Chapter 17
DIVIDENDS AND
DIVIDEND POLICY
Corporate Taxes
Value of the firm and WACC
EBIT = $195 million; Tax rate = 35%; Debt
= $155 million; Cost of debt = 8%;
Unlevered cost of capital = 20%
◦ WACC = ?
◦ RE = ?
1
Corporate Taxes
Value of the firm and WACC
EBIT = $195 million; Tax rate = 35%; Debt =
$155 million; Cost of debt = 8%; Unlevered
cost of capital = 20%
 VU =975*.65 =633.75
 VL = 633.75 + 155*.35 = 688
 E = 688 -155 = 533

WACC=(533/688)*.2227 + (155/688)(.08)(.65) =
.1725 + .0117= .1842
◦ RE = .2 + (.2 – .08)(155/533)(.65) = .2227
2
Value of the firm – Proposition I
with Corporate Taxes
◦ EBIT = $95 million; Tax rate = 35%; Debt =
$55 million; Cost of debt = 11%; Unlevered
cost of capital = 22%
VU =95*.65/.22=280.68
 VL =280.68 + 55*.35=299.93
 E = 299.93 – 55 = 244.93

◦ RE = .22 + (.22 – .11)(55/244.93)(.65)=.2361
WACC = (244.93/299.93)*.2361 +
(55/299.93)(.11)(.65) =.1928 + .0131 = .2059
3
Value of the firm – Proposition I
with Corporate Taxes
◦ EBIT = $95 million; Tax rate = 35%; Debt =
$85 million; Cost of debt = 11%; Unlevered
cost of capital = 22%
VU =95*.65/.22=280.68
 VL =280.68 + 85*.35=310.43
 E = 310.43 – 85 = 225.43

◦ RE = .22 + (.22 – .11)(85/225.43)(.65)=.247
WACC = (225.43/310.43)*.247 +
(85/310.43)(.11)(.65) =.1794 + .0196 = .1990
4
Chapter Outline







Cash Dividends and Dividend Payment
Method of Cash Dividend Payment
Does Dividend Policy Matter?
Real-World Factors Favoring a Low Payout and
High Payout
Establishing a Dividend Policy
Stock Repurchase
Not Real Dividends: Stock Dividends and Stock
Splits
5
Cash Dividends
Regular cash dividend – cash payments
made directly to stockholders, usually
each quarter
 Extra cash dividend – indication that
the “extra” amount may not be repeated
in the future
 Liquidating dividend – some or all of
the business has been sold

6
Dividend Reinvestment Plans
(DRIPs)
System that allows shareholders to
automatically reinvest their dividends into
the purchase of additional company
shares
 Advantages for the firm:
 Retains cash
 Reduces transaction costs of making the
payments
 Saves on underwriting fees

7
DRIPs: advantages
 Advantages
for the investor:
 Shares purchased without transaction
costs
 Discount – usually 3-5% to the market
price
8
Dividend Payment
1.
2.
Declaration Date – Board declares the dividend and it
becomes a liability of the firm
Ex-dividend Date
◦ Occurs two business days before date of record
◦ If you buy stock on or after this date, you will not receive
the dividend
◦ Stock price generally drops by about the amount of the
dividend
3.
4.
Date of Record – Holders of record are determined
and they will receive the dividend payment
Date of Payment – cheques are mailed
9
Dividend Payment Chronology
10
What Happens to the Price of a Stock
around Ex-dividend Day?
11
Does Dividend Policy Matter?
Dividends matter – the value of the
stock is based on the present value of
expected future dividends
 Dividend policy may not matter

◦ Dividend policy is the decision to pay
dividends versus retaining funds to reinvest in
the firm
◦ In theory, if the firm reinvests capital now, it
will grow and can pay higher dividends in the
future
12
Why Dividend Policy Doesn’t
Matter?

