Dividend Policy

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Dividend Policy

 Passive Versus Active Dividend Policies

 Factors Influencing Dividend Policy
 Dividend Stability
 Stock Dividends and Stock Splits
 Stock Repurchase
 Administrative Considerations

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 Dividends as a Passive
Residual
Can the payment of cash dividends affect
shareholder wealth?
If so, what dividend-payout ratio will
maximize shareholder wealth?
◦ The firm uses earnings plus the additional financing that
the increased equity can support to finance any expected
positive-NPV projects.
◦ Any unused earnings are paid out in the form of
dividends. This describes a passive dividend policy.

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 Irrelevance of Dividends

A. Current dividends versus retention

of earnings
 M&M contend that the effect of
dividend payments on shareholder
wealth is exactly offset by other means
of financing.
 The dividend plus the “new” stock
price after dilution exactly equals the
stock price prior to the dividend
distribution.
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Irrelevance of Dividends

B. Conservation of value
 M&M and the total-value principle ensures
that the sum of market value plus current
dividends of two firms identical in all
respects other than dividend-payout ratios
will be the same.
 Investors can “create” any dividend policy
they desire by selling shares when the the
dividend payout is too low or buying
shares when the dividend payout is
excessive.
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Relevance of Dividends

A. Preference for dividends

 Uncertainty surrounding future
company profitability leads certain
investors to prefer the certainty of
current dividends.
 Investors prefer “large” dividends.
 Investors do not like to manufacture
“homemade” dividends, but prefer the
company to distribute them directly.
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Relevance of Dividends

B. Taxes on the investor

 Capital gains taxes are deferred until the
actual sale of stock. This creates a timing
option.
 Capital gains are preferred to dividends,
everything else equal. Thus, high
dividend-yielding stocks should sell at a
discount to generate a higher before-tax
rate of return.
 Certain institutional investors pay no tax.
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Relevance of Dividends

B. Taxes on the investor (continued)

 Corporations can typically exclude 70% of
dividend income from taxation. Thus,
corporations generally prefer to receive
dividends rather than capital gains.
 The result is clienteles of investors with different
dividend preferences. In equilibrium, there will
be the proper distribution of firms with differing
dividend policies to exactly meet the needs of
investors.
 Thus, dividend-payout decisions are irrelevant.
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 Other Dividend Issues
 Flotation costs
 Transaction costs and divisibility of
securities
 Institutional restrictions
 Financial signaling

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Empirical Testing of Dividend
Policy

Tax Effect
◦ Dividends are taxed more heavily than capital gains, so
before-tax returns should be higher for high-dividend-
paying firms.
◦ Empirical results are mixed -- recently the evidence is
largely consistent with dividend neutrality.
Financial Signaling
◦ Expect that increases (decreases) in dividends lead to
positive (negative) excess stock returns.
◦ Empirical results are consistent with these expectations.

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 Implications for
Corporate Policy

Establish a policy that will maximize

shareholder wealth.
Distribute excess funds to shareholders and
stabilize the absolute amount of dividends
if necessary (passive).
Payouts greater than excess funds should
occur only in an environment that has a net
preference for dividends.

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 Implications for
Corporate Policy

 There is a positive value associated with

a modest dividend. Could be due to
institutional restrictions or signaling
effects.
 Dividends in excess of the passive policy
does not appear to lead to share price
improvement because of taxes and
flotation costs.

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 Factors Influencing
Dividend Policy

Legal Rules
 Capital Impairment Rule -- many states prohibit the
payment of dividends if these dividends impair
“capital” (usually either par value of common stock
or par plus additional paid-in capital).
 Insolvency Rule -- some states prohibit the payment
of cash dividends if the company is insolvent under
either a “fair market valuation” or “equitable” sense.
 Undue Retention of Earnings Rule -- prohibits the
undue retention of earnings in excess of the present
and future investment needs of the firm.
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 Factors Influencing
Dividend Policy
Other Issues to Consider
Funding Needs of the Firm
Liquidity
Abilityto Borrow
Restrictions in Debt Contracts
Control

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Dividend Stability

Stability -- maintaining the position of the firm’s

dividend payments in relation to a trend line.
4 50% of earnings Earnings per share
Dollars Per Share

paid out as dividends

3

2
Dividends
1 per share

Time 15
Dividend Stability

Dividends begin at 50% of earnings, but are stable and

increase only when supported by growth in earnings.

