Dividend Policy and Internal Financing

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Dividend Policy and Internal Financing

• Chapter 13

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Stock Returns

• P1 - Po D1
• Po
• P1 - Po D1
• Po Po

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Dilemma Should the firm use retained earnings
for

• a) Financing profitable capital investments?
• b) Paying dividends to stockholders?

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• If we retain earnings for profitable investments,
  dividend yield will be zero, but the stock price
  will increase, resulting in a higher capital
  gain.

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• If we pay dividends, stockholders receive an
  immediate cash reward for investing, but the
  capital gain will decrease, since this cash is
  not invested in the firm.

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So, dividend policy really involves 2 decisions

• How much of the firms earnings should be
  distributed to shareholders as dividends, and
• How much should be retained for capital
  investment?

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Is Dividend Policy Important?

• Three viewpoints
• 1) Dividends are Irrelevant. If we assume
  perfect markets (no taxes, no transaction costs,
  etc.) dividends do not matter. If we pay a
  dividend, shareholders dividend yield rises, but
  capital gains decrease.

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• With perfect markets, investors are concerned
  only with total returns, and do not care whether
  returns come in the form of capital gains or
  dividend yields.
• Therefore, one dividend policy is as good as
  another.

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2) High Dividends are Best

• Some investors may prefer a certain dividend now
  over a risky expected capital gain in the future.

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3) Low Dividends are Best

• Dividends are taxed immediately. Capital gains
  are not taxed until the stock is sold.
• Therefore, taxes on capital gains can be deferred
  indefinitely.

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Do Dividends Matter?

• Other Considerations
• 1) Residual Dividend Theory
• The firm pays a dividend only if it has retained
  earnings left after financing all profitable
  investment opportunities.
• This would maximize capital gains for
  stockholders and minimize flotation costs of
  issuing new common stock.

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Do Dividends Matter?

• 2) Clientele Effects
• Different investor clienteles prefer different
  dividend payout levels.
• Some firms, such as utilities, pay out over 70
  of their earnings as dividends. These attract a
  clientele that prefers high dividends.
• Growth-oriented firms which pay low (or no)
  dividends attract a clientele that prefers price
  appreciation to dividends.

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Do Dividends Matter?

• 3) Information Effects
• Unexpected dividend increases usually cause stock
  prices to rise, and unexpected dividend decreases
  cause stock prices to fall.
• Dividend changes convey information to the market
  concerning the firms future prospects.

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Do Dividends Matter?

• 4) Agency Costs
• Paying dividends may reduce agency costs between
  managers and shareholders.
• Paying dividends reduces retained earnings and
  forces the firm to raise external equity
  financing.
• Raising external equity subjects the firm to
  scrutiny of regulators (SEC) and investors and
  therefore helps monitor the performance of
  managers.

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Do Dividends Matter?

• 5) Expectations Theory
• Investors form expectations concerning the amount
  of a firms upcoming dividend.
• Expectations are based on past dividends,
  expected earnings, investment and financing
  decisions, the economy, etc.
• The stock price will likely react if the actual
  dividend is different from the expected dividend.

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Dividend Policies

• 1) Constant Dividend Payout Ratio if directors
  declare a constant payout ratio of, for example,
  30, then for every dollar of earnings available
  to stockholders, 30 cents would be paid out as
  dividends.
• The ratio remains constant over time, but the
  dollar value of dividends changes as earnings
  change.

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Dividend Policies

• 2) Stable Dollar Dividend Policy the firm
  tries to pay a fixed dollar dividend each
  quarter.
• Firms and stockholders prefer stable dividends.
  Decreasing the dividend sends a negative signal!

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Dividend Policies

• 3) Small Regular Dividend plus Year-End Extras
• The firm pays a stable quarterly dividend and
  includes an extra year-end dividend in prosperous
  years.
• By identifying the year-end dividend as extra,
  directors hope to avoid signaling that this is a
  permanent dividend.

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Dividend Payments
Jan.4 Jan.30 Feb.1
Mar. 11
Declare Ex-div. Record
Payment dividend date date
date

• 1) Declaration Date the board of directors
  declares the dividend, determines the amount of
  the dividend, and decides on the payment date.

