Dividend Policy

Recall: Stock ReturnsRecall: Stock Returns

PP11 - Po + D - Po + D11

PoPoReturn =Return =


PP11 - Po + D - Po + D11

PoPo

PP11 - Po D - Po D11

Po PoPo Po+

Return =Return =

=

Return =Return =

Capital GainCapital Gain


PP11 - Po + D - Po + D11

PoPo

PP11 - Po - Po D D11

PoPo Po Po+=

Return =Return =

Capital GainCapital Gain Dividend YieldDividend Yield


PP11 - Po + D - Po + D11

PoPo

PP11 - Po - Po DD11

Po Po PoPo+=

Dilemma: Should the firm use Dilemma: Should the firm use retained earnings for:retained earnings for:

a) Financing profitable capital a) Financing profitable capital investments?investments?

b) Paying dividends to stockholders?b) Paying dividends to stockholders?

If we retain earnings for profitable If we retain earnings for profitable investments,investments,


Po PoPo Po+Return =Return =

If we retain earnings for profitable If we retain earnings for profitable investments, investments, dividend yield will be zero,dividend yield will be zero,



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



If we pay dividends, If we pay dividends,



If we pay dividends, If we pay dividends, stockholders receive stockholders receive an immediate cash reward for investing,an immediate cash reward for investing,



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



So, dividend policy really So, dividend policy really involves 2 decisions:involves 2 decisions:

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

How much should be retained for How much should be retained for capital investment.capital investment.

Is Dividend Policy Important?Is Dividend Policy Important?

Three viewpoints:Three viewpoints: 1) 1) Dividends are IrrelevantDividends are Irrelevant.. If we assume If we assume

perfect markets (no taxes, no perfect markets (no taxes, no transactions costs, etc.) dividends do not transactions costs, etc.) dividends do not matter. If we pay a dividend, matter. If we pay a dividend, shareholders’ dividend yield rises, but shareholders’ dividend yield rises, but capital gains decrease.capital gains decrease.

Dividend irrelevance:Dividend irrelevance: In perfect In perfect markets, an increase in dividendsmarkets, an increase in dividends

Po = D1kc - g

Dividend irrelevance:Dividend irrelevance: In perfect In perfect markets, an increase in dividendsmarkets, an increase in dividends

Po = D1kc - g

Dividend irrelevance:Dividend irrelevance: In perfect In perfect markets, an increase in dividends means markets, an increase in dividends means less money will be invested, so the growth less money will be invested, so the growth rate declines. rate declines.

Po = D1kc - g


Po = D1kc - g


The increase inThe increase in D D11 is offset by the is offset by the decrease in decrease in gg..

Po = D1kc - g

Dividend irrelevance:Dividend irrelevance: In perfect markets, an In perfect markets, an increase in dividends means less money will increase in dividends means less money will be invested, so the growth rate declines. be invested, so the growth rate declines.

The increase inThe increase in D D11 is offset by the decrease in is offset by the decrease in gg..

Consequently, dividend policy does not affect Consequently, dividend policy does not affect stock price.stock price.

Po = D1kc - g

Dividend irrelevance:Dividend irrelevance: In perfect In perfect markets, investors do not care if markets, investors do not care if returns come in the form of dividend returns come in the form of dividend yields or capital gains.yields or capital gains.









2) High Dividends are Best2) High Dividends are Best

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

2) High Dividends are Best2) High Dividends are Best

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



3) Low Dividends are Best3) Low Dividends are Best

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

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

Do Dividends Matter?Do Dividends Matter?

Other Considerations:Other Considerations:1) Residual Dividend Theory1) Residual Dividend Theory: : The firm pays a dividend only if it has The firm pays a dividend only if it has

retained earnings left after financing all retained earnings left after financing all profitable investment opportunities.profitable investment opportunities.

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


2) Clientele Effects2) Clientele Effects:: Different investor clienteles prefer Different investor clienteles prefer

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

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

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


3) Information Effects3) Information Effects:: Raising a firm’s dividend usually causes Raising a firm’s dividend usually causes

the stock price to rise and decreasing the the stock price to rise and decreasing the dividend causes the stock price to fall. dividend causes the stock price to fall.

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


4) Agency Costs4) Agency Costs:: Paying dividends may reduce agency costs Paying dividends may reduce agency costs

between managers and shareholders.between managers and shareholders. Paying dividends reduces retained earnings Paying dividends reduces retained earnings

and forces the firm to raise external equity and forces the firm to raise external equity financing.financing.

