Div Policy

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Chapter 18Chapter 18

Dividend PolicyDividend PolicyDividend PolicyDividend Policy

© Pearson Education Limited 2004Fundamentals of Financial Management, 12/e

Created by: Gregory A. Kuhlemeyer, Ph.D.Carroll College, Waukesha, WI

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After studying Chapter 18, After studying Chapter 18, you should be able to:you should be able to:

Understand the dividend retention versus distribution dilemma faced by the firm.

Explain the Modigliani and Miller (M&M) argument that dividends are irrelevant.

Explain the counterarguments to M&M - that dividends do matter.

Identify and discuss the factors affecting a firm's dividend and retention of earnings policy.

Define, compare, and justify cash dividends, stock dividends, stock splits, and reverse stock splits.

Define “stock repurchase” and explain why (and how) a firm might repurchase stock.

Summarize the standard cash dividend payment procedures and critical dates.

Define and discuss dividend reinvestment plans (DRIPs).

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Dividend PolicyDividend Policy

Passive Versus Active Dividend Policies

Factors Influencing Dividend Policy Dividend Stability Stock Dividends and Stock Splits Stock Repurchase Administrative Considerations

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Dividends as a Dividends as a Passive ResidualPassive Residual

The firm uses earnings plus the additional financing that the increased equity can support to finance any expected positive-NPV projects.

Any unused earnings are paid out in the form of dividends. This describes a passive dividend policy.

Can the payment of cash dividends affect Can the payment of cash dividends affect shareholder wealth?shareholder wealth?

If so, what dividend-payout ratio will If so, what dividend-payout ratio will maximize shareholder wealth?maximize shareholder wealth?

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Irrelevance of DividendsIrrelevance of Dividends

M&M contend that the effect of dividend payments on shareholder wealth is exactly offset by other means of financing.

The dividend plus the “new” stock price after dilutiondilution exactly equals the stock price prior to the dividend distribution.

A. Current dividends versus retention A. Current dividends versus retention of earningsof earnings

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Irrelevance of DividendsIrrelevance of Dividends

M&M and the total-value principle ensures that the sum of market value plus current dividends of two firms identical in all respects other than dividend-payout ratios will be the same.

Investors can “create” any dividend policy they desire by selling shares when the dividend payout is too low or buying shares when the dividend payout is excessive.

B. Conservation of valueB. Conservation of value

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Relevance of DividendsRelevance of Dividends

Uncertainty surrounding future company profitability leads certain investors to prefer the certainty of current dividends.

Investors prefer “large” dividends.

Investors do not like to manufacture “homemade” dividends, but prefer the company to distribute them directly.

A. Preference for dividendsA. Preference for dividends

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Capital gains taxes are deferred until the actual sale of stock. This creates a timing option.

Capital gains are preferred to dividends, everything else equal. Thus, high dividend-yielding stocks should sell at a discount to generate a higher before-tax rate of return.

Certain institutional investors pay no tax.

B. Taxes on the investorB. Taxes on the investor

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Corporations can typically exclude 70% of dividend income from taxation. Thus, corporations generally prefer to receive dividends rather than capital gains.

The result is clienteles of investors with different dividend preferences. In equilibrium, there will be the proper distribution of firms with differing dividend policies to exactly meet the needs of investors.

Thus, dividend-payout decisions are irrelevant.Thus, dividend-payout decisions are irrelevant.

B. Taxes on the investor (continued)B. Taxes on the investor (continued)

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Other Dividend IssuesOther Dividend Issues

Flotation costs

Transaction costs and divisibility of securities

Institutional restrictions

Financial signaling

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Empirical Testing Empirical Testing of Dividend Policyof Dividend Policy

Tax EffectTax Effect Dividends are taxed more heavily (in PV terms) than

capital gains, so before-tax returns should be higher for high-dividend-paying firms.

Empirical results are mixed -- recently the evidence is largely consistent with dividend neutrality.

Financial SignalingFinancial Signaling Expect that increases (decreases) in dividends lead

to positive (negative) excess stock returns. Empirical results are consistent with these

expectations.

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Implications for Implications for Corporate PolicyCorporate Policy

Establish a policy that will maximize shareholder wealth.

Distribute excess funds to shareholders and stabilize the absolute amount of dividends if necessary (passive).

Payouts greater than excess funds should occur only in an environment that has a net preference for dividends.

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Implications for Implications for Corporate PolicyCorporate Policy

There is a positive value associated with a modest dividend. Could be due to institutional restrictions or signaling effects.

Dividends in excess of the passive policy does not appear to lead to share price improvement because of taxes and flotation costs.

