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CHAPTER

18
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Dividends and Other Payouts

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Chapter Outline
18.1 18.2 18.3 18.4 18.5 18.6 18.7 18.8 Different Types of Dividends Standard Method of Cash Dividend Payment Home made Dividend Policy Repurchase of Stock Personal Taxes, Issuance Costs, and Dividends Real World Factors Favoring a High Dividend Policy The Clientele Effect What We Know and Do Not Know About Dividend Policy

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18.1 Different Types of Dividends

Many companies pay a regular cash dividend.
Public companies often pay quarterly. Sometimes firms will throw in an extra cash dividend. The extreme case would be a liquidating dividend.

Often companies will declare stock dividends.

No cash leaves the firm. The firm increases the number of shares outstanding.

Some companies declare a dividend in kind.

Wrigleys Gum sends around a box of chewing gum.

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18.2 Standard Method of Cash Dividend Payment

Cash Dividend - Payment of cash by the firm to its shareholders. The mechanics of dividend payment: Declaration Date: On January 1(diclaration date) the board of directors passes a resolution to pay a dividend of $1 per share on February 16 to all holders. Ex-Dividend Date The second day before the date of record which is January 28 is called the Ex-dividend date..
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18.2 Standard Method of Cash Dividend Payment

Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend. Record Date - Person who owns stock on this date received the dividend. The corporation prepares a list on January 30 of all individuals/shareholders as of this date.

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Procedure for Cash Dividend Payment

15 Jan. Thursday Declaration Date 27 Jan. Tuesday 28Jan. Wenday 30Jan. Fri. 16 Feb. Mon.

ExCumRecord Payment dividend dividend Date Date Date Date Declaration Date: The Board of Directors declares a payment of dividends. Cum-Dividend Date: The last day that the buyer of a stock is entitled to the dividend. Ex-Dividend Date: The first day that the seller of a stock is entitled to the dividend. Record Date: The corporation prepares a list of all individuals believed to be stockholders as of 30 January. Payment Date: The dividend cheques are mailed to shareholders of records.
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Price Behavior around the Ex-Dividend Date

In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date.
-t $P $P - div The price drops Exby the amount of dividend Date the cash Taxes complicate things a bit. Empirically, the price dividend drop is less than the dividend and occurs within the first
few minutes of the ex-date.
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18.3 The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy

A compelling case can be made that dividend policy is irrelevant. Dividend policy will have no impact on the value of the firm because investors can create whatever income stream they prefer by using homemade dividends.

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Homemade Dividends
Bianchi Inc. is a $42 stock about to pay a $2 cash dividend. Bob Investor owns 80 shares and prefers $3 cash dividend. Bobs homemade dividend strategy:
Sell 2 shares ex-dividend

homemade dividends Cash from dividend $160 Cash from selling stock $80 Total Cash $240 Value of Stock Holdings $40 78 = $3,120
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$3 Dividend $240 $0 $240 $39 80 = $3,120

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Dividend Policy is Irrelevant

Since investors do not need dividends to convert shares to cash, dividend policy will have no impact on the value of the firm. In the above example, Bob Investor began with total wealth of $3,360: $42
$3,360 = 80 shares
share

After a $3 dividend, his total wealth is still $3,360:

$3,360 = 80 shares
$39 + $240 share

After a $2 dividend, and sale of 2 ex-dividend shares,his total wealth is still $3,360:
$3,360 = 78 shares
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$40 + $ 160 + $80 share

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Irrelevance of Stock Dividends: Example

Shimano USA has 2 million shares currently outstanding at $15 per share. The company declares a 50% stock dividend. How many shares will be outstanding after the dividend is paid? A 50% stock dividend will increase the number of shares by 50%: 2 million1.5 = 3 million shares

After the stock dividend what is the new price per share and what is the new value of the firm?
The value of the firm was $2m $15 per share = $30 m. After the dividend, the value will remain the same. Price per share = $30m/ 3m shares = $10 per share
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Dividends and Investment Policy

Firms should never forgo positive NPV projects to increase a dividend. Recall that on of the assumptions underlying the dividend-irrelevance arguments was The investment policy of the firm is set ahead of time and is not altered by changes in dividend policy.

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18.4 Repurchase of Stock

Instead of declaring cash dividends, a firm may use excess cash to repurchase shares of its own stock. Recently share repurchase has become an important way of distributing earnings to shareholders.

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18.4 Repurchase of Stock

Three ways of Share Repurchase:
Open Market Purchases Firms may simply purchase their own stock like other investors. The firm does not reveal itself as buyer Tender Price The firm announces to all of its shareholders to buy a fixed number of share at specified price. Targeted repurchase Firms may repurchase share from specified individual stockholder are called targeted repurchase.
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Stock Repurchase versus Dividend

Consider a firm that wishes to distribute $100,000 to its shareholders.
Assets A.Original balance sheet Liabilities & Equity

Cash $150,000 Debt 0 Otherassets 850,000 Equity 1,000,000 Value of Firm 1,000,000 Value of Firm 1,000,000
Shares outstanding = 100,000 Price per share= $1,000,000 /100,000 = $10
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Stock Repurchase versus Dividend

If they distribute the $100,000 as cash dividend, the balance sheet will look like this: Assets Cash Other assets $50,000 850,000 Debt Equity Liabilities s & Equity 0 900,000

B. After $1 per share cash dividend

Value of Firm 900,000

Value of Firm 900,000

Shares outstanding g = 100,000 Price per share = $900,000/100,000 = $9

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Stock Repurchase versus Dividend

If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:

Assets C. After stock repurchase

Liabilities& Equity

Cash $50,000 Debt 0 Other assets 850,000 Equity 900,000 Value of Firm 900,000 Value of Firm 900,000 Shares outstanding = 90,000 Price pershare = $900,000 / 90,000 = $10
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Stock Repurchase versus Dividend

Why some firms choose repurchase over dividend?

