Chapter 17 – Dividend Policy

and International Financing

 2005, Pearson Prentice Hall

 Stock Returns:

Return = P1 - Po + D1
Po
 Stock Returns:

Return = P1 - Po + D1
Po

P1 - Po D1
= +
Po Po
 Stock Returns:

Return = P1 - Po + D1
Po

P1 - Po D1
= +
Po Po

Capital Gain
 Stock Returns:

Return = P1 - Po + D1
Po

P1 - Po D1
= +
Po Po

Capital Gain Dividend Yield

Dilemma: Should the firm use
retained earnings for:

a) Financing profitable capital

investments?
b) Paying dividends to
stockholders?
 Financing Profitable Capital
Investments:

If we retain earnings for profitable

investments,

P1 - Po D1
Return = +
Po Po
 Financing Profitable Capital
Investments:

If we retain earnings for profitable

investments, dividend yield will be zero,

P1 - Po D1
Return = +
Po Po
 Financing Profitable Capital
Investments:

If we retain earnings for profitable

investments, dividend yield will be zero,
but the stock price will increase, resulting
in a higher capital gain.

P1 - Po D1
Return = +
Po Po
 Paying Dividends:

If we pay dividends,

P1 - Po D1
Return = +
Po Po
 Paying Dividends:

If we pay dividends, stockholders receive

an immediate cash reward for investing,

P1 - Po D1
Return = +
Po Po
 Paying Dividends:

If we pay dividends, stockholders receive

an immediate cash reward for investing,
but the capital gain will decrease, since
this cash is not invested in the firm.

P1 - Po D1
Return = +
Po Po
 So, dividend policy really
involves two decisions:

 How much of the firm’s earnings

should be distributed to
shareholders as dividends, and
 How much should be retained
for capital investment?
Is Dividend Policy Important?

Three viewpoints:
1) Dividends are Irrelevant
2) High Dividends are Best
3) Low Dividends are Best
 Three viewpoints:

1) Dividends are Irrelevant. If we

assume perfect markets (no taxes,
no transaction costs, etc.) dividends
do not matter. If we pay a dividend,
shareholders’ dividend yield rises,
but capital gains decrease.
 Dividends are Irrelevant

With perfect markets, investors are

concerned only with total returns
and do not care whether returns
come in the form of capital gains or
dividend yields.

P1 - Po D1
Return = +
Po Po
 Dividends are Irrelevant

Therefore, one dividend policy is as

good as another.

P1 - Po D1
Return = +
Po Po
 High Dividends are Best

Some investors may prefer a certain

dividend now over a risky expected
capital gain in the future.
 High Dividends are Best

Some investors may prefer a certain

dividend now over a risky expected
capital gain in the future.

P1 - Po D1
Return = +
Po Po
 Low Dividends are Best

 Dividends are taxed immediately.

Capital gains are not taxed until the
stock is sold.
 Therefore, taxes on capital gains can
be deferred indefinitely.
 Do Dividends Matter?
Other Considerations:
1) Residual Dividend Theory
2) Clientele Effects
3) Information Effects
4) Agency Costs
5) Expectations Theory
 Other Considerations
1) Residual Dividend Theory:
 The firm pays a dividend only if it
has retained earnings left after
financing all profitable investment
opportunities.
 This would maximize capital gains
for stockholders and minimize
flotation costs of issuing new
common stock.
 Other Considerations

2) Clientele Effects:
 Different investor clienteles prefer
different dividend payout levels.
 Some firms, such as utilities, pay out
over 70% of their earnings as
dividends. These attract a clientele that
prefers high dividends.
 Growth-oriented firms which pay low
(or no) dividends attract a clientele that
prefers price appreciation to dividends.
 Other Considerations
3) Information Effects:
 Unexpected dividend increases
usually cause stock prices to rise,
and unexpected dividend decreases
cause stock prices to fall.
 Dividend changes convey
information to the market
concerning the firm’s future
prospects.
 Other Considerations
4) Agency Costs:
 Paying dividends may reduce agency
costs between managers and
shareholders.
 Paying dividends reduces retained
earnings and forces the firm to raise
external equity financing.
 Raising external equity subjects the
firm to scrutiny of regulators (SEC) and
investors and therefore helps monitor
the performance of managers.
 Other Considerations
5) Expectations Theory:
 Investors form expectations concerning
the amount of a firm’s upcoming
dividend.
 Expectations are based on past dividends,
expected earnings, investment and
financing decisions, the economy, etc.
 The stock price will likely react if the
actual dividend is different from the
expected dividend.
 Dividend Policies
1) Constant Dividend Payout Ratio: If
directors declare a constant payout
ratio of, for example, 30%, then for
every dollar of earnings available to
stockholders, 30 cents would be paid
out as dividends.
 The ratio remains constant over time,
but the dollar value of dividends
changes as earnings change.
 Dividend Policies

2) Stable Dollar Dividend Policy:

The firm tries to pay a fixed dollar
dividend each quarter.
 Firms and stockholders prefer
stable dividends. Decreasing the
dividend sends a negative signal!
 Dividend Policies
3) Small Regular Dividend plus Year-
End Extras
 The firm pays a stable quarterly
dividend and includes an extra year-
end dividend in prosperous years.
 By identifying the year-end dividend
as “extra,” directors hope to avoid
signaling that this is a permanent
dividend.
 Dividend Payments
1) Declaration Date: The board of
directors declares the dividend,
determines the amount of the dividend,
and decides on the payment date.

