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18-1
Dividends and Other Payouts
18-2
Three Key Issues:
How much to be distributed
Forms of dividend
How stable dividend should be
How much to be distributed
Forms of dividend
How stable dividend should be
18-3
Objectives of Dividend Policy
Adequate provision of fundsReturn to shareholders
Maximization of shareholders wealth
Adequate provision of fundsReturn to shareholders
Maximization of shareholders wealth
18-4
Dividend Vs Capital Gain
18-5
Three Dividend Theories
Dividend Irrelevance Theory
Bird in the Hand Theory
Tax Preference Theory
Dividend Irrelevance Theory
Bird in the Hand Theory
Tax Preference Theory
18-6
The dividend policy involves the allocation of profits between dividend payments to shareholders and retention for reinvestment in the company• Cash dividends are usually paid twice a year– an interim dividend and a final dividend.
Definition
18-7
Different Types of Dividends
Many companies pay a regular cash dividend.Public companies often pay quarterly.Sometimes firms will throw in an extra cash dividend.The extreme case would be a liquidating dividend.
Often companies will 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 around a box of chewing gum.
Many companies pay a regular cash dividend.Public companies often pay quarterly.Sometimes firms will throw in an extra cash dividend.The extreme case would be a liquidating dividend.
Often companies will 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 around a box of chewing gum.
18-8
Standard Method of CashDividend Payment
Record Date - Person who owns stock on this date received the dividend.
Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend.
Cash Dividend - Payment of cash by the firm to its shareholders.
18-9
Procedure for Cash Dividend Payment
25 Oct. 1 Nov. 2 Nov. 6 Nov. 7 Dec.
Declaration Date
Cum-dividend
Date
Ex-dividend
Date
Record Date
Payment Date
…
Declaration Date: The Board of Directors declares a payment of dividends.Cum-Dividend Date: The last day that the buyer of a stock is entitled to the dividend.Ex-Dividend Date: The first day that the seller of a stock is entitled to the dividend.Record Date: The corporation prepares a list of all individuals believed to be stockholders as of 6 November.
18-10
Price Behavior around the Ex-Dividend Date
In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date.In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date.
$P
$P - div
Ex-dividend
Date
The price drops by the amount of the cash dividend
-t … -2 -1 0 +1 +2 …
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.
18-11
Homemade Dividends
Bianchi Inc. is a $42 stock about to pay a $2 cash dividend.
Bob Investor owns 80 shares and prefers $3 cash dividend.
Bob’s homemade dividend strategy:Sell 2 shares ex-dividend
Bianchi Inc. is a $42 stock about to pay a $2 cash dividend.
Bob Investor owns 80 shares and prefers $3 cash dividend.
Bob’s homemade dividend strategy:Sell 2 shares ex-dividend
homemade dividendsCash from dividend $160Cash from selling stock $80Total Cash $240Value of Stock Holdings $40 × 78 =
$3,120
$3 Dividend$240
$0$240
$39 × 80 =$3,120
18-12
Dividend Policy is Irrelevant
Since investors do not need dividends to convert shares to cash, dividend policy will have no impact on the value of the firm.
In the above example, Bob Investor began with total wealth of $3,360:
share
42$shares 80360,3$
240$share
39$shares 80360,3$
80$160$share
40$shares 78360,3$
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:
18-13
Firms Without Sufficient Cash to Pay a Dividend
In a world of personal taxes, firms should not issue stock to pay a dividend.
In a world of personal taxes, firms should not issue stock to pay a dividend.
FirmStock
Holders
Cash: stock issue
Cash: dividends
Gov.
Taxes
Investment BankersThe direct costs of stock issuance will add to this effect.
18-14
Firms With Sufficient Cash toPay a Dividend
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.
The firm has several options:Select additional capital budgeting projects (by assumption, these are negative NPV).
Acquire other companies
Purchase financial assets
Repurchase shares
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.
The firm has several options:Select additional capital budgeting projects (by assumption, these are negative NPV).
Acquire other companies
Purchase financial assets
Repurchase shares
18-15
Repurchase of Stock
Instead of declaring cash dividends, firms can rid itself of excess cash through buying shares of their own stock.
