Chapter 18

Dividend Policy

18-1

Pearson Education Limited 2004

Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI

After studying Chapter 18,

you should be able to:

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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).

Dividend Policy

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Passive Versus Active Dividend

Policies
Factors Influencing Dividend Policy
Dividend Stability
Stock Dividends and Stock Splits
Stock Repurchase
Administrative Considerations

Dividends as a
Passive Residual
Can the payment of cash dividends affect
shareholder wealth?
If so, what dividend-payout ratio will
maximize shareholder wealth?

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.

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Irrelevance of Dividends
A. Current dividends versus retention
of earnings

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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.

Irrelevance of Dividends
B. Conservation of value

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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.

Relevance of Dividends
A. Preference for dividends

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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.

Relevance of Dividends
B. Taxes on the investor

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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 dividendyielding stocks should sell at a discount to
generate a higher before-tax rate of return.

Certain institutional investors pay no tax.

Relevance of Dividends
B. Taxes on the investor (continued)

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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.

Other Dividend Issues

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Flotation costs

Transaction costs and

divisibility of securities

Institutional restrictions

Financial signaling

Empirical Testing
of Dividend Policy
Tax Effect

Dividends are taxed more heavily (in PV terms) 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

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Expect that increases (decreases) in dividends lead

to positive (negative) excess stock returns.
Empirical results are consistent with these
expectations.

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.

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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.

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Factors Influencing
Dividend Policy
Legal Rules

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).

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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.

Factors Influencing
Dividend Policy
Legal Rules

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.

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Factors Influencing
Dividend Policy
Other Issues to Consider

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Funding Needs of the Firm

Liquidity

Ability to Borrow

Restrictions in Debt Contracts

(protective covenants)

Control

Dividend Stability

Dollars Per Share

Stability -- maintaining the position of the firms

dividend payments in relation to a trend line.

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50% of earnings
paid out as dividends

Earnings per share

3
2
Dividends
per share

Time

Dividend Stability

Dollars Per Share

Dividends begin at 50% of earnings, but are stable and

increase only when supported by growth in earnings.

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50% dividend-payout
rate with stability

Earnings per share

3
2
1

Dividends per share

Time

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.

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Types of Dividends
Regular Dividend

The dividend that is normally expected to

be paid by the firm.

Extra dividend

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A nonrecurring dividend paid to

shareholders in addition to the regular
dividend. It is brought about by special
circumstances.

Stock Dividends
and Stock Splits
Stock Dividend -- A payment of additional
shares of stock to shareholders. Often used
in place of or in addition to a cash dividend.
Small-percentage stock dividends

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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?

B/S Changes for the SmallPercentage Stock Dividend

$800,000 ($5 x 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.

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Small-Percentage
Stock Dividends
Before 5% Stock Dividend
Common stock
($5 par; 400,000 shares)
$ 2,000,000
shares
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
shares
Additional paid-in capital 1,700,000
Retained earnings 6,200,000
Total shareholders equity
$10,000,000
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Stock Dividends,
EPS, and Total Earnings
After a small-percentage stock dividend, what
happens to EPS and total earnings of
individual investors?

Assume that investor SP owns 10,000 shares and the

firm earned $2.50 per share.

Total earnings = $2.50 x 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).
EPS

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Stock Dividends
and Stock Splits
Large-percentage stock dividends

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Typically 25% 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?

B/S Changes for the LargePercentage Stock Dividend

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$2 million ($5 x 400,000 new

shares) transferred (on paper)
out of retained earnings.

$2 million transferred into

common stock account.

Large-Percentage
Stock Dividends
Before 100% Stock Dividend
Common stock
($5 par; 400,000 shares)
$ 2,000,000
shares
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
shares
Additional paid-in capital 1,000,000
Retained earnings 5,000,000
Total shareholders equity
$10,000,000
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Stock Dividends
and Stock Splits
Stock Split -- An increase in the number of
shares outstanding by reducing the par value
of the stock.

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?

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Stock Splits
Before 2-for-1 Stock Split
Common stock
($5 par; 400,000 shares)
$ 2,000,000
shares
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
shares
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders equity
$10,000,000
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Value to Investors of Stock

Dividends or Stock Splits

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Effect on investor total wealth

Effect on investor psyche

Effect on cash dividends

More popular trading range

Informational content

Stock Dividends
and Stock Splits
Reverse Stock Split -- A stock split in which the
number of shares outstanding is decreased.

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?

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Reverse Stock Splits

Before 1-for-4 Stock Split
Common stock
($5 par; 400,000 shares)
$ 2,000,000
shares
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
shares
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders equity
$10,000,000
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Stock Repurchase
Stock Repurchase -- The repurchase (buyback)
of stock by the issuing firm, either in the open
(secondary) market or by self-tender offer.
Reasons for stock repurchase:

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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

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.

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Repurchasing as
Part of Dividend Policy
Assume:

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Earnings after taxes

$ 800,000

Number of common
shares outstanding

400,000

Earnings per share

Current market price

per share

31

Expected dividend per share

Expected total dividends

to be paid out

$ 400,000

Repurchasing as
Part of Dividend Policy
If dividend is paid, shareholders receive :
Expected dividend per share
$
Market price per share
$
30
Total value
$
31
If shares repurchased, shareholders receive :

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Dividend per share

$
Market price per share*
Total value
$
31

0
$

31

* Shares repurchased
= $400,000 / $31
= 12,903
Original P/E ratio = $30/$2
= 15
$30
New EPS
= $800,000 / 387,097 = $2.07
New market price
= $2.07 x 15
= $31

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

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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.

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.

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Investment or
Financing Decision?
Investing Decision

Not really, as stock that is repurchased is held as

treasury stock and does not provide an expected
return like other investments.

Financing Decision

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It possesses capital structure or dividend policy

motivations.

For example, a repurchase immediately changes

the debt-to-equity ratio (higher financial leverage).

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.

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Administrative Considerations:
Procedural Aspects
May 8

May 29

May 31

June 15

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 8th to declare
a dividend payable to shareholders on June 15th
to the shareholders of record on May 31st.
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Administrative Considerations:
Procedural Aspects
May 8

May 29 May 31

June 15

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.
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Administrative Considerations:
Procedural Aspects
May 8

May 29

May 31

June 15

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.
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Dividend
Reinvestment Plans
Dividend Reinvestment Plan (DRIP) -- An optional plan
allowing shareholders to automatically reinvest
dividend payments in additional shares of the
companys stock.

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.

18-44