#15 & #16 Dividend Policy

8/2/2019 #15 & #16 Dividend Policy

1/27

Session

15Dividends and Other

CF-II (Term III 2012) Dr. Kulbir Singh (IMT-Nagpur)

16


2/27

Slide 2

1. Different Types ofDividends

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.

Dr. Kulbir Singh (IMT-Nagpur)Term III (2012)

.

No cash leaves the firm.

The firm increases the number of shares outstanding.

Some companies declare a dividend in kind. Wrigleys Gum sends a box of chewing gum.

Dundee Crematoria offers shareholders discountedcremations.


3/27

Slide 3

2. Standard Method of Cash

Dividend

Ex-Dividend Date - Date that determines

Cash Dividend - Payment of cash by the firm

to its shareholders.


Record Date Date on which company

determines existing shareholders.

whether a stockholder is entitled to a dividend

payment; anyone holding stock immediately

before this date is entitled to a dividend.


4/27

Slide 4

Procedure for Cash Dividend

25 Oct. 1 Nov. 2 Nov. 5 Nov. 7 Dec.

Declaration

Date

Cum-

dividendDate

Ex-

dividendDate

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.


5/27

Slide 5

Price Behavior

In a perfect world, the stock price will fall by theamount of the dividend on the ex-dividend date.

$P

-t -2 -1 0 +1 +2


$P - div

Ex-

dividend

Date

The price drops

by the amount of

the cashdividend. 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.


6/27

Slide 6

3. The Irrelevance of

Dividend Policy A compelling case can be made that dividendpolicyis 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 noimpact on the value of the firm becauseinvestors can create whatever income streamthey prefer by using homemade dividends.


7/27

Slide 7

Example



8/27

Slide 8

Example

After the imminent dividend is paid, the stockprice will immediately fall to

$9.09 (= $19.09 - $10).

Several members of Bristols board haveex ressed dissatisfaction with the current


dividend policy and have asked you to analyze analternative policy.


9/27

Slide 9

Example: Alternative Policy

Another policy is for the firm to pay a dividend of$11 per share immediately - the extra $1,000must be raised in one of a few ways.

Issue $1,000 of bonds or stock now (at date 0).

Assume that stock is issued and the newstockholders will desire enough cash flow at date


1 to let them earn the required 10 percent returnon their date 0 investment.

The new stockholders will demand $1,100 of the

date 1 cashflow, leaving only $8,900 to the oldstockholders. The dividends to the oldstockholders will be these:


10/27

Slide 10

Example: Alternative Policy

Date 0 Date 1Aggregate Dividends to OldShareholders

$11,000 $8,900

Dividends per Share $11.00 $8.90



11/27

Slide 11

Homemade Dividends

Bianchi Inc. is a $42 stock about to pay a $2cash dividend.

Bob Investor owns 80 shares and prefers a $3dividend.

Bobs homemade dividend strategy:


Sell 2 shares ex-dividend

homemade dividends

Cash from dividend $160Cash from selling stock $80

Total Cash $240

Value of Stock Holdings $40 78 =

$3,120

$3 Dividend

$240$0

$240

$39 80 =

$3,120


12/27

Slide 12

Dividend Policy is Irrelevant

In the above example, Bob Investor began witha total wealth of $3,360:

share

42$shares80360,3$ =


240$share

39$shares80360,3$ +=

80$160$share

40$shares78360,3$ ++=

After a $3 dividend, his total wealth is still $3,360:

After a $2 dividend and sale of 2 ex-dividend shares, histotal wealth is still $3,360:


13/27

Slide 13Dividends and InvestmentPolicy

Firms should never forgo positive NPVprojects to increase a dividend (or to pay a

dividend for the first time).


underlying the dividend-irrelevanceargument is: The investment policy of the

firm is set ahead of time and is not alteredby changes in dividend policy.


14/27

Slide 14

4. Repurchase of Stock

Instead of declaring cash dividends, firmscan rid themselves of excess cash through

buying shares of their own stock.


,an important way of distributing earningsto shareholders.


15/27

Slide 15Stock Repurchase versusDividend

sheetbalanceOriginalA.

Equity&LiabilitiesAssets

Consider a firm that wishes to distribute $100,000 to its

shareholders.


