Chapter 16
Dividend Policy
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
Slide Contents
• Learning Objectives
• Principles Used in This Chapter
1. How Do Firms Distribute Cash to their
Shareholders?
2. Does Dividend Policy Matter?
3. Cash Distribution Policies in Practice
• Key Terms
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16-2
Learning Objectives
1. Distinguish between the use of cash
dividends and share repurchases.
2. Understand the tax treatments of
dividends and capital gains, and stock
dividends and stock splits.
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Learning Objectives (cont.)
3. Discuss the conditions under which
dividend policy is an important
determinant of stock price.
4. Describe corporate dividend policies that
are commonly used in practice.
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Principles Used in This Chapter
• Principle 1: Money Has a Time Value.
• Principle 3: Cash Flows Are the Source of
Value.
• Principle 4: Market Prices Reflect
Information.
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Introduction
• When a firm generates cash from
operations, what can the firm do with the
cash?
1. Use the cash to fund new investments,
2. Use the cash to pay off some of its debt,
and/or
3. Distribute the cash back to the firm’s
shareholders either as a cash dividend or as
stock repurchases.
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Introduction (cont.)
• This chapter provides answers to three questions
regarding a firm’s dividend policy:
1. What are the pros and cons of the methods
the firm can use to distribute cash?
2. Why should the firm’s shareholders care
about the firm’s dividend policy given that
they can generate cash when they need it by
selling some of their shares?
3. What cash distribution policies do most firms
use in practice?
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16.1 How Do
Firms Distribute
Cash to their
Shareholders?
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How Do Firms Distribute Cash to
their Shareholders?
• Cash distributions can take two basic
forms:
1. Cash dividend
2. Share repurchase
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How Do Firms Distribute Cash to
their Shareholders? (cont.)
• With cash dividend, cash is paid directly
to the shareholders.
• With a share repurchase, a company
uses cash to buy back its own shares from
the market place, thereby reducing the
number of outstanding shares.
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How Do Firms Distribute Cash to
their Shareholders? (cont.)
• The impact on the balance sheet will be as
follows:
– On the Assets side, cash will be reduced due to
cash dividend or share repurchase.
– On the Equity side, there will be a
corresponding decrease.
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Figure 16.1 (Cont.)
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Figure 16.1 (Cont.)
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Cash Dividends
• A firm’s dividend policy determines how
much cash it will distribute to its
shareholders and when these distributions
will be made.
• Dividends are generally described in terms
of dividend payout ratio, which indicates
the amount of dividends paid relative to
the company’s earnings.
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Dividend Payment Procedures
• Generally, companies pay dividends on a
quarterly basis. There are several dates
that are important with regard to dividend
payment:
• (a) Announcement date: It is the date on
which dividend is formally declared by the
board of directors.
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Dividend Payment Procedures
(cont.)
• (b) Date of record: Investors who own stock on
this date receive the dividend. However, this date
was pushed forward two days to ex-dividend
date.
(c) Ex-dividend date: This is two days before the
date of record and any investor who buys shares
after the ex-dividend date is not entitled to
dividend.
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Dividend Payment Procedures
(cont.)
• (d) Payment date: This is the date on
which dividend checks are mailed to the
investors.
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Dividend Payment Procedures
(cont.)
Date
Explanation
Calendar Date
Announcement Date
Dividend is declared.
March 15
Ex-Dividend Date
Shares begin trading
ex-dividend.
May 17
Record Date
Dividend will be paid to
shareholders who own
the stock on this date.
May 19
Payment Date
Dividends are
distributed to the
shareholders of record
on the record date.
May 27
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Stock Repurchases (Stock Buyback)
• Stock repurchase is when a firm uses its
cash to repurchase some of its own stock.
• This results in a reduction in the firm’s
cash balance as well as the number of
shares of stock outstanding. Firms use one
of three methods to purchase the shares:
Open market repurchase, tender offer, and
direct purchase.
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How do Firms Repurchase Their
Shares?
• Open Market Repurchase
– Here the firm acquires the stock on the market,
often buying a relatively small number of
shares everyday. This will put upward pressure
on share prices. This is the most widely used
method for stock repurchase.
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How do Firms Repurchase Their
Shares? (cont.)
• Tender Offer
– A company uses this method when it wants to
buy a relatively large number of shares very
quickly.
– The company makes a formal offer to buy a
specified number of shares at a stated price.
– The price is set above the market price to
attract sellers.
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How do Firms Repurchase Their
Shares? (cont.)
• Direct Purchase from a large investor
– Here the firm purchases the stock from one or
more major stockholders on a negotiated basis.
This method is not used frequently.
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Personal Tax Considerations –
Dividend Versus Capital Gains Income
• Historically, tax laws have favored capital
gains income over dividend income.
• However, the 2006 Tax Act lowered the tax
rate on dividends and long-term capital
gains (stock held for more than 1 year) to
15% for most people.
