Lecture Note 2
Dividend Policy
Corporate Finance Lecture Note 2
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What is in This Note?
•
•
•
•
•
Overview of Types of Dividends
Overview of Forms of Dividends
Overview of Dividend Policies
Overview of Real World Dividend Decisions
Reference: Chapter 18 of RWJJ, Chapter
16 of BMA
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Roadmap
 Understand dividend types and how they are
paid
 Understand why share repurchases are an
alternative to dividends
 Understand dividend polices
 Understand real world dividend decisions
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Types of dividends
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Different Types of Dividends
• Many companies pay a regular cash dividend.
– Public companies often pay quarterly.
– Sometimes firms will pay an extra cash dividend.
– The extreme case would be a liquidating dividend.
• Companies will often declare stock dividends.
– No cash leaves the firm.
– The firm increases the number of shares outstanding.
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Standard Method of Cash Dividend
Cash Dividend - Payment of cash by the firm
to its shareholders.
Ex-Dividend Date (除息日) - Date that
determines whether a stockholder is entitled to
a dividend payment; anyone holding stock
immediately before this date is entitled to a
dividend.
Record Date – Date on which company
determines existing shareholders.
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Procedure for Cash Dividend
25 Oct.
1 Nov.
2 Nov.
5 Nov.
7 Dec.
…
Declaration
Date
ExCumdividend dividend
Date
Date
Record
Date
Payment
Date
Declaration Date: The Board of Directors declares a payment
of dividends.
Cum-Dividend Date: Buyer of stock still receives the dividend.
Ex-Dividend Date: Seller of the stock retains the dividend.
Record Date: The corporation prepares a list of all individuals
believed to be stockholders as of 5 November.
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Stock price
St
D: Cash dividend
S0
S0- De-rt
t: Ex-dividend date
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time
8
Stock price
St
D*(1-dividend tax)
S0
S0- (D *(1-dividend tax)) e-rt
t: Ex-dividend date
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The stock price will decrease proportionally
with the amount of cash dividends.
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In-Class Exercise
• Ross, Westerfield, and Jaffe Question 1 (pp. 543)
• Lee Ann has declared a $6 per share cash
dividend. Suppose that the capital gains are not
taxed, but dividends are taxed at 15% for the
representative investor. Lee Ann sells for $90
per share, what do you think the ex-equilibrium
dividend price will be?
• Ans: Aftertax dividend = $6.00(1 – .15) = $5.10.
The stock price should drop by the aftertax
dividend amount, or: Ex-dividend price = $90 –
5.10 = $84.90
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Forms of Dividends
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Forms of Dividend Payments
Stock Repurchase - Firm buys back stock
from its shareholders.
Stock Dividend - Distribution of additional
shares to a firm’s stockholders.
Stock Splits - Issue of additional shares to
firm’s stockholders.
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Repurchase of Stock (股份購回 or
庫藏股實施之宣告)
• Instead of declaring cash dividends, firms
can rid themselves of excess cash through
buying shares of their own stock.
• Recently, share repurchase has become
an important way of distributing earnings
to shareholders.
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Stock Repurchase versus Dividend
Consider a firm that wishes to distribute $100,000 to its
shareholders.
Assets
Liabilities & Equity
A.Original balance sheet
Cash
$150,000 Debt
0
Other Assets 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 a cash dividend, the
balance sheet will look like this:
Assets
Liabilities & Equity
B. After$1 per share cash dividend
Cash
$50,000
Debt
Other Assets
850,000
Equity
Value of Firm 900,000
0
900,000
Value of Firm 900,000
Shares outstanding = 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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Share Repurchase (股份購回 or 庫
藏股實施之宣告 )
• Flexibility for shareholders
• Keeps stock price higher
– Good for insiders who hold stock options
• As an investment of the firm
(undervaluation of the stock price)
• Tax benefits
• 中華電信 ,威剛(3260),智原（3035） , etc
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In-Class Exercise
Ross, Westerfield, and Jaffe Question 17 (pp. 545)
• Lee Ann is considering a cash dividend versus ’s
stock repurchase. In either case € 5,000 would
be spent. Current EPS is € 0.95 per share and
the stock price is € 40 per share. There are
1,000 shares outstanding. Ignore taxes
• 1. Evaluate the two alternatives on shareholder
wealth
• 2. What will be the effect on Lee Ann’s EPS and
PE ratio under these two different alternatives?
