© Prentice Hall, 2000

1

Chapter 15

Dividend Policy

Shapiro and Balbirer: Modern Corporate Finance:

A Multidisciplinary Approach to Value Creation

Graphics by Peeradej Supmonchai

© Prentice Hall, 2000

2

Learning Objectives Explain the procedures for cash dividends, and

discuss the legal and Internal Revenue Service constraints on dividend payments.

Describe the difference and similarities between stock dividends and stock splits.

Discuss the rationale for share repurchases.

Explain why dividend policy is irrelevant in perfect markets.

Explain how taxes and agency costs make dividend policy relevant.

List the factors that a firm should consider when setting its dividend policy.

© Prentice Hall, 2000

3

Dividend Payment Procedures

Declaration Date

Holder-of-Record Date

Ex-Dividend Date

Payment Date

© Prentice Hall, 2000

4

Dividend Payment Procedures - Time Line

Declaration

Date

Ex-dividend

Date

Holder-of-Record

Date

Payment

Date

© Prentice Hall, 2000

5

Constraints on Dividend Payments

Restrictive covenants in debt and preferred stock agreements

Net profits rule

Capital impairment rule

Insolvency rule

Penalty taxes on retained earnings

© Prentice Hall, 2000

6

Approaches to Dividend Policy

Pure Residual Policy

Smoothed Residual Policy

Constant Payout Policy

© Prentice Hall, 2000

7

Dividend Policies in Practice

Most US companies tend to follow the

smoothed residual approach.

Dividend cuts are infrequent.

After-tax earnings are more volatile than

dividends.

Dividend changes lag earnings changes.

© Prentice Hall, 2000

8

Stock Dividends and Stock Splits

Stock Dividends - Payment of additional shares

to common stockholders. A 10% stock dividend

means that shareholders get 1 additional share

for every 10 they own.

Stock Splits - A proportionate increase in the

number of common shares. A 2:1 stock split

means that stockholders will receive one

additional share for every one they own.

© Prentice Hall, 2000

9

Reasons for Stock Dividends and Stock Splits

Stock dividends conserve cash while still

maintaining a record of dividends.

Keep share in “popular” trading range in

order to appeal to small investors.

Signals management’s confidence in the

future. However, increases in stock price

will be transitory unless management

delivers results.

© Prentice Hall, 2000

10

Stock Repurchase

A way for a firm to distribute cash to

shareholders by buying back its own stock.

The share repurchase is essentially a

liquidating dividend for those stockholders

who opt to sell their shares.

© Prentice Hall, 2000

11

Methods of Share Repurchase

Tender Offer

Open Market Purchases

Private Transactions - Often associated

with greenmail

© Prentice Hall, 2000

12

Reasons for Share Repurchase

Tax Benefits - Dividends are taxed as

ordinary income; repurchases are taxed

as capital gains. IRS might regard regular

share repurchases as a dividend and tax

them accordingly.

Signal of Management’s Confidence

© Prentice Hall, 2000

13

MM Dividend Irrelevance Proposition

In perfect capital markets, dividend policy is

irrelevant in the sense that it cannot effect

shareholder value. The effect of any dividend policy

can be offset by management adjusting the sale of

new stock or by investors adjusting their dividend

stream through stock purchases or sales.

© Prentice Hall, 2000

14

Dividend Irrelevance - MicroGeneral

Balance Sheet (Market Values)

Cash $ 2,000 Debt $ 4,000

Fixed Assets $ 5,000

Growth Opportunities* $ 3,000 Equity $ 6,000

Total Assets $10,000 Value of Firm $10,000

*The value of future opportunities to invest in positive NPV projects

© Prentice Hall, 2000

15

Dividend Irrelevance - MicroGeneral

MicroGeneral needs $2,000 in cash to invest in

growth opportunities. Each share is worth $60.

Suppose management decides to pay a dividend of

$10 a share for a total of $1,000. Total assets drop

to $9,000 giving the firm a net worth of $5,000. The

new price of the stock is $50 a share, a decline of

$10 a share.

© Prentice Hall, 2000

16

Dividend Irrelevance - MicroGeneral

Holding capital structure constant, MicroGeneral must

raise $1,000 in new equity by issuing 20 new shares at $50

a share for a total of $1,000. MicroGeneral’s new balance

sheet will look identical to the old except that the equity

account will list 120 shares. MicroGeneral’s old

stockholders’ wealth position remains the same since the

value of their shares ($5,000) plus the dividend of $1,000

equals their original position.

© Prentice Hall, 2000

17

Signaling With Dividends

Much of the data we have on a firm is

accounting-based. To the extent that this

information is incomplete, dividends may

have communications value if investors

value this information, and the information

cannot be communicated by any other

means

© Prentice Hall, 2000

18

Bird-in-the-Hand Argument

An argument for paying dividends based on

the idea that since investors are risk-averse,

they prefer a stream of relatively certain

dividends over uncertain capital gains. This

argument confuses the investment and

dividend decision.

© Prentice Hall, 2000

19

Dividends and Taxes

In the real world, dividends are taxed at a

significantly higher rate than capital gains.

This tax treatment favors retentions (and

capital gains) over dividends.

© Prentice Hall, 2000

20

Dividends and Taxes - An Example

Suppose that tax on dividend income for the

highest earning individual is 39.6%,

whereas, capital gains are taxed at 20%.

What are the differences in valuation for a

firm that pays no dividends, and one that

pays out all of its earnings in dividends?

© Prentice Hall, 2000

21

Dividends and Taxes - An Example

Company

A B

Dividend Payout Ratio 0% 100%

Income Available to Shareholder E E

Investors’ After Tax Return 0.80E0.604E

After-Tax Required Return on Equity r r

Market Value of the Equity 0.80E/r 0.604E/r

© Prentice Hall, 2000

22

The Case for Tax Neutrality of Dividends

Dividends help those investors who need

current income and would incur transaction

costs to sell off part of their holdings. Each

investor, therefore, trades off the trans-

action cost benefits of dividends against the

tax disadvantages.

© Prentice Hall, 2000

23

The Case for Tax Neutrality of Dividends

Investors sort themselves into three “clienteles”:

those that prefer dividends

those that are indifferent towards dividends

those that are averse to dividends

Thus, companies don’t have to worry about their

payout policy since clienteles will select the payout

policy that serves them best.

© Prentice Hall, 2000

24

Agency Costs and the Case for Dividends

Dividends eliminate some of the in-

formation asymmetries underlying the

shareholder - manager agency conflict.

Dividend payments reduce management’s

control over free cash flow.

© Prentice Hall, 2000

25

Setting Dividend Policy

Firms should ask the following questions when establishing dividend policy:

What are our investment opportunities?

What kind of business risk do we face?

Who are our stockholders?

What is our liquidity position?

Is legal listing important to us?

Is control an issue?