15-1
Fundamentals
of Corporate
Finance
Second Canadian Edition
prepared by:
Carol Edwards
BA, MBA, CFA
Instructor, Finance
British Columbia Institute of Technology
copyright © 2003 McGraw Hill Ryerson Limited
15-2
Chapter 16
Dividend Policy
Chapter Outline
How Dividends are Paid
 How Do Companies Decide on Dividend
Payments?
 Why dividend Policy Should Not Matter
 Why Dividends May Increase Firm Value
 Why Pay Dividends? A Look at Tax Law
Implications

copyright © 2003 McGraw Hill Ryerson Limited
15-3
Dividend Policy
• Introduction


Your objective as a financial manager is to
undertake actions which will maximize the
value of your firm.
A cash dividend is a payment of cash by the
firm to its shareholders.
 Some
firms have a policy of low or no dividends,
others have a policy of high dividends.

The key question this chapter will pose is:
Can you change the value of your firm
by changing its dividend policy?
copyright © 2003 McGraw Hill Ryerson Limited
15-4
How Dividends Are Paid
• Cash


Dividends
Regular cash dividends are generally paid
quarterly.
Under certain circumstances, the firm will pay
an extra dividend.
 Such
a dividend is a one-time event and is unlikely
to be repeated.
 The word “extra” alerts shareholders to this fact.

With all dividends, there is a payment date
when the company mails cheques to
shareholders.
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15-5
How Dividends Are Paid
• Cash

Dividends
The key question is:
 Who
receives the dividend cheque?
Given that shares trade constantly, the
company’s record of the names and
addresses of its shareholders can never be
up-to-date.
 As a consequence, the company arbitrarily
sets a Date of Record.

 All
shareholders recorded on the company’s
books at this date receive the dividend,
regardless of who actually owns the shares.
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15-6
How Dividends Are Paid
• Cash
Dividends
Stock exchanges set a cut-off date, the
ex-dividend date, two business days
prior to the date of record.
 If you buy the shares on, or after, this
date, you will not be on the company’s
books on the date of record.

 As
a consequence, you will not receive
the dividend.
copyright © 2003 McGraw Hill Ryerson Limited
15-7
How Dividends Are Paid
• Cash

Dividends
Thus, stocks are said to trade:
 Cum
dividend - with the dividend.
 If you buy a stock cum dividend, and you hold
the shares until the ex-dividend date, then you
would be on the company’s shareholder records
and would receive the dividend.
 If you sell a stock cum dividend, you give-up the
right to receive the dividend as well as giving-up
the stock.
 Ex-dividend - without the dividend.
 Anyone buying a stock ex-dividend, is
ineligible to receive the dividend.
copyright © 2003 McGraw Hill Ryerson Limited
15-8
How Dividends Are Paid
• Cash

Dividends
A company has declared a dividend with a
payment date of June 30th. The date of record
is Monday, June 6th.
 What
Cum
dividend
Wed.
1
is the ex-dividend date?
Ex-dividend – June 2nd
Thur.
Fri.


Sun.
x
Sat.
Mon.
x
2
3
4
5
Count back 2 business days.
6
Date of Rec.
copyright © 2003 McGraw Hill Ryerson Limited
15-9
How Dividends Are Paid
• Cash Dividends
 The difference between buying a share cum and
ex-dividend is you do not receive the dividend.
 Thus, you should expect that on the ex-dividend
date, the price of the stock should drop by the
value of the dividend.
 For example, assume a $1 dividend has been
declared on XYZ shares.
Cum dividend they trade at $10 apiece and the buyer
of the shares is entitled to the $1 dividend.
 On the ex-dividend date, the buyer loses the right to
this $1 dividend and thus should be willing to offer only
$9 for each share.

copyright © 2003 McGraw Hill Ryerson Limited
15-10
How Dividends Are Paid
• Stock
Dividends vs Stock Splits
A stock dividend is the distribution of
additional shares, instead of cash, to
the firm’s shareholders.
 A stock split is the issue of additional
shares to a firm’s shareholders.
 In both cases, a shareholder is given a
fixed number of new shares for each
share held.