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In-Class Exercise
1. Dividend per share = €5,000/1,000 shares =
€5.00. The ex-dividend stock price will be: €40 –
5 = €35 per share. Shares repurchased =
€5,000/€40 = 125 shares
• 2. If the company pays dividends, the current
EPS is €0.95, and the P/E ratio is: P/E =
€35/€0.95 = 36.84. If the company repurchases
stock, we find the EPS under the repurchase is:
EPS = €0.95(1,000)/(1,000  125) = €1.0857.
The stock price will remain at €40 per share, so
the P/E ratio is:P/E = €40/€1.0857 = 36.84
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Stock Dividends
• Pay additional shares of stock instead of
cash
• Increases the number of outstanding shares
• Small stock dividend
– Less than 20 to 25%
– If you own 100 shares and the company
declared a 10% stock dividend, you would
receive an additional 10 shares.
• Large stock dividend – more than 20 to 25%
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In-Class Exercise
Ross, Westerfield, and Jaffe Question 2 (pp. 543)
• Lee Ann’s stock is sold at $25 per share and it declares a
10% stock dividend. How many new shares are issued
and how would the equity account change? and if it
declares a 25% stock dividend. How many new shares are
issued and how would the equity account change.
•
Common stock ($ 1 par value)
Capital surplus
Retained earnings
10,000
180,000
586,500
Total owner's equity
776,500
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In-Class Exercise
Common stock ($ 1 par value)
11,000
Capital surplus
Retained earnings
204,000
561,500
Total owner's equity
776,500
Common stock ($ 1 par value)
Capital surplus
12,500
240,000
Retained earnings
524,000
Total owner's equity
776,500
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Stock Splits
• Stock splits – essentially the same as a
stock dividend except it is expressed as a
ratio
– For example, a 2 for 1 stock split is the same
as a 100% stock dividend.
• Stock price is reduced when the stock
splits.
• Common explanation for split is to return
price to a “more desirable trading range.”
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台灣沒有股票分割
• 91XX類的股票屬於TDR，可以不受台灣股票面額
10元限制，在面額限制下的其他股票，似乎沒有
其他股票分割案例
• 國內台灣存託憑證TDR): TDR即是指在證期會認
可的海外16個證券交易所掛牌上市後，以原股發
行存託憑證（DR）在台第二上市.
• TDR: 福雷電、東亞科、美德醫、萬宇科、泰金寶
五家
• 9103美德醫:民國96年6月11日 4 for 1 stock split
• 9105泰金寶:民國94年4月7日 10 for 1 stock split
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Reverse Stock Splits
• Stock price is increased when there is a
reverse stock split.
• Common explanation for reverse split is to
return price to a “more desirable trading
range.”
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In-Class Exercise
Ross, Westerfield, and Jaffe Question 3 (pp. 543)
• Lee Ann’s stock is sold at $25 per share and it
declares a four-for-one stock split. There are
10,000 shares outstanding. How many shares
are outstanding now? and if it declares a onefor-four reverse stock split. How many shares
are outstanding now?
• Ans: four-for-one stock split, New shares
outstanding = 10,000(4/1) = 40,000. one-forfour reverse stock split, New shares outstanding
= 10,000(1/4) = 2,500.
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Dividend Policy
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What is “dividend policy”?
• It’s the decision to pay out earnings
versus retaining and reinvesting them.
Includes these elements:
1.
2.
3.
4.
High or low payout?
Stable or irregular dividends?
How frequent?
Do we announce the policy?
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Roadmap
 Dividend Irrelevance Theory
 Tax Preference Theory
 Dividends Preference Theory
 The Clientele Effect
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Dividend Irrelevance Theory
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Dividend Irrelevance Theory
• dividend policy is irrelevant in the sense that it
cannot affect shareholder value
• Investors are indifferent between dividends and
retention-generated capital gains. If they want
cash, they can sell stock. If they don’t want cash,
they can use dividends to buy stock.
• Modigliani-Miller support irrelevance.
• Theory is based on no taxes or brokerage costs,
hence may not be true
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The Irrelevance of Dividend
Policy
• A compelling case can be made that dividend
policy is irrelevant in the sense that it cannot
affect shareholder value.
• Since investors do not need dividends to
convert shares to cash; they will not pay
higher prices for firms with higher dividends.
• In other words, 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 a
$3 dividend.
• Bob’s 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 =
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$3,120
$3 Dividend
$240
$0
$240
$39 × 80 =
$3,12034
Dividend Policy is Irrelevant
• In the above example, Bob Investor began with
a total wealth of $3,360:
$42
$3,360  80 shares 
share
 After a $3 dividend, his total wealth is still $3,360:
$39
$3,360  80 shares 
 $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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Dividends and Investment
Policy
• Firms should never forgo positive NPV
projects to increase a dividend (or to pay a
dividend for the first time).
