Lecture Note 2

Dividend Policy

Corporate Finance Lecture Note 2 1

 What is in This Note?
Overview
Overview of
of Types
Types of
of Dividends
Dividends
Overview
Overview of
of Forms
Forms of
of Dividends
Dividends
Overview
Overview of
of Dividend
Dividend Policies
Policies
Overview
Overview of
of Real
Real World
World Dividend
Dividend Decisions
Decisions
Reference:
Reference: Chapter
Chapter 18
18 of
of RWJJ,
RWJJ, Chapter
Chapter
16
16 of
of BMA
BMA

Corporate Finance Lecture Note 2 2

Roadmap
Understand dividend types and how they are
paid
Understand why share repurchases are an
alternative to dividends
Understand dividend polices
Understand real world dividend decisions

Corporate Finance Lecture Note 2 3

Types of dividends

Corporate Finance Lecture Note 2 4

 Different Types of Dividends
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.
Companies will often declare stock dividends.
No cash leaves the firm.
The firm increases the number of shares outstanding.

Corporate Finance Lecture Note 2 5

Standard Method of Cash Dividend

Cash Dividend - Payment of cash by the firm

to its shareholders.

Ex-Dividend Date ( ) - Date that

determines whether a stockholder is entitled to
a dividend payment; anyone holding stock
immediately before this date is entitled to a
dividend.
Record Date Date on which company
determines existing shareholders.
Corporate Finance Lecture Note 2 6
 Procedure for Cash Dividend
25 Oct. 1 Nov. 2 Nov. 5 Nov. 7 Dec.

Declaration Cum- Ex- Record Payment

Date dividend dividend Date Date
Date 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.
Corporate Finance Lecture Note 2 7
 Stock price

St
D: Cash dividend
S0

S0- De-rt

t: Ex-dividend date time

Corporate Finance Lecture Note 2 8

 Stock price

St
D*(1-dividend tax)
S0

S0- (D *(1-dividend tax)) e-rt

t: Ex-dividend date time

Corporate Finance Lecture Note 2 9

The stock price will decrease proportionally
with the amount of cash dividends.
Corporate Finance Lecture Note 2 10
 In-Class Exercise
Ross, Westerfield, and Jaffe Question 1 (pp. 543)
Lee Ann has declared a $6 per share cash
dividend. Suppose that the capital gains are not
taxed, but dividends are taxed at 15% for the
representative investor. Lee Ann sells for $90 per
share, what do you think the ex-equilibrium
dividend price will be?
Ans: Aftertax dividend = $6.00(1 .15) = $5.10.
The stock price should drop by the aftertax
dividend amount, or: Ex-dividend price = $90
5.10 = $84.90
Corporate Finance Lecture Note 2 11
Forms of Dividends

Corporate Finance Lecture Note 2 12

Forms of Dividend Payments
Stock Repurchase - Firm buys back stock
from its shareholders.

Stock Dividend - Distribution of additional

shares to a firms stockholders.

Stock Splits - Issue of additional shares to

firms stockholders.

Corporate Finance Lecture Note 2 13

Repurchase of Stock ( or
)
Instead of declaring cash dividends, firms
can rid themselves of excess cash
through buying shares of their own stock.
Recently, share repurchase has become
an important way of distributing earnings
to shareholders.

Corporate Finance Lecture Note 2 14

Stock Repurchase versus Dividend
Consider a firm that wishes to distribute $100,000 to its
shareholders.
Assets Liabilities & Equity
A.Original balance sheet
Cash $150,000 Debt 0
Other Assets 850,000 Equity 1,000,000
Value of Firm 1,000,000 Value of Firm 1,000,000
Shares outstanding = 100,000
Price per share= $1,000,000 /100,000 = $10

Corporate Finance Lecture Note 2 15

Stock Repurchase versus Dividend
If they distribute the $100,000 as a cash dividend, the
balance sheet will look like this:
Assets Liabilities & Equity
B. After$1 per share cash dividend
Cash $50,000 Debt 0
Other Assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding = 100,000
Price per share = $900,000/100,000 = $9