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15-11
How Dividends Are Paid
• Stock

Dividends vs Stock Splits
In other words, except for minor technical
details of how they are recorded on the firm’s
books, a stock dividend achieves the same
results as a stock split.
 For
example, a two-for-one stock split and a 100%
stock dividend both result in twice as many shares
outstanding.
 But neither changes the assets or cash flows
generated by the firm.
If markets are efficient, what should
happen to the stock price?
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15-12
How Dividends Are Paid
• Stock


Dividends vs Stock Splits
You should expect the stock price to fall by
half, leaving the total market value of the firm
(price per share x number of shares
outstanding) unchanged.
Often, though, the announcement of a stock
split does result in a rise in the market value of
the firm.
 This
occurs even though investors know that the
company’s assets and business will not be
affected.
 Why?
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15-13
How Dividends Are Paid
• Stock

Dividends vs Stock Splits
The reason:
Investors
take the decision to split as a
signal of management’s confidence in
the company’s future prospects.
They bid up the price in response to
this perceived signal.
copyright © 2003 McGraw Hill Ryerson Limited
15-14
How Dividends Are Paid
• Stock

Dividends vs Stock Splits
Sometimes firms will opt for a reverse
split.
 In
a reverse split, the firm reduces the
number of shares outstanding, thus
increasing the price per share.
 For example, in a one-for-two reverse split,
shareholders would exchange two existing
shares for one new share.
 Theoretically, each share should be worth
twice as much as before the reverse split.
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15-15
How Dividends Are Paid
• Dividends




vs Stock Repurchases
If a firm wishes to distribute money to its
shareholders, usually it would declare a cash
dividend.
An increasingly popular alternative is to declare
a stock repurchase.
In a stock repurchase, the firm buys back its
shares from its shareholders.
If you look at Table 16.1 on page 484 of your
text, you can see that a cash dividend and a
share repurchase leave a shareholder in the
same financial position.
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15-16
How Dividends Are Paid
• Dividends

vs Stock Repurchases
Look at panel A of Table 16.1.
 Assume
you own 1000 shares, worth $10 each.
 The value of your portfolio is $10,000.

Look at Panel B.
 Here
you see the results if the firm declared a
$1 per share dividend.
 After receiving the dividend, you still own 1000
shares, but they are now worth $9 each.
 However, you also have a cheque for $1,000.
 The value of your portfolio is thus still $10,000.
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15-17
How Dividends Are Paid
• Dividends

vs Stock Repurchases
Look at panel C.
 Here
you see the results if the firm
declared a stock repurchase.
 After selling 100 shares back to the
company, you own 900 shares, worth $10
each.
 However, you also received a cheque for
$1,000 for the shares you sold to the firm.
 The value of your portfolio is thus still
$10,000.
copyright © 2003 McGraw Hill Ryerson Limited
15-18
The Dividend Decision
• How
Companies Decide on Dividend
Payments



How does the Board of Directors decide what
type of dividend to declare?
To help answer this question, John Lintner
conducted a series of interviews with
managers about their firm’s dividend policy.
He developed four “stylized facts” which
describe how dividends are determined.
copyright © 2003 McGraw Hill Ryerson Limited
15-19
The Dividend Decision
• Lintner’s
Four Stylized Facts
1. Firms have a long run dividend payout ratio.
 This ratio is that fraction of earning which the
company intends to pay out as dividends.
2. Managers focus on dividend changes rather
than absolute levels of dividends.
 Paying
a $2 dividend is important if last year’s
dividend was $1. It is unimportant if last year’s
dividend was $2.
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15-20
The Dividend Decision
• Lintner’s
Four Stylized Facts
3. Dividend changes respond to long-run
sustainable changes in earnings, but not to
short-run changes.
 Managers
are unlikely to change dividends in
response to temporary variations in earnings.
 Instead, they “smooth” dividends.
4. Managers are reluctant to make dividend
changes which might have to be reversed.
 They
are particularly worried about having to
reverse a dividend increase.
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15-21
The Dividend Decision
• The

Lintner Model
Managers in Lintner’s survey behaved this way
because they believe that shareholders prefer
a steady progression in dividends.
 Investors
see a dividend decrease as an
unfavourable signal from management about the
company’s future earnings ability.
 In other words, investors worry that the assets will
not generate enough cash flow to support the
dividend.
copyright © 2003 McGraw Hill Ryerson Limited
15-22
The Dividend Decision
• The

Lintner Model
Thus, if circumstances would warrant a large
increase in dividends, managers will move only
partway towards their target payout.
 They
will wait to see if the earnings increase is
permanent before the dividend is fully adjusted.

