Dividend Policy After Studying Chapter 18 you should be able to Understand the dividend retention versus distribution dilemma faced by the firm Explain the Modigliani and Miller MampM argument that dividends are irrelevant ID: 269807
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Slide1
Chapter 18
Dividend PolicySlide2
After Studying Chapter 18, 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).Slide3
Dividend Policy
Passive Versus Active Dividend Policies
Factors Influencing Dividend Policy
Dividend Stability
Stock Dividends and Stock Splits
Stock Repurchase
Administrative ConsiderationsSlide4
Dividends as a Passive 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 shareholder wealth?
If so, what dividend-payout ratio will maximize shareholder wealth?Slide5
Irrelevance 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
dilution
exactly equals the stock price prior to the dividend distribution.
A. Current dividends versus retention of earningsSlide6
Irrelevance 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 valueSlide7
Relevance 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 dividendsSlide8
Relevance of Dividends
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 investorSlide9
Relevance of Dividends
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.
B. Taxes on the investor (continued)Slide10
Other Dividend Issues
Flotation costs
Transaction costs and divisibility of securities
Institutional restrictions
Financial signalingSlide11
Empirical Testing of Dividend Policy
Tax Effect
Dividends are taxed more heavily 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 Signaling
Expect that increases (decreases) in dividends lead to positive (negative) excess stock returns.
Empirical results are consistent with these expectations.Slide12
Implications for Corporate 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.Slide13
Implications for Corporate 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.Slide14
Factors Influencing Dividend Policy
Capital 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 RulesSlide15
Factors Influencing Dividend Policy
Insolvency 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 Rule
– prohibits the undue retention of earnings in excess of the present and future investment needs of the firm.
Legal RulesSlide16
Factors Influencing Dividend Policy
Funding Needs of the Firm
Liquidity
Ability to Borrow
Restrictions in Debt Contracts (protective covenants)
Control
Other Issues to ConsiderSlide17
Dividend Stability
Stability
– maintaining the position of the firm’s dividend payments in relation to a trend line.
Dollars Per Share
3
4
2
1
Earnings per share
Dividends
per share
Time
50% of earnings
paid out as dividendsSlide18
Dividend Stability
Dividends begin at 50% of earnings, but are stable and increase only when supported by growth in earnings.
Dollars Per Share
3
4
2
1
Earnings per share
Dividends per share
Time
50% dividend-payout
rate with stabilitySlide19
Valuation of Dividend Stability
Information 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 desires
– some investors who desire a specific periodic income will prefer a company with stable dividends to one with unstable dividends.
Institutional 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.”Slide20
Types of Dividends
Extra dividend
A nonrecurring dividend paid to shareholders in addition to the regular dividend. It is brought about by special circumstances.
Regular Dividend
The dividend that is normally expected to be paid by the firm.Slide21
Stock Dividends and Stock Splits
Small-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 accounts?
Stock Dividend
– A payment of additional shares of stock to shareholders. Often used in place of or in addition to a cash dividend.Slide22
B/S Changes for the Small-Percentage Stock Dividend
$800,000 ($5 × 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.Slide23
Small-Percentage Stock Dividends
Before 5% Stock Dividend
Common stock
($5 par;
400,000 shares
)
$ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings
7,000,000
Total shareholders’ equity $10,000,000
After 5% Stock Dividend
Common stock
($5 par;
420,000 shares
)
$ 2,100,000
Additional paid-in capital 1,700,000
Retained earnings
6,200,000
Total shareholders’ equity $10,000,000Slide24
Stock Dividends,
EPS, and Total Earnings
Assume that investor SP owns 10,000 shares and the firm earned $2.50 per share.
Total earnings = $2.50 × 10,000 = $25,000.
After the 5% dividend, investor SP owns
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
).
After a small-percentage stock dividend, what happens to EPS and total earnings of individual investors?Slide25
Stock Dividends and Stock Splits
Typically 20% 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?
Large-percentage stock dividendsSlide26
B/S Changes for the Large-Percentage Stock Dividend
$2 million ($5 × 400,000 new shares) transferred (on paper) “out of” retained earnings.