• Recall that one of the assumptions
underlying the dividend-irrelevance
argument is: “The investment policy of the
firm is set ahead of time and is not altered
by changes in dividend policy.”
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Tax Preference Theory
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Personal Taxes 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.
• This could cause investors to prefer firms with low cash
dividends.
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Firms without Sufficient Cash
Investment Bankers
Cash: stock issue
Firm
The direct costs of
stock issuance will
add to this effect.
Stock
Holders
Cash: dividends
Taxes
Gov.
In a world of personal taxes,
firms should not issue stock
to pay a dividend.
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Firms with Sufficient Cash
• 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.
– Select additional capital budgeting projects
(by assumption, these are negative NPV).
– Acquire other companies
– Purchase financial assets
– Repurchase shares
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Taxes 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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Dividends Preference Theory
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台塑主管表示，台塑近年沒大型投
資支出，手上不缺資金，加上創辦
人王永慶認為「公司有賺錢，最好
馬上分給股東，否則錢一直放著，
經營者若不能幫股東找出路，對經
營者是很大的負擔」，台塑因此連
年發放高現金股利，將實際經營成
果直接回饋股東
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• 郭台銘：下半年景氣不明朗 因應成本上漲
錢留公司擴展業務
• 鴻海 2317(TW) 今(2)日召開股東會，董事
長郭台銘 表示，目前市場對景氣看法不同
調，下半年景氣還是不 明朗，加上中國實
施勞動合同法以及原物料價格上漲等 因素
，鴻海傾向將錢留在公司，以利業務擴展
，股利確 定僅發放4.5元。不僅低於市場預
期，也是近年來最低
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Real-World Factors Favoring High
Dividends
• Desire for Current Income: Retired
investors
• Behavioral Finance
– It forces investors to be disciplined.
• Agency Costs
– High dividends reduce free cash flow.
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Behavioral Finance-Dividends
• A natural rule people might create to
prevent themselves from over consuming
their wealth is “only consume the
dividend, but don’t touch the portfolio
capital”.
• In other words, people may like dividends
because dividends help them surmount
self-control problems through the creation
of simple rules.
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Implications of 3 Theories for Managers
Theory
Irrelevance
Implication
Any payout OK
Tax preference
Set low payout
Dividends preference Set high payout
But which, if any, is correct???
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Which theory is most correct?
• Empirical testing has not been able to
determine which theory, if any, is correct.
• Thus, managers use judgment when
setting policy.
• Analysis is used, but it must be applied
with judgment.
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The Clientele Effect
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The Clientele Effect
• Clienteles for various dividend payout
policies are likely to form in the following
way:
Group
Stock Type
High Tax Bracket Individuals
Low Tax Bracket Individuals
Tax-Free Institutions
Corporations
Zero-to-Low payout
Low-to-Medium payout
Medium payout
High payout
Once the clienteles have been satisfied, a corporation is
unlikely to create value by changing its dividend policy.
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What’s the “clientele effect”?
• Different groups of investors, or clienteles,
prefer different dividend policies.
• Firm’s past dividend policy determines its
current clientele of investors.
• Clientele effects impede changing
dividend policy. Taxes & brokerage costs
hurt investors who have to switch
companies.
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The Dividend Decision
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What We Know and Do Not
Know
•
•
•
•
Corporations “smooth” dividends.
Fewer companies are paying dividends.
Dividends provide information to the market.
Firms should follow a sensible policy:
– Do not 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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The Dividend Decision: Lintner’s “Stylized
Facts”
(How Dividends are Determined)
1. Firms have longer term target dividend payout ratios.
2. Managers focus more on dividend changes than on
absolute levels.
3. Dividends changes follow shifts in long-run, sustainable
levels of earnings rather than short-run changes in
earnings.
4. Managers are reluctant to make dividend changes that
might have to be reversed.
5. Firms repurchase stock when they have accumulated a
large amount of unwanted cash or wish to change their
capital structure by replacing equity with debt.
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The Dividend Decision
• Attitudes concerning dividend targets vary
DIV1  target dividend
 target ratio  EPS1
• Dividend Change
DIV1 - DIV0  target change
 target ratio  EPS1 - DIV0
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The Dividend Decision
• Dividend changes confirm the following
DIV1 - DIV0  adjustment rate  target change
 adjustment rate  target ratio  EPS1 - DIV0 
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Conclusion
• What are the dividend polices?
• Which dividend policy favors high (low)
dividend payouts?
• What is the Modigliani-Miller Propositions
about dividend polices?
• What are the Lintner’s “Stylized Facts”
about dividends decisions?
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