$10=/100,000$1,000,000=Price per share100,000=outstandingShares

1,000,000Value of Firm1,000,000Value of Firm

1,000,000Equity850,000AssetsOther

,


16/27

Slide 16Stock Repurchase versusDividend

dividendcashshareper$1AfterB.

Equity&sLiabilitieAssets

If they distribute the $100,000 as a cash dividend, the balance

sheet will look like this:


$9=00,000$900,000/1=shareperPrice100,000=goutstandinShares

900,000FirmofValue900,000FirmofValue

900,000Equity850,000AssetsOther

,


17/27

Slide 17

Stock Repurchase versusDividend

Assets Liabilities & Equity

C. After stock repurchase

If they distribute the $100,000 through a stock repurchase, the

balance sheet will look like this:


Cash $50,000 Debt 0

Other Assets 850,000 Equity 900,000

Value of Firm 900,000 Value of Firm 900,000

Shares outstanding= 90,000Price pershare = $900,000 / 90,000 = $10


18/27

Slide 18

Share Repurchase

Flexibility for shareholders

Keeps stock price higher..Executivecompensation Good for insiders who hold stock o tions


Existing stock options have greater value dueto share repurchase...

As an investment of the firm(undervaluation)

Tax benefits


19/27

Slide 19

5. Personal Taxes and

Dividends To get the result that dividend policy is

irrelevant, we needed three assumptions: No taxes

No transactions costs


In the United States, both cash dividends andcapital gains are taxed at a maximum rate of 15percent.

Since capital gains can be deferred, the tax rateon dividends is greater than the effective rate oncapital gains.


20/27

Slide 20

Firms without Sufficient Cash

Cash: stock issue

Investment Bankers The direct costs ofstock issuance willadd to this effect.


In a world of personal taxes,firms should not issue stockto pay a dividend.

Firmoc

HoldersCash: dividends

Gov.

Taxes


21/27

Slide 21

Firms with Sufficient Cash

The above argument does not necessarilyapply to firms with excess cash.

Consider a firm that has $1 million in cash

after selecting all available positive NPV


.

Select additional capital budgeting projects(by assumption, these are negative NPV).

Acquire other companies Purchase financial assets

Repurchase shares


22/27

Slide 22

Taxes and Dividends

In the presence of personal taxes:

1. A firm should not issue stock to pay adividend.


.alternative uses for funds to reducedividends.

3. Though personal taxes mitigate against thepayment of dividends, these taxes are notsufficient to lead firms to eliminate alldividends.


23/27

Slide 23

6. Real-World Factors FavoringHigh Dividends

Desire for Current Income

Behavioral Finance

It forces investors to be disciplined.


Tax Arbitrage

Investors can create positions in high dividendyield securities that avoid tax liabilities.

Agency Costs

High dividends reduce free cash flow.


24/27

Slide 24

7. The Clientele Effect Clienteles for various dividend payout

policies are likely to form in the followingway:

Group Stock Type


High Tax Bracket Individuals

Low Tax Bracket Individuals

Tax-Free InstitutionsCorporations

Zero-to-Low payout

Low-to-Medium payout

Medium payoutHigh payout

Once the clienteles have been satisfied, a corporation is

unlikely to create value by changingits dividend policy.


25/27

Slide 25

8. What We Know and Do Not Know

Corporations smooth dividends..Lintners Study

Fewer companies are paying dividends.

Dividends provide information to the market


earnings & dividends

Firms should follow a sensible policy:

Do not forgo positive NPV projects just to pay adividend.

Avoid issuing stock to pay dividends.

Consider share repurchase when there are few better

uses for the cash.


26/27

Slide 26

9. Stock Dividends

Pay additional shares of stock instead ofcash

Increases the number of outstanding shares

Small stock dividend


Less than 20 to 25%

If you own 100 shares and the companydeclared a 10% stock dividend, you would

receive an additional 10 shares.

Large stock dividend more than 20 to 25%


27/27

Slide 27

Stock Splits

Stock splits essentially the same as astock dividend except it is expressed as aratio

For example, a 2 for 1 stock split is the sameas a 100% stock dividend.


Stock price is reduced when the stocksplits.

Common explanation for split is to returnprice to a more desirable trading range.

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#15 & #16 Dividend Policy

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