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Factors Influencing Factors Influencing Dividend PolicyDividend Policy

Capital Impairment RuleCapital Impairment Rule -- many states prohibit the payment of dividends if these dividends impair “capital” (usually either par value of common stock or par plus additional paid-in capital).

Incorporation in some states (notably Delaware) allows a firm to use the “fair value,” rather than “book value,” of its assets when judging whether a dividend impairs “capital.”

Legal RulesLegal Rules

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Insolvency RuleInsolvency Rule -- some states prohibit the payment of cash dividends if the company is insolvent under either a “fair market valuation” or “equitable” sense.

Undue Retention of Earnings RuleUndue Retention of Earnings Rule -- prohibits the undue retention of earnings in excess of the present and future investment needs of the firm.

Legal RulesLegal Rules

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Funding Needs of the Firm Liquidity Ability to Borrow Restrictions in Debt Contracts

(protective covenants) Control

Other Issues to ConsiderOther Issues to Consider

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Dividend StabilityDividend Stability

Stability Stability -- maintaining the position of the firm’s -- maintaining the position of the firm’s dividend payments in relation to a trend line.dividend payments in relation to a trend line.

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Earnings per shareEarnings per share

DividendsDividendsper shareper share

Time

50% of earningspaid out as dividends

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Dividend StabilityDividend Stability

Dividends begin at 50% of earnings, but are stable and Dividends begin at 50% of earnings, but are stable and increase only when supported by growth in earnings.increase only when supported by growth in earnings.

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Earnings per shareEarnings per share

Dividends per shareDividends per share

Time

50% dividend-payoutrate with stability

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Valuation of Valuation of Dividend StabilityDividend Stability

Information contentInformation content -- management may be able to affect the expectations of investors through the informational content of dividends. A stable dividend suggests that the company expects stable or growing dividends in the future.

Current income desiresCurrent income desires -- some investors who desire a specific periodic income will prefer a company with stable dividends to one with unstable dividends.

Institutional considerationsInstitutional considerations -- a stable dividend may permit certain institutional investors to buy the common stock as they meet the requirements to be placed on the organizations “approved list.”

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Types of DividendsTypes of Dividends

Extra dividendExtra dividend A nonrecurring dividend paid to

shareholders in addition to the regular dividend. It is brought about by special circumstances.

Regular DividendRegular Dividend The dividend that is normally expected to

be paid by the firm.

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Stock Dividends Stock Dividends and Stock Splitsand Stock Splits

Small-percentage stock dividendsSmall-percentage stock dividends Typically less than 25% of previously

outstanding common stock. Assume a company with 400,000 shares of $5 par

common stock outstanding pays a 5% stock dividend. The pre-dividend market value is $40. How does this impact the shareholders’ equity How does this impact the shareholders’ equity accounts?accounts?

Stock DividendStock Dividend -- A payment of additional shares of stock to shareholders. Often used in place of or in addition to a cash dividend.

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B/S Changes for the Small-B/S Changes for the Small-Percentage Stock DividendPercentage Stock Dividend

$800,000 ($5 x 20,000 new shares) transferred (on paper) “out of” retained earnings.

$100,000 transferred “into” common stock account.

$700,000 ($800,000 - $100,000) transferred “into” additional paid-in-capital.

“Total shareholders’ equity” remains unchanged at $10 million.

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Small-Percentage Small-Percentage Stock DividendsStock Dividends

Before 5% Stock DividendBefore 5% Stock DividendCommon stock ($5 par; 400,000 shares400,000 shares) $ 2,000,000$ 2,000,000Additional paid-in capitalAdditional paid-in capital 1,000,000 1,000,000Retained earningsRetained earnings 7,000,000 7,000,000 Total shareholders’ equity $10,000,000

After 5% Stock DividendAfter 5% Stock DividendCommon stock ($5 par; 420,000 shares420,000 shares) $ 2,100,000$ 2,100,000Additional paid-in capitalAdditional paid-in capital 1,700,000 1,700,000Retained earningsRetained earnings 6,200,000 6,200,000 Total shareholders’ equity $10,000,000

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Stock Dividends, Stock Dividends, EPS, and Total EarningsEPS, and Total Earnings

Assume that investor SP owns 10,000 shares and the Assume that investor SP owns 10,000 shares and the firm earned $2.50 per share.firm earned $2.50 per share.

Total earnings = $2.50 x 10,000 = $25,000.

After the 5% dividend, investor SP owns 10,500 shares 10,500 shares and the same proportionate earnings of $25,000.

EPS is then reduced to $2.38 per share because of the stock dividend ($25,000 / 10,500 shares = $2.38 EPS$2.38 EPS).

After a small-percentage stock dividend, what After a small-percentage stock dividend, what happens to EPS and total earnings of happens to EPS and total earnings of

individual investors?individual investors?

