The document discusses different types of payouts companies can use to distribute cash to shareholders, including regular cash dividends, stock dividends, dividends in kind, and stock buybacks. It also covers the standard procedure for paying cash dividends, including declaration date, ex-dividend date, record date, and payment date. Additionally, it discusses the theory that dividend policy is irrelevant to the value of the firm since investors can create their own income streams through stock transactions.

1. Dividends Policy
19-1

2. 8.1 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.
19-2

3. Advantages of paying dividend
• Cash dividend can underscore good results and provides
support to the share price.
• Dividends may attract institutional investors who prefer some
mix return in the form of dividends. A mix of institutions and
individual investors may allow a firm to raise capital at lower
cost because of the ability of the firm to reach a wider
market.
• Share price usually increase with the announcement of a new
or increased dividends.
• Dividends absorb excess cash flow and many reduce agency
costs that arise from conflicts between management and
shareholders.
19-3

4. Disadvantages of paying dividend
• Dividends can reduce internal sources of financing.
Dividends may force the firm to forgo positive NPV
projects or to rely on costly external equity financing.
• Once established, dividends cuts are hard to make
without adversely affecting the firm’s share price.
19-4

5. 19.2 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.
19-5

6. 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.
19-6

7. 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.
19-7

8. 8.3 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.
19-8

9. 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
19-9

10. 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
19-10

11. 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.”
19-11

12. 8.4 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.
19-12

13. 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
19-13

14. 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
19-14

15. 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
19-15

16. 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
19-16

17. Share repurchase and cash
dividend
• Similarities
• Share repurchase and cash dividend programs are mechanism for
transferring excess finds from a corporation to its shareholders.
• Differences
• Dividend programs require an ongoing cash outflow that is
difficult to reduce or terminate.
• Share repurchase programs on the other hand, are structured
such that a firm can be control both the timing and the amount of
the cash outflows.
• While a share program is frequently announced, there is no
commitment to actually purchase the shares.
• This provides a lot more flexibility to the firm than a dividend
program.
19-17

18. 8.5 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.
19-18

19. Firms without Sufficient Cash
The direct costs of
Investment Bankers
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. 19-19

20. 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 19-20

21. 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.
19-21

22. 8.6 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.
19-22

23. 8.7 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.
19-23

24. 8.8 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.
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25. 8.9 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.
19-25

26. 8.10 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%
19-26

27. 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.”
19-27