Dividend Policy

and Internal Financing

© 2002, Prentice Hall, Inc.

 Stock Returns:

Return = P1 - Po + D1
Po

P1 - Po D1
= +
Po Po

Capital Gain
 Stock Returns:

Return = P1 - Po + D1
Po

P1 - Po D1
= +
Po Po

Capital Gain Dividend Yield

 Dilemma: Should the firm use
retained earnings for:

a) Financing profitable capital

investments?
b) Paying dividends to stockholders?
 P1 - Po D1
Return = +
Po Po

• If we retain earnings for profitable

investments, dividend yield will be zero,
but the stock price will increase, resulting
in a higher capital gain.
 P1 - Po D1
Return = +
Po Po

• If we pay dividends, stockholders receive

an immediate cash reward for investing,
but the capital gain will decrease, since
this cash is not invested in the firm.
 So, dividend policy really
involves 2 decisions:
• How much of the firm’s earnings
should be distributed to
shareholders as dividends, and
• How much should be retained for
capital investment?
 Is Dividend Policy Important?

Three viewpoints:
1) Dividends are Irrelevant. If we
assume perfect markets (no taxes,
no transaction costs, etc.) dividends
do not matter. If we pay a
dividend, shareholders’ dividend
yield rises, but capital gains
decrease.
 P1 - Po D1
Return = +
Po Po

• With perfect markets, investors are

concerned only with total returns,
and do not care whether returns
come in the form of capital gains or
dividend yields.
• Therefore, one dividend policy is as
good as another.
 2) High Dividends are Best

• Some investors may prefer a certain

dividend now over a risky expected
capital gain in the future.
 2) High Dividends are Best

• Some investors may prefer a certain

dividend now over a risky expected
capital gain in the future.

P1 - Po D1
Return = +
Po Po
 3) Low Dividends are Best

• Dividends are taxed immediately.

Capital gains are not taxed until the
stock is sold.
• Therefore, taxes on capital gains can
be deferred indefinitely.
 Do Dividends Matter?
Other Considerations:
1) Residual Dividend Theory:
• The firm pays a dividend only if it has
retained earnings left after financing
all profitable investment
opportunities.
• This would maximize capital gains for
stockholders and minimize flotation
costs of issuing new common stock.
 Do Dividends Matter?
2) Clientele Effects:
• Different investor clienteles prefer different
dividend payout levels.
• Some firms, such as utilities, pay out over
70% of their earnings as dividends. These
attract a clientele that prefers high
dividends.
• Growth-oriented firms which pay low (or
no) dividends attract a clientele that prefers
price appreciation to dividends.
 Do Dividends Matter?
3) Information Effects:
• Unexpected dividend increases
usually cause stock prices to rise, and
unexpected dividend decreases cause
stock prices to fall.
• Dividend changes convey information
to the market concerning the firm’s
future prospects.
 Do Dividends Matter?
4) Agency Costs:
• Paying dividends may reduce agency
costs between managers and
shareholders.
• Paying dividends reduces retained
earnings and forces the firm to raise
external equity financing.
• Raising external equity subjects the firm
to scrutiny of regulators (SEC) and
investors and therefore helps monitor the
performance of managers.
 Do Dividends Matter?
5) Expectations Theory:
• Investors form expectations concerning
the amount of a firm’s upcoming
dividend.
• Expectations are based on past dividends,
expected earnings, investment and
financing decisions, the economy, etc.
• The stock price will likely react if the
actual dividend is different from the
expected dividend.
 Dividend Policies
1) Constant Dividend Payout Ratio: if
directors declare a constant payout
ratio of, for example, 30%, then for
every dollar of earnings available to
stockholders, 30 cents would be paid
out as dividends.
• The ratio remains constant over time,
but the dollar value of dividends
changes as earnings change.
 Dividend Policies