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Typically 25% or greater of previously outstanding common stock.

The material effect on the market price per share causes the transaction to be accounted for differently. Reclassification is limited to the par value of additional shares rather than pre-stock-dividend value of additional shares.

Assume a company with 400,000 shares of $5 par common stock outstanding pays a 100% stock dividend. The pre-stock-dividend market value per share is $40. How does this impact the shareholders’ equity accounts?How does this impact the shareholders’ equity accounts?

Large-percentage stock dividendsLarge-percentage stock dividends

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B/S Changes for the Large-B/S Changes for the Large-Percentage Stock DividendPercentage Stock Dividend

$2 million ($5 x 400,000 new shares) transferred (on paper) “out of” retained earnings.

$2 million transferred “into” common stock account.

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Large-Percentage Large-Percentage Stock DividendsStock Dividends

Before 100% Stock DividendBefore 100% Stock DividendCommon stock ($5 par; 400,000 shares400,000 shares) $ 2,000,000$ 2,000,000Additional paid-in capitalAdditional paid-in capital 1,000,000 1,000,000Retained earningsRetained earnings 7,000,000 7,000,000 Total shareholders’ equity $10,000,000

After 100% Stock DividendAfter 100% Stock DividendCommon stock ($5 par; 800,000 shares800,000 shares) $ 4,000,000$ 4,000,000Additional paid-in capitalAdditional paid-in capital 1,000,000 1,000,000Retained earningsRetained earnings 5,000,000 5,000,000 Total shareholders’ equity $10,000,000

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Similar economic consequences as a 100% stock dividend.

Primarily used to move the stock into a more Primarily used to move the stock into a more popular trading range and increase share demand.popular trading range and increase share demand.

Assume a company with 400,000 shares of $5 par common stock splits 2-for-1. How does this impact How does this impact the shareholders’ equity accounts?the shareholders’ equity accounts?

Stock SplitStock Split -- An increase in the number of shares outstanding by reducing the par value

of the stock.

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Stock SplitsStock Splits

Before 2-for-1 Stock SplitBefore 2-for-1 Stock SplitCommon stock ($5 par; 400,000 shares400,000 shares) $ 2,000,000$ 2,000,000Additional paid-in capitalAdditional paid-in capital 1,000,000 1,000,000Retained earningsRetained earnings 7,000,000 7,000,000 Total shareholders’ equity $10,000,000

After 2-for-1 Stock SplitAfter 2-for-1 Stock SplitCommon stock ($2.50 par; 800,000 shares800,000 shares) $ 2,000,000$ 2,000,000Additional paid-in capitalAdditional paid-in capital 1,000,000 1,000,000Retained earningsRetained earnings 7,000,000 7,000,000 Total shareholders’ equity $10,000,000

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Value to Investors of Stock Value to Investors of Stock Dividends or Stock SplitsDividends or Stock Splits

Effect on investor total wealth

Effect on investor psyche

Effect on cash dividends

More popular trading range

Informational content

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Used to move the stock into a more popular trading range and increase share demand.

Usually signals negative information to the market upon its announcement (consistent with empirical evidence).

Assume a company with 400,000 shares of $5 par common stock splits 1-for-4. How does this impact How does this impact the shareholders’ equity accounts?the shareholders’ equity accounts?

Reverse Stock SplitReverse Stock Split -- A stock split in which the number of shares outstanding is decreased.

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Reverse Stock SplitsReverse Stock Splits

Before 1-for-4 Stock SplitBefore 1-for-4 Stock SplitCommon stock ($5 par; 400,000 shares400,000 shares) $ 2,000,000$ 2,000,000Additional paid-in capitalAdditional paid-in capital 1,000,000 1,000,000Retained earningsRetained earnings 7,000,000 7,000,000 Total shareholders’ equity $10,000,000

After 1-for-4 Stock SplitAfter 1-for-4 Stock SplitCommon stock ($20 par; 100,000 shares100,000 shares) $ 2,000,000$ 2,000,000Additional paid-in capitalAdditional paid-in capital 1,000,000 1,000,000Retained earningsRetained earnings 7,000,000 7,000,000 Total shareholders’ equity $10,000,000

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Stock RepurchaseStock Repurchase

Reasons for stock repurchase:

Available for management stock-option plans

Available for the acquisition of other companies

“Go private” by repurchasing all shares from outside stockholders

To permanently retire the shares

Stock RepurchaseStock Repurchase -- The repurchase (buyback) of stock by the issuing firm, either in the open

(secondary) market or by self-tender offer.

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Methods of RepurchaseMethods of Repurchase Fixed-price self-tender offerFixed-price self-tender offer -- An offer by a firm to

repurchase some of its own shares, typically at a set price.