Jan.4 Jan.30 Feb.1 Mar. 11

Declare Ex-div. Record Payment

dividend date date date
 Dividend Payments
2) Ex-Dividend Date: To receive the
dividend, you have to buy the stock before
the ex-dividend date. On this date, the stock
begins trading “ex-dividend” and the stock
price falls approximately by the amount of
the dividend.

Jan.4 Jan.30 Feb.1 Mar. 11

Declare Ex-div. Record Payment

dividend date date date
 Dividend Payments
3) Date of Record: Two days after the ex-
dividend date, the firm receives the list of
stockholders eligible for the dividend.
 Often, a bank trust department acts as
registrar and maintains this list for the
firm.

Jan.4 Jan.30 Feb.1 Mar. 11

Declare Ex-div. Record Payment

dividend date date date
 Dividend Payments

4) Payment Date: Date on which the

firm mails the dividend checks to
the shareholders of record.

Jan.4 Jan.30 Feb.1 Mar. 11

Declare Ex-div. Record Payment

dividend date date date
Stock Dividends and Stock Splits

Stock Dividend: Payment of additional

shares of stock to common stockholders.
 Example: Citizens Bancorporation of
Maryland announces a 5% stock
dividend to all shareholders of record.
For each 100 shares held, shareholders
receive another five shares.
 Does the shareholders’ wealth increase?
 Stock Dividends and Stock Splits
Stock Split: The firm increases the number of
shares outstanding and reduces the price of
each share.
 Example: Joule, Inc. announces a
3-for-2 stock split. For each 100 shares
held, shareholders receive another 50
shares.
 Does this increase shareholder wealth?
 Are a stock dividend and a stock split the
same?
 Stock Dividends and Stock Splits
Stock Splits and Stock Dividends are
economically the same: The number of
shares outstanding increases and the price
of each share drops. The value of the firm
does not change.
Example: A 3-for-2 stock split is the same as
a 50% stock dividend. For each 100
shares held, shareholders receive another
50 shares.
 Stock Dividends and Stock Splits
Effects on Shareholder Wealth:
 Stock Dividends and Stock Splits
Effects on Shareholder Wealth: These will
cut the company “pie” into more pieces
but will not create wealth. A 100% stock
dividend (or a 2-for-1 stock split) gives
shareholders two half-sized pieces for each
full-sized piece they previously owned.
 Stock Dividends and Stock Splits
Effects on Shareholder Wealth: These will
cut the company “pie” into more pieces
but will not create wealth. A 100% stock
dividend (or a 2-for-1 stock split) gives
shareholders two half-sized pieces for each
full-sized piece they previously owned.
Example: This would double the number of
shares, but would cause a $60 stock price
to fall to $30.
Stock Dividends and Stock Splits
Why bother?
 Proponents argue that these are used to
reduce high stock prices to a “more
popular” trading range (generally $15 to
$70 per share).
 Opponents argue that most stocks are
purchased by institutional investors who
have millions of dollars to invest and are
indifferent to price levels. Plus, stock splits
and stock dividends are expensive!
 Stock Dividend Example

An investor has 120 shares. Does the

value of the investor’s shares
change?
 Shares outstanding: 1,000,000.
 Net income = $6,000,000.
 P/E = 10.
 25% stock dividend.
Before the 25% stock dividend:
 EPS = 6,000,000/1,000,000 = $6.
 P/E = P/6 = 10, so P = $60 per share.
 Value = $60 x 120 shares = $7,200.
After the 25% stock dividend:
 # shares = 1,000,000 x 1.25 = 1,250,000.
 EPS = 6,000,000/1,250,000 = $4.80.
 P/E = P/4.80 = 10, so P = $48 per share.
 Investor now has 120 x 1.25 = 150 shares.
 Value = $48 x 150 = $7,200.
 Stock Dividends
In-class Problem

What is the new stock price?

 Shares outstanding: 250,000.
 Net income = $750,000.
 Stock price = $84.
 50% stock dividend.
 Hint:

stock price
P/E =
(
net income
# shares )
Before the 50% stock dividend:
 EPS = 750,000 / 250,000 = $3.
 P/E = 84 / 3 = 28.
After the 50% stock dividend:
 # shares = 250,000 x 1.50 = 375,000.
 EPS = 750,000 / 375,000 = $2.
 P/E = P / 2 = 28, so P = $56 per share.
(A 50% stock dividend is equivalent to a
3-for-2 stock split.)
 Stock Repurchases
 Stock Repurchases may be a good
substitute for cash dividends.
 If the firm has excess cash, why not
buy back common stock?
 Stock Repurchases
 Stock Repurchases may be a good
substitute for cash dividends.
 If the firm has excess cash, why not
buy back common stock?
 Stock Repurchases
 Repurchases drive up the stock
price, producing capital gains for
shareholders.
 Repurchases increase leverage, and
can be used to move toward the
optimal capital structure.
 Repurchases signal positive
information to the market—which
increases stock price.
 Stock Repurchases

 Repurchases may be used to avoid

a hostile takeover.
Example: T. Boone Pickens
attempted raids on Phillips
Petroleum and Unocal in 1985.
Both were unsuccessful because
the target firms undertook stock
repurchases.
 Stock Repurchases
Methods:
 Buy shares in the open market
through a broker.
 Buy a large block by negotiating the
purchase with a large block holder,
usually an institution (targeted stock
repurchase).
 Tender offer: offer to pay a specific
price to all current stockholders.