Dividends and Other PayoutsChapter 19Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Key Concepts and SkillsUnderstand dividend types and how they are paidUnderstand the issues surrounding dividend policy decisionsUnderstand why share repurchases are an alternative to dividendsUnderstand the difference between cash and stock dividends

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Chapter Outline19.1 Different Types of Payouts19.2 Standard Method of Cash Dividend Payment19.3 The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy19.4Repurchase of Stock19.5 Personal Taxes, Dividends, and Stock Repurchases19.6 Real-World Factors Favoring a High Dividend Policy19.7 The Clientele Effect: A Resolution of Real-World Factors?19.8 What We Know and Do Not Know about Dividend Policy19.9Putting It All Together19.10 Stock Dividends and Stock Splits

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19.1 Different Types of PayoutsMany 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.Some companies declare a dividend in kind.Wrigleys Gum sends a box of chewing gum.Other companies use stock buybacks.

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19.2 Standard Method of Cash Dividend

Record Date Date on which company determines existing 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.Cash Dividend - Payment of cash by the firm to its shareholders.

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Procedure for Cash Dividend25 Oct.1 Nov.2 Nov.5 Nov.7 Dec.Declaration DateCum-dividend DateEx-dividend DateRecord DatePayment DateDeclaration 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.

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Price BehaviorIn a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date.$P$P - divEx-dividend DateThe price drops by the amount of the cash dividend. -t -2-10+1+2 Taxes complicate things a bit. Empirically, the price drop is less than the dividend and occurs within the first few minutes of the ex-date.

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19.3 The Irrelevance of Dividend PolicyA compelling case can be made that dividend policy is irrelevant.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.

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Homemade DividendsBianchi 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 dividendsCash from dividend$160Cash from selling stock$80Total Cash$240Value of Stock Holdings $40 78 =$3,120 $3 Dividend$240$0$240$39 80 =$3,120

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Dividend Policy Is IrrelevantIn the above example, Bob Investor began with a total wealth of $3,360:After a $3 dividend, his total wealth is still $3,360:After a $2 dividend and sale of 2 ex-dividend shares, his total wealth is still $3,360:

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Dividends and Investment PolicyFirms 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.

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19.4 Repurchase of StockInstead 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.

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Stock Repurchase versus Dividend Consider a firm that wishes to distribute $100,000 to its shareholders.

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Stock Repurchase versus DividendIf they distribute the $100,000 as a cash dividend, the balance sheet will look like this:

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Stock Repurchase versus DividendIf they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:

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Share RepurchaseFlexibility for shareholdersKeeps stock price higher Good for insiders who hold stock optionsAs an investment of the firm (undervaluation)Tax benefits

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19.5 Personal Taxes, Dividends, and Stock RepurchasesTo get the result that dividend policy is irrelevant, we needed three assumptions:No taxesNo transactions costsNo uncertaintyIn the United States, both cash dividends and capital gains are (currently) 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.

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Firms without Sufficient Cash In a world of personal taxes, firms should not issue stock to pay a dividend.FirmStock Holders Cash: stock issueCash: dividendsGov.TaxesInvestment BankersThe direct costs of stock issuance will add to this effect.

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Firms with Sufficient CashThe 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 companiesPurchase financial assetsRepurchase shares

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

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19.6 Real-World Factors Favoring High DividendsDesire for Current IncomeBehavioral FinanceIt forces investors to be disciplined.Tax ArbitrageInvestors can create positions in high dividend yield securities that avoid tax liabilities.Agency CostsHigh dividends reduce free cash flow.

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19.7 The Clientele EffectClienteles for various dividend payout policies are likely to form in the following way:

GroupStock TypeHigh Tax Bracket IndividualsLow Tax Bracket IndividualsTax-Free InstitutionsCorporations Zero-to-Low payoutLow-to-Medium payoutMedium payoutHigh payoutOnce the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy.

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19.8 What We Know and Do Not KnowCorporations 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.

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19.9 Putting It All TogetherAggregate payouts are massive and have increased over time.Dividends are concentrated among a small number of large, mature firms.Managers are reluctant to cut dividends.Managers smooth dividends.Stock prices react to unanticipated changes in dividends.

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19.10 Stock DividendsPay additional shares of stock instead of cashIncreases the number of outstanding sharesSmall stock dividendLess 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%

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Stock SplitsStock splits essentially the same as a stock dividend except it is expressed as a ratioFor 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.

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Quick QuizWhat are the different types of dividends, and how is a dividend paid?What is the clientele effect, and how does it affect dividend policy irrelevance?What is the information content of dividend changes?What are stock dividends, and how do they differ from cash dividends?How are share repurchases an alternative to dividends, and why might investors prefer them?

**5*19*15*16*17*The dividend and capital gains tax rates are subject to change at the discretion of Congress.*www: Click on the web surfer icon to find out about upcoming stock splits and dividends