If you look at Figure 16.2 on page 485, you will
see confirmation of Lintner’s results:
 While
earnings fluctuate erratically, dividends are
relatively stable, tracking almost a flat line.
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15-23
Why Dividend Policy Should Not Matter
•
The Irrelevancy of Dividend Policy


Does it matter to the shareholders whether a
firm has a policy of paying no dividends, low
dividends or high dividends?
This a controversial question, with three
opposing beliefs:
 Paying
a high dividend will maximize the value
of the firm.
 Paying a low dividend will maximize the value of
the firm.
 Dividend policy is irrelevant and cannot affect
share value.
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15-24
Should Dividend Policy Matter?
• Dividend


Policy in Competitive Markets
Modigliani and Miller (MM), whom we met in
the last chapter, proved that under ideal
conditions, capital structure is irrelevant.
MM maintain that under ideal conditions,
dividend policy is also irrelevant.
 Ideal
conditions means perfect capital markets with
no taxes or costs of financial distress.
 It also means that markets are efficient and assets
are fairly priced given the information available to
investors.
copyright © 2003 McGraw Hill Ryerson Limited
15-25
Should Dividend Policy Matter?
• Dividend

Policy in Competitive Markets
MM’s logic is very simple:
A
dividend is quite simply a way for a firm to put
cash in its shareholders’ pockets.
 However, shareholders do not need dividends to
get cash in their pocket.

They can simply sell shares to get cash.
 Thus,
rational investors will not pay higher
prices for firms with higher dividend payouts.
copyright © 2003 McGraw Hill Ryerson Limited
15-26
Seeking the Optimal Dividend Policy
• Why
Dividends May Increase the Value
of the Firm



Most economists believe that MM’s
conclusions are correct given their
assumptions of perfect and efficient capital
markets.
However, no one believes this is an exact
description of the “real” world.
Thus, the impact of dividends on firm value
boils down to the effects of imperfections and
inefficiencies.
copyright © 2003 McGraw Hill Ryerson Limited
15-27
Seeking the Optimal Dividend Policy
• Why
Dividends May Increase the Value
of the Firm


The argument for paying higher dividends rests
on their desirability to investors.
For example:
 Some
institutional investors are not allowed to hold
stock if it lacks an established dividend record.
 Some investors (trusts, endowment funds, retirees)
rely on the dividends from their portfolio to provide
them with income.
copyright © 2003 McGraw Hill Ryerson Limited
15-28
Seeking the Optimal Dividend Policy
• Why
Dividends May Increase the Value
of the Firm

These investors could just sell their shares to
generate the cash they need, but this ignores
the transactions costs and inconvenience they
would incur selling a small number of shares.
 It
is so much simpler and cheaper for the firm to
simply send them a dividend cheque.

Conclusion: Investors should prefer firms with
higher dividends and bid up their share price.
copyright © 2003 McGraw Hill Ryerson Limited
15-29
Seeking the Optimal Dividend Policy
• Clientele




Effect
Unfortunately, life is not that simple!
While it may be true that investors prefer
companies paying higher dividends that
doesn’t mean you can increase the value of
your firm just by increasing its dividend payout.
Afterall, lots of smart financial managers would
have recognized this fact years ago.
They would already have satisfied this clientele
for high dividend stocks.
copyright © 2003 McGraw Hill Ryerson Limited
15-30
Seeking the Optimal Dividend Policy
• Clientele

Effect
You don’t hear business people saying
there is a clientele for cars, so we should
be manufacturing cars.
 They
know that clientele was probably
satisfied years ago.

Likewise, the clientele for high dividend
stocks has a wide variety of stocks to
choose from.
 No
one will notice if you add your firm to that
already long list!
copyright © 2003 McGraw Hill Ryerson Limited
15-31
Seeking the Optimal Dividend Policy
• Dividends

as Signals
Another argument for higher dividends
relies on the fact that investors are
constantly seeking clues as to which
companies are most successful.
 How
can an investor separate the marginally
profitable companies from the real money
makers?

One clue they can use is dividends.
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15-32
Seeking the Optimal Dividend Policy
• Dividends

as Signals
Accounting numbers may lie, but dividends
require the firm to come up with hard cash.
A
firm that reports good earnings, but does not
back it up with generous dividends may be
tweaking its numbers.
 But a high dividend policy will be costly to firms
that do not have the cash flow to support it.

Thus dividend increases signal a company’s
good fortune and its managers’ confidence in
its future cash flows.
copyright © 2003 McGraw Hill Ryerson Limited
15-33
Seeking the Optimal Dividend Policy
• Information
Content of Dividends
Since dividends are interpreted by investors
as a signal about future earnings,
announcements of dividend cuts are usually
taken as bad news.
 You should read the Finance in Action
boxes on pages 492 and 493 for more details
on the information content of dividends.

