High
Dividends
• Desire for Current Income
• Behavioral Finance
– It forces investors to be disciplined.
• Agency Costs
– High dividends reduce free cash flow.
 18.7 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.
 18.8 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.
 18.9 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%
 Stock Splits
• Stock splits – essentially the same as a stock
dividend except it is 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.”
 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?