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Dividends andDividend Policy

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Outline

Cash Dividends and Dividend PaymentDoes Dividend Policy Matter?Some Real-World Factors Favoring a Low Payout

Some Real-World Factors Favoring a High Payout A Resolution of Real-World FactorsEstablishing a Dividend PolicyStock Repurchase: An Alternative to Cash Dividends

Stock Dividends and Stock Splits

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Cash Dividends

Regular cash dividend cash paymentsmade directly to stockholders, usually eachquarter Extra cash dividend indication that theextra amount may not be repeated in thefuture

Special cash dividend similar to extradividend, but definitely wont be repeated Liquidating dividend some or all of thebusiness has been sold

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Dividend Payment

Declaration Date Board declares the dividend andit becomes a liability of the firmEx-dividend Date

Occurs two business days before date of recordIf you buy stock on or after this date, you will not receivethe dividendStock price generally drops by about the amount of thedividend

Date of Record Holders of record are determinedand they will receive the dividend paymentDate of Payment checks are mailed

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Dividend and stock price

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Does Dividend Policy Matter?

Dividends matter the value of the stock isbased on the present value of expectedfuture dividendsDividend policy may not matter

Dividend policy is the decision to pay dividendsversus retaining funds to reinvest in the firm

In theory, if the firm reinvests capital now, it willgrow and can pay higher dividends in the future

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Illustration of Irrelevance

Consider a firm that can either pay out dividends of $10,000 per year for each of the next two years or can pay $9000 this year, reinvest the other $1000

into the firm and then pay $11,120 next year.Investors require a 12% return.Market Value with constant dividend = $16,900.51Market Value with reinvestment = $16,900.51

If the company will earn the required return, then itdoesnt matter when it pays the dividends

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Low Payout Please

Why might a low payout be desirable?Individuals in upper income tax brackets mightprefer lower dividend payouts, given the

immediate tax liability, in favor of higher capitalgains with the deferred tax liabilityFlotation costs low payouts can decrease theamount of capital that needs to be raised, therebylowering flotation costsDividend restrictions debt contracts might limitthe percentage of income that can be paid out asdividends

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High Payout Please

Why might a high payout be desirable?Desire for current income

Individuals that need current income, i.e. retirees

Groups that are prohibited from spending principal(trusts and endowments)Uncertainty resolution no guarantee that the higher futuredividends will materializeTaxes

Dividend exclusion for corporationsTax- exempt investors dont have to worry aboutdifferential treatment between dividends and capitalgains

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Dividends and Signals Asymmetric information managers have moreinformation about the health of the company thaninvestorsChanges in dividends convey information

Dividend increasesManagement believes it can be sustainedExpectation of higher future dividends, increasing presentvalueSignal of a healthy, growing firm

Dividend decreasesManagement believes it can no longer sustain the currentlevel of dividendsExpectation of lower dividends indefinitely; decreasingpresent value

Signal of a firm that is having financial difficulties

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Clientele Effect

Some investors prefer low dividend payoutsand will buy stock in those companies thatoffer low dividend payoutsSome investors prefer high dividend payoutsand will buy stock in those companies thatoffer high dividend payouts

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Implications of the ClienteleEffect

What do you think will happen if a firmchanges its policy from a high payout to a lowpayout?What do you think will happen if a firmchanges its policy from a low payout to a highpayout?

If this is the case, does dividend POLICYmatter?

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Dividend Policy in Practice

Residual dividend policyConstant growth dividend policy dividendsincreased at a constant rate each year Constant payout ratio pay a constantpercent of earnings each year Compromise dividend policy

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Residual Dividend Policy

Determine capital budgetDetermine target capital structureFinance investments with a combination of debt and equity in line with the target capitalstructure

Remember that retained earnings are equity

If additional equity is needed, issue new sharesIf there are excess earnings, then pay theremainder out in dividends

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Example Residual DividendPolicy

GivenNeed $5 million for new investmentsTarget capital structure: D/E = 2/3Net Income = $4 million

Finding dividend40% financed with debt (2 million)60% financed with equity (3 million)NI equity financing = $1 million, paid out asdividends

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Compromise Dividend Policy

Goals, ranked in order of importance Avoid cutting back on positive NPV projects topay a dividend

Avoid dividend cuts Avoid the need to sell equityMaintain a target debt/equity ratio

Maintain a target dividend payout ratioCompanies want to accept positive NPVprojects, while avoiding negative signals

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Managements View of DividendPolicy

Agree or Strongly Agree93.8% Try to avoid reducing dividends per share89.6% Try to maintain a smooth dividend from year to year

41.7% pay dividends to attract investors subject to prudentman restrictions

Important or Very Important84.1% Maintaining consistency with historic dividend policy

71.9% Stability of future earnings9.3% Flotation costs to issue new equity

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Stock Repurchase

Company buys back its own shares of stockTender offer company states a purchase priceand a desired number of shares

Open market buys stock in the open marketSimilar to a cash dividend in that it returnscash from the firm to the stockholdersThis is another argument for dividend policyirrelevance in the absence of taxes or other imperfections

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Real-World Considerations

Stock repurchase allows investors to decide if they want the current cash flow andassociated tax consequencesIn our current tax structure, repurchases maybe more desirable due to the optionsprovided stockholders

The IRS recognizes this and will not allow astock repurchase for the sole purpose of allowing investors to avoid taxes

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Information Content of StockRepurchases

Stock repurchases send a positive signal thatmanagement believes that the current price islowTender offers send a more positive signalthan open market repurchases because thecompany is stating a specific price

The stock price often increases whenrepurchases are announced

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Example: RepurchaseAnnouncementAmerica West Airlines announced that its Board of Directors has

authorized the purchase of up to 2.5 million shares of its Class Bcommon stock on the open market as circumstances warrantover the next two years

Following the approval of the stock repurchase program by thecompanys Board of Directors earlier today. W. A. Franke,chairman and chief officer said The stock repurchase programreflects our belief that America West stock may be an attractiveinvestment opportunity for the Company, and it underscores our commitment to enhancing long- term shareholder value.

The shares will be repurchased with cash on hand, but only if andto the extent the Company holds unrestricted cash in excess of $200 million to ensure that an adequate level of cash and cashequivalents is maintained.

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Stock Dividends

Pay additional shares of stock instead of cashIncreases the number of outstanding sharesSmall stock dividend

Less than 20 to 25%If you own 100 shares and the company declareda 10% stock dividend, you would receive an

additional 10 sharesLarge stock dividend more than 20 to 25%

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Stock Splits

Stock splits essentially the same as a stockdividend except expressed as a ratio

For example, a 2 for 1 stock split is the same as a100% stock dividend

Stock price is reduced when the stock splitsCommon explanation for split is to returnprice to a more desirable trading range

http://www.stocksplits.net/

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Quick QuizWhat are the different types of dividends and how is adividend paid?What is the clientele effect and how does it affect dividendpolicy relevance?

What is the information content of dividend changes?What is the difference between a residual dividend policyand a compromise dividend policy?What are stock dividends and how do they differ from cashdividends?How are share repurchases an alternative to dividends andwhy might investors prefer them?