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Personal Tax Considerations – Dividend
Versus Capital Gains Income (cont.)
• To qualify for the lower tax rate on
dividends, the stock must be held for more
than 60 days during the 120-day period
that begins 60 days before the ex-dividend
date.
• If not, dividends will be taxed as ordinary
income.
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Non-Cash Distributions: Stock
Dividends and Stock Splits
• A stock dividend is a pro-rata distribution
of additional shares of stock to the firm’s
current stockholders. These distributions
are generally defined in terms of a fraction
paid per share.
– For example, a firm might pay a stock dividend
of .20 shares of stock per share or 2 shares for
every 10 held.
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Non-Cash Distributions: Stock
Dividends and Stock Splits (cont.)
• Stock split is essentially a very large
stock dividend. For example, a 2-for-1 split
would entail receiving two new shares for
every old share currently held.
• With a 2-for-1 split, the number of shares
will double and the share price will drop in
half.
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Rationale for a Stock Dividend or
Stock Split
• One rationale for splits and stock dividends
is that there is an optimal price range for
the firm’s stock. Also, beyond a certain
price range, there might be lower demand
for shares from investors.
• If the price exceeds that optimal range, it
can be brought back to the optimal range
by doing a stock split or paying stock
dividend.
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16.2 Does
Dividend Policy
Matter?
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Does Dividend Policy Matter?
• Modigiliani and Miller suggest that without
taxes and transaction costs, cash
dividends and share repurchases are
equivalent and the timing of the
distribution is unimportant.
• This is known as the Modigiliani and Miller
dividend irrelevancy proposition.
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The Irrelevance of the Distribution
Choice
• The distribution choice is irrelevant under
the following assumptions:
1. There are no taxes.
2. No transaction costs are incurred in either
buying or selling shares of stock.
3. The firm’s operating and investment policies
are fixed.
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The Irrelevance of the Distribution
Choice (cont.)
• The dividend irrelevancy proposition can
be illustrated in two ways:
1.Timing of dividend distributions does not affect
firm value.
2.In the absence of taxes and transaction costs,
a cash dividend is equivalent to a share
repurchase.
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The Timing
of Dividend
is Irrelevant
Figure 16.2 (Cont.)
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Figure 16.2 (Cont.)
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The Timing of Dividend is Irrelevant
(cont.)
• Figure 16-2 considers two alternatives:
1. Pay $35 million now and $135 million in one
year
2. Pay $52.5 million now and $114.875 million
in one year
–
In both cases, the value of share remains the
same at $15.24 per share.
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Checkpoint 16.1
Stock Price and the Timing of Dividend Payments
After operating for more than 50 years, the owners of the Northwest Wire
and Cable Company decided that it was time to shut down the firm’s business
at the end of the year. However, the firm has $4 million in cash available for
distribution to its shareholders today and expects to have $30 million at the
end of the year to pay as a liquidating dividend. Northwest has 3 million
shares outstanding today and is contemplating one of two cash distribution
policies. The first (Alternative #1) involves simply paying cash dividends
equal to the firm’s cash flow both today and at the end of the year.
Alternative #2 involves paying a much larger dividend today of $12 million
and issuing new shares of stock to raise the $8 million in additional funds
needed to fund the dividend. The company’s stockholders require a 12% rate
of return on the firm’s shares. What is the value of the firm’s equity in total
and per share under the two dividend payment plans where the firm has 1
million shares of stock outstanding before issuing any new shares?
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Checkpoint 16.1
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Checkpoint 16.1
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Checkpoint 16.1
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Checkpoint 16.1: Check Yourself
Consider Alternative #3 in which Northwest Wire and Cable
decides to increase its current period dividend to only $8
million. Show that the firm’s equity under this scenario would
be $30.79 million.
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Step 1: Picture the Problem
• The firm is considering two alternatives:
– Pay $4 million today and $30 in year 1 as
liquidating dividend; or
– Pay $8 million today and pay $25.52 in year 1
($30 million - $4million*1.12 paid to new
shareholders)
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Step 2: Decide on a Solution
Strategy
• The value of Northwest Wire and Cable
company’s equity is equal to the present
value of the firm’s expected cash
dividends. We can estimate the value
using equation 16-1.
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Step 3: Solve
• Value – Alternative 1
Value = $4 million + $25.52 million /(1.12)1
= $30.79 million
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Step 3: Solve (cont.)
• Value – Alternative 2
Value = $8 million + $30 million /(1.12)1
= $30.79 million
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Step 4: Analyze
• This example illustrates that the timing of
dividend payment does not affect the
value of the firm.
• This was true because we held constant
the firm’s investment cash flows. We also
assumed that the new shares could be
issued under the same terms as the
existing shares.
