14.0
Chapter
14
McGraw-Hill/Irwin
Dividends and
Dividend
Policy
©2001 The McGraw-Hill Companies All Rights Reserved
14.1
Key Concepts and Skills
 Understand
dividend types and how they are
paid
 Understand the issues surrounding dividend
policy decisions
 Understand the difference between cash and
stock dividends
 Understand why share repurchases are an
alternative to dividends
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14.2
Chapter Outline
 Cash
Dividends and Dividend Payment
 Does Dividend Policy Matter?
 Establishing a Dividend Policy
 Stock Repurchase: An Alternative to Cash
Dividends
 Stock Dividends and Stock Splits
McGraw-Hill/Irwin
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14.3
Dividends and Dividend Policy
 The
heart of the dividend policy question is
should the firm:
pay out money to its shareholders or
 take that money and invest it for its shareholders?

 There
are many good reasons to:
Pay high dividends as well as
 Pay low dividends

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14.4
14.1 Cash Dividends and Dividend Payment
McGraw-Hill/Irwin
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14.5
Dividends and Distributions
Payment made out of a firm’s
earnings to its owners, in the form of either
cash or stock
 Dividend:

Usually refers to cash paid out of earnings
 Distribution:
Payment made by a firm to its
owners from sources other than current or
accumulated retained earnings
 However, the terms are somewhat
interchangeable
McGraw-Hill/Irwin
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14.6
The Basic Types of Cash Dividends:
Regular cash dividend – cash payment made by a firm
to its owners in the normal course of business, usually
made four times a year
 Extra cash dividend – indication that the “extra”
amount may not be repeated in the future
 Special cash dividend – similar to extra dividend, but
definitely won’t be repeated
 Liquidating dividend – some or all of the business has
been sold

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14.7
Cash Dividends
 The
most common type of dividend
 Made directly to shareholders in cash
 Made in the regular course of business
Nothing unusual about the dividend
 No reason why it won’t be continued

 Reduces

corporate cash and retained earnings
Except in the case of a liquidating dividend

(where paid-in capital may be reduced)
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14.8
Standard Method of Cash Dividend Payment
Decision to pay rests in the hands of the board of
directors
 Once “declared” – becomes a liability of the firm and
can’t be rescinded easily
 After declaration – distributed to all shareholders as of
some “specific date”
 Usually expressed in terms of dollars per share
(dividends per share)
 Also expressed as:

Percentage of: market price (dividend yield)
 Percentage of: net income or earnings per share
(dividend payout)
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
14.9
Dividend Payment: A Chronology
 1.
Declaration Date: Date on which the board
of directors passes a resolution to pay a
dividend
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14.10
Dividend Payment: A Chronology

2. Ex-dividend Date: two business days prior to the date of
record


The ex-dividend date removes any ambiguity about who is entitled
to the dividend
Before this date: the stock is said to trade “with dividend”
you buy the stock “before” this date,
you’re entitled to the dividend
 If

After this date: the stock trades “ex dividend”
you buy the stock “on” or “after” this
date, the previous owner will get the
dividend
 Since the dividend is valuable, the stock price
will be affected ©2001
when
the stock goes “ex”
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 If
14.11
Dividend Payment: A Chronology
 3.
Date of Record: Date by which holders
must be on record to receive a dividend
 4. Date of Payment: Date the dividend checks
are mailed
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14.12
More on the Ex-Dividend Date

Two business days before the date of record


If you buy the stock before the ex-dividend date:


Note: Saturdays, Sundays and holidays are NOT business days!
the stock trades “with dividend” and the holder will receive the
dividend
If you buy the stock on or after the ex-dividend date:


The stock trades “ex-dividend” and the holder will not receive the
dividend
When the stock goes “ex dividend”, the value of a share of stock
will go down by about the dividend amount
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14.13
Figure 14.2 The Ex-Day Price Drop
Price= $10
-t
-2
-1
0
+1
+2
t
$1 is the ex-dividend price drop
Price= $9
The stock price will fall by the amount of the dividend on the ex date
(Time 0). If the dividend is $1 per share, the price will be equal to
$10 – 1 = $9 on the ex date.
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14.14
Ex-Dividend Stock Price
Example: Not in Book

The board of directors of XYZ Inc. declared a dividend of
$0.75 per share payable on Monday, January 28 to
shareholders of record as of Monday, January 14. You
owned 500 shares of XYZ on Wednesday, January 9 when the
price was $7.50 per share. Under NYSE rules, if you sell your
500 shares of XYZ on Friday, January 11, what price will you
receive, all else the same?



