9780273713654_pp18.ppt

18.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Chapter 18
Dividend Policy

After Studying Chapter 18,
you should be able to:
1. Understand the dividend retention versus distribution dilemma
faced by the firm.
2. Explain the Modigliani and Miller (M&M) argument that
dividends are irrelevant.
3. Explain the counterarguments to M&M - that dividends do
matter.
4. Identify and discuss the factors affecting a firm's dividend and
retention of earnings policy.
5. Define, compare, and justify cash dividends, stock dividends,
stock splits, and reverse stock splits.
6. Define “stock repurchase” and explain why (and how) a firm
might repurchase stock.
7. Summarize the standard cash dividend payment procedures
and critical dates.
8. Define and discuss dividend reinvestment plans (DRIPs).

Dividend Policy
• Passive Versus Active Dividend
Policies
• Factors Influencing Dividend Policy
• Dividend Stability
• Stock Dividends and Stock Splits
• Stock Repurchase
• Administrative Considerations

Dividends as a
Passive Residual
• 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.
Can the payment of cash dividends affect
shareholder wealth?
If so, what dividend-payout ratio will
maximize shareholder wealth?

Irrelevance of Dividends
• 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.
A. Current dividends versus retention
of earnings

Irrelevance of Dividends
• 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
dividend payout is too low or buying shares
when the dividend payout is excessive.
B. Conservation of value

Relevance of 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.
A. Preference for dividends

• 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.
B. Taxes on the investor

• 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.
B. Taxes on the investor (continued)

Other Dividend Issues
• Flotation costs
• Transaction costs and
divisibility of securities
• Institutional restrictions
• Financial signaling

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.

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.

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.

Factors Influencing
Dividend Policy
• 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).
• Incorporation in some states (notably
Delaware) allows a firm to use the “fair
value,” rather than “book value,” of its assets
when judging whether a dividend impairs
“capital.”
Legal Rules

Factors Influencing
Dividend Policy
• 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.
Legal Rules

Factors Influencing
Dividend Policy
• Funding Needs of the Firm
• Liquidity
• Ability to Borrow
• Restrictions in Debt Contracts
(protective covenants)
• Control
Other Issues to Consider

Dividend Stability
Stability – maintaining the position of the firm’s
dividend payments in relation to a trend line.
Dollars
Per
Share
3
4
2
1
Earnings per share
Dividends
per share
Time
50% of earnings
paid out as dividends

Dividend Stability
Dividends begin at 50% of earnings, but are stable and
increase only when supported by growth in earnings.
Dollars
Per
Share
3
4
2
1
Earnings per share
Dividends per share
Time
50% dividend-payout
rate with stability

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.”

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

Stock Dividends
and Stock Splits
Small-percentage stock dividends
• Typically less than 25% 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?
Stock Dividend – A payment of additional
shares of stock to shareholders. Often used
in place of or in addition to a cash dividend.

B/S Changes for the Small-
Percentage Stock Dividend
• $800,000 ($5 × 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 shareholders’ equity” remains
unchanged at $10 million.

Small-Percentage
Stock Dividends
Before 5% Stock Dividend
Common stock
($5 par; 400,000 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) $ 2,100,000

Stock Dividends,
EPS, and Total Earnings
• Assume that investor SP owns 10,000 shares and the
firm earned $2.50 per share.
• Total earnings = $2.50 × 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).
After a small-percentage stock dividend, what
happens to EPS and total earnings of
individual investors?

Stock Dividends
and Stock Splits
• 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.
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?
Large-percentage stock dividends

B/S Changes for the Large-
Percentage Stock Dividend
• $2 million ($5 × 400,000 new
shares) transferred (on paper)
“out of” retained earnings.
• $2 million transferred “into”
common stock account.

Large-Percentage
Stock Dividends
Before 100% Stock Dividend
Common stock
($5 par; 400,000 shares) $ 2,000,000
After 100% Stock Dividend
Common stock
($5 par; 800,000 shares) $ 4,000,000

Stock Dividends
and Stock Splits
• Similar economic consequences as a 100% stock
dividend.
• Primarily used to move the stock into a more
popular trading range and increase share demand.
common stock splits 2-for-1. How does this impact
the shareholders’ equity accounts?
Stock Split – An increase in the number of
shares outstanding by reducing the par value
of the stock.

Stock Splits
Before 2-for-1 Stock Split
Common stock
($5 par; 400,000 shares) $ 2,000,000
After 2-for-1 Stock Split
Common stock
($2.50 par; 800,000 shares) $ 2,000,000

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

Stock Dividends
and Stock Splits
• 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?
Reverse Stock Split – A stock split in which the
number of shares outstanding is decreased.

Reverse Stock Splits
Before 1-for-4 Stock Split
Common stock
($5 par; 400,000 shares) $ 2,000,000
After 1-for-4 Stock Split
Common stock
($20 par; 100,000 shares) $ 2,000,000

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

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.

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
to be paid out $ 400,000

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 = 15
“New” EPS = $800,000 / 387,097 = $2.07
“New” market price = $2.07 × 15 = $31

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.

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.

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

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.

Administrative Considerations:
Procedural Aspects
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 31st.
May 8 May 29 May 31 June 15

Procedural Aspects
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.

Procedural Aspects
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.

Dividend
Reinvestment Plans
• 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.
Dividend Reinvestment Plan (DRIP) – An optional plan
allowing shareholders to automatically reinvest
dividend payments in additional shares of the
company’s stock.

9780273713654_pp18.ppt

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