Chapter 15 Dividends

Background
Dividends as a Basis for Value
Dividends are important in determining stock value
Individual investors buy stocks expecting dividends and price
appreciation

D1 D2 Dn Pn
P0 ...
(1 k ) (1 k ) 2
(1 k ) (1 k ) n
n

From the whole market view, todays stock price is the

present value of an infinite stream of dividends
Focus on the individual view
 Example 15-1

The Bokberry Corporation maintains a dividend payout

ratio of 40% and recently distributed an annual dividend
of $2.50. The firm has a P/E of 19.
Calculate Bokberrys EPS and the market price of the
stock.
How much more dividend income would a stockholder
who owns 500 shares have received if Bockberrys
payout ratio was 55%?
If there are 3.5 million shares of Bockberry stock
outstanding, how much equity capital was made available
for capital budgeting from retained earnings under two
payout ratios?
Solution:

a) to find EPS:
d=dividend per share/EPS
.4=$2.5/EPS
EPS=$2.5/4=$6.25

to find price:
P/E= price/EPS
19=price/6.25
Price=19(6.25)=118.75
b) At 55% payout ratio, the per-share dividend would be
Dividend per share= (d)(EPS)=.55(6.25)=$3.44
for a dividend increase of
$3.44 - $2.50=$0.94
multiply by the shares held for Stockholders additional
dividend income (500)($0.94)=$470
c) Total earnings: ($6.25)(3,500,000)=$21,875,000
The funds available for each case
d=40%: $21,875,000(.6) = $13,125,000
d=55%: $21,875,000(.45)=$ 9,843,750
-----------------
Difference $3,281,250
Understanding the Dividend Decision

The Discretionary Nature of Dividends

Board of Directors determines the dividend
Can be more than earnings or nothing

The Dividend Decision

Whether to pay cash dividends or retain earnings
for growth
Current income
Deferred income

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 The Dividend Controversy
Does paying or not paying dividends affect stock
price?
Do stockholders prefer current or deferred
income?
Three arguments regarding investors
preferences for or against dividends
1. Dividend Irrelevance
2. Dividend Preference
3. Dividend Aversion

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 Dividend Irrelevance
Most theorists say dividends matter very little to stock
price
Value of eliminated early dividends is offset by
growth-created value in the future

D1 D2 Dn Pn
P0 ...
(1 k ) (1 k ) 2 (1 k ) n (1 k ) n

In valuation equation loss of D1, D2 . is made up

by gains in later Di (i = 1, 2,n) and Pn
 Concept Connection Example 15-3
Tailoring the Income Stream
The Winters are retirees with most of their savings
invested in 10,000 shares of Ajax Corporation
(AJAX). AJAX sells for $10 per share and pays an
annual dividend of $0.50 per share.

This year AJAX eliminated the dividend, but began

to grow at 5% a year due to the reinvested
earnings.

How can the Winters maintain their income and

their position in AJAX?

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 Concept Connection Example 15-3
Tailoring the Income Stream
Original value of the Winters AJAX shares
$10 10,000 shares = $100,000.
Eliminated dividend
10,000 shares $0.50 = $5,000.
After one year of 5% growth, AJAX should sell for
$10 1.05 = $10.50.
To maintain their income the Winters must sell
$5,000 $10.50 = 476 shares
After which they would have
10,000 476 = 9,524 shares
Worth $10.50 x 9,524 = $100,002.
 Dividend Irrelevance

Transaction costs
The more significant the transactions costs, the
less valid the irrelevance theory becomes
Income taxes
Dividends are taxed as ordinary income
Appreciation is taxed as a capital gain
The View from Within the Company
Dividends represent a cash outflow
Firms prefer not paying dividends if it avoids
selling new stock
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 Dividend Preference

Investors prefer immediate cash to

uncertain future benefits
Poor management may waste the funds
rather than using effectively for growth
Inconsistency in theory:
If investors are worried about management
not using resources effectively, why did they
invest in the firm in the first place?

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 Dividend Aversion

Investors prefer future capital gains to current

dividends because of tax rates
Price appreciation taxed as capital gain
Dividends taxed as ordinary income
Argument hinges on current tax rates on dividend
income vs. capital gains income
Capital gains taxes are not paid until stock is sold
so taxes are deferred

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 Other Theories and Ideas
The Clientele Effect
Investors choose stocks for dividend policy so any
change in payments policy is disruptive
The Residual Dividend Theory
Dividends are paid from earnings only after viable
projects are funded
The Signaling Effect of Dividends
Cash dividends signal managements confidence
The Expectations Theory
A refinement of the signaling effect
Dividends that fail to fulfill stockholders expectations
send a negative message even if the payment is good

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 Problem 1

Chandler Communications CFO has provided the

following information:

The companys capital budget is expected to be P5,000,000.

The companys target capital structure is 70 percent debt and

30 percent equity.
The companys net income is P4,500,000.