Remember: the ex-dividend date is - 2 business days prior to
the date of record. Here the ex-dividend date is January 10.
When the stock goes ex dividend, the value of a share of stock
will go down by about the dividend amount.
Friday, January 11th is after the ex-dividend date of January 10th,
so the stock trades ex-dividend (without dividend)
500 shares x (7.50 - .75) = $3,375.00
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14.15
14.2 Does Dividend Policy Matter?
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14.16
Does Dividend Policy Matter?
Should
the firm:
Pay out cash now or
Invest the cash and pay it out later
McGraw-Hill/Irwin
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14.17
An Illustration of:
The Irrelevance of Dividend Policy
A powerful
argument can be made
that dividend policy does not matter.
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14.18
An Illustration of:
The Irrelevance of Dividend Policy
Wharton Corporation Case: – Bottom of Page 401
 Wharton
is an all-equity firm that has existed
for 10 years. The current financial managers
plan to dissolve the firm in two years. The
total cash flows the firm will generate,
including the proceeds from liquidation, are
$10,000 in each of the next two years.
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14.19
Wharton Corporation Case: – Bottom of Page 401
Current Policy: Dividends Set Equal to Cash Flow
 Dividends
are set equal to the cash flow of
$10,000
 100 shares outstanding, so the dividend per
share will be $100

$10,000 / 100 shares o/s = $100
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14.20
Wharton Corporation Case: – Bottom of Page 401
Current Policy: Dividends Set Equal to Cash Flow
Remember: The value of the stock is equal to the
present value of the future dividends.
 Assuming a 10 percent required return, the value of a
share of stock today, P0, is:
 P0 = D1 / (1 + R)1 + D2 / (1 +R)2
 P0 = $100 / 1.10 + 100 / 1.102
 P0 = $173.55
 The firm as a whole is thus worth:
 100 x $173.55 = $17,355

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14.21
Wharton Corporation Case: – Top of Page 402
Alternative Policy: Initial Dividend Greater Than Cash Flow
 Pay
a dividend of $110 per share on the first
date (Date 1)
100 shares x $110 = $11,000
 Cash flow = only $10,000
 An extra $1,000 must be raised
 Could issue $1,000 worth of bonds or stock at Date 1
 Assume that stock is issued
 The new stockholders will desire enough cash flow at
Date 2 so that they earn the required 10 percent
return on their Date 1 investment

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14.22
Wharton Corporation Case: – Top of Page 402
Alternative Policy: Initial Dividend Greater Than Cash Flow
 What
is the value of the firm with this new
dividend policy?
The new stockholders invest $1,000 at Date 1
 They will require a 10% return of the Date 2 cash
flow


$1,000 x 1.10 = $1,100
This leaves only $8,900 ($10,000 – 1,100) to the old
stockholders
 The dividends to the old stockholders will be:

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14.23
Wharton Corporation Case: – Top of Page 402
Alternative Policy: Initial Dividend Greater Than Cash Flow

Date 1: $11,000


Date 2: $ 8,900


Dividends per share: $11,000 / 100 shares = $110
Dividends per share:
$8,900 / 100 shares = $89
The present value of the dividends per share is
therefore:



P0 = $110 / 1.10 + 89 / 1.102 = $173.55
This is the same value as before
The value of the stock is not affected by this switch in
dividend policy even though new stock had to be sold to
finance the dividend
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An Illustration of:
The Irrelevance of Dividend Policy
14.24
Wharton Corporation Case
 For the Wharton Corporate, dividend policy
makes no difference
 Any increase in a dividend at some point in
time is exactly offset by a decrease somewhere
else, so the net effect, once we account for time
value, is zero.
McGraw-Hill/Irwin
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14.25
A Test

True or false: Dividends are irrelevant?





