Dividend Policy

2002, Prentice Hall, Inc.

Return =

Capital Gain

P1 - Po + D1

Po

P1 - Po D1

Po Po+=

Stock Returns:

Return =

Capital Gain Dividend Yield

+=

Stock Returns:

P1 - Po + D1

Po

P1 - Po D1

Po Po

Dilemma: Should the firm use retained earnings for:

a) Financing profitable capital investments?

b) Paying dividends to stockholders?

• If we retain earnings for profitable investments, dividend yield will be zero, but the stock price will increase, resulting in a higher capital gain.

P1 - Po D1

Po Po+Return =

• If we pay dividends, stockholders receive an immediate cash reward for investing, but the capital gain will decrease, since this cash is not invested in the firm.

P1 - Po D1

Po Po+Return =

So, dividend policy really involves 2 decisions:

• How much of the firm’s earnings should be distributed to shareholders as dividends, and

• How much should be retained for capital investment?

Is Dividend Policy Important?

Three viewpoints:

1) Dividends are Irrelevant. If we assume perfect markets (no taxes, no transaction costs, etc.) dividends do not matter. If we pay a dividend, shareholders’ dividend yield rises, but capital gains decrease.

• With perfect markets, investors are concerned only with total returns, and do not care whether returns come in the form of capital gains or dividend yields.

• Therefore, one dividend policy is as good as another.

P1 - Po D1

Po Po+Return =

2) High Dividends are Best

• Some investors may prefer a certain dividend now over a risky expected capital gain in the future.

2) High Dividends are Best

• Some investors may prefer a certain dividend now over a risky expected capital gain in the future.

P1 - Po D1

Po Po+Return =

3) Low Dividends are Best

• Dividends are taxed immediately. Capital gains are not taxed until the stock is sold.

• Therefore, taxes on capital gains can be deferred indefinitely.

Do Dividends Matter?

Other Considerations:

1) Residual Dividend Theory:

• The firm pays a dividend only if it has retained earnings left after financing all profitable investment opportunities.

• This would maximize capital gains for stockholders and minimize flotation costs of issuing new common stock.


2) Clientele Effects: • Different investor clienteles prefer different

dividend payout levels.• Some firms, such as utilities, pay out over

70% of their earnings as dividends. These attract a clientele that prefers high dividends.

• Growth-oriented firms which pay low (or no) dividends attract a clientele that prefers price appreciation to dividends.


3) Information Effects:

• Unexpected dividend increases usually cause stock prices to rise, and unexpected dividend decreases cause stock prices to fall.

• Dividend changes convey information to the market concerning the firm’s future prospects.


4) Agency Costs: • Paying dividends may reduce agency

costs between managers and shareholders.

• Paying dividends reduces retained earnings and forces the firm to raise external equity financing.

• Raising external equity subjects the firm to scrutiny of regulators (SEC) and investors and therefore helps monitor the performance of managers.


5) Expectations Theory:

• Investors form expectations concerning the amount of a firm’s upcoming dividend.

• Expectations are based on past dividends, expected earnings, investment and financing decisions, the economy, etc.

• The stock price will likely react if the actual dividend is different from the expected dividend.

Dividend Policies

1) Constant Dividend Payout Ratio: if directors declare a constant payout ratio of, for example, 30%, then for every dollar of earnings available to stockholders, 30 cents would be paid out as dividends.

• The ratio remains constant over time, but the dollar value of dividends changes as earnings change.

Dividend Policies

2) Stable Dollar Dividend Policy: the firm tries to pay a fixed dollar dividend each quarter.

• Firms and stockholders prefer stable dividends. Decreasing the dividend sends a negative signal!

Dividend Policies

3) Small Regular Dividend plus Year-End Extras

• The firm pays a stable quarterly dividend and includes an extra year-end dividend in prosperous years.

• By identifying the year-end dividend as “extra,” directors hope to avoid signaling that this is a permanent dividend.

Dividend Payments

1) Declaration Date: the board of directors declares the dividend, determines the amount of the dividend, and decides on the payment date.

Jan.4 Jan.30 Feb.1 Mar. 11

Declare Ex-div. Record Paymentdividend date date date

Dividend Payments2) Ex-Dividend Date:



Dividend Payments2) Ex-Dividend Date: To receive the

dividend, you have to buy the stock before the ex-dividend date. On this date, the stock begins trading “ex-dividend” and the stock price falls approximately by the amount of the dividend.



Dividend Payments3) Date of Record:



Dividend Payments3) Date of Record: 2 days after the ex-

dividend date, the firm receives the list of stockholders eligible for the dividend.

• Often, a bank trust department acts as registrar and maintains this list for the firm.



Dividend Payments

4) Payment Date: date on which the firm mails the dividend checks to the shareholders of record.



Stock Dividends and Stock Splits

• Stock dividend: payment of additional shares of stock to common stockholders.