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


5) Expectations Theory5) Expectations Theory:: Investors form expectations concerning Investors form expectations concerning

the amount of a firm’s upcoming dividend.the amount of a firm’s upcoming dividend. Expectations are based on past dividends, Expectations are based on past dividends,

expected earnings, investment and expected earnings, investment and financing decisions, the economy, etc.financing decisions, the economy, etc.

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

Dividend PoliciesDividend Policies

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

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


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

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


3) 3) Small Regular Dividend plus Year-End Small Regular Dividend plus Year-End ExtrasExtras

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

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

Dividend PaymentsDividend Payments

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

Jan.4 Jan.28 Feb.1 Mar. 11Jan.4 Jan.28 Feb.1 Mar. 11

Declare Ex-div. Record PaymentDeclare Ex-div. Record Paymentdividend date date datedividend date date date


2) 2) Ex-Dividend DateEx-Dividend Date::



Dividend PaymentsDividend Payments2) 2) Ex-Dividend DateEx-Dividend Date:: To receive the To receive the

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




3) 3) Date of RecordDate of Record::




3) 3) Date of RecordDate of Record:: 4 days after the ex- 4 days after the ex-dividend date, the firm receives the list of dividend date, the firm receives the list of stockholders eligible for the dividend. stockholders eligible for the dividend.

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




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



Stock Dividends and Stock Stock Dividends and Stock SplitsSplits

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

Example: Citizens Bancorporation of Example: Citizens Bancorporation of Maryland announced a 5% stock dividend Maryland announced a 5% stock dividend to all shareholders of record on March 27, to all shareholders of record on March 27, 1987. For each 100 shares held, 1987. For each 100 shares held, shareholders received another 5 shares.shareholders received another 5 shares.

Did the shareholders’ wealth increase?Did the shareholders’ wealth increase?


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

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

Does this increase shareholder wealth?Does this increase shareholder wealth? Are a stock dividend and a stock split the Are a stock dividend and a stock split the

same?same?


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

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


Effects on Shareholder WealthEffects on Shareholder Wealth::


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


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

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


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

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

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

Stock Dividend Example Stock Dividend Example shares outstanding: 1,000,000shares outstanding: 1,000,000 net income = $6,000,000; P/E = 10net income = $6,000,000; P/E = 10 25% stock dividend. 25% stock dividend. An investor has 120 shares. Does the An investor has 120 shares. Does the

value of the investor’s shares value of the investor’s shares change?change?

Before the 25% stock dividendBefore the 25% stock dividend:: EPS = 6,000,000/1,000,000 = $6EPS = 6,000,000/1,000,000 = $6 P/E = P/6 = 10, so P = $60 per share.P/E = P/6 = 10, so P = $60 per share. Value = $60 x 120 shares = Value = $60 x 120 shares = $7,200$7,200After the 25% stock dividendAfter the 25% stock dividend:: # shares = 1,000,000 x 1.25 = 1,250,000.# shares = 1,000,000 x 1.25 = 1,250,000. EPS = 6,000,000/1,250,000 = $4.80EPS = 6,000,000/1,250,000 = $4.80 P/E = P/4.80 = 10, so P = $48 per share.P/E = P/4.80 = 10, so P = $48 per share. Investor now has 120 x 1.25 = 150 shares.Investor now has 120 x 1.25 = 150 shares. Value = $48 x 150 = Value = $48 x 150 = $7,200$7,200

Stock RepurchasesStock Repurchases

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

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


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

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

Stock RepurchasesStock Repurchases Repurchases Repurchases drive up the stock pricedrive up the stock price, ,

producing capital gains for shareholders.producing capital gains for shareholders. Repurchases Repurchases increase leverageincrease leverage, and can , and can

be used to move toward the optimal be used to move toward the optimal capital structure.capital structure.

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

Stock RepurchasesStock Repurchases Repurchases may be used to avoid a Repurchases may be used to avoid a

hostile takeover.hostile takeover.Example: T. Boone Pickens attempted Example: T. Boone Pickens attempted

raids on Phillips Petroleum and Unocal raids on Phillips Petroleum and Unocal in 1985. Both were unsuccessful in 1985. Both were unsuccessful because the target firms undertook because the target firms undertook stock repurchases.stock repurchases.


MethodsMethods:: Buy shares in the Buy shares in the open marketopen market through a through a

broker.broker. Buy a Buy a large blocklarge block by negotiating the by negotiating the

purchase with a large block holder, purchase with a large block holder, usually an institution. (targeted stock usually an institution. (targeted stock repurchase)repurchase)

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

Dividend Policy

Documents

growth rate

gs dividend

stock splitss

po po p1

record date

capital gains

dividend irrelevance

capital gain