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Dividend Payments
Jan.4 Jan.30 Feb.1
Mar. 11
Declare Ex-div. Record
Payment dividend date date
date

• 2) Ex-Dividend Date To receive the dividend,
  you have to buy the stock before the ex-dividend
  date. On this date, the stock begins trading
  ex-dividend and the stock price falls
  approximately by the amount of the dividend.

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Dividend Payments
Jan.4 Jan.30 Feb.1
Mar. 11
Declare Ex-div. Record
Payment dividend date date
date

• 3) Date of Record 2 days after the ex-dividend
  date, the firm receives the list of stockholders
  eligible for the dividend.
• Often, a bank trust department acts as registrar
  and maintains this list for the firm.

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Dividend Payments
Jan.4 Jan.30 Feb.1
Mar. 11
Declare Ex-div. Record
Payment dividend date date
date

• 4) Payment Date date on which the firm mails
  the dividend checks to the shareholders of record.

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Stock Dividends and Stock Splits

• Stock dividend payment of additional shares of
  stock to common stockholders.
• Example Citizens Bancorporation of Maryland
  announces a 5 stock dividend to all shareholders
  of record. For each 100 shares held,
  shareholders receive another 5 shares.
• Does the shareholders wealth increase?

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Stock Dividends and Stock Splits

• Stock Split the firm increases the number of
  shares outstanding and reduces the price of each
  share.
• Example Joule, Inc. announces a 3-for-2 stock
  split. For each 100 shares held, shareholders
  receive another 50 shares.
• Does this increase shareholder wealth?
• Are a stock dividend and a stock split the same?

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Stock Dividends and Stock Splits

• Stock Splits and Stock Dividends are economically
  the same the number of shares outstanding
  increases and the price of each share drops. The
  value of the firm does not change.
• Example A 3-for-2 stock split is the same as a
  50 stock dividend. For each 100 shares held,
  shareholders receive another 50 shares.

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Stock Dividends and Stock Splits

• Effects on Shareholder Wealth these will cut
  the company pie into more pieces but will not
  create wealth. A 100 stock dividend (or a
  2-for-1 stock split) gives shareholders 2
  half-sized pieces for each full-sized piece they
  previously owned.
• For example, this would double the number of
  shares, but would cause a 60 stock price to fall
  to 30.

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Stock Dividends and Stock Splits

• Why bother?
• Proponents argue that these are used to reduce
  high stock prices to a more popular trading
  range (generally 15 to 70 per share).
• Opponents argue that most stocks are purchased by
  institutional investors who have millions of
  dollars to invest and are indifferent to price
  levels. Plus, stock splits and stock dividends
  are expensive!

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Stock Dividend Example

• shares outstanding 1,000,000
• net income 6,000,000
• P/E 10
• 25 stock dividend.
• An investor has 120 shares. Does the value of
  the investors shares change?

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• Before the 25 stock dividend
• EPS 6,000,000/1,000,000 6
• P/E P/6 10, so P 60 per share.
• Value 60 x 120 shares 7,200
• After the 25 stock dividend
• shares 1,000,000 x 1.25 1,250,000.
• EPS 6,000,000/1,250,000 4.80
• P/E P/4.80 10, so P 48 per share.
• Investor now has 120 x 1.25 150 shares.
• Value 48 x 150 7,200

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Stock DividendsIn-class Problem

• shares outstanding 250,000
• net income 750,000
• stock price 84
• 50 stock dividend.
• What is the new stock price?

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Hint

• stock price
• P/E net income
• shares

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• Before the 50 stock dividend
• EPS 750,000 / 250,000 3
• P/E 84 / 3 28.
• After the 50 stock dividend
• shares 250,000 x 1.50 375,000.
• EPS 750,000 / 375,000 2
• P/E P / 2 28, so P 56 per share.
• (a 50 stock dividend is equivalent to a
• 3-for-2 stock split)

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Stock Repurchases

• Stock Repurchases may be a good substitute for
  cash dividends.
• If the firm has excess cash, why not buy back
  common stock?

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Stock Repurchases

• Repurchases drive up the stock price, producing
  capital gains for shareholders.
• Repurchases increase leverage, and can be used to
  move toward the optimal capital structure.
• Repurchases signal positive information to the
  market - which increases stock price.

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Stock Repurchases

• Repurchases may be used to avoid a hostile
  takeover.
• Example T. Boone Pickens attempted raids on
  Phillips Petroleum and Unocal in 1985. Both were
  unsuccessful because the target firms undertook
  stock repurchases.

