Dividends, Dividend Policy and Stock Splits

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1. Understand the formal process for paying dividends and differentiate between the most common types.

2. Explain individual preferences and issues surrounding different dividend polices.

3. Explains how a company selects its dividend policy.

4. Understand stock splits and reverse splits and why companies use them.

5. Understand stock repurchases and dividend reinvestment programs.

LEARNING OBJECTIVES

17.1 Cash Dividends

• Payments to owners from the company…their company• At the height nearly 85% of NYSE firms paid cash dividends• Today about 60% of NYSE firms pay cash dividends

• Some quick information items on buying and selling stock• Transaction agreement is forward contract• Settlement is two days after agreed to sale, stock delivered for

cash• Most stocks trade in street name (broker’s name)• Owner is beneficiary owner of stock• Brokerage company is the owner of record

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17.1 Cash Dividends• Issuing Dividend: by the Board of Directors

• 1. Declaration Date -- the day board announces the amount and timing of the forthcoming dividend

• 2. Ex-dividend date (Ex-date) – the date that establishes the receipt of the actual dividend

• 3. Record Date – determines which shareholder is currently holding the stock

• 4. Payment Date – date payment is made to owner • See Table 17.1 for how the timing impacts the

proceeds

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17.1 Cash Dividends

Not all dividends are cash dividendsRegular cash dividends -- most common is

quarterly cash dividendsSpecial or extra cash dividendsStock dividends (no real dividend)Liquidating dividend (termination of ownership)

Quarterly Cash Dividend (Pattern)Sticky DividendsRaised annually in same quarterSee Table 17.2 for PepsiCo pattern

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17.2 Dividend Policy• Is there an optimal dividend policy?

• Should companies pay large dividends or• Should companies pay small dividends and have

more to reinvest in the company or• Does dividend policy matter at all?

• Dividend Clienteles– Some owners prefer large dividends– Some owners want small or no dividends– Some owners will create their own policy

– Dividend Policy Irrelevance

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17.2 Dividend PolicyDividend Policy Irrelevancy in a world of no taxes

You own 1,000 shares of Company XYZThe company shares currently sell for $40 per shareThe company declares a $1.50 cash dividend…Your wealth before dividend declaration is $40,000

You want a dividend of $2,000 – make it happenYou want a dividend of $1,500 – make it happenYou want a dividend of $1,000 – make it happen

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17.2 Dividend PolicyGetting a $2,000 dividend…

Take cash dividend of $1,500 and sell 13 shares at $38.50 (ex-dividend price) for $500…total cash flow is $2,000

Wealth is $2,000 + 987 x $38.50 = $40,000 Getting a $1,500 dividend…

Take cash dividend of $1,500 and keep all shares at $38.50 per share

Wealth is $1,500 + 1,000 x $38.50 = $40,000Getting a $1,000 dividend

Take cash dividend of $1,500 and then use $500 to buy 13 shares Wealth is net cash flow of $1,000 + 1,013 x $38.50 = $40,000

You can get any dividend cash flow you want regardless of the declared dividend policy of the firm…irrelevant policy

 

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17.2 Dividend Policy

• What happens when we add taxes? Does the policy become relevant to owners…• We need to add some new parameters

• Capital gains and ordinary income tax is the same• Current price of the stock is the original purchase price• Stock price falls by the size of the cash dividend

• Same scenario as before…1,000 shares at $40 before cash dividend of $1.50 versus no cash dividend policy but 25% tax on capital gains and ordinary income

• If you want $2,000 cash flow…which policy is better?

