Chapter
17
Dividends and
Payout Policy
17-1
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
•Dividend Payments
•Dividend Theory
•Does Dividend Policy Matter?
•Factors Favoring a Low Dividend Payout
•Factors Favoring a High Dividend Payout
•Experience with Dividend Policies
17-2
Chapter Outline
•Dividend Payments
•Dividend Theory
•Does Dividend Policy Matter?
•Factors Favoring a Low Dividend Payout
•Factors Favoring a High Dividend Payout
•Experience with Dividend Policies
17-3
Dividends and Retained
Earnings
Net Income
Dividends
17-4
Retained
Earnings
Dividends and Retained
Earnings
Net Income
Dividends
17-5
Retained
Earnings
The decision as to how many dividend dollars to
allocate from the net income
is the firm’s Dividend Policy.
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
17-6
Cash Dividends
•Special cash dividend – similar to
extra dividend, but definitely will
not be repeated
•Liquidating dividend – some or all
of the business has been sold
17-7
Vocabulary for
Dividend Payments
1. Declaration Date – Board declares the
dividend, and it becomes a liability of
the firm
2. 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
17-8
Vocabulary for
Dividend Payments
3. Date of Record – Holders of record are
determined, and they will receive the
dividend payment
4. Date of Payment – checks are mailed
17-9
Timing of
Dividend Payments
17-10
Bonus Dividends
Bonus Dividend –
The payment of additional dollars to each
shareholder (above the “regular” dividend
payment). This is another name for extra
cash dividends.
17-11
Stock Dividends
•Pay additional shares
of stock instead of
cash
•Increases the number
of outstanding shares
17-12
Stock Dividends
• 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%
17-13
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
• The stock price is reduced when the stock
splits
• The common explanation for split is to
return price to a “more desirable trading
range”
17-14
Work the Web
Find out about current
Stock Splits
17-15
Stock Repurchase
A company buys back its own shares
of stock
•Tender offer – company states a
purchase price and a desired number
of shares
•Open market – buys its own common
stock in the open market
17-16
Stock Repurchase
A company buys back its own
shares of stock
•Similar to a cash dividend in that it
returns cash from the firm to the
stockholders
•This is another argument for dividend
policy irrelevance in the absence of
taxes or other imperfections
17-17
Real-World Considerations
• Stock repurchase allows investors to decide if
they want the current cash flow and
associated tax consequences.
• Given our tax structure, repurchases may be
more desirable due to the options provided
stockholders.
17-18
The IRS recognizes this and will not allow a
stock repurchase for the sole purpose of
allowing investors to avoid taxes.
Information Content of
Stock Repurchases
•Stock repurchases send a positive signal that
management believes 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
17-19
An Actual Example:
Repurchase Announcement
“America West Airlines announced that its Board of Directors has
authorized the purchase of up to 2.5 million shares of its Class B
common stock on the open market as circumstances warrant over the
next two years …
Following the approval of the stock repurchase program by the
company’s Board of Directors earlier today. W. A. Franke, chairman and
chief officer said ‘The stock repurchase program reflects our belief that
America West stock may be an attractive investment opportunity for the
Company, and it underscores our commitment to enhancing long-term
shareholder value.’
The shares will be repurchased with cash on hand, but only if and to the
extent the Company holds unrestricted cash in excess of $200 million to
ensure that an adequate level of cash and cash equivalents is
maintained.”
17-20
Chapter Outline
•Dividend Payments
•Dividend Theory
•Does Dividend Policy Matter?
•Factors Favoring a Low Dividend Payout
•Factors Favoring a High Dividend Payout
•Experience with Dividend Policies
17-21
Dividend Policy Theory
The “Residual Theory of Dividends”
Given three pieces of information, we can
construct the theoretical optimal dividend
payout for a firm:
1.The estimated (forecasted) profits,
2.The firm’s Optimal Capital Structure,
3.The total cash needed to purchase next year’s
projects (the firm’s shopping list for projects)
17-22
Dividend Policy Theory
Residual Theory of Dividends
An example will explain this better:
1. The estimated (forecasted) profits:
$3,000,000
2. The Optimal Capital Structure:
D/E = .65/.35
3. The total cash needed for future projects:
$2,150,000
17-23
Dividend Policy Theory
Residual Theory of Dividends
Estimate the equity needed for purchasing:
$2,150,000 ( .35) = $752,500
Now construct the division of estimated profits
to retained earning and dividends:
17-24
Dividends and
Retained Earnings
Estimated Net Income
$3,000,000
The residual is
paid out as
dividends:
Dividends
$2,247,500
17-25
Retained
Earnings
$752,500
Chapter Outline
•Dividend Payments
•Dividend Theory
•Does Dividend Policy Matter?
