Dividends and Payout Policy

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Topic 12

• Dividends and Payout Policy

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1 Learning Objectives

• LO 12.1 Explain the financial function of
  dividends and the rationale for the payout policy
  of the firm.
• LO 12.2 Explain the use of share repurchases in
  lieu of the payment of dividends.

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2 Excel Features

• None this week!

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3 Different Types of Dividends

• 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.
• Wrigleys Gum sends a box of chewing gum.
• Dundee Crematoria offers shareholders discounted
  cremations.

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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.
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Procedure for Cash Dividend
25 Oct.
1 Nov.
2 Nov.
5 Nov.
7 Dec.

Ex-dividend Date
Declaration Date
Cum-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.
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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 by the amount of the cash
dividend.
Ex-dividend Date
Taxes complicate things a bit. Empirically, the
price drop is less than the dividend and occurs
within a few minutes of the ex-date.
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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.

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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.
• Bobs 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
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Dividend Policy is Irrelevant

• In the above example, Bob Investor began with a
  total wealth of 3,360

• 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

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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.

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5 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.

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Stock Repurchase versus Dividend
Consider a firm that wishes to distribute
100,000 to its shareholders.

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Stock Repurchase versus Dividend
If they distribute the 100,000 as a cash
dividend, the balance sheet will look like this
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Stock Repurchase versus Dividend
If they distribute the 100,000 through a stock
repurchase, the balance sheet will look like this
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Share Repurchase

• Flexibility for shareholders
• Keeps stock price higher
• Good for insiders who hold stock options
• As an investment of the firm
• Tax benefits

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6 Personal Taxes, Issuance Costs, and Dividends

• 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 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.

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Firms without Sufficient Cash
Investment Bankers
The direct costs of stock issuance will add to
this effect.
Cash stock issue
Firm
Stock Holders
Cash dividends

• In a world of personal taxes, firms should not
  issue stock to pay a dividend.

Taxes
Gov.
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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

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Taxes, Issuance Costs, and Dividends

• In the presence of personal taxes
• A firm should not issue stock to pay a dividend.
• Managers have an incentive to seek alternative
  uses for funds to reduce dividends.
• Though personal taxes mitigate against the
  payment of dividends, these taxes are not
  sufficient to lead firms to eliminate all
  dividends.

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7 Real-World Factors

• What are the empirical facts about dividends?

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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.

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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.
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What We Know and Do Not Know

• Corporations smooth dividends.
• Dividends provide information to the market.
• Firms should follow a sensible dividend policy
• Dont 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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8 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

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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.