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2005, Pearson Prentice Hall
Chapter 17 Dividend Policy
and Internal Financing
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,
P1 - Po D1
Po Po
+ Return =
Financing Profitable Capital
Investments:
If we retain earnings for profitable
investments, dividend yield will be zero,
P1 - Po D1
Po Po
+ Return =
Financing Profitable Capital
Investments:
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 =
Financing Profitable Capital
Investments:
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If we pay dividends,
Paying Dividends:
P1 - Po D1
Po Po
+ Return =
If we pay dividends, stockholders receive
an immediate cash reward for investing,
Paying Dividends:
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 =
Paying Dividends:
So, dividend policy really
involves two decisions:
How much of the firms 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
2) High Dividends are Best
3) Low Dividends are Best
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.
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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.
P1 - Po D1
Po Po
+ Return =
Dividends are Irrelevant
Therefore, one dividend policy is as
good as another.
P1 - Po D1
Po Po
+ Return =
Dividends are Irrelevant
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 =
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
2) Clientele Effects
3) Information Effects
4) Agency Costs
5) Expectations Theory
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.
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Other Considerations
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.
Other Considerations
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 firms future
prospects.
Other Considerations
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.
Other Considerations
5) Expectations Theory:
Investors form expectations concerning
the amount of a firms 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 peso of earnings available to
stockholders, 30 centavos would be
paid out as dividends.
The ratio remains constant over time,
but the peso value of dividends changes
as earnings change.
Dividend Policies
2) Stable Peso Dividend Policy: The
firm tries to pay a fixed peso
dividend each quarter.
Firms and stockholders prefer
stable dividends. Decreasing the
dividend sends a negative signal!
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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 Payment
dividend date date date
Dividend Payments
2) 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.
Jan.4 Jan.30 Feb.1 Mar. 11
Declare Ex-div. Record Payment
dividend date date date
Dividend Payments
3) Date of Record: A few 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.
Jan.4 Jan.30 Feb.1 Mar. 11
Declare Ex-div. Record Payment
dividend date date date
Dividend Payments
4) Payment Date: Date on which the
firm mails the dividend checks to
the shareholders of record.
Jan.4 Jan.30 Feb.1 Mar. 11
Declare Ex-div. Record Payment
dividend date date date
Stock Dividends and Stock Splits
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?
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Stock Dividends and Stock Splits
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.
Stock Dividends and Stock Splits
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 two half-sized pieces for each
full-sized piece they previously owned.
Example: This would double the number of
shares, but would cause a P 60.00 stock
price to fall to P 30.00.
Stock Dividends and Stock Splits
Why bother?
Proponents argue that these are used to
reduce high stock prices to a more
popular trading range
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
An investor has 120 shares. Does the
value of the investors shares
change?
Shares outstanding: 1,000,000
Net income = P 6,000,000.00
P/E = 10
25%stock dividend
Before the 25% stock dividend:
EPS = 6,000,000/1,000,000 = P 6.00
P/E = P/6 = 10, so P = P 60.00 per share
Value = P 60.00 x 120 shares = P 7,200.00
After the 25% stock dividend:
# shares = 1,000,000 x 1.25 = 1,250,000
EPS = 6,000,000/1,250,000 = P 4.80
P/E = P/4.80 = 10, so P = P 48.00 per
share
Investor now has 120 x 1.25 = 150 shares
Value = P 48.00 x 150 = P 7,200.00
Stock Dividends
In-class Problem
What is the new stock price?
Shares outstanding: 250,000
Net income = P 750,000.00
Stock price = P 84.00
50% stock dividend
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Hint:
stock price
P/E = net income
# shares
( )
Before the 50% stock dividend:
EPS = 750,000 / 250,000 = P 3.00
P/E = 84 / 3 = P 28.00
After the 50% stock dividend:
# shares = 250,000 x 1.50 = 375,000
EPS = 750,000 / 375,000 = P 2.00
P/E = P / 2 = 28, so P = P 56.00 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
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 marketwhich
increases stock price.
Stock Repurchases
Repurchases may be used to avoid
a hostile takeover.
Example: T. Boone Pickens
attempted raids on Phillips
Petroleum and Unocal in 1985.
Both were unsuccessful because
the target firms undertook stock
repurchases.
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.