•Factors Favoring a Low Dividend Payout
•Factors Favoring a High Dividend Payout
•Experience with Dividend Policies
17-26
Does Dividend Policy Matter?
We know that many firms do
NOT follow the “Residual
Theory of Dividends”. What
is going on? It appears that
there are other factors at play
when it comes to a firm’s
dividend policy.
17-27
M & M’s “Information
Content of Dividends”
Modigliani and Miller (M & M)
postulate that the payment of
dividends, the non- payment of
dividends, or the change of
pattern to the past payment of
dividends all signal important
information to the shareholders.
17-28
Dividends and Signals
Asymmetric information –
Managers have more
information about the health
of the company than investors
17-29
Dividends and Signals
Changes in dividends convey
information:
Dividend increases:
• Management believes it can be sustained
• Expectation of higher future dividends,
increasing present value
• Signal of a healthy, growing firm
17-30
Dividends and Signals
Changes in dividends convey
information:
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
17-31
Does Dividend Policy Matter?
Dividends may matter – the value
of the stock is based on the
present value of expected future
dividends
17-32
Does Dividend Policy Matter?
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
17-33
Illustration of Irrelevance
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 this year, reinvest the other
$1,000 into the firm and then pay $11,120 next
year.
(Investors require a 12% return.)
17-34
Illustration of Irrelevance
Consider a firm that can either pay out
dividends of $10,000 per year for each of the
next two years
$10,000/ (1.12) + $10,000/ (1.12)2
= $ 8,928.57 + $7,971.94 = $16,900.51
or can pay $9,000 this year, reinvest the other
$1,000 into the firm and then pay $11,120 next
year.
$ 9,000/ (1.12) + $11,120/ (1.12)2
= $ 8,035.71 + $8,864.80 = $16,900.51
Thus, it makes no difference!
17-35
Chapter Outline
•Dividend Payments
•Dividend Theory
•Does Dividend Policy Matter?
•Factors Favoring a Low Dividend Payout
•Factors Favoring a High Dividend Payout
•Experience with Dividend Policies
17-36
Low Payout, Please
Why might a low payout be desirable?
1. Individuals in upper income tax
brackets might prefer lower dividend
payouts, given the immediate tax
liability, in favor of higher capital
gains with the deferred tax liability
17-37
Taxes for the Wealthy
Net Income
Dividends
Taxed at ordinary
income tax level
(high taxes)
17-38
Retained
Earnings
Taxed at a fixed tax rate for
capital gains
when the stock is sold
(lower tax rate)
Low Payout, Please
Why might a low payout be desirable?
2. Flotation costs – low payouts can
decrease the amount of capital that
needs to be raised, thereby lowering
flotation costs
3. Dividend restrictions – debt contracts
might limit the percentage of income
that can be paid out as dividends
17-39
Chapter Outline
•Dividend Payments
•Dividend Theory
•Does Dividend Policy Matter?
•Factors Favoring a Low Dividend Payout
•Factors Favoring a High Dividend Payout
•Experience with Dividend Policies
17-40
High Payout, Please
Why might a high payout be desirable?
1. Desire for current income
17-41
•
Individuals that need current income
(for example, retirees needing fixed
incomes)
•
Groups that are legally prohibited from
spending principal (for example, managers
of trusts and endowments)
High Payout, Please
Why might a high payout be desirable?
2. Uncertainty resolution – no guarantee that the
higher future dividends will materialize
3. Taxes
• Dividend exclusion for corporations
• Tax-exempt investors don’t have to worry
about differential treatment between
dividends and capital gains
17-42
Clientele Effect
(It’s all about the investors!)