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The form of Payment (Cash Dividend
Versus Share Repurchase) is Irrelevant
• Table 16-1 illustrates two possibilities for
the use of $1,000,000 in cash flows:
1.A $1,000,000 cash dividend
2.A $1,000,000 stock repurchase
– It is observed that the value is the same so an
investor will be indifferent between the two
options.
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Individual Investor Wealth Effects –
Personal Taxes
• What are the tax rules with regard to
dividends and share repurchases?
1. 100% of cash dividends are taxable in the
year in which they are received.
2. When individuals sell shares, tax is assessed
only on the capital gain (i.e. price appreciation
of stock).
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Individual Wealth Effects –
Personal Taxes (cont.)
3. If an individual decides not to sell his or
her share back to the company making
the stock repurchase, they will not incur
any taxes.
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Individual Wealth Effects –
Personal Taxes (cont.)
• Table 16-2 shows the cash flow
consequences of the alternative methods
for distributing cash to the shareholders
that were introduced in Table 16-1.
• It is assumed that both dividends and
capital gains are taxed at 15%.
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Why Dividend Policy is Important?
• Transactions are costly
– Since taxes are incurred when dividends are
received and transactions costs are incurred
when buying and selling shares, investors will
prefer to select companies whose dividend
policy match up with their own preferences.
Because firms with different dividends attract
different dividend clienteles, it is important
that dividend policy remain somewhat stable.
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Why Dividend Policy is Important?
(cont.)
• The Information Conveyed by Dividend
and Share Repurchase Announcement
– Investors and stock market are constantly
trying to decipher the information released by
firms to better understand what they imply
about firm values.
– Firms tend to increase their dividends when
dividends can be sustained in the future. In
such cases, dividend increase is clearly good
news.
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Why Dividend Policy is Important?
(cont.)
• Share repurchases are also viewed very
favorably as it reveals that the firm has
generated more money than it currently
needs. Share repurchases may also reveal
that the equity is currently underpriced.
• The empirical evidence indicates that
dividends and share repurchases do in fact
convey favorable information to investors.
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Why Dividend Policy is Important?
(cont.)
• The Information Conveyed by Stock
Dividends and Stock Splits
– The announcement of stock dividends and
stock splits also tend to generate positive stock
returns. This increase is harder to explain as
stock dividends and stock splits do not affect
firm’s cash flows.
– Some researchers have suggested that firms
have a preferred trading range and stock splits
help bring stock prices to that trading range.
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Why Dividend Policy is Important?
(cont.)
• A second possibility is that stock splits and
stock dividends tend to attract attention.
Naturally, firm would like to attract
attention only when the prospects are
favorable.
• Thus even though there is no direct effect
on cash flows, the market reacts favorably.
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16.3 Cash
Distribution
Policies in
Practice
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Cash Distribution Policies in Practice
• Stable Payout
– In a survey of CEOs, most CEOs recognized the
importance of maintaining consistency and
stability in dividend policy.
– See figure 16-3, panel a and b.
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Figure 16.3 (Cont.)
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Figure 16.3 (Cont.)
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Stock Repurchase Decisions
• Figure 16-4 reveals that stock repurchase
decisions are driven by executive’s feeling
that the stock is a good investment
relative to its true value and that there are
a lack of good investment opportunities to
invest in.
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Dividends versus Repurchases
• Table 16-3 provides a summary of factors
influencing the payout policy.
• Flexibility emerges as a major factor in the
choice of repurchases as opposed to
dividends.
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Residual Dividend Policy
• With a residual dividend policy, the firm
first finances its investments using its own
earnings. Dividends are paid out of the
residual earnings that are not needed to
finance new investment opportunities.
• While this policy minimizes the cost of
financing, it can lead to unstable dividends
for shareholders.
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Other Factors Playing a Role in
How Much to Distribute
• Liquidity Position
– Because dividend payments and stock
repurchases are made with cash, and not with
retained earnings, the firm must have cash
available for payouts to be made.
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Other Factors Playing a Role in How
Much to Distribute (cont.)
• Lack of Other Sources of Financing
– Many small or new companies may not have
access to the capital markets, and must
depend upon internally generated funds to fund
their investment opportunities. As a result, the
dividend pay out ratio for such firms is
generally lower.
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Other Factors Playing a Role in How
Much to Distribute (cont.)
• Earnings Predictability
– A company’s payout ratio depends to some
extent on the predictability of a firm’s profits
over time. Firms with stable earnings will
typically pay out a larger portion of its
earnings.
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Key Terms
•
•
•
•
•
•
•
Cash dividend
Date of record
Declaration date
Dividend clienteles
Dividend payout ratio
Dividend policy
Ex-dividend date
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Key Terms (cont.)
•
•
•
•
•
•
•
Open market repurchases
Payment date
Residual dividend payout policy
Stock dividend
Stock repurchase
Stock split
Tender offer
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