Corporate Finance Lecture Note 2 16

Stock Repurchase versus Dividend
If they distribute the $100,000 through a stock repurchase,
the balance sheet will look like this:
Assets Liabilities& Equity
C. After stock repurchase
Cash $50,000 Debt 0
Other Assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding= 90,000
Price pershare = $900,000 / 90,000 = $10

Corporate Finance Lecture Note 2 17

 Share Repurchase ( or
)
Flexibility for shareholders
Keeps stock price higher
Good for insiders who hold stock options
As an investment of the firm
(undervaluation of the stock price)
Tax benefits
, (3260), 3035 ,
etc

Corporate Finance Lecture Note 2 18

 In-Class Exercise

Ross, Westerfield, and Jaffe Question 17 (pp. 545)

Lee Ann is considering a cash dividend versus s
stock repurchase. In either case 5,000 would
be spent. Current EPS is 0.95 per share and
the stock price is 40 per share. There are
1,000 shares outstanding. Ignore taxes
1. Evaluate the two alternatives on shareholder
wealth
2. What will be the effect on Lee Anns EPS and
PE ratio under these two different alternatives?

Corporate Finance Lecture Note 2 19

 In-Class Exercise
1. Dividend per share = 5,000/1,000 shares =
5.00. The ex-dividend stock price will be: 40
5 = 35 per share. Shares repurchased =
5,000/40 = 125 shares
2. If the company pays dividends, the current
EPS is 0.95, and the P/E ratio is: P/E =
35/0.95 = 36.84. If the company repurchases
stock, we find the EPS under the repurchase is:
EPS = 0.95(1,000)/(1,000 125) = 1.0857.
The stock price will remain at 40 per share, so
the P/E ratio is:P/E = 40/1.0857 = 36.84
Corporate Finance Lecture Note 2 20
 Stock Dividends
Pay additional shares of stock instead of
cash
Increases the number of outstanding shares
Small stock dividend
Less than 20 to 25%
If you own 100 shares and the company
declared a 10% stock dividend, you would
receive an additional 10 shares.
Large stock dividend more than 20 to 25%

Corporate Finance Lecture Note 2 21

 In-Class Exercise
Ross, Westerfield, and Jaffe Question 2 (pp. 543)
Lee Anns stock is sold at $25 per share and it declares a 10% stock dividend. How many new
shares are issued and how would the equity account change? and if it declares a 25% stock
dividend. How many new shares are issued and how would the equity account change.

Common stock ($ 1 par value) 10,000

Capital surplus 180,000
Retained earnings 586,500

Total owner's equity 776,500

Corporate Finance Lecture Note 2 22

 In-Class Exercise

Common stock ($ 1 par value) 11,000

Capital surplus 204,000
Retained earnings 561,500

Total owner's equity 776,500

Common stock ($ 1 par value) 12,500

Capital surplus 240,000
Retained earnings 524,000

Total owner's equity 776,500

Corporate Finance Lecture Note 2 23

 Stock Splits
Stock splits essentially the same as a
stock dividend except it is expressed as a
ratio
For example, a 2 for 1 stock split is the same
as a 100% stock dividend.
Stock price is reduced when the stock
splits.
Common explanation for split is to return
price to a more desirable trading range.

Corporate Finance Lecture Note 2 24


91XX TDR 10


TDR): TDR
16
DR .
TDR:

9103 : 96 6 11 4 for 1 stock split

9105 : 94 4 7 10 for 1 stock split

Corporate Finance Lecture Note 2 25

 Reverse Stock Splits
Stock price is increased when there is a
reverse stock split.
Common explanation for reverse split is to
return price to a more desirable trading
range.

Corporate Finance Lecture Note 2 26

 In-Class Exercise
Ross, Westerfield, and Jaffe Question 3 (pp. 543)
Lee Anns stock is sold at $25 per share and it
declares a four-for-one stock split. There are
10,000 shares outstanding. How many shares
are outstanding now? and if it declares a one-
for-four reverse stock split. How many shares
are outstanding now?
Ans: four-for-one stock split, New shares
outstanding = 10,000(4/1) = 40,000. one-for-
four reverse stock split, New shares outstanding
= 10,000(1/4) = 2,500.
Corporate Finance Lecture Note 2 27
Dividend Policy

Corporate Finance Lecture Note 2 28

 What is dividend policy?