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
17-43
Implications of the
Clientele Effect
•What do you think will happen if a firm
changes its policy from a high payout to a low
payout?
•What do you think will happen if a firm
changes its policy from a low payout to a high
payout?
•If this is the case, does dividend policy matter?
17-44
Chapter Outline
•Dividend Payments
•Dividend Theory
•Does Dividend Policy Matter?
•Factors Favoring a Low Dividend Payout
•Factors Favoring a High Dividend Payout
•Experience with Dividend Policies
17-45
What We Know
(and Do Not Know)
• Corporations “smooth” dividends
• Dividends provide valuable
information to the market
• Corporations rarely change their
dividend policy
17-46
What We Know
(and Do Not Know)
• Firms should follow a sensible dividend
policy:
1. Don’t forgo positive NPV projects just to pay a
dividend
2. Avoid issuing stock to pay dividends
3. Consider share repurchase when there are few
better uses for the cash
17-47
Putting the Pieces Together
• Aggregate payouts are massive and have
increased over time
• Dividends are concentrated among a small
number of large, mature firms
• Managers are reluctant to cut dividends
• Managers smooth dividends
• Stock prices react to unanticipated
changes in dividends
17-48
Management View of
Dividend Policy: Survey Results
Agree or Strongly Agree:
• 93.8% Try to avoid reducing
dividends per share
• 89.6% Try to maintain a smooth
dividend from year to year
• 41.7% Pay dividends to attract
investors subject to “prudent man”
restrictions
17-49
Management View of
Dividend Policy: Survey Results
Important or Very Important
• 84.1% Maintaining consistency
with historic dividend policy
• 71.9% Stability of future earnings
• 9.3% Flotation costs to issue new
equity
17-50
Ethics Issues
 Should a company initiate a dividend
policy exclusively to reduce the taxes
paid by some of their shareholders?
 Should the management of a company
announce the increase payment of
dividends when they have knowledge
of significant cash flow problems?
17-51
Quick Quiz
 What are the different types of dividends, and how is a
dividend paid?
 What is the clientele effect, and how does it affect
dividend policy relevance?
 What is the information content of dividend changes?
 What are stock dividends, and how do they differ from
cash dividends?
 How are share repurchases an alternative to dividends,
and why might investors prefer them?
17-52
Comprehensive Problem
A company’s stock is priced at $50 per share, and it
plans to pay a $2 cash dividend.
 Assuming perfect capital markets, what will the per share
price be after the dividend payment?
 If the average tax rate on dividends is 25%, what will the
new share price be?
17-53
Comprehensive Problem
A company’s stock is priced at $50 per share, and it
plans to pay a $2 cash dividend.
 Assuming perfect capital markets, what will the per share
price be after the dividend payment?
In a perfect market, new price = $50-$2 = $48.00
 If the average tax rate on dividends is 25%, what will the
new share price be?
In an imperfect market, new price = 48 + 2*.25
= $48.50
17-54
Terminology
•Dividend Policy
•Cash Dividend
•Stock Dividend
•Bonus Dividend
•Stock Split
•Stock Repurchase
•Signaling Effect
•Clientele Effect
17-55
Terminology
•Declaration Date
•Ex-dividend Date
•Date of Record
•Date of Payment
17-56
Key Concepts and Skills
•Define the types of dividends
•Describe how and when dividends are
paid
•Why are dividends paid (or not paid,
for that matter)?
•Explain how cash and stock dividends
differ
•How can stock repurchases be used as
an alternative to dividend payments?
17-57
What are the most important
topics of this chapter?
1. Dividend Policy is the decision by
management to pay dividends versus
keeping retained earnings.
2. Dividends are typically paid quarterly
in the form of cash.
3. Alternatives to cash dividends are
stock dividends and repurchasing.
17-58
What are the most
important topics of this
chapter?
4. Firms have reasons for high or low
dividend payouts often involving
“information”.
5. Investors have separate reasons for
high or low dividend payouts often
involving taxes or cash needs.
17-59
17-60