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Foundations of FinanceArthur Keown John D. Martin

J. William Petty

Dividend Policy and Internal FinancingChapter 13

Learning Objectives1.

Describe the trade-off between paying dividends and retaining the profits within the company Explain the relationship between a corporations dividend policy and the market price of its common stock Describe practical considerations that may be important to the firms dividend policy Distinguish among the types of dividend policies corporations frequently use.Keown Martin Petty - Chapter 13 3

2.

3.

4.

Learning Objectives5.

Specify the procedures a company follows in administering the dividend payment.Describe why and how a firm might pay noncash dividends (stock dividends and stock splits) instead of cash dividends. Explain the purpose and procedures related to stock repurchases.

6.

7.

8.

Understanding the relationship between a policy of low-dividend payments and international capital budgeting opportunities that confront the multinational firm.Keown Martin Petty - Chapter 13 4

Slide Contents1. 2. 3. 4. 5. 6.

Principles Used in this Chapter Dividends Dividend Policy and Shareholder Wealth

Conclusions on Dividend PolicyDividend Decision in Practice Stock Dividend/Split/Repurchase

7.

Finance and the Multinational FirmKeown Martin Petty - Chapter 13 5

1. Principles Used in this Chapter

Principles used in this Chapter

Principle 2:

The time value of money A dollar received today is worth more than a dollar received in the future.

Principle 8:

Taxes bias business decisions

Keown Martin Petty - Chapter 13

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2. Dividends

What are Dividends?

Dividends are distribution from the firm's assets to the shareholders. Firms are not obligated to pay dividends or maintain a consistent policy with regard to dividends. Dividends can be paid in cash or stocks.

Keown Martin Petty - Chapter 13

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Dividend Policy

A firms dividend policy includes two components:1.

Dividend Payout ratio

Indicates amount of dividend paid relative to the companys earnings. Example: If dividend per share is $1 and earnings per share is $2, the payout ratio is 50% (1/2)

2.

Stability of dividends over timeKeown Martin Petty - Chapter 13 10

Dividend Policies Vary

General Electric (GE) has paid dividends continuously since 1899. Microsoft (MSFT) went public in 1986 but did not pay dividends until June, 2003. Berkshire Hathaway (BRK) has not yet paid dividends.

Keown Martin Petty - Chapter 13

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Dividend Policy Trade-offs

If management has decided how much to invest and has chosen the debt-equity mix, decision to pay a large dividend means retaining less of the firms profits. This means the firm will have to rely more on external equity financing. Similarly, a smaller dividend payment will lead to less reliance on external financing.Keown Martin Petty - Chapter 13 12

Keown Martin Petty - Chapter 13

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3. Dividend Policy and Shareholders Wealth

Dividend Policy and Share Prices

Dividend policy is considered as a puzzle with no clear answers. As Fischer Black concluded more than 30 years ago:

"What should the individual investor do about dividends in the portfolio? We don't know! What should the corporation do about dividend policy? We don't know!

Keown Martin Petty - Chapter 13

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Three Views

There are three basic views with regard to the impact of dividend policy on share prices:1.2. 3.

Dividend policy is irrelevant.High dividends will increase share prices.

Low dividends will increase share prices.Keown Martin Petty - Chapter 13 16

View #1 Dividend policy is irrelevant

Irrelevance implies shareholder wealth is not affected by dividend policy (whether the firm pays 0% or 100% of its earnings as dividends).

This view is based on two assumptions:(a) Perfect capital markets exist; and (b) The firms investment and borrowing decisions have been made and will not be altered by dividend payment.

Keown Martin Petty - Chapter 13

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View #2

High dividends increase stock value

This position in based on bird-in-the-hand theory, which argues that investors may prefer dividend today as it is less risky compared to uncertain future capital gains. Thus shareholders will demand a relatively higher rate of return for stocks that do not pay low or no dividends.