False: Dividends “are” relevant
Investors prefer higher dividends to lower dividends at
any single date, if the dividend level is held constant at
every other date
If the dividend per share at a given date is raised while
the dividend per share at every other date is held
constant, the stock price will rise
The reason: the present value of the future dividends
must go up if this occurs
Accomplished by improved productivity, increased tax
savings, improved product marketing strength, or
improved cash flow
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14.26
A Test
 True
or false: Dividend Policy is irrelevant
True: Dividend Policy “is” irrelevant
 Dividend “Policy” by itself cannot raise the dividend
at one date while keeping it the same at all other
dates.
 Dividend “Policy” merely establishes the trade-off
between dividends at one date and dividends at
another date
 Once we allow for time value, the PV of the dividend
stream is unchanged

McGraw-Hill/Irwin
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14.27
A Test
 In
the previous simple-world example,
dividend “policy” did not matter

Because managers choosing either to raise or to
lower the current dividend did not affect the current
value of the firm.
 However,
we’ve ignored several real-world
factors that might lead us to change our minds:
Taxes
 Flotation Costs

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14.28
Some Real-World Factors
Favoring a Low Payout: Taxes
A firm that adopts a low-dividend payout will reinvest
the money instead of paying it out
 This reinvestment increases the value of the firm and
of the equity
 The expected capital gain will be higher in the future
 For individual shareholders: tax rates on dividend
income are higher (taxed as ordinary income) than tax
rates on capital gains (lower tax rates deferred until
the stock is sold)
 The fact that capital gains are taxed favorable may
lead us to prefer a low dividend payout approach

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14.29
Some Real-World Factors
Favoring a Low Payout: Flotation Costs
 Selling
new stock (to pay a dividend) can be
very expensive
 If we include the costs of selling stock
(“flotation” costs”) in our argument, then we
will find that the value of the stock decreases if
we sell new stock
 Flotation Costs may lead us to prefer a low
dividend payout approach
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14.30
Some Real-World Factors
Dividend Restrictions
 Bond
indenture covenants can prohibit
dividend payments above some level
 Corporations may be prohibited by state law
from paying dividends if the dividend amount
exceeds the firm’s retained earnings
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Some Real-World Factors
Favoring a High Payout:
14.31
Desire for Current Income
 Many
individuals desire current income and are
willing to pay a premium to get a higher
dividend yield
Retired people
 Others living on a fixed income

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Some Real-World Factors
Favoring a High Payout:
14.32
Desire for Current Income

In a simple world with no brokerage fees or
transaction costs:



An individual preferring high current cash flow but
holding low-dividend securities could easily sell off
shares to provide the necessary funds
An individual desiring a low current cash flow but
holding high-dividend securities could just reinvest the
dividends
However, the real world does have brokerage fees and
transactions costs associated with these transactions
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Some Real-World Factors
Favoring a High Payout:
14.33
Tax & Legal Benefits from High Dividends
 The
fact that dividends are taxed unfavorably
for individual investors is a powerful argument
for a low payout
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Some Real-World Factors
Favoring a High Payout:
14.34
Corporate Investors
A Corporate stockholder receiving either common or
preferred dividends is granted a 70% dividend
exclusion tax break
 This 70% exclusion does not apply to capital gains
 This tax advantage is why high-dividend, low-capital
gains stocks may be more appropriate for corporations
to hold and is why corporations hold a substantial
percentage of the o/s preferred stock in the economy

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Some Real-World Factors
Favoring a High Payout:
14.35
Tax-Exempt Investors

Tax consequences are irrelevant for those in zero tax
brackets: Pension Funds, Endowment Funds, and
Trust Funds