4 50% dividend-payout Earnings per share

Dollars Per Share

rate with stability

3

1 Dividends per share

Time 16
 Valuation of Dividend
Stability
 Information content -- management may be able
to affect the expectations of investors through the
informational content of dividends. A stable
dividend suggests that the company expects
stable or growing dividends in the future.
 Current income desires -- some investors who
desire a specific periodic income will prefer a
company with stable dividends to one with
unstable dividends.
 Institutional considerations -- a stable dividend
may permit certain institutional investors to buy
the common stock as they meet the requirements
to be placed on the organizations “approved list.”
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Types of Dividends

Regular Dividend
 The dividend that is normally expected to
be paid by the firm.
Extra dividend
◦ A nonrecurring dividend paid to shareholders in addition
to the regular dividend. It is brought about by special
circumstances.

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 Stock Dividends and
Stock Splits
Stock dividend -- A payment of additional
shares of stock to shareholders. Often used
in place of or in addition to a cash dividend.
Small-percentage stock dividends
◦ Typically less than 20% of previously outstanding
common stock.
◦ Assume a company with 400,000 shares of $5 par
common stock outstanding pays a 5% stock dividend.
The pre-dividend market value is $40. How does this
impact the shareholders’ equity accounts?

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B/S Changes for the Small-
Percentage Stock Dividend

 $800,000 ($5 x 20,000 new shares)

transferred (on paper) “out of” retained
earnings.
 $100,000 transferred “into” common
stock account.
 $700,000 ($800,000 - $100,000)
transferred “into” additional paid-in-
capital.
 “Total sharheolders’ equity” remains
unchanged at $10 million.
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 Small-Percentage Stock
Dividends
Before 5% Stock Dividend
Common stock
($5 par; 400,000 shares)
shares $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000

After 5% Stock Dividend

Common stock
($5 par; 420,000 shares)
shares $ 2,100,000
Additional paid-in capital 1,700,000
Retained earnings 6,200,000
Total shareholders’ equity $10,000,000
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 Stock Dividends, EPS, and
Total Earnings
After a small-percentage stock dividend, what
happens to EPS and total earnings of
individual investors?
 Assume that investor SP owns 10,000 shares and the firm
earned $2.50 per share.
 Total earnings = $2.50 x 10,000 = $25,000.
 After the 5% dividend, investor SP owns 10,500 shares
and the same proportionate earnings of $25,000.
 EPS is then reduced to $2.38 per share because of the
stock dividend. ($25,000 / 10,500 shares = $2.38 EPS).
EPS

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 Stock Dividends and
Stock Splits
Large-percentage stock dividends
 Typically 20% or greater of previously outstanding
common stock.
 The material effect on the market price per share
causes the transaction to be accounted for
differently. Reclassification is limited to the par
value of additional shares rather than pre-stock-
dividend value of additional shares.
 Assume a company with 400,000 shares of $5 par
common stock outstanding pays a 100% stock
dividend. The pre-stock-dividend market value per
share is $40. How does this impact the
shareholders’ equity accounts? 23
B/S Changes for the Large-
Percentage Stock Dividend
 $2 million ($5 x 400,000 new shares)
transferred (on paper) “out of” retained
earnings.
 $2 million transferred “into” common
stock account.

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 Large-Percentage Stock
Dividends
Before 100% Stock Dividend
Common stock
($5 par; 400,000 shares)
shares $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000

After 100% Stock Dividend

Common stock
($5 par; 800,000 shares)
shares $ 4,000,000
Additional paid-in capital 1,000,000
Retained earnings 5,000,000
Total shareholders’ equity $10,000,000
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 Stock Dividends and
Stock Splits
Stock split -- An increase in the number of
shares outstanding by reducing the par value
of the stock.
 Similar economic consequences as a 100% stock
dividend.
 Primarily used to move the stock into a more
popular trading range and increase share
demand.
 Assume a company with 400,000 shares of $5
par common stock splits 2-for-1. How does this
impact the shareholders’ equity accounts? 26
Stock Splits

Before 2-for-1 Stock Split

Common stock
($5 par; 400,000 shares)
shares $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000

After 2-for-1 Stock Split

Common stock
($2.50 par; 800,000 shares)
shares $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000
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Value to Investors of Stock
Dividends or Stock Splits
 Effect on investor total wealth
 Effect on investor psyche
 Effect on cash dividends
 More popular trading range
 Informational content

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 Stock Dividends and
Stock Splits
Reverse stock split -- A stock split in which the
number of shares outstanding is decreased.
 Used to move the stock into a more popular
trading range and increase share demand.
 Usually signals negative information to the
market upon its announcement (consistent with
empirical evidence).
 Assume a company with 400,000 shares of $5
par common stock splits 1-for-4. How does this
impact the shareholders’ equity accounts?
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Reverse Stock Splits

Before 1-for-4 Stock Split

Common stock
($5 par; 400,000 shares)
shares $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000

After 1-for-4 Stock Split

Common stock
($20 par; 100,000 shares)
shares $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000
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Stock Repurchase