Its the decision to pay out earnings

versus retaining and reinvesting them.
Includes these elements:
1. High or low payout?
2. Stable or irregular dividends?
3. How frequent?
4. Do we announce the policy?

Corporate Finance Lecture Note 2 29

Roadmap
Dividend Irrelevance Theory
Tax Preference Theory
Dividends Preference Theory
The Clientele Effect

Corporate Finance Lecture Note 2 30

Dividend Irrelevance Theory

Corporate Finance Lecture Note 2 31

 Dividend Irrelevance Theory
dividend policy is irrelevant in the sense that it
cannot affect shareholder value
Investors are indifferent between dividends and
retention-generated capital gains. If they want
cash, they can sell stock. If they dont want cash,
they can use dividends to buy stock.
Modigliani-Miller support irrelevance.
Theory is based on no taxes or brokerage costs,
hence may not be true

Corporate Finance Lecture Note 2 32

 The Irrelevance of Dividend
Policy
A compelling case can be made that dividend
policy is irrelevant in the sense that it cannot
affect shareholder value.
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 no
impact on the value of the firm because
investors can create whatever income stream
they prefer by using homemade dividends.
Corporate Finance Lecture Note 2 33
 Homemade Dividends
Bianchi Inc. is a $42 stock about to pay a $2 cash
dividend.
Bob Investor owns 80 shares and prefers a $3 dividend.
Bobs homemade dividend strategy:
Sell 2 shares ex-dividend

homemade dividends $3 Dividend

Cash from dividend $160 $240
Cash from selling stock $80 $0
Total Cash $240 $240
Value of Stock Holdings $40 78 = $39 80 =
$3,120
Corporate Finance Lecture Note 2 $3,12034
 Dividend Policy is Irrelevant
In the above example, Bob Investor began with
a total wealth of $3,360:
$42
$3,360 80 shares
share
After a $3 dividend, his total wealth is still $3,360:
$39
$3,360 80 shares $240
share
After a $2 dividend and sale of 2 ex-dividend shares, his
total wealth is still $3,360:
$40
$3,360 78 shares $160 $80
share
Corporate Finance Lecture Note 2 35
 Dividends and Investment
Policy
Firms should never forgo positive NPV
projects to increase a dividend (or to pay a
dividend for the first time).
Recall that one of the assumptions
underlying the dividend-irrelevance
argument is: The investment policy of the
firm is set ahead of time and is not altered
by changes in dividend policy.

Corporate Finance Lecture Note 2 36

Tax Preference Theory

Corporate Finance Lecture Note 2 37

 Personal Taxes and Dividends
To get the result that dividend policy is irrelevant, we
needed three assumptions:
No taxes
No transactions costs
No uncertainty
In the United States, both cash dividends and capital
gains are taxed at a maximum rate of 15 percent.
Since capital gains can be deferred, the tax rate on
dividends is greater than the effective rate on capital
gains.
This could cause investors to prefer firms with low cash
dividends.

Corporate Finance Lecture Note 2 38

 Firms without Sufficient Cash
Investment Bankers The direct costs of
stock issuance will
add to this effect.
Cash: stock issue
Stock
Firm
Holders
Cash: dividends

Taxes
In a world of personal taxes,
firms should not issue stock
Gov. to pay a dividend.
Corporate Finance Lecture Note 2 39
 Firms with Sufficient Cash
The above argument does not necessarily
apply to firms with excess cash.
Consider a firm that has $1 million in cash after
selecting all available positive NPV projects.
Select additional capital budgeting projects (by
assumption, these are negative NPV).
Acquire other companies
Purchase financial assets
Repurchase shares

Corporate Finance Lecture Note 2 40

 Taxes and Dividends
In the presence of personal taxes:
1. A firm should not issue stock to pay a
dividend.
2. Managers have an incentive to seek
alternative uses for funds to reduce dividends.
3. Though personal taxes mitigate against the
payment of dividends, these taxes are not
sufficient to lead firms to eliminate all
dividends.