Flexibility
Firms view dividend as a commitment to their shareholders. Repurchases do not represent a similar commitment.

Executive Compensation
Executives are given stock options a part of their compensation.

Offset dilution
Exercise of stock option increases the number of share outstanding causes dilution of stock. Firms buy back shares of stock to offset this dilution.
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Stock Repurchase versus Dividend

Why some firms choose repurchase over dividend?

Repurchase as investment
Recent studies has shown that the long-term stock price performance of securities after a buyback is significantly better than the stock price performance of comparable companies that do not repurchase.

Taxes
Repurchases provide a tax advantage over dividend.

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18.5 Personal Taxes, Issuance Costs, and Dividends

To get the result that dividend policy is irrelevant, we needed three assumptions:
No taxes No transactions costs No uncertainty

In the United States, both cash dividends and capital gains are taxed at a maximum rate of 15 percent. Since capital gains can be deferred, the tax rate on dividends is greater than the effective rate on capital gains.
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Firms Without Sufficient Cash to Pay a Dividend

Investment Bankers

The direct costs of stock issuance will add to this effect.

Cash: stock issue

Firm
Cash: dividends

Stock Holders

Taxes
Gov.
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In a world of personal taxes, firms should not issue stock to pay a dividend.
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Firms With Sufficient Cash to Pay a Dividend

The above argument does not necessarily apply to firms with excess cash. Consider a firm that has $1 million in cash after selecting all available positive NPV projects. The firm has several options:
Select additional capital budgeting projects (by assumption, these are negative NPV). Acquire other companies Purchase financial assets Repurchase shares
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Taxes, Issuance Costs, and Dividends

In the presence of personal taxes:
1. A firm should not issue stock to pay a dividend. 2. Managers have an incentive to seek alternative uses

for funds to reduce dividends. 3. Though personal taxes mitigate against the payment of dividends, these taxes are not sufficient to lead firms to eliminate all dividends.

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18.6 Real World Factors Favoring a High Dividend Policy

Desire for Current Income Resolution of Uncertainty Tax Arbitrage Agency Costs

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Desire for Current Income

The homemade dividend argument relies on no transactions costs. To put this in perspective, mutual funds can repackage securities for individuals at very low cost: they could buy low-dividend stocks and with a controlled policy of realizing gains, pay their investors at a higher rate.

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Resolution of Uncertainty
It would be erroneous to conclude that increased dividends can make the firm less risky. A firms overall cash flows are not necessarily affected by dividend policyas long as capital spending and borrowing are not changes. Thus, it is hard to see how the risks of the overall cash flows can be changed with a change in dividend policy.
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Tax Arbitrage
Investors can create positions in high dividendyield securities that avoid tax liabilities. Thus, corporate managers need not view dividends as tax-disadvantaged.

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Agency Costs
The potential conflict between bondholders and shareholders; bondholders would like shareholders to leave as much cash as possible in the firm to bondholders. Conversely, Shareholders would like to keep this extra cash for themselves. Agency Cost of Debt
Firms in financial distress are reluctant to cut dividends. To protect themselves, bondholders frequently create loan agreements stating dividends can only be paid if the firm has earns, cash flow and working capital above pre-specified levels.
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Agency Costs
The conflict between bondholders and shareholders; the manager may per sue selfish goal at the expense of shareholders when firm has plenty of cash flow. Agency Costs of Equity
Managers will find it easier to squander funds if they have a low dividend payout.

By paying dividends equal to the amount of surplus cash flows, a firm can reduce managements ability to squander the funds.
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Information Content of dividends and dividend Signaling

The stock price of a firm will rise when the firm announces an increase in the dividend & fall when a dividend reduction is announced. A dividend increase is managements signal to the market the firm is expected to do well. The rise in the share price following the dividend signal is called the information-content effect. This rises an interesting corporate strategy. Increase in dividends just to make the market think that cash flow will be higher even though management knows that cash flows will not rise.
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18.7 The Clientele Effect

Different types of shareholders that prefer one kind of dividend policy due to the difference in tax brackets. Clienteles for various dividend payout policies are likely to form in the following way:
High Tax Bracket Individuals Low Tax Bracket Individuals Tax-Free Institutions Corporations

Group

Zero to Low payout stocks Low-to-Medium payout Medium Payout Stocks High Payout Stocks

Stock

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18.8 What We Know and Do Not Know About Dividend Policy

Corporate dividends are substantial
Dividends are tax disadvantage relative to capital gains; nevertheless, dividends are substantial. Taxation on dividends is minimal for low tax bracket individuals or tax free for pension fund.

Corporations Smooth Dividends

Firms set long-term target ratios of dividend to earnings. Low target ratios if many NPV project; i. e. good times. High target ratios if few NPV projects; i. e. bad times.

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18.8 What We Know and Do Not Know About Dividend Policy

Dividends Provide Information to the Market
The price of stock rises when current dividend is increased or stock purchased is announced. Conversely, the price of stock falls when its dividend is cut.

Firms should follow a sensible dividend policy:

Dont forgo positive NPV projects just to pay a dividend. Avoid issuing stock to pay dividends. Consider share repurchase when there are few better uses for the cash.
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