Stock repurchase -- The repurchase (buyback)

of stock by the issuing firm, either in the open
(secondary) market or by self-tender offer.
Reasons for stock repurchase:
◦ Available for management stock-option plans
◦ Available for for the acquisition of other companies
◦ “Go private” by repurchasing all shares from outside
stockholders
◦ To permanently retire the shares

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 Methods of Repurchase
 Fixed-price self-tender offer -- An offer by a firm
to repurchase some of its own shares, typically at
a set price.
 Dutch auction self-tender offer -- A buyer (seller)
seeks bids within a specified price range, usually
for a large block of stock or bonds. After
evaluating the range of bid prices received, the
buyer (seller) accepts the lowest price that will
allow it to acquire (dispose of) the entire block.
 Open-market purchase -- A company repurchases
its stock through a brokerage house on the
secondary market.
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 Repurchasing as Part of
Dividend Policy
Assume:
◦ Earnings after taxes $ 800,000
◦ Number of common
shares outstanding  400,000
◦ Earnings per share $ 2
◦ Current market price
per share $ 31
◦ Expected dividend per share $ 1
◦ Expected total dividends
be paid out $ 400,000

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 Repurchasing as Part of
Dividend Policy
If dividend is paid, shareholders receive:
◦ Expected dividend per share $ 1
◦ Market price per share $ 30
◦ Total value $ 31
If shares repurchased, shareholders receive:
◦ Dividend per share $ 0
◦ Market price per share* $ 31
◦ Total value $ 31
* Shares repurchased = $400,000 / $31 = 12,903
Original P/E ratio = $30/$2
$30 = 15
“New” EPS = $800,000 / 387,097 = $2.07
“New” market price = $2.07 x 15 = $31

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Summary of Repurchasing as
Part of Dividend Policy
The capital gain arising from the
repurchase (stock rising from $30 to $31)
exactly equals the dividend ($1) that
would have otherwise been paid.
This result holds in the absence of taxes
and transaction costs.
To the taxable investor, capital gains
(repurchases) are favored to dividend
income as the tax on the capital gain is
postponed until the actual sale of the
common shares.
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Summary of Repurchasing as Part
of Dividend Policy

 Stock repurchases are most relevant for firms

with large amounts of excess cash that might
otherwise generate a significant taxable
transaction to investors.
 Firms must be careful not to make regularly
occurring repurchases or the IRS may consider
the capital gains as dividends for tax purposes.

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 Investment or
Financing Decision?

Investing Decision
 Not really, as stock that is repurchased is held as
treasury stock and does not provide an expected
return like other investments.
Financing Decision
◦ It possesses capital structure or dividend policy
motivations.
◦ For example, a repurchase immediately changes the
debt-to-equity ratio (higher financial leverage).

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 Possible Signaling Effect

 Repurchases have a positive signaling effect.

 For example, if the stock is undervalued
management may tender for shares at a
“premium”. This signals that the share prices
are undervalued.
 Dutch-auction self-tenders have less signaling
power likely due to a smaller tender premium.
 Open-market purchases have only a modest
positive signaling effect likely due to many
programs being instituted after significant share
price declines.
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 Administrative Considerations:
Procedural Aspects
May 8 May 29 May 31 June 15

Record Date -- The date, set by the board of

directors when a dividend is declared, on which
an investor must be a shareholder of record to
be entitled to the upcoming dividend.
The board of directors met on May 8th to declare
a dividend payable to shareholders on June 15th
to the shareholders of record on May 31.
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Administrative Considerations:
Procedural Aspects
May 8 May 29 May 31 June 15

Ex-dividend Date -- The first date on which a

stock purchaser is no longer entitled to the
recently declared dividend.
The buyer and seller of the shares have several days
to settle (pay for the shares or deliver the shares).
The brokerage industry has a rule that new
shareholders are entitled to dividends only if they
purchase the stock at least two business days prior
to the record date.
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Administrative Considerations:
Procedural Aspects
May 8 May 29 May 31 June 15

Declaration Date -- The date that the board of

directors announces the amount and date of the next
dividend.

Payment Date -- The date when the corporation

actually pays the declared dividend.

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Dividend Reinvestment Plans

Dividend Reinvestment Plan (DRIP) -- An optional plan

allowing shareholders to automatically reinvest
dividend payments in additional shares of the
company’s stock.
 The firm can use existing stock. A trustee (e.g., a
bank) purchases the stock on the open-market
and credits current shareholders with the new
shares.
 The firm can issue new stock. This method raises
“new” funds for the firm. The plan essentially
reduces the effective dividend-payout ratio.
 Some plans offer discounts and eliminate
brokerage costs for current shareholders. 42