• Example: Citizens Bancorporation of Maryland announces a 5% stock dividend to all shareholders of record. For each 100 shares held, shareholders receive another 5 shares.

• Does the shareholders’ wealth increase?


• Stock Split: the firm increases the number of shares outstanding and reduces the price of each share.

• Example: Joule, Inc. announces a 3-for-2 stock split. For each 100 shares held, shareholders receive another 50 shares.

• Does this increase shareholder wealth?

• Are a stock dividend and a stock split the same?


• Stock Splits and Stock Dividends are economically the same: the number of shares outstanding increases and the price of each share drops. The value of the firm does not change.

• Example: A 3-for-2 stock split is the same as a 50% stock dividend. For each 100 shares held, shareholders receive another 50 shares.


• Effects on Shareholder Wealth:


• Effects on Shareholder Wealth: these will cut the company “pie” into more pieces but will not create wealth. A 100% stock dividend (or a 2-for-1 stock split) gives shareholders 2 half-sized pieces for each full-sized piece they previously owned.


• Effects on Shareholder Wealth: these will cut the company “pie” into more pieces but will not create wealth. A 100% stock dividend (or a 2-for-1 stock split) gives shareholders 2 half-sized pieces for each full-sized piece they previously owned.

• For example, this would double the number of shares, but would cause a $60 stock price to fall to $30.


• Why bother? • Proponents argue that these are used to

reduce high stock prices to a “more popular” trading range (generally $15 to $70 per share).

• Opponents argue that most stocks are purchased by institutional investors who have millions of dollars to invest and are indifferent to price levels. Plus, stock splits and stock dividends are expensive!

Stock Dividend Example

• shares outstanding: 1,000,000

• net income = $6,000,000;

• P/E = 10

• 25% stock dividend.

• An investor has 120 shares. Does the value of the investor’s shares change?

Before the 25% stock dividend:

• EPS = 6,000,000/1,000,000 = $6

• P/E = P/6 = 10, so P = $60 per share.

• Value = $60 x 120 shares = $7,200

After the 25% stock dividend:

• # shares = 1,000,000 x 1.25 = 1,250,000.

• EPS = 6,000,000/1,250,000 = $4.80

• P/E = P/4.80 = 10, so P = $48 per share.

• Investor now has 120 x 1.25 = 150 shares.

• Value = $48 x 150 = $7,200

Stock DividendsIn-class Problem

shares outstanding: 250,000

net income = $750,000;

stock price = $84

50% stock dividend.

What is the new stock price?

Hint:

stock price

P/E = net income

# shares( )

Before the 50% stock dividend:

• EPS = 750,000 / 250,000 = $3

• P/E = 84 / 3 = 28.

After the 50% stock dividend:

• # shares = 250,000 x 1.50 = 375,000.

• EPS = 750,000 / 375,000 = $2

• P/E = P / 2 = 28, so P = $56 per share.

(a 50% stock dividend is equivalent to a 3-for-2 stock split)

Stock Repurchases

• Stock Repurchases may be a good substitute for cash dividends.

• If the firm has excess cash, why not buy back common stock?

Stock Repurchases

• Stock Repurchases may be a good substitute for cash dividends.

• If the firm has excess cash, why not buy back common stock?

Stock Repurchases

• Repurchases drive up the stock price, producing capital gains for shareholders.

• Repurchases increase leverage, and can be used to move toward the optimal capital structure.

• Repurchases signal positive information to the market - which increases stock price.

Stock Repurchases

Methods:

• Buy shares in the open market through a broker.

• Buy a large block by negotiating the purchase with a large block holder, usually an institution (targeted stock repurchase).

• Tender offer: offer to pay a specific price to all current stockholders.

Practice Problems

1) ABC Corporation has 1.3 million common shares outstanding and total earnings of $2.4 million. The firm paid dividends totaling $550,000. The firm has no preferred stock.

– What were the dividends per share paid by ABC?

– What was ABC’s dividend payout ratio?

2) Price stock sells for $275 per share and you own 300 shares.

– What is the current market value of your investment?

– What is the new price per share, new amount of shares you will own, and the new market value of your investment if the firm declares a 3 for 1 stock split? If the firm declares a 15% stock dividend?

Practice Problems

3) Semi-Nowl Corporation has 1.1 million shares of 8% cumulative preferred stock outstanding with a stated value of $100 per share. If dividends are not paid for four years, what will be the amount of arrearage?

4) Suppose you own 500 shares of FSU Inc. 12% convertible preferred stock. If each preferred share is convertible into 25 common shares, what is the conversion value of your 5,000 preferred shares if the common stock is trading at $30 per share?

Practice Problems

5) KLM Company issued $3 million of 9.75% $80 par preferred shares in 2001. Calculate the total amount of dividends paid on this issue per year and the annual amount of the dividends per share.

Documents

Dividend Policy