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Learning Outcomes
Chapter 13
Describe the views that have been proposed to explain why
firms follow particular dividend policies and why investors react
when firms change dividend policies.
Discuss (a) the types of dividend payments and (b) payment
procedures that firms follow in practice.
Discuss factors that firms consider when making dividend
policy decisions.
Describe stock dividends and stock splits, and discuss how
stock prices are affected by these activities.
Describe stock repurchases and discuss reasons firms use
repurchases.
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Dividend Policy
Dividends
 Payments made to stockholders from the firm’s
earnings, whether those earnings were generated
in the current period or in previous periods
Dividends affect capital structure:
 Retaining earnings increases common equity
relative to debt.
 Financing with retained earnings is cheaper than
issuing new common equity.
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Dividend Policy and Stock Value
Dividend Irrelevance Theory
 Theory states that a firm’s dividend policy has no
effect on either its value or its cost of capital
 Investors value dividends and capital gains equally
Optimal Dividend Policy
 Strikes a balance between current dividends and future
growth that maximizes the firm’s stock price
Dividend Relevance Theory
 A firm’s value is affected by its dividend policy
 The optimal dividend policy is the one that maximizes
the firm’s value
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Investors and Dividend Policy
Information Content, or Signaling
 Signaling hypothesis says that investors regard dividend
changes as signals of management’s earnings forecasts.
Clientele Effect
 The tendency of a firm to attract the type of investor who
likes its dividend policy
Free Cash Flow Hypothesis
 All else equal, firms that pay dividends from cash flows that
cannot be reinvested in positive net present value projects
(free cash flows), have higher values than firms that retain
free cash flows.
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Types of Dividend Payments in Practice
Residual Dividend Policy:
 A policy in which the dividend paid is set equal to the
actual earnings minus the amount of retained earnings
necessary to finance the firm’s optimal capital budget
Stable, Predictable Dividend Policy
 Payment of a specific dollar dividend each year, or
periodically increasing the dividend at a constant rate
 The annual dividend is somewhat predictable by
investors.
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Types of Dividend Payments in Practice
Constant Payout Ratio
 Percentage of earnings, such as 50 percent
 Must watch out for reductions, which may seem to signal
permanent earnings decline
Low Regular Dividend Plus Extras
 A low regular dividend plus a year-end extra in good years
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Dividend Payments in Practice
Declaration Date
 Date on which a firm’s board of directors issues a statement
declaring a dividend
Holder-of-Record Date
 The date on which the company opens the ownership books
to determine who will receive the dividend
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Dividend Payments in Practice
Ex-Dividend Date
 The date on which the right to the next dividend
no longer accompanies a stock
 Usually two business days prior to the holder-ofrecord date
Payment Date
 The date on which the company actually mails
dividend checks
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Dividend Reinvestment Plans (DRIPs)
Plans that enable stockholders to
automatically reinvest dividends received
back into the stock of the paying firm
Firms either repurchase existing shares or
issue new shares that are part of DRIPs
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Factors Influencing Dividend Policy
1.
Constraints on dividend payments:
•
Debt contract restrictions
•
Cannot exceed “retained earnings”
•
Cash availability
•
IRS restrictions on improperly accumulated
retained earnings
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Factors Influencing Dividend Policy
2.
Investment opportunities
• Large capital budgeting projects affect dividend-payout
ratios.
3.
Alternative sources of capital
4.
Ownership dilution
5.
Effects of dividend policy on rS
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Stock Dividends and Stock Splits
Both stock dividends and stock splits increase the
number of shares outstanding, so “the pie is
divided into smaller pieces.”
Unless the stock dividend or stock split conveys
information, or is accompanied by another event
like higher dividends, the stock price falls so as to
keep each investor’s wealth unchanged.
But splits/stock dividends may help firm reach an
“optimal price range.”
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Balance Sheet Effects of a Stock Split
Before a Stock Split
Common stock (5 million shares outstanding, $1 par value)
Additional paid-in capital
Retained earnings
Total common stockholders’ equity
Book value per share = $300/5
After a 2-for-1 Stock Split
Common stock (10 million shares outstanding, $0.50 par value)
Additional paid-in capital
Retained earnings
Total common stockholders’ equity
Book value per share = $300/10
$
5.0
10.0
285.0
$300.0
$ 60.0
$
5.0
10.0
285.0
$300.0
$ 30.0
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Balance Sheet Effects of Stock Dividends
Before a Stock Split of Stock Dividend
Common stock (5 million shares outstanding, $1 par value)
Additional paid-in capital
Retained earnings
Total common stockholders’ equity
Book value per share = $300/5
After a 20 Percent Stock Dividend
Common stock (6 million shares outstanding, $1 par value)a
Additional paid-in capitalb
Retained earningsb
Total common stockholders’ equity
Book value per share = $300/6
a
b
$
5.0
10.0
285.0
$300.0
$ 60.0
$
6.0
99.0
195.0
$300.0
$ 50.0
Shares outstanding are increased by 20 percent, from 5 million to 6 million.
A transfer equal to the market value of the new shares is made from the retained
earnings account to the additional paid-in capital and common stock accounts:
Transfer = [(5,000,000 shares)(.020)]$90 = $90,000,000
Of this $90 million, $1,000,000 = ($1 par)(1,000,000 shares) goes in the Common stock
account and the remaining $89 million goes in the Paid-in capital account.
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Reasons for Stock Repurchases
To distribute excess funds to stockholders
To adjust the firm’s capital structure
To acquire shares needed for employee options
or compensation
To protect against a takeover attempt
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Advantages of Stock Repurchases
1.
A company can use a stock repurchase to distribute excess
cash (free cash flows) without increasing the amount of the
dividends that might otherwise be paid during the year.
2.
A repurchase is an effective method to immediately change
the firm’s capital structure when the proportion of equity is
substantially higher than the target capital structure
prescribes.
3.
When a firm expects managers and other employees to
exercise stock options that have been paid to them as
compensation in previous years, a repurchase can be used to
minimize the “dilution effect” associated with exercising the
options.
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Advantages of Stock Repurchases
4.
Stockholders do not have to sell their shares to the
company during a repurchase period.
5.
Many investors believe that a stock repurchase program
is a signal from management that the firm’s stock is
undervalued in the financial markets, and thus it is a
bargain to purchase.
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Disadvantages of Stock Repurchases
1.
The company might pay too much for stock that
is repurchased.
2.
The interval between one stock repurchase and
another one generally is irregular, which means
that participating investors cannot rely on the
cash that they receive from stock repurchases.
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Capital Structures and Dividend Policies
Around the World
Companies in Italy and Japan use more debt
than companies in the United States or
Canada, but companies in the United
Kingdom use less than any of these.
Different accounting practices make
comparisons difficult.
Gap has narrowed in recent years.
Dividend-payout ratios vary greatly also.
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Capital Structures and Dividend Policies
Around the World
Tax codes generally favor use of debt in
developed countries.
In countries where capital gains are not
taxed, investors should show a preference for
stocks compared with countries that have
capital gains taxes.
Investor preferences should lead to relatively
low equity capital costs in those countries
that do not tax capital gains.
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Capital Structures and Dividend Policies
Around the World
What about risk, especially bankruptcy costs?
 Foreign banks are closely linked to corporations
that borrow from them, and have substantial
influence over the management of the debtor
firms
 Equity monitoring costs are comparatively low in
the United States
 These low monitoring costs indicate that U.S.
firms should have more equity and less debt than
firms in countries like Japan and Germany
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