Payout Policy
1Finance - Pedro Barroso
Different Types of Dividends• 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
2Finance - Pedro Barroso
Procedure for Cash Dividend25 Oct. 2 Nov. 5 Nov. 7 Dec.
Declaration Date
Ex-dividend
Date
Record Date
Payment Date
…
Declaration Date: The Board of Directors declares a payment of dividendsEx-Dividend Date: If you purchase the stock on and after ex-dividend date you are not entitled to receive dividendRecord Date: Corporation prepares a list of all individuals believed to be stockholdersPayment Date: Stockholders receive dividend
3Finance - Pedro Barroso
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
4Finance - Pedro Barroso
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
5Finance - Pedro Barroso
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 on ex-dividend date
Homemade dividend $3 Dividend
Cash from dividend $2 x 80 = $160 $3 x 80 = $240
Cash from selling stock $40 x 2 = $80 $0
Total cash $240 $240
Value of stock holdings $40 x 78 = $3,120 $39 x 80 = $3,120
6Finance - Pedro Barroso
Dividend Policy is Irrelevant
• In the above example, Bob Investor began with a total wealth of $3,360:
42$shares 80360,3$
240$39$shares 80360,3$
80$160$40$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:
7Finance - Pedro Barroso
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”
8Finance - Pedro Barroso
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
9Finance - Pedro Barroso
Stock Repurchase versus Dividend
$10=/100,000$1,000,000Price per share100,000outstanding 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
10Finance - Pedro Barroso
Stock Repurchase versus Dividend
$9=00,000$900,000/1 shareper Price100,000 Shares outstanding
900,000Firm of Value900,000Firm of Value900,000Equity850,000AssetsOther
0Debt$50,000Cash
dividendcash shareper $1After B.Equity & Liabilities Assets
If they distribute the $100,000 as a cash dividend, the balance sheet will look like this:
11Finance - Pedro Barroso
Stock Repurchase versus Dividend
Assets Liabilities & EquityC. After stock repurchase
Cash $50,000 Debt 0Other Assets 850,000 Equity 900,000Value of Firm 900,000 Value of Firm 900,000
Shares outstanding 90,000Price per share $900,000 / 90,000 = $10
If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:
12Finance - Pedro Barroso
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– Taxes on capital gains are usually lower than taxes
on dividends
13Finance - Pedro Barroso
Personal Taxes and Dividends
• 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 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
14Finance - Pedro Barroso
Firms without Sufficient Cash
In a world of personal taxes, firms should not issue stock to pay a dividend.
Firm Stock Holders
Cash: stock issue
Cash: dividends
Gov.
Taxes
Investment Bankers The direct costs of stock issuance will add to this effect.
15Finance - Pedro Barroso
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
16Finance - Pedro Barroso
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
17Finance - Pedro Barroso
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
18Finance - Pedro Barroso
The Clientele Effect• Clienteles for various dividend payout policies
are likely to form in the following way:
Group Stock Type
High Tax Bracket IndividualsLow Tax Bracket IndividualsTax-Free InstitutionsCorporations
Zero-to-Low payoutLow-to-Medium payoutMedium payoutHigh payout
Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy
19Finance - Pedro Barroso
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
20Finance - Pedro Barroso
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”
21Finance - Pedro Barroso