Dividend Policy

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Chapter 15

• Dividend Policy

Shapiro and Balbirer Modern Corporate Finance
A Multidisciplinary Approach to Value
Creation Graphics by Peeradej Supmonchai
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Learning Objectives

• Explain the procedures for cash dividends, and
  discuss the legal and Internal Revenue Service
  constraints on dividend payments.
• Describe the difference and similarities between
  stock dividends and stock splits.
• Discuss the rationale for share repurchases.
• Explain why dividend policy is irrelevant in
  perfect markets.
• Explain how taxes and agency costs make dividend
  policy relevant.
• List the factors that a firm should consider when
  setting its dividend policy.

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Dividend Payment Procedures

• Declaration Date
• Holder-of-Record Date
• Ex-Dividend Date
• Payment Date

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Dividend Payment Procedures - Time Line
Declaration Date
Ex-dividend Date
Holder-of-Record Date
Payment Date
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Constraints on Dividend Payments

• Restrictive covenants in debt and preferred stock
  agreements
• Net profits rule
• Capital impairment rule
• Insolvency rule
• Penalty taxes on retained earnings

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Approaches to Dividend Policy

• Pure Residual Policy
• Smoothed Residual Policy
• Constant Payout Policy

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Dividend Policies in Practice

• Most US companies tend to follow the smoothed
  residual approach.
• Dividend cuts are infrequent.
• After-tax earnings are more volatile than
  dividends.
• Dividend changes lag earnings changes.

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Stock Dividends and Stock Splits

• Stock Dividends - Payment of additional shares to
  common stockholders. A 10 stock dividend means
  that shareholders get 1 additional share for
  every 10 they own.
• Stock Splits - A proportionate increase in the
  number of common shares. A 21 stock split means
  that stockholders will receive one additional
  share for every one they own.

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Reasons for Stock Dividends and Stock Splits

• Stock dividends conserve cash while still
  maintaining a record of dividends.
• Keep share in popular trading range in order to
  appeal to small investors.
• Signals managements confidence in the future.
  However, increases in stock price will be
  transitory unless management delivers results.

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Stock Repurchase
A way for a firm to distribute cash to
shareholders by buying back its own stock. The
share repurchase is essentially a liquidating
dividend for those stockholders who opt to sell
their shares.
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Methods of Share Repurchase

• Tender Offer
• Open Market Purchases
• Private Transactions - Often associated with
  greenmail

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Reasons for Share Repurchase

• Tax Benefits - Dividends are taxed as ordinary
  income repurchases are taxed as capital gains.
  IRS might regard regular share repurchases as a
  dividend and tax them accordingly.
• Signal of Managements Confidence

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MM Dividend Irrelevance Proposition
In perfect capital markets, dividend policy is
irrelevant in the sense that it cannot effect
shareholder value. The effect of any dividend
policy can be offset by management adjusting the
sale of new stock or by investors adjusting their
dividend stream through stock purchases or sales.
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Dividend Irrelevance - MicroGeneral

• Balance Sheet (Market Values)
• Cash 2,000 Debt 4,000
• Fixed Assets 5,000
• Growth Opportunities 3,000 Equity 6,000
• Total Assets 10,000 Value of Firm 10,000
• The value of future opportunities to invest in
  positive NPV projects

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Dividend Irrelevance - MicroGeneral
MicroGeneral needs 2,000 in cash to invest in
growth opportunities. Each share is worth 60.
Suppose management decides to pay a dividend of
10 a share for a total of 1,000. Total assets
drop to 9,000 giving the firm a net worth of
5,000. The new price of the stock is 50 a
share, a decline of 10 a share.
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Dividend Irrelevance - MicroGeneral
Holding capital structure constant, MicroGeneral
must raise 1,000 in new equity by issuing 20 new
shares at 50 a share for a total of 1,000.
MicroGenerals new balance sheet will look
identical to the old except that the equity
account will list 120 shares. MicroGenerals old
stockholders wealth position remains the same
since the value of their shares (5,000) plus the
dividend of 1,000 equals their original position.
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Signaling With Dividends
Much of the data we have on a firm is
accounting-based. To the extent that this
information is incomplete, dividends may have
communications value if investors value this
information, and the information cannot be
communicated by any other means
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Bird-in-the-Hand Argument
An argument for paying dividends based on the
idea that since investors are risk-averse, they
prefer a stream of relatively certain dividends
over uncertain capital gains. This argument
confuses the investment and dividend decision.
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Dividends and Taxes
In the real world, dividends are taxed at a
significantly higher rate than capital gains.
This tax treatment favors retentions (and capital
gains) over dividends.
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Dividends and Taxes - An Example
Suppose that tax on dividend income for the
highest earning individual is 39.6, whereas,
capital gains are taxed at 20. What are the
differences in valuation for a firm that pays no
dividends, and one that pays out all of its
earnings in dividends?
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Dividends and Taxes - An Example
Company A B Dividend
Payout Ratio 0 100 Income Available to
Shareholder E E Investors After Tax
Return 0.80E 0.604E After-Tax Required Return
on Equity r r Market Value of the
Equity 0.80E/r 0.604E/r
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The Case for Tax Neutrality of Dividends
Dividends help those investors who need current
income and would incur transaction costs to sell
off part of their holdings. Each investor,
therefore, trades off the trans-action cost
benefits of dividends against the tax
disadvantages.
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The Case for Tax Neutrality of Dividends

• Investors sort themselves into three
  clienteles
• those that prefer dividends
• those that are indifferent towards dividends
• those that are averse to dividends
• Thus, companies dont have to worry about their
  payout policy since clienteles will select the
  payout policy that serves them best.

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Agency Costs and the Case for Dividends

• Dividends eliminate some of the in-formation
  asymmetries underlying the shareholder - manager
  agency conflict.
• Dividend payments reduce managements control
  over free cash flow.

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Setting Dividend Policy

• Firms should ask the following questions when
  establishing dividend policy
• What are our investment opportunities?
• What kind of business risk do we face?
• Who are our stockholders?
• What is our liquidity position?
• Is legal listing important to us?
• Is control an issue?