Institutions such as pension and trust funds often manage
money for the benefit of others and have “fiduciary
responsibility” to invest money prudently
It has been considered imprudent in courts of law to buy
stock in companies with no established dividend record
University endowment funds and trust funds are frequently
prohibited from spending any of the principal and therefore
prefer high-dividend yield stocks – current income
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14.36
Clientele Effects:
A Resolution of Real-World Factors?
 Some
groups (wealthy individuals, for
example) have an incentive to pursue lowpayout (or zero payout) stocks
 Other groups (corporations, for example) have
an incentive to pursue high-payout stocks
 High-payout companies will attract one group
while low-payout companies will attract
another
 These different groups are called clienteles
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14.37
Clientele Effects:
A Resolution of Real-World Factors?
 Clientele
Effect: Argument that stocks attract
particular groups based on dividend yield and
the resulting tax effects.
 When a firm chooses a particular dividend
policy, the only effect is to attract a particular
clientele
 If a firm changes its dividend policy, then it
just attracts a different clientele
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14.38
Clientele Effects:
A Resolution of Real-World Factors?
Simple Supply and Demand Argument:
 If 40% of all investors prefer high dividends, but only
20 percent of the firms pay high dividends, the highdividend firms will be in short supply; thus their stock
prices will rise
 Consequently, low-dividend firms will find it
advantageous to switch policies until 40% of all firms
have high payouts
 At this point, the dividend market is in equilibrium
 Further changes in dividend policy are pointless
because all of the clienteles are satisfied

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14.39
14.3 Establishing a Dividend Policy
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14.40
Residual Dividend Approach
 If
a firm wishes to avoid new equity sales, then
it will have to rely on internally generated cash
flow to finance new, positive NPV projects
 Dividends can only be paid out of what is left
over
 This leftover is call the residual, and such a
dividend policy is called a residual dividend
approach
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14.41
Residual Dividend Approach


Residual Dividend Approach: Policy under which a firm pays
dividends only after meeting its investment needs (i.e. all
profitable investment opportunities are exhausted) while
maintaining a desired debt-equity ratio
Given this objective we expect:

Firms with many investment opportunities to pay a small percentage
of their earnings as dividends


Young, fast-growing firms commonly employ
a low payout ratio
Firms with fewer opportunities to pay a high percentage of their
earnings as dividends
Older, slower-growing firms in more mature
industries use a higher
ratio Companies All Rights Reserved
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
14.42
Residual Dividend Policy
Example: Problem 15 (b) – Page 417







Wildcat, Inc., predicts that earnings in the coming year will
be $30 million. There are 8 million shares, and Wildcat
maintains a debt-equity ratio of 1.5. (b) Suppose the firm
uses a residual dividend policy. Planned capital
expenditures total $40 million. Based on this information,
what will the dividend per share be? What dividend will be
paid?
$30M + 1.5($30M) = $75M
$30M Equity + $45M Debt = $75M
Equity %: $30M / $75M = 40% (1.5 x .40 = 60% debt)
Equity to retain for cap ex: $40M x .40 = $16M
Dividend Paid: $30M - $16M = $14M
Dividend per Share: $14M / 8M shares = $1.75
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14.43
Residual Dividend Policy
Example: Not in Book

Smith, Inc. has a target debt/equity ratio of .75.
Aftertax earnings for 2001 were $850,000 and the
firm needs $1,150,000 for new investments. If the
company follows a residual dividend policy, what
dividend will be paid?

$850,000 + .75($850,000) = $1,487,500
$850,000 + $637,500 = $1,487,500
Equity %: $850,000 / $1,487,500 = 57% (leave in calculator)




(.75 x .57 = 43%)
Equity to retain for new investments: $1,150,000 x .57 =
$657,142.86
Dividend Paid: = $850,000 - $657,142.86 = $192,857

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14.44
Dividend Stability
 If
investment opportunities in one period are
quite high, dividends will be low or zero
 Dividends might be high in the next period if
investment opportunities are considered less
promising
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14.45
Dividend Stability

If a firm’s earnings are forecast to be equal from year to year
but quarterly earnings change through the year, the firm can
choose between at least two types of dividend policies:

A cyclical dividend policy
Each quarter’s dividend are a fixed percentage
of that quarter’s earnings
 Dividends payments will vary throughout the
year


