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Foundations of FinanceArthur Keown

John D. Martin

J. William Petty

Dividend Policy and Internal Financing

Chapter 13

Keown Martin Petty - Chapter 13

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Learning Objectives

1. Describe the trade-off between paying dividends and retaining the profits within the company

2. Explain the relationship between a corporation’s dividend policy and the market price of its common stock

3. Describe practical considerations that may be important to the firm’s dividend policy

4. Distinguish among the types of dividend policies corporations frequently use.


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5. Specify the procedures a company follows in administering the dividend payment.

6. Describe why and how a firm might pay noncash dividends (stock dividends and stock splits) instead of cash dividends.

7. Explain the purpose and procedures related to stock repurchases.

8. Understanding the relationship between a policy of low-dividend payments and international capital budgeting opportunities that confront the multinational firm.

Learning Objectives


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Slide Contents

1. Principles Used in this Chapter

2. Dividends

3. Dividend Policy and Shareholder Wealth

4. Conclusions on Dividend Policy

5. Dividend Decision in Practice

6. Stock Dividend/Split/Repurchase

7. Finance and the Multinational Firm

1. Principles Used in this Chapter


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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

2. Dividends


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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.


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Dividend Policy A firm’s dividend policy includes two

components:

1. Dividend Payout ratio

Indicates amount of dividend paid relative to the company’s 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 time


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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.


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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 firm’s 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.


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3. Dividend Policy and Shareholder’s Wealth


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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!”


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Three Views

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

1. Dividend policy is irrelevant.

2. High dividends will increase share prices.

3. Low dividends will increase share prices.


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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 firm’s investment and borrowing decisions have been made and will not be altered by dividend payment.


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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.

Kate Stephenson

Does this sentence read correctly? "Shareholders will demand a relatively higher rate of return for stocks that do not pay low or no dividends" or "Shareholders will demand a relativel higher reate of return for stocks that pay low or no dividends"?


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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).


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Some other explanations

1. Residual Dividend theory

2. Clientele effect

3. Information effect

4. Agency costs

5. Expectations theory


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Residual Dividend Theory

1. Determine the optimal capital budget.

2. Determine the amount of equity needed for financing.

3. First, use retained earnings to supply this equity.

4. 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.


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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.


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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 firm’s dividend policy may be seen as a signal about firm’s financial condition. Thus, high dividend could signal expectations of high earnings in the future and vice versa.


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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 management’s investment activities and helps reduce agency costs, and may enhance the value of the firm.


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Expectations Theory Expectation theory suggests that the market

reaction does not only reflect response to the firm’s 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.

4. Conclusions on Dividend Policy


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What are we to conclude?

Here are some conclusions about the relevance of dividend policy:

1. As a firm’s investment opportunities increase, its dividend payout ratio should decrease.

2. Investors use the dividend payment as a source of information of expected earnings.


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3. Relationship between stock prices and dividends may exist due to implications of dividends for taxes and agency costs.

4. Based on expectations theory, firms should avoid surprising investors with regard to dividend policy.

5. The firm’s dividend policy should effectively be treated as a long-term residual.

What are we to conclude?

5. Dividend Decision in Practice


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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.


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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.

Dividend Decision in Practice


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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.


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A small regular dividend plus a year-end extra.

The company follows the policy of paying a small, regular dividend plus a year-end extra dividend in prosperous years.

Alternative Dividend Policies


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Dividend Payment Procedures

Generally, companies pay dividend on a quarterly basis. The final approval of a dividend payment comes from the firm’s board of directors.

For example, GE pays $6.72 per share in annual dividend in four equal installments of $1.68 each.


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Important Dates Declaration date – The date when the dividend is

formally declared by the board of directors. (Ex. February 7)

Date of Record – Investors shown to own stocks on this date receive the dividend. (Ex. February 17)

Ex-Dividend date – Two working days prior to date of record (Ex. February 15). Shareholders buying stock on or after ex-dividend date will not receive dividends.

Payment date – The date when dividend checks are mailed. (ex. March 10)

6. Stock Dividends, Stock Splits and Stock Repurchase


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Stock Dividends

A stock dividend entails the distribution of additional shares of stock in lieu of cash payment.

While the number of common stock outstanding increases, the firm’s investments and future earnings prospects do not change.


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Stock Split A stock split involves exchanging more (or less

in the case of “reverse” split) shares of stock for firm’s outstanding shares.

While the number of common stock outstanding increases (or decreases in the case of reverse split), the firm’s investments and future earnings prospects do not change.

Stock splits and stock dividends are far less frequent than cash dividends.


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Stock Repurchase A stock repurchase (stock buyback)

occurs when a firm repurchases its own stock. This results in a reduction in the number of shares outstanding.

From shareholder’s perspective, a stock repurchase has potential tax advantages as opposed to cash dividends.


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Stock Repurchase - Benefits1. A means of providing an internal investment

opportunity2. An approach for modifying the firm’s capital

structure3. A favorable impact on earnings per share4. The elimination of a minority ownership

group of stockholders5. The minimization of the dilution of earnings

per share associated with mergers 6. The reduction in the firm’s costs associated

with servicing small stockholders


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Stock Repurchase Procedure

1. Open Market – Shares are acquired from a stockbroker at the current market price.

2. Tender Offer – An offer made by the company to buy a specified number of shares at a predetermined price, set above the current market price.

3. Purchase from one or more major stockholders.

7. Finance and the Multinational Firm


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Finance and the Multinational Firm During general economic prosperity, the

multinational firms look towards international markets for high NPV projects for two reasons:

To reduce country related economic risk by diversifying geographically; and

To achieve a cost advantage over one’s competitors.