7. Dividend Policy.ppt

8/14/2019 7. Dividend Policy.ppt

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2002, Prentice Hall, Inc.


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Stock Returns:

P1- Po + D1

PoReturn =


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P1- Po + D1

Po

P1 - Po D1

Po Po+

Return =

=

Stock Returns:


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Return =

Capital Gain

P1- Po + D1

Po

P1 - Po D1

Po Po+=

Stock Returns:


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Return =

Capital Gain DividendYield

+=

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,

P1 - Po D1

Po Po

+Return =


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investments, dividend yield will be zero,

P1 - Po D1

Po Po

+Return =


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investments, dividend yield will be zero,but the stock price will increase, resulting

in a higher capital gain.

P1 - Po D1

Po Po

+Return =


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If we pay dividends,

P1 - Po D1

Po Po

+Return =


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If we pay dividends, stockholders receive

an immediate cash reward for investing,

P1 - Po D1

Po Po

+Return =


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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.

P1 - Po D1

Po Po

+Return =


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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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I s 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 dividendyield 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 gainsor

dividend yields.

P1 - Po D1

Po Po

+Return =


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come in the form of capital gains or

dividend yields.

P1 - Po D1

Po Po

+Return =


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come in the form of capital gains or

dividend yields. Therefore, one dividend policy is as

good as another.

P1 - Po D1

Po Po

+Return =


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2) H igh Dividends are Best

Some investors may prefer a certain

dividendnow over a risky expected

capital gainin the future.


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2) H igh Dividends are Best

Some investors may prefer a certain

dividendnow over a risky expected

capital gainin the future.

P1 - Po D1

Po Po+Return =


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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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Dividends I rrelavence

Example

Q: The WWs are retirees with most of their savings invested in10,000 shares of Ajax Corporation (AJAX). AJAX sells for $10per share and pays an annual dividend of $0.50 per share. Thisyear AJAX eliminated the dividend but began to grow at 5% ayear due to the reinvested earnings. How can the Winters

maintain their income and their position in AJAX?A: Their original value of AJAX shares was $10 per share 10,000

shares, or $100,000, which they wish to maintain. But, theywere generating an annual dividend of 10,000 shares $0.50 or$5,000 before AJAX eliminated the dividend. After one year of

5% growth, AJAXs shares should be selling for $10.50. Thus,by selling 476 shares ($5,000 $10.50) they can generate$5,000 in cash. Their remaining 9,524 shares would be worth$10.50 each for a total of $100,002.


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Do Dividends Matter?

Other Considerations:

1) Residual Dividend Theory:

The firm pays a dividend only if it hasretained 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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2) Clientele Effects:

Different investor clienteles prefer different

dividend payout levels.

Some firms, such as utilities, pay out over70% 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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3) Information Effects:

Unexpected dividend increases

usually cause stock prices to rise, and

unexpected dividend decreases cause

stock prices to fall.

Dividend changes convey informationto the market concerning the firms

future prospects.


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4) Agency Costs: 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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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 dividendis different from the

expected dividend.


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Dividend Policies

1) Constant Dividend Payout Ratio: ifdirectors declare a constant payout

ratio of, for example, 30%, then for

every dollar of earnings available tostockholders, 30 cents would be paid

out as dividends.

The ratio remains constant over time,

but the dollar value of dividends

changesas 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 avoidsignalingthat this is a permanentdividend.


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Dividend Payments

1) Declaration Date: the board ofdirectors declares the dividend,

determines the amount of the dividend,

and decides on the payment date.

Jan.4 Jan.30 Feb.1 Mar. 11

Declare Ex-div. Record Payment

dividend date date date


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Dividend Payments

2) Ex-Dividend Date:





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Dividend Payments

2) Ex-Dividend Date: To receive thedividend, 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

3) Date of Record:





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Dividend Payments

3) Date of Record: 2 days after the ex-dividend date, the firm receives the list ofstockholders eligible for the dividend.

Often, a bank trust department acts asregistrar and maintains this list for thefirm.




4 30 1 11


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Dividend Payments

4) Payment Date: date on which thefirm mails the dividend checks to the

shareholders of record.





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Stock Dividends and Stock Spli ts

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 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 Splits and Stock Dividends are

economically the same: the number of

shares outstanding increases and the priceof each share drops. The value of the firm

does not change.

Example: A 3-for-2 stock split is the sameas a 50% stock dividend. For each 100

shares held, shareholders receive another

50 shares.


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Effects on Shareholder Wealth:


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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) givesshareholders 2 half-sized pieces for each

full-sized piece they previously owned.


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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) givesshareholders 2 half-sized pieces for each

full-sized piece they previously owned.

For example, this would double thenumber of shares, but would cause a $60

stock price to fall to $30.


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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 whohave 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 Dividends

In-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 = $56per 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 goodsubstitute for cash dividends.

If the firm has excess cash, why not

buy back common stock?


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Stock Repurchases

Stock Repurchases may be a goodsubstitute 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 stockprice, producing capital gains forshareholders.

Repurchases increase leverage, andcan be used to move toward theoptimal capital structure.


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Stock Repurchases

Repurchases may be used to avoid

a hostile takeover.

Example: T. Boone Pickensattempted raids on PhillipsPetroleum and Unocal in 1985.Both were unsuccessful because

the target firms undertook stockrepurchases.


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Stock Repurchases

Methods: Buy shares in the open market

through a broker.

Buy a large blockby negotiating thepurchase with a large block holder,

usually an institution (targeted stock

repurchase).

Tender offer: offer to pay a specific

Documents

7. Dividend Policy.ppt