$2 million transferred “into” common stock account.Slide27
Large-Percentage Stock Dividends
Before 100% Stock Dividend
Common stock
($5 par;
400,000 shares
)
$ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings
7,000,000
Total shareholders’ equity $10,000,000
After 100% Stock Dividend
Common stock
($5 par;
800,000 shares
)
$ 4,000,000
Additional paid-in capital 1,000,000
Retained earnings
5,000,000
Total shareholders’ equity $10,000,000Slide28
Stock Dividends and Stock Splits
Similar economic consequences as a 100% stock dividend.
Primarily used to move the stock into a more 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 the shareholders’ equity accounts?
Stock Split
– An increase in the number of shares outstanding by reducing the par value of the stock.Slide29
Stock Splits
Before 2-for-1 Stock Split
Common stock
($5 par;
400,000 shares
)
$ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings
7,000,000
Total shareholders’ equity $10,000,000
After 2-for-1 Stock Split
Common stock
($2.50 par;
800,000 shares
)
$ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings
7,000,000
Total shareholders’ equity $10,000,000Slide30
Value to Investors of Stock Dividends or Stock Splits
Effect on investor total wealth
Effect on investor psyche
Effect on cash dividends
More popular trading range
Informational contentSlide31
Stock Dividends and Stock Splits
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 the shareholders’ equity accounts?
Reverse Stock Split
– A stock split in which the number of shares outstanding is decreased.Slide32
Reverse Stock Splits
Before 1-for-4 Stock Split
Common stock
($5 par;
400,000 shares
)
$ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings
7,000,000
Total shareholders’ equity $10,000,000
After 1-for-4 Stock Split
Common stock
($20 par;
100,000 shares
)
$ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings
7,000,000
Total shareholders’ equity $10,000,000Slide33
Stock 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 Repurchase
– The repurchase (buyback) of stock by the issuing firm, either in the open (secondary) market or by self-tender offer.Slide34
Methods of Repurchase
Fixed-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 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 purchase
– A company repurchases its stock through a brokerage house on the secondary market.Slide35
Repurchasing as
Part of Dividend Policy
Assume
:
Earnings after taxes $ 800,000
Number of common shares outstanding
¸
400,000
Earnings per share $ 2
Current market price per share $ 31
Expected dividend per share $ 1
Expected total dividends to be paid out $ 400,000Slide36
Repurchasing as
Part of Dividend Policy
If dividend is paid, shareholders receive
:
Expected dividend per share $ 1
Market price per share
$ 30
Total value $ 31
If shares repurchased, shareholders receive
:
Dividend per share $ 0
Market price per share*
$ 31
Total value $ 31
Shares repurchased = $400,000 / $31 = 12,903
Original P/E ratio =
$30
/$2 = 15
“New” EPS = $800,000 / 387,097 = $2.07
“New” market price = $2.07 × 15 = $31Slide37
Summary of Repurchasing as 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.Slide38
Summary of Repurchasing as 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.Slide39
Investment or Financing Decision?
Financing Decision
It possesses capital structure or dividend policy motivations.
For example, a repurchase immediately changes the debt-to-equity ratio (higher financial leverage).
Investing Decision
Not really, as stock that is repurchased is held as treasury stock and does not provide an expected return like other investments.Slide40
Possible 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.Slide41
Administrative Considerations: Procedural Aspects
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 8
th
to declare a dividend payable to shareholders on June 15
th
to the shareholders of record on May 31
st
.
May 8
May 29
May 31
June 15Slide42
Administrative Considerations: Procedural Aspects
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
settle
(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 29
May 31
June 15Slide43
Administrative Considerations: Procedural Aspects
Declaration Date
– The date that the board of directors announces the amount and date of the next dividend.
Payment Date
– The date when the corporation actually pays the declared dividend.
May 8
May 29
May 31
June 15Slide44
Dividend Reinvestment 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)
– An optional plan allowing shareholders to automatically reinvest dividend payments in additional shares of the company’s stock.