Post on 22-Nov-2014
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Copyright ©2003 South-Western/Thomson Learning
Chapter 15Dividend Policy
Introduction
• This chapter examines the factors that
influence a company’s choice of
dividend policy. It includes:
– Importance of firm’s dividend policy
– Corporate dividend policies
– Mechanics of dividend payments
– Stock splits/dividends
– Share repurchase plans
Importance of Dividend Policy
One of Several Decisions Influencing Value of the Firm:
• Investment Decisions (Ch 10)– Determine the level of future earnings and future potential
dividends• Financing Decisions (Ch 12)
– Influence the cost of capital, which can determine the number of acceptable investment opportunities
• Dividend Decisions (Ch 15)– Influence the amount of equity capital (via retained earnings)
in a firm’s capital structure and the cost of capital– Influence stock price and types of investors
Determinants of Dividend Policy
• Variations in payout(p. 520-521)
• Legal constraints• Restrictive
covenants• Tax considerations• Liquidity and CF
considerations
• Borrowing capacity & access to capital markets
• Earnings stability• Growth prospects• Shareholder
preference• Protection against
dilution
Argument for Irrelevance of Dividends
• Modigliani and Miller (Ch 13) argue that value of firm is solely dependent upon investment decisions.
• Therefore, value of the firm not affected by dividend policy.
• But, MM recognize dividends can have:– Informational content– Signaling effect– Clientele effect
Argument for Relevance of Dividends
Most finance experts believe div. policy is relevant:• Shareholder preferences (div’s vs. capital gain):
– Risk aversion--“bird in the hand”concept– Taxes—pay (15%) now versus deferral – Transaction costs—higher with deferral– “Never spend the principal” attitude
• Management preferences (cash is good):– Issuance/agency costs– Maintenance of cash reserves– Cost of external capital
• Common stock valuation—PV of future cash flows• Meet investor return objectives (Handouts)• Informational content
Conclusion
• When establishing an optimal dividend policy, a firm must balance: – Shareholder preferences – Investment opportunities– Cost of retained earnings versus external
capital
Dividend Policies
• Passive residual policy
• Stable dollar dividend policy
• Constant payout policy
• Small quarterly payments plus year-end extra
Will cover on next slides
Passive Residual Policy
• A firm should retain its earnings as long as it has investment opportunities that promise higher rates of return than the investor’s required return on equity (k).
• Dividends can fluctuate significantly or can be insignificant over time.– Depends on the firm’s investment opportunities
• In practice, dividends can be smoothed.• Growth firms will have low-dividend payouts
and yields. Ex: Dell (0% yield), Microsoft (1.2%)
• See Table, 15.3, p. 524
Stable Dollar Dividend Policies
• Most firms prefer stable div. policy—relatively small with annual growth
• Reluctance to reduce dividends—investors hate cuts; also a negative “signal”
• Increases in dividends tend to lag earnings.• Desirability of stable div policy:
– Information content– Many shareholders depend on dividends.– Stability tends to reduce uncertainty.– Legally desirable– “Legal list” – Helps stock price valuation
• See pp. 530-531
Other Dividend Payment Policies
• Constant Payout Ratio– Pays a constant percent of earnings as dividends– But, dividends fluctuate
• Small Regular Dividends Plus Extras– Stockholders can depend on regular dividends– Accommodates changing earnings and investment
requirements – GM in prior years—see p. 533, next slide
Note: GM has paid an annual dividend since 1915
• Small Firms and Dividends– Tend to pay out a smaller percent of earnings– Rapid growth and limited access to capital markets
Multinational Firms & Dividends
• Primary means of transferring funds from
foreign subs to parent company
• Key factors:
– Tax
– Foreign Exchange
– Political risk
– Funds availability
– Financing needs
Mechanics of Paying Dividends
• Declaration Date– Board of directors announce a dividend.
• Record Date– Shareholders of record will receive dividends.
• Ex-dividend Date – 2 business days before record date
– Stock trades ex-dividend, stock price usually declines
• Payment Date– 4 weeks after the record date
– Dividend checks mailed or direct deposited
• See Fig. 15.4, p. 534
Dividend Reinvestment Plan
• Cash dividend reinvested
automatically into additional shares
• Purchase new or existing shares
– Purchasing new shares raises new equity
capital for the firm.
• No brokerage commissions
• But, income tax liability
Stock Dividends/Splits: Payment of additional shares of C/S
• Stock splits similar to stock dividends.• Increases the number of shares
outstanding• Accounting transaction
– Transfer pre-dividend market value from retained earnings to other stockholders equity accounts (see pp. 535-536)
• Market price of C/S should decline in proportion to the number of new shares issued (Ex: bottom, p. 536)—no increase in S/H value
Reasons for Declaring a Stock Dividend or Split
• Broaden the ownership of the firm’s shares
• May result in an effective increase in cash dividends – Provided the level of cash dividends is not
reduced
• Reduction in share price may broaden the appeal of the stock to investors.– Resulting in a real increase in market value– Interpreted as “bullish” signal
Stock Repurchase
• Tender offer in the open market or by
negotiation with large holders
• Becomes treasury stock
• Reduces the number of shares
outstanding
• Increases EPS
• Usually announced in advance
Stock Repurchase Pros and Cons
• Advantages:– Substitutes for a cash dividend
– Converts dividend income into capital gain
– Increases existing S/H ownership of company/cash flow
– Increases stock price
– More flexible--does not lock management into a policy
– Important signal of higher expected earnings/cash flow
• Disadvantages:– Some shareholders may want cash dividends
– Tax/IRS implications
– Firm may overpay
– Firm admits inv. opportunities are limited
• Ex: P. 538
Summary
• Relevance of Dividends• Dividend Policies
– Passive residual policy– Stable dollar dividend policy– Constant payout policy– Small quarterly payments plus year-end extra
• How dividends are paid• Other forms of dividends:
– Stock dividends and splits– Share repurchases– Application: Ex: p. 535-538
Chapter 15 Homework Problems
Homework Problems• # 1, 2, 3, 4, 5, 6, 7, 8• Assignment 4 B: Ch 15, problems 7, 8
Next Class• Chapter 9: Capital Budgeting and Cash Flow
Analysis• Chapter 10: Capital budgeting Decision Criteria• Chapter 23: Valuation of Merger, pp.775-776• Review for mid-term