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With taxes and cash dividend policy: target of $1,000Take the $1,500 cash dividend but pay taxes of 33% or

$500…plus shares remain at 1,000 x $38.50 or wealth is now $40,000 - $500 = $39,500 ($38,500 paper and $1,000 cash dividend after tax)

With taxes and no cash dividend policy: target of $1,000 Sell 25 shares (note price is steady at $40) for $1,000No capital gains (price of sale equals original purchase

priceWealth is still $40,000 because you avoided taxes

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17.2 Dividend Policy

17.2 Dividend PolicyIn a world of taxes…

With capital gains tax the same as ordinary income taxAnd stock price at original purchase pricePrefer NO CASH DIVIDEND POLICY

But…Add capital gains on sale of stockCash dividend policy the same…wealth at $39,500

($1,000 cash and $38,500 paper)No cash dividend policy…

Assume original purchase price was $20 When you sell a share you must pay $20 x 0.33 taxes per

share Net is only $33.40 per share, must sell 30 shares for $1,000 Wealth is now $1,000 + 970 x $40.00 = $39,800

Still prefer no cash dividend policy…BUT

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17.2 Dividend PolicySeems like no cash dividend policy would always

be preferred if Capital gains tax ≤ ordinary taxes (nearly always

the case)Capital gains is less than 100% of the current stock

priceBut…other things matter

Personal marginal tax rateDesired cash flowTransaction costs (selling stock versus receiving

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17.2 Dividend Policy

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What clienteles want low dividends•Avoidance or postponement of taxes•Higher potential future returns if more money is reinvested in the company•Less need for costly outside funding

•What clienteles want high dividends•Avoidance of transaction costs•Cash payment today (certain) versus risky payment tomorrow (uncertainty)

•Optimal Dividend Policy different for different owners at different times…

17.3 Selecting a Dividend Policy

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• Residual Dividend Policy•Pay what you can each time…•Owners do not know what is coming

• Sticky Dividend Policy•Pay same amount each period•Raises anticipated by owners and markets

• Other Considerations• Restrictions on Legal Capital• Restrictive bond covenants• Cash available (cash management

issues)

17.4 Stock Dividends, Stock Splits & Reverse Splits Stock dividends and stock splits are essentially

the same thing but differ in the amountBoth give owner’s more stock based on their

current holdingsStock dividend is usually less than 25% of the stockStock splits are usually 2 for 1 or multiples such as

3 for 1, 4 for 1, etc.Neither are wealth changers…it is like changing a

$20 bill for two $10 bills. You have more paper but not more wealth

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17.4 Stock Dividends, Stock Splits & Reverse Splits• If no actual value and it is costly to send out more

shares…why do companies initiate stock splits?– Preferred Trading Range

– Attract more potential investors if stock is trading in $20 to $40 range

– Signaling Hypothesis– Company performance is strong and will continue into

the future so price will not naturally fall back to preferred range

– Increased Liquidity– Current owners benefit from increased liquidity in the

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17.4 Stock Dividends, Stock Splits & Reverse Splits

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What is a reverse split?Companies reduce the number of outstanding

shares by proportionally shrinking the number of shares Reverse 1 for 10 stock split would reduce the number of

shares by a factor of 10. If you held ten shares before the split you now have one share

Price increases by share split factor. If price before was $5.00 per share it will now be $50.00 per share.

Why a reverse split?Again, move stock to preferred trading rangeAvoid delisting

17.5 Special Dividend PlansStock Repurchases

A way around cash dividends, maybeCompanies buy back their own stock in an

announced program Will buy so many shares over the coming months About one-third complete the targeted repurchase About one-third are partially completed About one-third are never implemented at all

If fully completed would be the same as completing a similar size cash dividend

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17.4 Stock Dividends, Stock Splits & Reverse Splits

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• Look at Balance Sheet for cash dividend and stock repurchase• Under both cash is reduced by exact

same amount• Under both equity is reduced by

exact same amount• Under cash, retained earnings

reduced• Under repurchase, common stock

is reducedShareholders choose if they want a

dividend by selling their shares and get dividend as a capital gain (if government does not rule otherwise)

17.4 Stock Dividends, Stock Splits & Reverse Splits

Dividend Reinvestment Programs (DRIPs) A way for owners to automatically reinvest their dividend into the

company Shareholder elects to forego cash dividend and receives stock instead

(usually free of transaction costs) Optional cash purchase plans attached to DRIPs

Can buy additional shares in relatively small amounts Amounts smaller than a single share

Types of DRIPS Company Run Transfer Agent Run Programs Brokerage Run Programs

Recall that stocks are in street name and brokers can buy shares with cash dividends for a client and avoid sending on the dividend

 

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