 The
information content of dividends means that
dividends are used as a source of information to
investors about a firm’s future performance.
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15-34
Seeking the Optimal Dividend Policy
• Why
Dividends May Decrease the Value
of the Firm

If dividends are taxed more heavily than capital
gains, then a policy of paying high dividends
would hurt firm value.
 Investors
would avoid the shares of such firms,
causing their stock price to drop.
 Plowing earnings back into the firm, instead of
declaring dividends, would produce the capital gains
desired by investors.
 Companies with high retention rates would be
rewarded by investor demand for their shares and
higher share prices.
copyright © 2003 McGraw Hill Ryerson Limited
15-35
Seeking the Optimal Dividend Policy
• Why
Pay Dividends? A look at Tax
Law Implications

In Chapter 2 you learned about how
dividends and capital gains are taxed in
Canada.
 Both

are a tax advantaged source of income.
That is, both capital gains and dividends are
taxed at a lower rate than interest and other
types of income.
copyright © 2003 McGraw Hill Ryerson Limited
15-36
Seeking the Optimal Dividend Policy
• Why
Pay Dividends? A look at Tax Law
Implications


One of the key differences between dividends
and capital gains is that taxes on dividends
must be paid immediately.
Taxes on capital gains are deferred until the
shares are sold and the capital gains are
realized.
 Thus,
investors can control when they pay
capital gains tax.
copyright © 2003 McGraw Hill Ryerson Limited
15-37
Seeking the Optimal Dividend Policy
• Tax

Clienteles
Overall, some investors in Canada are
taxed more heavily on dividends, while
others are taxed more heavily on capital
gains.
 Thus,
some investors have a tax reason for
preferring dividends to capital gains and vice
versa.

Does any of these clienteles play a
dominant role in the Canadian market?
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15-38
Seeking the Optimal Dividend Policy
• Tax
Clienteles
If the answer is “yes”, then we would expect
that dominant clientele to have an influence
on whether high-dividend yield stocks sell
for more or less than low-dividend yield
stocks on the basis of taxes.
 Unfortunately, it is difficult to measure such
clientele effects and the researchers have
not been able to come up with a definitive
answer.

copyright © 2003 McGraw Hill Ryerson Limited
15-39
Seeking the Optimal Dividend Policy
• Dividend
Clientele Effects
Even if a clientele existed for either high- or
low-dividend yield stocks, as we have
already seen, most such clienteles have
already been satisfied.
 Thus, changing your firm’s dividend policy
to suit that clientele would not lead to a
change in the value of your firm’s shares.

 That
is, changing your firm’s policy would lead to
a switch in investors holding your firm’s shares,
but it probably would not affect your firm’s value.
copyright © 2003 McGraw Hill Ryerson Limited
15-40
Seeking the Optimal Dividend Policy
• Share
Repurchases Instead of Cash
Dividends?




From a firm’s perspective a share repurchase
is very similar to paying a cash dividend.
However, the tax treatment for investors may
be quite different.
A dividend leads to an immediate tax
obligation.
However, an investor has the option of not
tendering his/her shares to a repurchase offer
and thus avoiding the capital gains tax.
copyright © 2003 McGraw Hill Ryerson Limited
15-41
Seeking the Optimal Dividend Policy
• Share
Repurchases Instead of Cash
Dividends?

The authors caution financial managers from
substituting share repurchases for dividends.
 The
tax department would recognize the share
repurchase for what it really is … a dividend in
disguise.
 They would then tax the payments accordingly!

This is probably why financial managers have
never announced a share repurchase to save
taxes.
 They
always give another reason.
copyright © 2003 McGraw Hill Ryerson Limited
15-42
Summary of Chapter 16

Dividends come in many forms, including cash
dividends, stock dividends, and extra dividends.


Studies have shown that managers have a target
dividend payout ratio.


There are also dividend-like payments such as stock
splits and share repurchases.
However to avoid fluctuations in dividend value,
mangers smooth the dividend by moving only partway
towards the target payout every year.
Furthermore, managers look to future cash flows
when setting the dividend.

Investors know this and interpret a dividend increase as
a sign of management optimism.
copyright © 2003 McGraw Hill Ryerson Limited
15-43
Summary of Chapter 16

MM proved in perfect and efficient capital
markets dividend policy is irrelevant.
 However,
there is considerable controversy
over the impact of dividend policy in a flawed
world.

Some groups hold that dividends should
be high to maximize firm value.
 Their
argument rests on the information
content of such high dividends.

Others hold that dividends should be low.
 Their
argument rests on different tax
treatment for dividends and capital gains.
copyright © 2003 McGraw Hill Ryerson Limited
15-44
Summary of Chapter 16

The dividend clientele effect argues that there
may be clienteles for high (low) dividends, but
that they are already satisfied.
 Thus
changing your firm’s dividend policy may
attract a new type of investor, but it will not
change the value of your firm.

Dividends are interpreted as a signal from
management about the future prospects of the
firm.
 If
a sharp dividend change is necessary, the firm
should provide as much forewarning and
explanation as possible.
copyright © 2003 McGraw Hill Ryerson Limited