Chapter 17 Dividend Policy and International Financing

2005, Pearson Prentice Hall

Stock Returns: Return =

P1 - Po + D1 Po

Stock Returns: Return =

P1 - Po + D1 Po D1 + Po

P1 - Po Po

Stock Returns: Return =

P1 - Po + D1 Po D1 + Po

P1 - Po Po

Capital Gain

Stock Returns: Return =

P1 - Po + D1 Po D1 + Po Dividend Yield

P1 - Po Po

Capital Gain

Dilemma: Should the firm use retained earnings for:

a) Financing profitable capital investments? b) Paying dividends to stockholders?

Financing Profitable Capital Investments:

If we retain earnings for profitable investments,

Return =

P1 - Po Po

D1 Po

Financing Profitable Capital Investments:

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

Return =

P1 - Po Po

D1 Po

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.

Return =

P1 - Po Po

D1 Po

Paying Dividends:

If we pay dividends,

Return =

P1 - Po Po

D1 Po

Paying Dividends:

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

Return =

P1 - Po Po

D1 Po

Paying Dividends:

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.

Return =

P1 - Po Po

D1 Po

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.

Dividends are Irrelevant

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 Po D1 Po

Return =

Dividends are Irrelevant Therefore, one dividend policy is as good as another.

Return =

P1 - Po Po

D1 Po

High Dividends are Best

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

High Dividends are Best Some investors may prefer a certain dividend now over a risky expected capital gain in the future.

Return =

P1 - Po Po

D1 Po

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.

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 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 YearEnd Extras The firm pays a stable quarterly dividend and includes an extra yearend 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
Declare dividend

Jan.30
Ex-div. date

Feb.1
Record date

Mar. 11
Payment date

Dividend Payments
2) Ex-Dividend Date: To receive the dividend, you have to buy the stock before the exdividend date. On this date, the stock begins trading ex-dividend and the stock price falls approximately by the amount of the dividend. Jan.4
Declare dividend

Jan.30
Ex-div. date

Feb.1
Record date

Mar. 11
Payment date

Dividend Payments
3) Date of Record: Two days after the exdividend 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
Declare dividend

Jan.30
Ex-div. date

Feb.1
Record date

Mar. 11
Payment date

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

Jan.4
Declare dividend

Jan.30
Ex-div. date

Feb.1
Record date

Mar. 11
Payment date

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 five shares. Does the shareholders wealth increase?

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?

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:

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.

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 $60 stock price to fall to $30.

Stock Dividends and Stock Splits

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

An investor has 120 shares. Does the value of the investors shares change? Shares outstanding: 1,000,000. Net income = $6,000,000. P/E = 10. 25% stock dividend.

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 Dividends
In-class Problem What is the new stock price? Shares outstanding: 250,000. Net income = $750,000. Stock price = $84. 50% stock dividend.

Hint:

P/E =

stock price 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 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.