A stable dividend policy
Each quarter’s dividend is a fixed percentage
of forcasted yearly earnings
 All dividend payments will be equal

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14.46
Dividend Stability
 Most
financial managers agree that a stable
dividend policy is in the best interest of the
firm and its stockholders
 Most companies try to maintain a steady
dividend through time

Increasing the dividend only when management is
confident the new dividend can be sustained
indefinitely
 Dividend

cuts are viewed as highly undesirable
Often interpreted as a sign of financial distress
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14.47
A Compromise Dividend Policy
 Many
firms follow a compromise dividend
policy based on 5 main goals:
Avoid cutting back on positive NPV projects to pay a
dividend
 Avoid dividend cuts
 Avoid the need to sell equity
 Maintain a target debt-equity ratio (long range)



May be allowed to vary in the short run to avoid a dividend
cut or the need to sell new equity
Maintain a target dividend payout ratio
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14.48
A Compromise Dividend Policy
 Financial
Managers tend to think investors are
entitled to a “fair” share of corporate income
 This share is the long-run target payout ratio:
The fraction of the earnings the firm expects to pay
as dividends under ordinary circumstances
 A firm’s long-term desired dividend-earnings ratio

McGraw-Hill/Irwin
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14.49
A Compromise Dividend Policy

Dividend instability can be minimized by creating two
types of dividends:


Regular Dividends: most likely a small fraction of
permanent earnings, so that it could be sustained easily
Extra Dividends: granted when an increase in earnings
is expected to be temporary



Investors view as a bonus with little disappointment when
not repeated
Few companies use in practice
A share repurchase does much the same thing with some
extra advantages
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14.50
14.4 Stock Repurchase:
An Alternative to Cash Dividends
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14.51
Cash Dividends versus Repurchase
 When
there are no taxes or other imperfections,
a cash dividend and a share repurchase are
essentially the same thing.
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14.52
Cash Dividends versus Repurchase
Cash dividend:
 Payout of cash dividends to the shareholder reduces
the value of the company by the amount of dividend
payment
 After the dividend payment





The shareholder has the same number of shares (reduced
in value by the amount of the cash payout per share)
Plus the dividend payment per share
The two equal the original value of the firm
Therefore, the shareholder’s wealth is unaffected
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14.53
Cash Dividends versus Repurchase
Share Repurchase:
 Company buys back its own shares of stock



Tender offer – company states a purchase price and a
desired number of shares
Open market – buys stock in the open market
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

McGraw-Hill/Irwin
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14.54
Cash Dividends versus Repurchase
Share Repurchases are :
 Usually initiated when firms have an excess amount
of cash on hand
 Rather than increase the quarterly dividend payout to
a level they might not be able to sustain in the future,
they turn to the next best alternative, a stock
repurchase
 When a firm repurchases shares of stock, it reduces
the amount of equity outstanding which increases
earnings and cash flow per share and is viewed by
many investors as a positive signal regarding the
firm’s future prospects.

McGraw-Hill/Irwin
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14.55
Cash Dividends versus Repurchase
 Thus
a firm’s stock price often jumps when a
share repurchase is announced as interest in the
stock increases
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14.56
Real-World Considerations
in a Repurchase
In the real world a repurchase has a significant tax
advantage over a cash dividend
 A cash dividend is fully taxed as ordinary income



The shareholder has no choice about whether or not to
receive the dividend
In a share repurchase, a shareholder pays taxes only if:


The shareholder actually chooses to sell and
The shareholder has a capital gain
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14.57
Real-World Considerations
in a Repurchase
Note: the IRS does not allow a repurchase solely for
the purpose of avoiding taxes
 There must be a business-related reason for doing it


The stock is undervalued, etc.
A “buyback” is another term for a share repurchase
 Share “buybacks” are very big business and seem to
be getting bigger and more common all the time

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Share Repurchase and EPS

A Share Repurchase:



Reduces the number of outstanding shares
Has no effect on total earnings
EPS rises



Same earnings divided by a reduced number of shares
outstanding
The EPS increase is simply an adjustment that reflects the
change in the number of shares outstanding
The increase in the EPS is exactly tracked by the increase in the
market price per share
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14.59
14.5 Stock Dividends and Stock Splits
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Stock Dividend

Stock Dividend: payment made by a firm to its
owners in the form of stock, diluting the value of each
share outstanding.