Corporate Finance Lecture Note 2 41

Dividends Preference Theory

Corporate Finance Lecture Note 2 42



Corporate Finance Lecture Note 2 43



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4.5

Corporate Finance Lecture Note 2 44
 Real-World Factors Favoring High
Dividends
Desire for Current Income: Retired
investors
Behavioral Finance
It forces investors to be disciplined.
Agency Costs
High dividends reduce free cash flow.

Corporate Finance Lecture Note 2 45

 Behavioral Finance-Dividends
A natural rule people might create to
prevent themselves from over consuming
their wealth is only consume the
dividend, but dont touch the portfolio
capital.
In other words, people may like dividends
because dividends help them surmount
self-control problems through the creation
of simple rules.
Corporate Finance Lecture Note 2 46
 Implications of 3 Theories for Managers

Theory Implication

Irrelevance Any payout OK

Tax preference Set low payout
Dividends preference Set high payout
But which, if any, is correct???

Corporate Finance Lecture Note 2 47

Which theory is most correct?
Empirical testing has not been able to
determine which theory, if any, is correct.
Thus, managers use judgment when
setting policy.
Analysis is used, but it must be applied
with judgment.

Corporate Finance Lecture Note 2 48

The Clientele Effect

Corporate Finance Lecture Note 2 49

 The Clientele Effect
Clienteles for various dividend payout
policies are likely to form in the following
way:
Group Stock Type

High Tax Bracket Individuals Zero-to-Low payout

Low Tax Bracket Individuals Low-to-Medium payout
Tax-Free Institutions Medium payout
Corporations High payout

Once the clienteles have been satisfied, a corporation is

unlikely to create value by changing its dividend policy.
Corporate Finance Lecture Note 2 50
 Whats the clientele effect?
Different groups of investors, or clienteles,
prefer different dividend policies.
Firms past dividend policy determines its
current clientele of investors.
Clientele effects impede changing
dividend policy. Taxes & brokerage costs
hurt investors who have to switch
companies.
Corporate Finance Lecture Note 2 51
The Dividend Decision

Corporate Finance Lecture Note 2 52

 What We Know and Do Not
Know
Corporations smooth dividends.
Fewer companies are paying dividends.
Dividends provide information to the market.
Firms should follow a sensible policy:
Do not forgo positive NPV projects just to pay
a dividend.
Avoid issuing stock to pay dividends.
Consider share repurchase when there are few
better uses for the cash.

Corporate Finance Lecture Note 2 53

The Dividend Decision: Lintners Stylized
Facts
(How Dividends are Determined)
1. Firms have longer term target dividend payout ratios.
2. Managers focus more on dividend changes than on
absolute levels.
3. Dividends changes follow shifts in long-run, sustainable
levels of earnings rather than short-run changes in
earnings.
4. Managers are reluctant to make dividend changes that
might have to be reversed.
5. Firms repurchase stock when they have accumulated a
large amount of unwanted cash or wish to change their
capital structure by replacing equity with debt.
Corporate Finance Lecture Note 2 54
 The Dividend Decision
Attitudes concerning dividend targets vary

DIV11 target
DIV targetdividend
dividend
target ratioEPS
targetratio EPS1 1

Dividend Change
DIV DIV00 target
DIV11--DIV targetchange
change
target ratioEPS
targetratio EPS1 --DIV
DIV0 1 0
Corporate Finance Lecture Note 2 55
 The Dividend Decision
Dividend changes confirm the following

DIV DIV00 adjustment

DIV11--DIV ratetarget
adjustmentrate targetchange
change
adjustment rate target
adjustmentrate ratioEPS
targetratio DIV0
EPS1 --DIV
1 0

Corporate Finance Lecture Note 2 56

 Conclusion
What are the dividend polices?
Which dividend policy favors high (low)
dividend payouts?
What is the Modigliani-Miller Propositions
about dividend polices?
What are the Lintners Stylized Facts
about dividends decisions?

Corporate Finance Lecture Note 2 57