Dividend PolicyTheories of investor preferencesStock repurchasesStock dividends and stock splits

Dividend Policy

DividendsDividendsPayments made to stockholders from the firm’s earnings, whether those earnings were generated in the current period or in previous periods

Dividends affect capital structureDividends affect capital structureRetaining earnings increases common equity relative to debtFinancing with retained earnings is cheaper than issuing new common equity

What is “dividend policy”?

It’s the decision to pay out earnings versus retaining and reinvesting them. Includes these elements:1. High or low payout?2. Stable or irregular dividends?3. How frequent?4. Do we announce the policy?

Do investors prefer high or low payouts? There are three theories:

Dividends are irrelevant: Investors don’t care about payout.

Bird-in-the-hand: Investors prefer a high payout.

Tax preference: Investors prefer a low payout, hence growth.

Dividend Irrelevance Theory

Investors are indifferent between dividends and retention-generated capital gains. If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock.

Modigliani-Miller support irrelevance.Theory is based on unrealistic assumptions

(no taxes or brokerage costs), hence may not be true. Need empirical test.

Bird-in-the-Hand Theory

Investors think dividends are less risky than potential future capital gains, hence they like dividends.

If so, investors would value high payout firms more highly, i.e., a high payout would result in a high P0.

Tax Preference Theory

Retained earnings lead to capital gains, which are taxed at lower rates than dividends: 28% maximum vs. up to 39.6%. Capital gains taxes are also deferred.

This could cause investors to prefer firms with low payouts, i.e., a high payout results in a low P0.

Implications of 3 Theories for Managers

Theory Implication

Irrelevance Any payout OK

Bird-in-the-hand Set high payout

Tax preference Set low payout

But which, if any, is correct???

Possible Stock Price Effects

Stock Price ($)

Payout 50% 100%

40

30

20

10

Bird-in-Hand

Indifference

Tax preference

0

Possible Cost of Equity Effects

Cost of equity (%)

Payout 50% 100%

15

20

10

Tax Preference

Indifference

Bird-in-Hand

0

Which theory is most correct?

Empirical testing has not been able to determine which theory, if any, is correct.

Thus, managers use judgment when setting policy.

Analysis is used, but it must be applied with judgment.

Dividend Policy in PracticePayment Procedures

Declaration DateDeclaration Date Date on which a firm’s board of directors

issues a statement declaring a dividend Ex-Dividend DateEx-Dividend Date

The date on which the right to the next dividend no longer accompanies a stock

Usually two business days prior to the holder-of-record date

Holder-Of-Record DateHolder-Of-Record Date The date on which the company opens the

ownership books to determine who will receive the dividend

Payment DatePayment DateThe date on which the company actually mails the dividend checks

Dividend Policy in PracticePayment Procedures

Example of Procedure for Dividend Payment

DaysThursday,Wednesday, Friday, Monday,January January JanuaryFebruary

15 28 30 16

DeclarationEx-dividend Record Paymentdate date date date

What’s the “information content,” or “signaling,” hypothesis?

Managers hate to cut dividends, so won’t raise dividends unless they think raise is sustainable. So, investors view dividend increases as signals of management’s view of the future.

Therefore, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends.

What’s the “clientele effect”?

Different groups of investors, or clienteles, prefer different dividend policies.

Firm’s past dividend policy determines its current clientele of investors.

Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies.

What’s the “residual dividend model”?

Find the retained earnings needed for the capital budget.

Pay out any leftover earnings (the residual) as dividends.

This policy minimizes flotation and equity signaling costs, hence minimizes the WACC.

What’s a “dividend reinvestmentplan (DRIP)”?

Shareholders can automatically reinvest their dividends in shares of the company’s common stock. Get more stock than cash.

There are two types of plans: Open market New stock

Open Market Purchase Plan

Dollars to be reinvested are turned over to trustee, who buys shares on the open market.

Brokerage costs are reduced by volume purchases.

Convenient, easy way to invest, thus useful for investors.

New Stock Plan

Firm issues new stock to DRIP enrollees, keeps money and uses it to buy assets.

No fees are charged, plus sells stock at discount of 5% from market price, which is about equal to flotation costs of underwritten stock offering.

Optional investments sometimes possible, up to $150,000 or so.

Firms that need new equity capital use new stock plans.

Firms with no need for new equity capital use open market purchase plans.

Setting Dividend Policy

Forecast capital needs over a planning horizon, often 5 years.

Set a target capital structure.Estimate annual equity needs.Set target payout based on the residual m

odel.Generally, some dividend growth rate em

erges. Maintain target growth rate if possible, varying capital structure somewhat if necessary.

Stock Repurchases

Reasons for repurchases:As an alternative to distributing cash as

dividends.To dispose of one-time cash from an

asset sale.To make a large capital structure change.

Repurchases: Buying own stock back from stockholders.

Stock Dividends vs. Stock Splits

Stock dividend: Firm issues new shares in lieu of paying a cash dividend. If 10%, get 10 shares for each 100 shares owned.

Stock split: Firm increases the number of shares outstanding, say 2:1. Sends shareholders more shares.

Both stock dividends and stock splits increase the number of shares outstanding, so “the pie is divided into smaller pieces.”

Unless the stock dividend or split conveys information, or is accompanied by another event like higher dividends, the stock price falls so as to keep each investor’s wealth unchanged.

But splits/stock dividends may get us to an “optimal price range.”

When should a firm consider splitting its stock?

There’s a widespread belief that the optimal price range for stocks is $20 to $80.

Stock splits can be used to keep the price in the optimal range.

Stock splits generally occur when management is confident, so are interpreted as positive signals.

Companies in Italy and Japan use more debt than companies in the United States or Canada, but companies in the United Kingdom use less than any of these

Different accounting practices make comparisons difficult

Gap has narrowed in recent years Dividend-payout ratios vary greatly also

Capital Structures and Dividend Policies Around the World

Quick Quiz

1. When would managers issue an “extra” cash dividend?

When management wishes to make a one-time cash distribution.2. Why does the price of a share of dividend-paying stock fall on the

ex-dividend date?Because the buyer no longer receives the right to the dividend.

3. What are the implications of the “clientele effect” for those who set the firm’s dividend policy?A dividend change, cet. par., is unlikely to attract additional investors.

4. What are the implications of the “clientele effect” for those who set the firm’s dividend policy?If all dividend clienteles are satisfied (i.e., the dividend market is in equilibrium), then further changes in dividend policy are pointless.