Dividend Policy and InternalFinancing

Learning Objectives

1.

2.

3.

4.

Describe the trade-off between paying dividends andretaining the profits within the company

Explain the relationship between a corporation’s dividendpolicy and the market price of its common stock

Describe practical considerations that may be important tothe firm’s dividend policy

Distinguish among the types of dividend policiescorporations frequently use.

Learning Objectives

5. Specify the procedures a company follows in administeringthe dividend payment.

6. Describe why and how a firm might pay noncash dividends(stock dividends and stock splits) instead of cash dividends.

7. Explain the purpose and procedures related to stockrepurchases.

8. Understanding the relationship between a policy of low-dividend payments and international capital budgetingopportunities that confront the multinational firm.

Slide Contents

1. Principles Used in this Chapter

2. Dividends

3. Dividend Policy and Shareholder Wealth

4. Conclusions on Dividend Policy

5. Dividend Decision in Practice

6. Stock Dividend/Split/Repurchase

7. Finance and the Multinational Firm

Principles used in this Chapter

Principle 2:The time value of money – A dollar received today is worth morethan a dollar received in the future.

Principle 8:Taxes bias business decisions

What are Dividends?

Dividends are distribution from the firm's assetsto the shareholders.

Firms are not obligated to pay dividends ormaintain a consistent policy with regard todividends.

Dividends can be paid in cash or stocks.

Dividend Policy

A firm’s dividend policy includes twocomponents:

1. Dividend Payout ratio

•

•

Indicates amount of dividend paid relative to the company’searnings.

Example: If dividend per share is $1 and earnings per share is$2, the payout ratio is 50% (1/2)

2. Stability of dividends over time

Dividend Policies Vary

General Electric (GE) has paid dividendscontinuously since 1899.

Microsoft (MSFT) went public in 1986 but did notpay dividends until June, 2003.

Berkshire Hathaway (BRK) has not yet paiddividends.

Dividend Policy Trade-offs

If management has decided how much to invest andhas chosen the debt-equity mix, decision to pay alarge dividend means retaining less of the firm’sprofits. This means the firm will have to rely moreon external equity financing.

Similarly, a smaller dividend payment will lead toless reliance on external financing.

3. Dividend Policy andShareholder’s Wealth

Dividend Policy andShare Prices Dividend policy is considered as a puzzle with no

clear answers. As Fischer Black concluded more than30 years ago:

"What should the individual investor do about dividendsin the portfolio? We don't know!

What should the corporation do about dividend policy?We don't know!”

Three Views

There are three basic views with regard to theimpact of dividend policy on share prices:

1.

2.

3.

Dividend policy is irrelevant.

High dividends will increase share prices.

Low dividends will increase share prices.

View #1

Dividend policy is irrelevant –

Irrelevance implies shareholder wealth is not affected bydividend policy (whether the firm pays 0% or 100% of itsearnings as dividends).

This view is based on two assumptions:

(a) Perfect capital markets exist; and

(b) The firm’s investment and borrowing decisions have beenmade and will not be altered by dividend payment.

View #2

High dividends increase stock value –

This position in based on “bird-in-the-hand theory”,which argues that investors may prefer “dividend today”as it is less risky compared to “uncertain future capitalgains”.

Thus shareholders will demand a relatively higher rate ofreturn for stocks that do not pay low or no dividends.

View #3

Low dividends increases stock value –

In 2003, the tax rates on capital gains and dividends were madeequal to 15 percent.

However, current dividends are taxed immediately while the taxon capital gains can be deferred until the stock is actually sold.Thus, using present value of money, capital gains have definitefinancial advantages for shareholders.

Thus stocks that allow tax deferral (low dividends-high capitalgains) will possibly sell at a premium relative to stocks thatrequire current taxation (high dividends – low capital gains).

Some other explanations

1. Residual Dividend theory

2. Clientele effect

3. Information effect

4. Agency costs

5. Expectations theory

Residual Dividend Theory

1. Determine the optimal capital budget.

2. Determine the amount of equity needed for financing.

3. First, use retained earnings to supply this equity.

4. If RE still left, pay out dividends.

Dividend Policy will be influenced by:

(a) investment opportunities or capital budgeting needs, and

(b) availability of internally generated capital.

The Clientele Effect

Different groups of investors have varying preferencestowards dividends.

For example, some investors may prefer a fixed incomestream so would prefer firms with high dividends whilesome investors, such as wealthy investors, would preferto defer taxes and will be drawn to firms that have lowdividend payout. Thus there will be a clientele effect.

The Information Effect

Evidence shows that large, unexpected change in dividendscan have a significant impact on the stock prices.

A firm’s dividend policy may be seen as a signal about firm’sfinancial condition. Thus, high dividend could signalexpectations of high earnings in the future and vice versa.