Increases the number of shares each owner holds
With more shares outstanding, each is worth less
Commonly expressed as a percentage
A 20% stock dividend means that a shareholder receives 1
new share for every 5 currently owned (1 / 5 = a 20%
increase)
 Since every shareholder owns 20% more stock, the total
number of shares o/s rises by 20%
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The McGraw-Hill
Companies
 Each share of stock ©2001
is worth
about 20%
less All Rights Reserved

14.61
Stock Dividend Price Adjustment Example:
Problem 6 (b) – Page 415-16

Bermuda Triangle Corporation (BTC) currently has
300,000 shares of stock outstanding that sell for $80
per share. Assuming no market imperfections or tax
effects exist, what will the share price be after:
(b) BTC has a 15 percent stock dividend?


300,000 s/o x $80 = $24,000,000 Market Value of Equity
300,000 s/o x 1.15 = 345,000 s/o after 15% stock dividend
$24,000,000 / 345,000 s/o = $69.57
or

$80(1/1.15) = $69.57

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Stock Dividend
 Small
 stock
 Large
 stock
Stock dividend
dividends less than 20 to 25%
stock dividend
dividends greater than 20 to 25%
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Stock Split
Split: An increase in a firm’s shares
outstanding without any change in owners’
equity
 Stock
Each share is split up to create additional shares
 In a 3 for 1 stock split, each old share is split into 3
new shares

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Stock Split Price Adjustment Example:
Problem 6 (a) – Page 415-16

Bermuda Triangle Corporation (BTC) currently has
300,000 shares of stock outstanding that sell for $80
per share. Assuming no market imperfections or tax
effects exist, what will the share price be after:
(a) BTC has a five-for-three stock split?

300,000 s/o x $80 = $24,000,000 Market Value of Equity
(300,000 s/o / 3) x 5 = 500,000
 $24,000,000 / 500,000 s/o = $48.00 or
 $80 (3/5) = $48.00

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Value of Stock Splits and Stock Dividends
 Stock
splits and stock dividends can:
 (1) leave the value of the firm unaffected
 (2) increase its value or
 (3) decrease its value
 Unfortunately, the issues are complex enough
that one cannot easily determine which of the
three relationships holds.
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Value of Stock Splits and Stock Dividends
The Benchmark Case
 A strong
case can be made that stock dividends
and splits do not change either the wealth of
any shareholder or the wealth of the firm as a
whole.

The number of shares outstanding is simply adjusted
 However,
there may be some benefits to these
actions.
 Stock split or stock dividend decisions are not
treated lightly in practice.
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Popular Trading Range
 Proponents
of stock dividends and stock splits
frequently argue that a security has a “proper”
Trading Range: price range between highest
and lowest prices at which a stock is traded.
 Above this level many investors do not have
the funds to buy the common trading unit of
100 shares called a round lot.

Commissions are greater for securities traded in
odd-lot form (fewer than 100 shares)
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Reverse Splits

Reverse Split: Stock split under which a firm’s number of
shares outstanding is reduced


i.e. in a one-for-three reverse split, each investor exchanges three
old shares for one new share.
A case can be made that a reverse split changes nothing
substantial about the company, however:




Transaction costs may be less after the reverse split
The liquidity and marketability of a company’s stock might be
improved when its price is raised to the popular trading range
Stocks selling below a certain level are not considered respectable
and some argue that a reverse split can achieve instant respectability
Stock exchanges have a minimum price per share requirements
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Suggested Homework and
Test Review
Know chapter theories, concepts and definitions
 Know how to calculate:


Stock Dividend Price Adjustment


Stock Split Price Adjustment


Problem 6 (a) – page 415-16
Ex-Dividend Stock Price


Problem 6 (b)(c) – page 415-16
Problem 1 – page 415
Residual Dividend


Problem 15 (b) – page 417 and
Example in this presentation (Slide 42)
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