If the company follows a residual dividend policy, what portion

of its net income should it pay out as dividends this year?
 Problem 2

Strategic Systems Inc. expects to have net

income of $800,000 during the next year. Its
target, and current, capital structure is 40
percent debt and 60 percent common equity.
The Director of Capital Budgeting has
determined that the optimal capital budget for
next year is $1.2 million. If Strategic uses the
residual dividend model to determine next
years dividend payout, what is the expected
dividend payout ratio?
 Problem 3

Brock Brothers wants to maintain its capital

structure that consists of 30 percent debt and 70
percent equity. The company forecasts that its
net income this year will be $1,000,000. The
company follows a residual dividend policy and
anticipates a dividend payout ratio of 40 percent.
What is the size of the companys capital
budget?
 Legal and Contractual Restrictions
on Dividends
Legal Restrictions Contractual Restrictions
Dividends cant be paid Loan indentures and
out of contributed covenants may limit
capital must come dividend payments to
from retained earnings protect creditors interests
Insolvent firms cant Cumulative feature of
pay dividends preferred stock limits
dividend payments

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 Dividend Policy
Dividend policy: Rationale for determining dividend payouts
Payout ratio
States dividends as a fraction of earnings

dividend dividend per share

payout ratio
earnings EPS

Stability
The constancy of dividends over time
A stable dividend is non-decreasing
A dividend with a stable growth rate increases at a fairly
constant growth rate
 Alternate Policies

Target Payout Ratio

Firm selects a long-run target payout ratio
Stable Dividends Per Share
A constant dividend is paid regardless of earnings
Small Regular Dividend with a Year-End Extra if
Earnings Permit
An effort to avoid the signaling effect

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The Mechanics of Dividend Payments

Each quarterly dividend has key dates:

Declaration Date: Date the board authorizes the
dividend
Date of Record: Date by which you must be an
owner to receive the dividend
Payment Date: Date on which the dividend will
actually be paid check in the mail
Ex-Dividend Date: Date from which new stock
buyers no longer receive the dividend

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Figure 15.1 The Dividend Declaration
and Payment Process

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 Dividend Reinvestment Plans

Large companies offer automatic dividend

reinvestment plans (DRIPs) to stockholders
Instead of receiving cash dividends, the stockholder
receives additional shares
The payment is taxable
Dont confuse with stock dividend

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 Example 15-5 Reinvestment Plan

Dinsmore has a dividend reinvestment plan in

which 40% of the shareholders participate
The firm typically pays out about 30% of
earnings in dividends
EPS is expected to be about $6.50
There is 6 million outstanding common shares
How much new equity capital is Dinsmore
likely to raise from retained earnings and its
reinvestment program?
 Solution Example 15-5
To compute for the total earnings
Earnings= EPS x Outstanding Shares
Earnings= $6.50 x 6 million
Earnings = 39 million
To compute for the Retained Earnings
Retained Earnings= retention ratio(r) x earnings
Retention ratio(r) = 1-d
d = dividend payout
Retained Earnings=(1-30%) x 39 million
Retained Earnings= 27.3 million
To compute for dividends
Dividends= Earnings Retained Earnings
Dividends= 39 million 27.3 million
Dividends= 11.7 million
 To compute for dividends
Dividends= Earnings Retained Earnings
Dividends= 39 million 27.3 million
Dividends= 11.7 million
To compute for reinvestment program
Reinvestment= dividends x participation rate
Reinvestment=11.7 million x 40%
Reinvestment= 4.68 million
NEW EQUITY FROM RETAINED
EARNINGS AND REINVESTMENT
PROGRAM
New Equity = Retained Earnings + Reinvested Dividends
New Equity = 27.3 million + 4.68 million
NEW EQUITY = 31.98 MILLION
 Stock Splits and Dividends

Stock Split Stock Dividend

Stockholders issued Similar to stock split
new shares in proportion
to current holdings Called a stock
The number of new dividend if the number
shares issued is greater of new shares is less
than 20% of previously than or equal to 20%
outstanding shares of previously
No change in outstanding shares
proportionate ownership
of company
Reverse splits also
possible

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 Rationale for Stock Splits and
Stock Dividends
Stock Split Stock Dividend
Trading Range Argument Giving Something that
for splits Doesnt Cost Anything
Splits keep stock Stock dividends are an
prices in a trading attempt at signaling
range: accessible to
Employed to send a
small investors
positive message
Stock usually split when
prices are increasing Doesnt really give
May give false shareholders anything
impression that price
increase is from split
 Effect On Price And Value

Splits and stock dividends increase

shares outstanding without changing
economic value of the underlying
company
Have no real economic effect

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Accounting for a Stock Split
Accounting for a Stock Dividend
 Stock Repurchases

Alternative to Dividend
Firms with cash on hand can pay dividends
or repurchase their own stock
Repurchase reduces the number of shares
outstanding and increases EPS
Remaining shares will increase in value if the
market maintains the P/E ratio after the
repurchase

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 Concept Connection Example 15-
6
Stock Repurchases
The Johnson Company has 2,500,000 shares of common stock
outstanding, net income of $5 million, and a P/E ratio of 10.

EPS = $5,000,000 / 2,500,000 = $2.00 per share;

Market price = $2.00 x 10 = $20.

Johnson has $1 million in cash to distribute to stockholders.

Per share dividend
$1,000,000 / 2,500,000 = $0.40 per share

If Johnson repurchases shares instead it will retire

$1,000,000 / $20 = 50,000 shares
leaving 2,450,000 shares outstanding

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 Stock Repurchases

The new EPS will be

$5,000,000 / 2,450,000 = $2.04
per share.

If the P/E ratio remains unchanged, the

stock price will be
$2.04 x 10 = $20.40
A price appreciation equal to the
dividend

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 Stock Repurchases

Methods of Repurchasing Shares

Buy on open market easiest method
Tender offer buy shares at a set price offered to
interested stockholders
Negotiated deal buy from a large investor who
owns a block of stock

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 Other Repurchase Issues

Opportunistic Repurchase
Stock is temporarily undervalued
Repurchase to Dispose of Excess Cash
Distributes cash without a signaling effect

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 Other Repurchase Issues

Taxes
Occasional stock repurchases can benefit
stockholders because capital gains tax rates may
be lower than ordinary rates
Repurchases to Restructure Capital
Borrowing money to repurchase stock raises
leverage level and debt ratio

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