Recently share repurchase has become an important way of distributing earnings to shareholders.
Instead of declaring cash dividends, firms can rid itself of excess cash through buying shares of their own stock.
Recently share repurchase has become an important way of distributing earnings to shareholders.
18-16
Stock Repurchase versus Dividend
$10=/100,000$1,000,000=Price per share
100,000=outstanding Shares
1,000,000Value of Firm1,000,000Value of Firm1,000,000Equity850,000assetsOther
0Debt$150,000Cash
sheet balance Original A.Equity &Liabilities Assets
Consider a firm that wishes to distribute $100,000 to its shareholders.
18-17
Stock Repurchase versus Dividend
$9=00,000$900,000/1 = shareper Price
100,000=goutstanding Shares
900,000Firm of Value900,000Firm of Value
900,000Equity850,000assetsOther
0Debt$50,000Cash
dividendcash shareper $1After B.
Equity & sLiabilities Assets
If they distribute the $100,000 as cash dividend, the balance sheet will look like this:
18-18
Stock Repurchase versus Dividend
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 per share = $900,000 / 90,000 = $10
If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:
18-19
Share Repurchase
Lower tax (but the IRS is watching)
Tender offersIf offer price is set wrong, some stockholders lose.
Open-market repurchase
Targeted repurchaseRepurchase as investment
Recent studies has shown that the long-term stock price performance of securities after a buyback is significantly better than the stock price performance of comparable companies that do not repurchase.
Lower tax (but the IRS is watching)
Tender offersIf offer price is set wrong, some stockholders lose.
Open-market repurchase
Targeted repurchaseRepurchase as investment
Recent studies has shown that the long-term stock price performance of securities after a buyback is significantly better than the stock price performance of comparable companies that do not repurchase.
18-20
Personal Taxes, Issuance Costs, and Dividends
To get the result that dividend policy is irrelevant, we needed three assumptions:
No taxesNo transactions costsNo 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.
To get the result that dividend policy is irrelevant, we needed three assumptions:
No taxesNo transactions costsNo 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.
18-21
Bonus shares are dividends paid in the form of additional shares.4 main motivations for bonus issues:1.do not require the use of cash (liquidity)2.growth firms have many positive NPVprojects, so a bonus issue can be usedto supplement a low dividend3.signal ability to pay future dividends4.improve market liquidity of shares
18-22
Real World Factors Favoringa High Dividend Policy
Desire for Current Income
Resolution of Uncertainty
Tax Arbitrage
Agency Costs
Desire for Current Income
Resolution of Uncertainty
Tax Arbitrage
Agency Costs
18-23
Desire for Current Income
The homemade dividend argument relies on no transactions costs.
To put this in perspective, mutual funds can repackage securities for individuals at very low cost: they could buy low-dividend stocks and with a controlled policy of realizing gains, pay their investors at a specified rate.
The homemade dividend argument relies on no transactions costs.
To put this in perspective, mutual funds can repackage securities for individuals at very low cost: they could buy low-dividend stocks and with a controlled policy of realizing gains, pay their investors at a specified rate.
18-24
Resolution of Uncertainty
It would be erroneous to conclude that increased dividends can make the firm less risky.
A firm’s overall cash flows are not necessarily affected by dividend policy—as long as capital spending and borrowing do not change.
Thus, it is hard to say how the risks of the overall cash flows can be changed with a change in dividend policy.
It would be erroneous to conclude that increased dividends can make the firm less risky.
A firm’s overall cash flows are not necessarily affected by dividend policy—as long as capital spending and borrowing do not change.
Thus, it is hard to say how the risks of the overall cash flows can be changed with a change in dividend policy.
18-25
Tax Arbitrage
Investors can create positions in high dividend-yield securities that avoid tax liabilities.
Thus, corporate managers need not view dividends as tax-disadvantaged.
Investors can create positions in high dividend-yield securities that avoid tax liabilities.
Thus, corporate managers need not view dividends as tax-disadvantaged.