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Stock Repurchases

• Methods
• Buy shares in the open market through a broker.
• Buy a large block by negotiating the purchase
  with a large block holder, usually an institution
  (targeted stock repurchase).
• Tender offer offer to pay a specific price to
  all current stockholders.

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Dividends
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What are Dividends?

• Dividends are distribution from the firm's assets
  to the shareholders.
• Firms are not obligated to pay dividends or
  maintain a consistent policy with regard to
  dividends.
• Dividends can be paid in cash or stocks.

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Dividend Policy

• A firms dividend policy includes two components
• Dividend Payout ratio
• Indicates amount of dividend paid relative to the
  companys earnings.
• Example If dividend per share is 1 and earnings
  per share is 2, the payout ratio is 50 (1/2)
• Stability of dividends over time

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Dividend Policies Vary

• General Electric (GE) has paid dividends
  continuously since 1899.
• Microsoft (MSFT) went public in 1986 but did not
  pay dividends until June, 2003.
• Berkshire Hathaway (BRK) has not yet paid
  dividends.

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Dividend Policy Trade-offs

• If management has decided how much to invest and
  has chosen the debt-equity mix, decision to pay a
  large dividend means retaining less of the firms
  profits. This means the firm will have to rely
  more on external equity financing.
• Similarly, a smaller dividend payment will lead
  to less reliance on external financing.

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Dividend Policy and Shareholders Wealth
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Dividend Policy and Share Prices

• Dividend policy is considered as a puzzle with no
  clear answers. As Fischer Black concluded more
  than 30 years ago
• "What should the individual investor do about
  dividends in the portfolio? We don't know!
• What should the corporation do about dividend
  policy? We don't know!

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Three Views

• There are three basic views with regard to the
  impact of dividend policy on share prices
• Dividend policy is irrelevant.
• High dividends will increase share prices.
• Low dividends will increase share prices.

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View 1

• Dividend policy is irrelevant
• Irrelevance implies shareholder wealth is not
  affected by dividend policy (whether the firm
  pays 0 or 100 of its earnings as dividends).
• This view is based on two assumptions
• (a) Perfect capital markets exist and
• (b) The firms investment and borrowing
  decisions have been made and will not be altered
  by dividend payment.

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View 2

• High dividends increase stock value
• This position in based on bird-in-the-hand
  theory, which argues that investors may prefer
  dividend today as it is less risky compared to
  uncertain future capital gains.
• Thus shareholders will demand a relatively higher
  rate of return for stocks that do not pay low or
  no dividends.

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View 3

• Low dividends increases stock value
• In 2003, the tax rates on capital gains and
  dividends were made equal to 15 percent.
• However, current dividends are taxed immediately
  while the tax on capital gains can be deferred
  until the stock is actually sold. Thus, using
  present value of money, capital gains have
  definite financial advantages for shareholders.
• Thus stocks that allow tax deferral (low
  dividends-high capital gains) will possibly sell
  at a premium relative to stocks that require
  current taxation (high dividends low capital
  gains).

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Some other explanations

• Residual Dividend theory
• Clientele effect
• Information effect
• Agency costs
• Expectations theory

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Residual Dividend Theory

• Determine the optimal capital budget.
• Determine the amount of equity needed for
  financing.
• First, use retained earnings to supply this
  equity.
• If RE still left, pay out dividends.
• Dividend Policy will be influenced by
• (a) investment opportunities or capital
  budgeting needs, and
• (b) availability of internally generated capital.

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The Clientele Effect

• Different groups of investors have varying
  preferences towards dividends.
• For example, some investors may prefer a fixed
  income stream so would prefer firms with high
  dividends while some investors, such as wealthy
  investors, would prefer to defer taxes and will
  be drawn to firms that have low dividend payout.
  Thus there will be a clientele effect.

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The Information Effect

• Evidence shows that large, unexpected change in
  dividends can have a significant impact on the
  stock prices.
• A firms dividend policy may be seen as a signal
  about firms financial condition. Thus, high
  dividend could signal expectations of high
  earnings in the future and vice versa.

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Agency Costs

• Dividend policy may be perceived as a tool to
  minimize agency costs.
• Dividend payment may require managers to issue
  stock to finance new investments. New investors
  will be attracted only if they are convinced that
  the capital will be used profitably. Thus,
  payment of dividends indirectly monitors
  managements investment activities and helps
  reduce agency costs, and may enhance the value of
  the firm.