2) Stable Dollar Dividend Policy:

the firm tries to pay a fixed dollar
dividend each quarter.
• Firms and stockholders prefer
stable dividends. Decreasing the
dividend sends a negative signal!
 Dividend Policies
3) Small Regular Dividend plus Year-
End Extras
• The firm pays a stable quarterly
dividend and includes an extra year-
end dividend in prosperous years.
• By identifying the year-end dividend
as “extra,” directors hope to avoid
signaling that this is a permanent
dividend.
 Stock Dividends and Stock Splits

• Stock dividend: payment of additional

shares of stock to common stockholders.
• Example: Citizens Bancorporation of
Maryland announces a 5% stock
dividend to all shareholders of record.
For each 100 shares held, shareholders
receive another 5 shares.
 Stock Dividends and Stock Splits

• Stock Split: the firm increases the number

of shares outstanding and reduces the
price of each share.
• Example: Joule, Inc. announces a 3-for-2
stock split. For each 100 shares held,
shareholders receive another 50 shares.
• Does this increase shareholder wealth?
• Are a stock dividend and a stock split the
same?
 Stock Dividends and Stock Splits

• Stock Splits and Stock Dividends are

economically the same: the number of
shares outstanding increases and the price
of each share drops. The value of the firm
does not change.
• Example: A 3-for-2 stock split is the same
as a 50% stock dividend. For each 100
shares held, shareholders receive another
50 shares.
 Stock Dividends and Stock Splits

• Effects on Shareholder Wealth: these will

cut the company “pie” into more pieces
but will not create wealth. A 100% stock
dividend (or a 2-for-1 stock split) gives
shareholders 2 half-sized pieces for each
full-sized piece they previously owned.
 Stock Dividends and Stock Splits

• Effects on Shareholder Wealth: these will

cut the company “pie” into more pieces
but will not create wealth. A 100% stock
dividend (or a 2-for-1 stock split) gives
shareholders 2 half-sized pieces for each
full-sized piece they previously owned.
• For example, this would double the
number of shares, but would cause a $60
stock price to fall to $30.
 Stock Dividend Example

• shares outstanding: 1,000,000

• net income = $6,000,000;
• P/E = 10
• 25% stock dividend.
• An investor has 120 shares. Does the
value of the investor’s shares
change?
Before the 25% stock dividend:
• EPS = 6,000,000/1,000,000 = $6
• P/E = P/6 = 10, so P = $60 per share.
• Value = $60 x 120 shares = $7,200
After the 25% stock dividend:
• # shares = 1,000,000 x 1.25 = 1,250,000.
• EPS = 6,000,000/1,250,000 = $4.80
• P/E = P/4.80 = 10, so P = $48 per share.
• Investor now has 120 x 1.25 = 150 shares.
• Value = $48 x 150 = $7,200
 Stock Dividends
In-class Problem

shares outstanding: 250,000

net income = $750,000;
stock price = $84
50% stock dividend.
What is the new stock price?
 Hint:

stock price

( )
P/E = net income
# shares
Before the 50% stock dividend:
• EPS = 750,000 / 250,000 = $3
• P/E = 84 / 3 = 28.

After the 50% stock dividend:

• # shares = 250,000 x 1.50 = 375,000.
• EPS = 750,000 / 375,000 = $2
• P/E = P / 2 = 28, so P = $56 per share.

(a 50% stock dividend is equivalent to a

3-for-2 stock split)
 Practice Problems

1) ABC Corporation has 1.3 million common shares outstanding

and total earnings of $2.4 million. The firm paid dividends
totaling $550,000. The firm has no preferred stock.
– What were the dividends per share paid by ABC?
– What was ABC’s dividend payout ratio?
2) Price stock sells for $275 per share and you own 300 shares.
– What is the current market value of your investment?
– What is the new price per share, new amount of shares you
will own, and the new market value of your investment if
the firm declares a 3 for 1 stock split?
 Practice Problems

3) Semi-Nowl Corporation has 1.1 million shares of

8% cumulative preferred stock outstanding with a
stated value of $100 per share. If dividends are not
paid for four years, what will be the amount of
arrearage?
4) Suppose you own 500 shares of FSU Inc. If each
preferred share is convertible into 25 common
shares, preferred shares if the common stock is
trading at $30 per share?