Keown Martin Petty - Chapter 13

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View #3

Low dividends increases stock value

In 2003, the tax rates on capital gains and dividends were made equal to 15 percent. However, current dividends are taxed immediately while the tax on capital gains can be deferred until the stock is actually sold. Thus, using present value of money, capital gains have definite financial advantages for shareholders. Thus stocks that allow tax deferral (low dividends-high capital gains) will possibly sell at a premium relative to stocks that require current taxation (high dividends low capital gains).Keown Martin Petty - Chapter 13 19

Some other explanations1. 2. 3. 4. 5.

Residual Dividend theory Clientele effect

Information effectAgency costs

Expectations theoryKeown Martin Petty - Chapter 13 20

Residual Dividend Theory1. 2. 3. 4.

Determine the optimal capital budget. Determine the amount of equity needed for financing. First, use retained earnings to supply this equity. If RE still left, pay out dividends. Dividend Policy will be influenced by:(a) investment opportunities or capital budgeting needs, and

(b) availability of internally generated capital.

Keown Martin Petty - Chapter 13

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The Clientele Effect

Different groups of investors have varying preferences towards dividends. For example, some investors may prefer a fixed income stream so would prefer firms with high dividends while some investors, such as wealthy investors, would prefer to defer taxes and will be drawn to firms that have low dividend payout. Thus there will be a clientele effect.

Keown Martin Petty - Chapter 13

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The Information Effect

Evidence shows that large, unexpected change in dividends can have a significant impact on the stock prices. A firms dividend policy may be seen as a signal about firms financial condition. Thus, high dividend could signal expectations of high earnings in the future and vice versa.

Keown Martin Petty - Chapter 13

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Agency Costs

Dividend policy may be perceived as a tool to minimize agency costs. Dividend payment may require managers to issue stock to finance new investments. New investors will be attracted only if they are convinced that the capital will be used profitably. Thus, payment of dividends indirectly monitors managements investment activities and helps reduce agency costs, and may enhance the value of the firm.

Keown Martin Petty - Chapter 13

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Expectations Theory

Expectation theory suggests that the market reaction does not only reflect response to the firms actions; it also indicates investors expectations about the ultimate decision to be made by management.

Thus if the amount of dividend paid is equal to the dividend expected by shareholders, the market price of stock will remain unchanged. However, market will react if dividend payment is not consistent with shareholders expectations.

Keown Martin Petty - Chapter 13

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4. Conclusions on Dividend Policy

What are we to conclude?

Here are some conclusions about the relevance of dividend policy:1.

As a firms investment opportunities increase, its dividend payout ratio should decrease. Investors use the dividend payment as a source of information of expected earnings.Keown Martin Petty - Chapter 13 27

2.

What are we to conclude?3.

Relationship between stock prices and dividends may exist due to implications of dividends for taxes and agency costs. Based on expectations theory, firms should avoid surprising investors with regard to dividend policy. The firms dividend policy should effectively be treated as a long-term residual.Keown Martin Petty - Chapter 13 28

4.

5.

5. Dividend Decision in Practice

Dividend Decision in Practice

Legal Restrictions

Statutory restrictions may prevent a company from paying dividends Debt and preferred stock contracts may impose constraints on dividend policy

Liquidity Constraints

A firm may show earnings but it must have cash to pay dividends.Keown Martin Petty - Chapter 13 30

Dividend Decision in Practice

Earnings Predictability

A firm with stable and predictable earnings is more likely to pay larger dividends.

Maintaining Ownership Control

Ownership of common stock gives voting rights. If existing stockholders are unable to participate in a new offering, control of current stockholders is diluted and issuing new stock will be considered unattractive.Keown Martin Petty - Chapter 13 31

Alternative Dividend Policies

Constant dividend payout ratio

The % of earnings paid out in dividends is held constant. Since earnings are not constant, the dollar amount of dividend will vary every year.

Stable dollar dividend per share

This policy maintains a constant dollar every year. Management will increase the dollar amount only if they are convinced that such increase can be maintained.Keown Martin Petty - Chapter 13 32

Alternative Dividend Policies

A small regular di