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Dividends and Other Payouts
Chapter 19
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
19-2
Key Concepts and Skills Understand dividend types and how they are
paid Understand the issues surrounding dividend
policy decisions Understand why share repurchases are an
alternative to dividends Understand the difference between cash and
stock dividends
19-3
Chapter Outline19.1 Different Types of Payouts19.2 Standard Method of Cash Dividend Payment19.3 The Benchmark Case: An Illustration of the Irrelevance of
Dividend Policy19.4 Repurchase of Stock19.5 Personal Taxes, Dividends, and Stock Repurchases19.6 Real-World Factors Favoring a High Dividend Policy19.7 The Clientele Effect: A Resolution of Real-World Factors?19.8 What We Know and Do Not Know about Dividend Policy19.9 Putting It All Together19.10 Stock Dividends and Stock Splits
19-4
19.1 Different Types of Payouts Many companies pay a regular cash dividend.
Public companies often pay quarterly. Sometimes firms will pay an extra cash dividend. The extreme case would be a liquidating dividend.
Companies will often 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 a box of chewing gum.
Other companies use stock buybacks.
19-5
19.2 Standard Method of Cash Dividend
Record Date – Date on which company determines existing shareholders.
Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock immediately before this date is entitled to a dividend.
Cash Dividend - Payment of cash by the firm to its shareholders.
19-6
Procedure for Cash Dividend25 Oct. 1 Nov. 2 Nov. 5 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: Buyer of stock still receives the dividend.
Ex-Dividend Date: Seller of the stock retains the dividend.
Record Date: The corporation prepares a list of all individuals believed to be stockholders as of 5 November.
19-7
Price Behavior 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.
19-8
19.3 The Irrelevance of Dividend Policy A compelling case can be made that dividend
policy is irrelevant. Since investors do not need dividends to convert
shares to cash; they will not pay higher prices for firms with higher dividends.
In other words, dividend policy will have no impact on the value of the firm because investors can create whatever income stream they prefer by using homemade dividends.
19-9
Homemade Dividends Bianchi Inc. is a $42 stock about to pay a $2 cash dividend. Bob Investor owns 80 shares and prefers a $3 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
19-10
Dividend Policy Is Irrelevant In the above example, Bob Investor began with a
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:
19-11
Dividends and Investment Policy Firms should never forgo positive NPV
projects to increase a dividend (or to pay a dividend for the first time).
Recall that one of the assumptions underlying the dividend-irrelevance argument is: “The investment policy of the firm is set ahead of time and is not altered by changes in dividend policy.”
19-12
19.4 Repurchase of Stock Instead of declaring cash dividends, firms can
rid themselves of excess cash through buying shares of their own stock.
Recently, share repurchase has become an important way of distributing earnings to shareholders.
19-13
Stock Repurchase versus Dividend
$10=/100,000$1,000,000=Price per share100,000=outstanding Shares
1,000,000Value of Firm1,000,000Value of Firm1,000,000Equity850,000 AssetsOther
0Debt$150,000Cash
sheet balance Original A.Equity &Liabilities Assets
Consider a firm that wishes to distribute $100,000 to its shareholders.
19-14
Stock Repurchase versus Dividend
$9=00,000$900,000/1 = shareper Price
100,000=goutstandin Shares
900,000Firm of Value900,000Firm of Value
900,000Equity850,000AssetsOther
0Debt$50,000Cash
dividendcash shareper $1After B.
Equity & sLiabilitie Assets
If they distribute the $100,000 as a cash dividend, the balance sheet will look like this:
19-15
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:
19-16
Share Repurchase Flexibility for shareholders Keeps stock price higher
Good for insiders who hold stock options As an investment of the firm (undervaluation) Tax benefits
19-17
19.5 Personal Taxes, Dividends, and Stock Repurchases To get the result that dividend policy is irrelevant, we
needed three assumptions: No taxes No transactions costs No uncertainty
In the United States, both cash dividends and capital gains are (currently) 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.
19-18
Firms without Sufficient Cash
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.
19-19
Firms with Sufficient Cash 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. Select additional capital budgeting projects (by
assumption, these are negative NPV). Acquire other companies Purchase financial assets Repurchase shares
19-20
Taxes and Dividends In the presence of personal taxes:
1. A firm should not issue stock to pay a dividend.
2. Managers have an incentive to seek alternative uses for funds to reduce dividends.
3. Though personal taxes mitigate against the payment of dividends, these taxes are not sufficient to lead firms to eliminate all dividends.
19-21
19.6 Real-World Factors Favoring High Dividends Desire for Current Income Behavioral Finance
It forces investors to be disciplined. Tax Arbitrage
Investors can create positions in high dividend yield securities that avoid tax liabilities.
Agency Costs High dividends reduce free cash flow.
19-22
19.7 The Clientele Effect Clienteles for various dividend payout policies
are likely to form in the following way:
Group Stock Type
High Tax Bracket Individuals
Low Tax Bracket Individuals
Tax-Free Institutions
Corporations
Zero-to-Low payout
Low-to-Medium payout
Medium payout
High payout
Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy.
19-23
19.8 What We Know and Do Not Know Corporations “smooth” dividends. Fewer companies are paying dividends. Dividends provide information to the market. Firms should follow a sensible policy:
Do not 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.
19-24
19.9 Putting It All Together Aggregate payouts are massive and have
increased over time. Dividends are concentrated among a small
number of large, mature firms. Managers are reluctant to cut dividends. Managers smooth dividends. Stock prices react to unanticipated changes in
dividends.
19-25
19.10 Stock Dividends Pay additional shares of stock instead of cash Increases the number of outstanding shares Small stock dividend
Less than 20 to 25% If you own 100 shares and the company declared a
10% stock dividend, you would receive an additional 10 shares.
Large stock dividend – more than 20 to 25%
19-26
Stock Splits Stock splits – essentially the same as a stock
dividend except it is expressed as a ratio For example, a 2 for 1 stock split is the same as a
100% stock dividend. Stock price is reduced when the stock splits. Common explanation for split is to return price
to a “more desirable trading range.”
19-27
Quick Quiz What are the different types of dividends, and how
is a dividend paid? What is the clientele effect, and how does it affect
dividend policy irrelevance? What is the information content of dividend
changes? What are stock dividends, and how do they differ
from cash dividends? How are share repurchases an alternative to
dividends, and why might investors prefer them?