This chapter discusses different types of payouts such as cash dividends, stock dividends, and share repurchases. It explains how dividend policy is irrelevant if investors can create their own income streams, but real-world factors like taxes make repurchases preferable to dividends. The chapter also covers the clientele effect where different types of investors prefer certain payout policies, and how stock dividends and splits differ from cash dividends in increasing the number of outstanding shares.

1. Dividends and Other Payouts
Chapter 19
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin

2. 19-1
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

3. 19-2
Chapter Outline
19.1 Different Types of Payouts
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, Dividends, and Stock Repurchases
19.6 Real-World Factors Favoring a High Dividend Policy
19.7 The Clientele Effect: A Resolution of Real-World Factors?
19.8 What We Know and Do Not Know about Dividend Policy
19.9 Putting It All Together
19.10 Stock Dividends and Stock Splits

4. 19-3
19.1 Different Types of Payouts
 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.
 Other companies use stock buybacks.

5. 19-4
19.2 Standard Method of Cash Dividend
Record Date – Date on which company
determines existing 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.
Cash Dividend - Payment of cash by the firm
to its shareholders.

6. 19-5
Procedure for Cash Dividend
25 Oct. 1 Nov. 2 Nov. 5 Nov. 7 Dec.
Declaration
Date
Cum-
dividend
Date
Ex-
dividend
Date
Record
Date
Payment
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.

7. 19-6
Price Behavior
 In a perfect world, the stock price will fall by the
amount of the dividend on the ex-dividend date.
$P
$P - div
Ex-
dividend
Date
The price drops
by the amount of
the cash
dividend.
-t … -2 -1 0 +1 +2 …
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.

8. 19-7
19.3 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.

9. 19-8
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
Cash from dividend $160
Cash from selling stock $80
Total Cash $240
Value of Stock Holdings $40 × 78 =
$3,120
$3 Dividend
$240
$0
$240
$39 × 80 =
$3,120

10. 19-9
Dividend Policy Is Irrelevant
 In the above example, Bob Investor began with a
total wealth of $3,360:
share
42
$
shares
80
360
,
3
$ 

240
$
share
39
$
shares
80
360
,
3
$ 


80
$
160
$
share
40
$
shares
78
360
,
3
$ 



 After a $3 dividend, his total wealth is still $3,360:
 After a $2 dividend and sale of 2 ex-dividend shares, his
total wealth is still $3,360:

11. 19-10
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.”

12. 19-11
19.4 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.

13. 19-12
Stock Repurchase versus Dividend
$10
=
/100,000
$1,000,000
=
Price per share
100,000
=
outstanding
Shares
1,000,000
Value of Firm
1,000,000
Value of Firm
1,000,000
Equity
850,000
Assets
Other
0
Debt
$150,000
Cash
sheet
balance
Original
A.
Equity
&
Liabilities
Assets
Consider a firm that wishes to distribute $100,000 to its
shareholders.

14. 19-13
Stock Repurchase versus Dividend
$9
=
00,000
$900,000/1
=
share
per
Price
100,000
=
g
outstandin
Shares
900,000
Firm
of
Value
900,000
Firm
of
Value
900,000
Equity
850,000
Assets
Other
0
Debt
$50,000
Cash
dividend
cash
share
per
$1
After
B.
Equity
&
s
Liabilitie
Assets
If they distribute the $100,000 as a cash dividend, the balance
sheet will look like this:

15. 19-14
Stock Repurchase versus Dividend
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
If they distribute the $100,000 through a stock repurchase, the
balance sheet will look like this:

16. 19-15
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

17. 19-16
19.5 Personal Taxes, Dividends, and
Stock Repurchases
 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 (currently) 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.

18. 19-17
Firms without Sufficient Cash
In a world of personal taxes,
firms should not issue stock to
pay a dividend.
Firm
Stock
Holders
Cash: stock issue
Cash: dividends
Gov.
Taxes
Investment Bankers
The direct costs of
stock issuance will
add to this effect.

19. 19-18
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

20. 19-19
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.

21. 19-20
19.6 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.

22. 19-21
19.7 The Clientele Effect
 Clienteles for various dividend payout policies
are likely to form in the following way:
Group Stock Type
High Tax Bracket Individuals
Low Tax Bracket Individuals
Tax-Free Institutions
Corporations
Zero-to-Low payout
Low-to-Medium payout
Medium payout
High payout
Once the clienteles have been satisfied, a corporation is
unlikely to create value by changing its dividend policy.

23. 19-22
19.8 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.

24. 19-23
19.9 Putting It All Together
 Aggregate payouts are massive and have
increased over time.
 Dividends are concentrated among a small
number of large, mature firms.
 Managers are reluctant to cut dividends.
 Managers smooth dividends.
 Stock prices react to unanticipated changes in
dividends.

25. 19-24
19.10 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%

26. 19-25
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.”

27. 19-26
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?