Consider a firm that can either pay out
dividends of $10,000 per year for each of the
next two years or can pay $9,000 in one year,
reinvest the other $1,000 into the firm and then
pay $11,120 in two years. Investors require a
12% return.
◦ Market Value with constant dividend:
◦ Market Value with reinvestment:

If the company will earn the required return,
then it doesn’t matter when it pays the
dividends
13
Homemade Dividends
Dividend policy is irrelevant when there are
no taxes or other market imperfections
 Shareholders can effectively undo the firm’s
dividend strategy
 The shareholder who receives a dividend
that is greater than desired can reinvest the
excess
 The shareholder who receives a dividend
that is smaller than desired can sell extra
shares of stock

14
Low Dividend Payout
Individuals in upper income tax brackets might
prefer lower dividend payouts, with the
immediate tax consequences, in favor of higher
capital gains
 Flotation costs – low payouts can decrease the
amount of capital that needs to be raised,
thereby lowering total flotation costs
 Dividend restrictions – debt contracts might
limit the percentage of income that can be paid
out as dividends

15
High Dividend Payout

Desire for current income
◦ Individuals in low tax brackets
Uncertainty resolution – no guarantee that the
higher future dividends will materialize
 Taxes

◦ Dividend exclusion for corporations
◦ Tax-exempt investors don’t have to worry about
differential treatment between dividends and capital
gains
16
Alternatives to Paying a Dividend

Select additional capital budgeting
projects

Repurchase shares

Acquire other companies

Purchase financial assets
17
Dividends and Signals
Asymmetric information –
managers have more information
about the health of the company
than investors
 Changes
in dividends convey
information
18
Dividend Increases
 Management
believes higher dividend
can be sustained
 Expectation
of higher future
dividends, increasing present value
 Signal
of a healthy, growing firm
19
Dividend Decreases
 Management
believes it can no
longer sustain the current level of
dividends
 Expectation
of lower dividends
indefinitely; decreasing present value
 Signal
of a firm that is having financial
difficulties
20
Clientele Effect
Some investors prefer low dividend payouts and
will buy stock in those companies that offer low
dividend payouts
 Some investors prefer high dividend payouts
and will buy stock in those companies that offer
high dividend payouts
 Investors will self-select into the stocks have
their preferred payout policy
 Managers should focus on capital budgeting
decisions and ignore investor preferences

21
Types of Dividend Policies

Residual dividend policy

Dividend stability

Compromise dividend policy
22
Residual Dividend Policy
1.
Determine capital budget
2.
Determine target capital structure
3.
Finance investments with a combination
of debt and equity in line with the target
capital structure
4.
If there are excess earnings, then pay the
remainder out in dividends
23
Residual Dividend Policy, example

Given
◦ Need $5 million for new investments
◦ Target capital structure: D/E = 2/3
◦ Net Income = $4 million

Dividend - ?
24
Dividend Stability

Cyclical dividend policy – dividend is a
fixed fraction of earnings

Stable dividend policy – all dividend
payments are equal
25
Compromise Dividend Policy

Goals, ranked in order of importance
1. Avoid cutting back on positive NPV projects
to pay a dividend
2. Avoid dividend cuts
3. Avoid the need to sell equity
4. Maintain a target debt/equity ratio
5. Maintain a target dividend payout ratio

Companies want to accept positive NPV
projects, while avoiding negative signals
26
Stock Repurchase

Company buys back its own shares of
stock

Similar to a cash dividend in that it
returns cash from the firm to the
stockholders

Another argument for dividend policy
irrelevance in the absence of taxes or
other imperfections
27
Repurchase methods
1.
Buy in the open market
2.
Buy back a fixed number of shares at a fixed
price – a company will make a tender offer to
repurchase a specific number of shares,
typically at a premium to the market price
3.
Repurchase by direct negotiation – a
company negotiates with the major
shareholder to buy back its shares
28
Information Content of Stock Repurchases
Stock repurchases sends a positive signal
that management believes that the
current price is low
 Tender offers send a more positive signal
than open market repurchases because
the company is stating a specific price
 The stock price often increases when
repurchases are announced

29
Stock Dividends
Pay additional shares of stock instead of
cash
 Increases the number of outstanding
shares
 If you own 100 shares and the company
declared a 10% stock dividend, you would
receive an additional 10 shares

30
Effect of a 3% stock dividend
Before dividend
After dividend
Shares outstanding
1,000,000
1,030,000
Earnings per share
$1.00
Stock price
$20.00
P/E
20
Total market value
$20mln.
Shares owned by investor X
100,000
Ownership value
31
Stock Splits

Stock splits – essentially the same as a
stock dividend except 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”
 Reverse stock splits

32
Effect of a six-for-five stock split
Before split
Shares outstanding
4mln.
Stock price
$40.00
EPS
$1.50
Dividends per share
$0.50
Dividends yield
1.25%
P/E
26.7
Market value of a company
$160mln.
After split
33