18-26
Agency Costs
Agency Cost of DebtFirms in financial distress are reluctant to cut dividends. To protect themselves, bondholders frequently create loan agreements stating dividends can only be paid if the firm has earns, cash flow and working capital above pre-specified levels.
Agency Costs of EquityManagers will find it easier to waste funds if they have a low dividend payout.
Agency Cost of DebtFirms in financial distress are reluctant to cut dividends. To protect themselves, bondholders frequently create loan agreements stating dividends can only be paid if the firm has earns, cash flow and working capital above pre-specified levels.
Agency Costs of EquityManagers will find it easier to waste funds if they have a low dividend payout.
18-27
Real World Factors
Reasons for Low DividendPersonal TaxesHigh Issuing Costs
Reasons for High DividendInformation Asymmetry
Dividends as a signal about firm’s future performance
Lower Agency Costscapital market as a monitoring devicereduce free cash flow, and hence wasteful spending
Bird-in-the-hand: Theory or Fallacy?Uncertainty resolution
Desire for Current Income
Reasons for Low DividendPersonal TaxesHigh Issuing Costs
Reasons for High DividendInformation Asymmetry
Dividends as a signal about firm’s future performance
Lower Agency Costscapital market as a monitoring devicereduce free cash flow, and hence wasteful spending
Bird-in-the-hand: Theory or Fallacy?Uncertainty resolution
Desire for Current Income
18-28
The Clientele Effect: A Resolution of Real-World Factors?
Clienteles for various dividend payout policies are likely to form in the following way:Clienteles for various dividend payout policies are likely to form in the following way:
Group Stock
High Tax Bracket Individuals
Low Tax Bracket Individuals
Tax-Free Institutions
Corporations
Zero to Low payout stocks
Low-to-Medium payout
Medium Payout Stocks
High Payout Stocks
Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy.
18-29
Establishing Dividend Policy
Residual Dividend Model
Low Regular Dividend Plus Extra
Constant payout ratio
Stable dividend
Residual Dividend Model
Low Regular Dividend Plus Extra
Constant payout ratio
Stable dividend
18-30
Factors Influencing Dividend Policy
Funding Needs of the FirmLiquidityAbility to BorrowRestrictions in Debt Contracts (protective covenants)Control
Other Issues to ConsiderOther Issues to Consider
18-31
Factors Influencing Dividend Policy
Internalprofitabilityliquidity andcapacity to attract external financing
institutional inability to pay dividends from legal capitalpossible restrictive loan covenantstaxation system – maximize after-tax return for the majority ofshareholders
market factorsasymmetric informationtransaction costsagency costs
18-32
Factors Influencing Dividend Policy
Nature of businessAge of companyLiquidity position of the companyNeed for additional capitalNature of ownershipDividend policy of other companiesRedemption of debtsInvestment opportunitiesFinancing policy of the companyState of present economyLegal issues laid by the governmentTaxation policyPublic opinion
18-33
Dividend Stability
Stability Stability -- maintaining the position of the firm’s -- maintaining the position of the firm’s dividend payments in relation to a trend line.dividend payments in relation to a trend line.
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Earnings per shareEarnings per share
DividendsDividendsper shareper share
Time
50% of earningspaid out as dividends
18-34
Dividend Stability
Dividends begin at 50% of earnings, but are stable and Dividends begin at 50% of earnings, but are stable and increase only when supported by growth in earnings.increase only when supported by growth in earnings.
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Earnings per shareEarnings per share
Dividends per shareDividends per share
Time
50% dividend-payoutrate with stability
18-35
Valuation of Dividend Stability
Information contentInformation 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 desiresCurrent income desires -- some investors who desire a specific periodic income will prefer a company with stable dividends to one with unstable dividends.Institutional considerationsInstitutional 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.”
18-36
What We Know and Do Not Know About Dividend Policy
Corporations “Smooth” Dividends.
Dividends Provide Information to the Market.
Firms should follow a sensible dividend policy:Don’t 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.
Corporations “Smooth” Dividends.
Dividends Provide Information to the Market.
Firms should follow a sensible dividend policy:Don’t 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.