Agency Costs

Dividend policy may be perceived as a tool to minimizeagency costs.

Dividend payment may require managers to issue stock tofinance new investments. New investors will be attractedonly if they are convinced that the capital will be usedprofitably. Thus, payment of dividends indirectly monitorsmanagement’s investment activities and helps reduce agencycosts, and may enhance the value of the firm.

Expectations Theory

Expectation theory suggests that the market reactiondoes not only reflect response to the firm’s actions; italso indicates investors’ expectations about the ultimatedecision to be made by management.

Thus if the amount of dividend paid is equal to thedividend expected by shareholders, the market price ofstock will remain unchanged. However, market will reactif dividend payment is not consistent with shareholdersexpectations.

4. Conclusions on Dividend Policy

What are we to conclude?

Here are some conclusions about the relevanceof dividend policy:

1.

2.

As a firm’s investment opportunities increase, its dividendpayout ratio should decrease.

Investors use the dividend payment as a source of informationof expected earnings.

What are we to conclude?

3.

4.

5.

Relationship between stock prices and dividends may exist due toimplications of dividends for taxes and agency costs.

Based on expectations theory, firms should avoid surprisinginvestors with regard to dividend policy.

The firm’s dividend policy should effectively be treated as a long-term residual.

5. Dividend Decision in Practice

Dividend Decision in Practice

Legal Restrictions

Statutory restrictions may prevent a company frompaying dividends

Debt and preferred stock contracts may imposeconstraints on dividend policy

Liquidity Constraints

A firm may show earnings but it must have cash to paydividends.

Dividend Decision in Practice

Earnings Predictability

A firm with stable and predictable earnings is morelikely to pay larger dividends.

Maintaining Ownership Control

Ownership of common stock gives voting rights. Ifexisting stockholders are unable to participate in anew offering, control of current stockholders isdiluted and issuing new stock will be consideredunattractive.

Alternative Dividend Policies

Constant dividend payout ratio

The % of earnings paid out in dividends is heldconstant.

Since earnings are not constant, the dollar amount ofdividend will vary every year.

Stable dollar dividend per share

This policy maintains a constant dollar every year.

Management will increase the dollar amount only ifthey are convinced that such increase can bemaintained.

Alternative Dividend Policies

A small regular dividend plus a year-endextra.

The company follows the policy of paying asmall, regular dividend plus a year-end extradividend in prosperous years.

Dividend Payment Procedures

Generally, companies pay dividend on a quarterlybasis. The final approval of a dividend paymentcomes from the firm’s board of directors.

For example, GE pays $6.72 per share in annualdividend in four equal installments of $1.68 each.

Important Dates

Declaration date – The date when the dividend is formallydeclared by the board of directors. (Ex. February 7)

Date of Record – Investors shown to own stocks on this datereceive the dividend. (Ex. February 17)

Ex-Dividend date – Two working days prior to date of record(Ex. February 15). Shareholders buying stock on or after ex-dividend date will not receive dividends.

Payment date – The date when dividend checks are mailed.(ex. March 10)

6. Stock Dividends, Stock Splits andStock Repurchase

Stock Dividends

A stock dividend entails the distribution ofadditional shares of stock in lieu of cash payment.

While the number of common stock outstandingincreases, the firm’s investments and futureearnings prospects do not change.

Stock Split

A stock split involves exchanging more (or less in the case of“reverse” split) shares of stock for firm’s outstanding shares.

While the number of common stock outstanding increases(or decreases in the case of reverse split), the firm’sinvestments and future earnings prospects do not change.

Stock splits and stock dividends are far less frequent thancash dividends.

Stock Repurchase

A stock repurchase (stock buyback) occurs when afirm repurchases its own stock. This results in areduction in the number of shares outstanding.

From shareholder’s perspective, a stock repurchasehas potential tax advantages as opposed to cashdividends.

Stock Repurchase - Benefits1.2.3.4.

5.

6.

A means of providing an internal investment opportunityAn approach for modifying the firm’s capital structureA favorable impact on earnings per shareThe elimination of a minority ownership group ofstockholdersThe minimization of the dilution of earnings per shareassociated with mergersThe reduction in the firm’s costs associated with servicingsmall stockholders

Stock Repurchase Procedure

1. Open Market – Shares are acquired from astockbroker at the current market price.

2. Tender Offer – An offer made by the company tobuy a specified number of shares at apredetermined price, set above the current marketprice.

3. Purchase from one or more major stockholders.

7. Finance andthe Multinational Firm

Finance and theMultinational Firm During general economic prosperity, the

multinational firms look towards internationalmarkets for high NPV projects for two reasons:

To reduce country related economic risk by diversifyinggeographically; and

To achieve a cost advantage over one’s competitors.