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Expectations Theory

• Expectation theory suggests that the market
  reaction does not only reflect response to the
  firms actions it also indicates investors
  expectations about the ultimate decision to be
  made by management.
• Thus if the amount of dividend paid is equal to
  the dividend expected by shareholders, the market
  price of stock will remain unchanged. However,
  market will react if dividend payment is not
  consistent with shareholders expectations.

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Conclusions on Dividend Policy
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What are we to conclude?

• Here are some conclusions about the relevance of
  dividend policy
• As a firms investment opportunities increase,
  its dividend payout ratio should decrease.
• Investors use the dividend payment as a source of
  information of expected earnings.

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What are we to conclude?

• Relationship between stock prices and dividends
  may exist due to implications of dividends for
  taxes and agency costs.
• Based on expectations theory, firms should avoid
  surprising investors with regard to dividend
  policy.
• The firms dividend policy should effectively be
  treated as a long-term residual.

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Dividend Decision in Practice
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Dividend Decision in Practice

• Legal Restrictions
• Statutory restrictions may prevent a company from
  paying dividends
• Debt and preferred stock contracts may impose
  constraints on dividend policy
• Liquidity Constraints
• A firm may show earnings but it must have cash to
  pay dividends.

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Dividend Decision in Practice

• Earnings Predictability
• A firm with stable and predictable earnings is
  more likely to pay larger dividends.
• Maintaining Ownership Control
• Ownership of common stock gives voting rights. If
  existing stockholders are unable to participate
  in a new offering, control of current
  stockholders is diluted and issuing new stock
  will be considered unattractive.

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Alternative Dividend Policies

• Constant dividend payout ratio
• The of earnings paid out in dividends is held
  constant.
• Since earnings are not constant, the dollar
  amount of dividend will vary every year.
• Stable dollar dividend per share
• This policy maintains a constant dollar every
  year.
• Management will increase the dollar amount only
  if they are convinced that such increase can be
  maintained.

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Alternative Dividend Policies

• A small regular dividend plus a year-end extra.
• The company follows the policy of paying a small,
  regular dividend plus a year-end extra dividend
  in prosperous years.

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Dividend Payment Procedures

• Generally, companies pay dividend on a quarterly
  basis. The final approval of a dividend payment
  comes from the firms board of directors.
• For example, GE pays 6.72 per share in annual
  dividend in four equal installments of 1.68 each.

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Important Dates

• Declaration date The date when the dividend is
  formally declared by the board of directors. (Ex.
  February 7)
• Date of Record Investors shown to own stocks on
  this date receive the dividend. (Ex. February 17)
• Ex-Dividend date Two working days prior to date
  of record (Ex. February 15). Shareholders buying
  stock on or after ex-dividend date will not
  receive dividends.
• Payment date The date when dividend checks are
  mailed. (ex. March 10)

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Stock Dividends, Stock Splits and Stock Repurchase
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Stock Dividends

• A stock dividend entails the distribution of
  additional shares of stock in lieu of cash
  payment.
• While the number of common stock outstanding
  increases, the firms investments and future
  earnings prospects do not change.

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Stock Split

• A stock split involves exchanging more (or less
  in the case of reverse split) shares of stock
  for firms outstanding shares.
• While the number of common stock outstanding
  increases (or decreases in the case of reverse
  split), the firms investments and future
  earnings prospects do not change.
• Stock splits and stock dividends are far less
  frequent than cash dividends.

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Stock Repurchase

• A stock repurchase (stock buyback) occurs when a
  firm repurchases its own stock. This results in a
  reduction in the number of shares outstanding.
• From shareholders perspective, a stock
  repurchase has potential tax advantages as
  opposed to cash dividends.

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Stock Repurchase - Benefits

• A means of providing an internal investment
  opportunity
• An approach for modifying the firms capital
  structure
• A favorable impact on earnings per share
• The elimination of a minority ownership group of
  stockholders
• The minimization of the dilution of earnings per
  share associated with mergers
• The reduction in the firms costs associated with
  servicing small stockholders

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Stock Repurchase Procedure

• Open Market Shares are acquired from a
  stockbroker at the current market price.
• Tender Offer An offer made by the company to
  buy a specified number of shares at a
  predetermined price, set above the current market
  price.
• Purchase from one or more major stockholders.