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Chap016 2
Chap016 2
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
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
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
16.1 Different Types of Dividends
16.2 Standard Method of Cash Dividend Payment
16.3 The Benchmark Case: An Illustration of the Irrelevance of
Dividend Policy
16.4 Repurchase of Stock
16.5 Personal Taxes, Issuance Costs, and Dividends
16.6 Real World Factors Favoring a High Dividend Policy
16.7 The Clientele Effect: A Resolution of Real-World Factors?
16.8 What We Know and Do Not Know About Dividend
Policy
16.9 Stock Dividends and Stock Splits
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
16.1 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.
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.
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
16.2 Standard Method of Cash Dividend
Cash Dividend - Payment of cash by the firm
to its shareholders.
$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.
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
16.3 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.
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
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
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
16.4 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.
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
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
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
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
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
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
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Share Repurchase
Flexibility for shareholders
Keeps stock price higher
Good for insiders who hold stock options
As an investment of the firm
Tax benefits
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
16.5 Personal Taxes, Issuance Costs, 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.
Since capital gains can be deferred, the tax rate on
dividends is greater than the effective rate on capital
gains.
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Firms without Sufficient Cash
Investment Bankers The direct costs of
stock issuance will
add to this effect.
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Taxes, Issuance Costs, 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.
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
16.6 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.
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
16.7 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.
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
16.8 What We Know and Do Not Know
Corporations “smooth” dividends.
Dividends provide information to the market.
Firms should follow a sensible dividend policy:
Don’t 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.
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
16.9 Stock Dividends
Pay additional shares of stock instead of cash
Increases the number of outstanding shares
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
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.”
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
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?
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.