Dutch auction self-tender offerDutch auction self-tender offer -- A buyer (seller) seeks bids within a specified price range, usually for a large block of stock or bonds. After evaluating the range of bid prices received, the buyer (seller) accepts the lowest price that will allow it to acquire (dispose of) the entire block.

Open-market purchaseOpen-market purchase -- A company repurchases its stock through a brokerage house on the secondary market.

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Repurchasing as Repurchasing as Part of Dividend PolicyPart of Dividend Policy

AssumeAssume:: Earnings after taxes $ 800,000 Number of common Number of common

shares outstanding shares outstanding 400,000 400,000 Earnings per share Earnings per share $ 2 $ 2 Current market price

per share $ 31 Expected dividend per share $ 1 Expected total dividendsExpected total dividends to be to be

paid outpaid out $ 400,000 $ 400,000

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Repurchasing as Repurchasing as Part of Dividend PolicyPart of Dividend Policy

If dividend is paid, shareholders receiveIf dividend is paid, shareholders receive:: Expected dividend per share $ 1 Market price per share Market price per share $ 30$ 30 Total valueTotal value $ 31 $ 31

If shares repurchased, shareholders receiveIf shares repurchased, shareholders receive:: Dividend per share $ 0 Market price per share* $ 31 Total valueTotal value $ 31 $ 31

* Shares repurchased = $400,000 / $31 = 12,903 Original P/E ratio = $30$30/$2 = 15 “New” EPS = $800,000 / 387,097 = $2.07 “New” market price = $2.07 x 15 = $31

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Summary of Repurchasing Summary of Repurchasing as Part of Dividend Policyas Part of Dividend Policy

The capital gain arising from the repurchase (stock rising from $30 to $31) exactly equals the dividend ($1) that would have otherwise been paid.

This result holds in the absence of taxes and transaction costs.

To the taxable investor, capital gains (repurchases) are favored to dividend income as the tax on the capital gain is postponed until the actual sale of the common shares.

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Summary of Repurchasing Summary of Repurchasing as Part of Dividend Policyas Part of Dividend Policy

Stock repurchases are most relevant for firms with large amounts of excess cash that might otherwise generate a significant taxable transaction to investors.

Firms must be careful not to make regularly occurring repurchases or the IRS may consider the capital gains as dividends for tax purposes.

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Investment or Investment or Financing Decision?Financing Decision?

Financing DecisionFinancing Decision It possesses capital structure or dividend policy

motivations.

For example, a repurchase immediately changes the debt-to-equity ratio (higher financial leverage).

Investing DecisionInvesting Decision Not really, as stock that is repurchased is held as

treasury stock and does not provide an expected return like other investments.

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Possible Signaling EffectPossible Signaling Effect

Repurchases have a positive signaling effect. For example, if the stock is undervalued

management may tender for shares at a “premium.” This signals that the share prices are undervalued.

Dutch-auction self-tenders have less signaling power likely due to a smaller tender premium.

Open-market purchases have only a modest positive signaling effect likely due to many programs being instituted after significant share price declines.

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Administrative Considerations: Administrative Considerations: Procedural AspectsProcedural Aspects

Record Date Record Date -- The date, set by the board of directors when a dividend is declared, on which an investor must be a shareholder of record to

be entitled to the upcoming dividend.

The board of directors met on May 8th to declare a dividend payable to shareholders on June 15th

to the shareholders of record on May 31st.

May 8 May 29 May 31May 31 June 15

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Ex-dividend Date Ex-dividend Date -- The first date on which a stock purchaser is no longer entitled to the

recently declared dividend.

The buyer and seller of the shares have several days to settlesettle (pay for the shares or deliver the shares). The

brokerage industry has a rule that new shareholders are entitled to dividends only if they purchase the stock at

least two business days prior to the record date.

May 8 May 29May 29 May 31 June 15

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Declaration Date Declaration Date -- The date that the board of directors announces the amount and date of the

next dividend.

Payment Date Payment Date -- The date when the corporation actually pays the declared dividend.

May 8May 8 May 29 May 31 June 15June 15

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Dividend Dividend Reinvestment PlansReinvestment Plans

The firm can use existing stock. A trustee (e.g., a bank) purchases the stock on the open market and credits current shareholders with the new shares.

The firm can issue new stock. This method raises “new” funds for the firm. The plan essentially reduces the effective dividend-payout ratio.

Some plans offer discounts and eliminate brokerage costs for current shareholders.

Dividend Reinvestment Plan (DRIP) Dividend Reinvestment Plan (DRIP) -- An optional plan allowing shareholders to automatically reinvest dividend payments in additional shares of the

company’s stock.

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