Post on 17-Dec-2015
Chapter 15 Dividends
Background
Dividends as a Basis for Value– Dividends are important in determining stock value
Individual investors buy stocks expecting dividends and price appreciation
»
– From the whole market view, today’s stock price is the present value of an infinite stream of dividends
Focus on the individual view
nn
nn
k
P
k
D
k
D
k
DP
)1()1(...
)1()1( 221
0
Understanding the Dividend Decision
The Discretionary Nature of Dividends– Board of Directors determines the dividend
Can be more than earnings or nothing
The Dividend Decision– Whether to pay cash dividends or retain earnings
for growth
Current income
Deferred income
3
The Dividend Controversy
Does paying or not paying dividends affect stock price?
Do stockholders prefer current or deferred income?
Three arguments regarding investors’ preferences for or against dividends
1. Dividend Irrelevance
2. Dividend Preference
3. Dividend Aversion
4
Dividend Irrelevance
Most theorists say dividends matter very little to stock price – Value of eliminated early dividends is offset by
growth-created value in the future
– In valuation equation loss of D1, D2 …. is made up by gains in later Di (i = 1, 2,…n) and Pn
nn
nn
k
P
k
D
k
D
k
DP
)1()1(...
)1()1( 221
0
Concept Connection Example 15-3 Tailoring the Income Stream
6
The Winters are retirees with most of their savings invested in 10,000 shares of Ajax Corporation (AJAX). AJAX sells for $10 per share and pays an annual dividend of $0.50 per share.
This year AJAX eliminated the dividend, but began to grow at 5% a year due to the reinvested earnings.
How can the Winters maintain their income and their position in AJAX?
Concept Connection Example 15-3 Tailoring the Income Stream
Original value of the Winters’ AJAX shares
$10 10,000 shares = $100,000.
Eliminated dividend
10,000 shares $0.50 = $5,000.
After one year of 5% growth, AJAX should sell for
$10 × 1.05 = $10.50.
To maintain their income the Winters must sell
$5,000 $10.50 = 476 shares
After which they would have
10,000 – 476 = 9,524 shares
Worth $10.50 x 9,524 = $100,002.
Dividend Irrelevance
Transaction costs– The more significant the transactions costs, the
less valid the irrelevance theory becomes
Income taxes– Dividends are taxed as ordinary income– Appreciation is taxed as a capital gain
The View from Within the Company– Dividends represent a cash outflow– Firms prefer not paying dividends if it avoids
selling new stock
8
Dividend Preference
Investors prefer immediate cash to uncertain future benefits – Poor management may waste the funds
rather than using effectively for growth
Inconsistency in theory:– If investors are worried about management
not using resources effectively, why did they invest in the firm in the first place?
9
Dividend Aversion
Investors prefer future capital gains to current dividends because of tax rates– Price appreciation taxed as capital gain– Dividends taxed as ordinary income
Argument hinges on current tax rates on dividend income vs. capital gains income – Capital gains taxes are not paid until stock is sold
so taxes are deferred
10
Other Theories and Ideas
The Clientele Effect– Investors choose stocks for dividend policy so any
change in payments policy is disruptive
The Residual Dividend Theory– Dividends are paid from earnings only after viable
projects are funded
The Signaling Effect of Dividends– Cash dividends signal management’s confidence
The Expectations Theory– A refinement of the signaling effect– Dividends that fail to fulfill stockholders’ expectations
send a negative message even if the payment is good
11
Legal and Contractual Restrictions on Dividends
Legal Restrictions
Dividends can’t be paid out of contributed capital – must come from retained earnings
Insolvent firms can’t pay dividends
Contractual Restrictions
Loan indentures and covenants may limit dividend payments to protect creditors’ interests
Cumulative feature of preferred stock limits dividend payments
12
Dividend Policy
Dividend policy: Rationale for determining dividend payouts
Payout ratio– States dividends as a fraction of earnings
Stability– The constancy of dividends over time– A stable dividend is non-decreasing– A dividend with a stable growth rate increases at a fairly
constant growth rate
EPSshare per dividend
earningsdividend
ratio payout
Alternate Policies
Target Payout Ratio– Firm selects a long-run target payout ratio
Stable Dividends Per Share– A constant dividend is paid regardless of earnings
Small Regular Dividend with a Year-End Extra if Earnings Permit– An effort to avoid the signaling effect
14
The Mechanics of Dividend Payments
Each quarterly dividend has key dates:– Declaration Date: Date the board authorizes the
dividend– Date of Record: Date by which you must be an
owner to receive the dividend– Payment Date: Date on which the dividend will
actually be paid – check in the mail– Ex-Dividend Date: Date from which new stock
buyers no longer receive the dividend
15
Figure 15.1 The Dividend Declaration and Payment Process
16
Dividend Reinvestment Plans
Large companies offer automatic dividend reinvestment plans (DRIPs) to stockholders– Instead of receiving cash dividends, the stockholder
receives additional shares – The payment is taxable– Don’t confuse with stock dividend
17
Stock Splits and Dividends
Stock Split– Stockholders issued
new shares in proportion to current holdings
– No change in proportionate ownership of company
– Reverse splits also possible
Stock Dividend– Similar to stock split – Called a stock
dividend if the number of new shares is less than or equal to 20% of previously outstanding shares
18
Rationale for Stock Splits and Stock Dividends
Stock Split
Trading Range Argument for splits– Splits keep stock
prices in a trading range: accessible to small investors
Stock usually split when prices are increasing– May give false
impression that price increase is from split
Stock Dividend
Giving Something that Doesn’t Cost Anything– Stock dividends are
an attempt at signaling
– Employed to send a positive message
– Doesn’t really give shareholders anything
Effect On Price And Value
Splits and stock dividends increase shares outstanding without changing economic value of the underlying company– Have no real economic effect
20
Accounting for a Stock Split
Accounting for a Stock Dividend
Stock Repurchases
Alternative to Dividend– Firms with cash on hand can pay dividends
or repurchase their own stockRepurchase reduces the number of shares outstanding and increases EPS
Remaining shares will increase in value if the market maintains the P/E ratio after the repurchase
23
24
Concept Connection Example 15-6 Stock Repurchases
The Johnson Company has 2,500,000 shares of common stock outstanding, net income of $5 million, and a P/E ratio of 10.
EPS = $5,000,000 / 2,500,000 = $2.00 per share; Market price = $2.00 x 10 = $20.
Johnson has $1 million in cash to distribute to stockholders.
Per share dividend $1,000,000 / 2,500,000 = $0.40 per share
If Johnson repurchases shares instead it will retire$1,000,000 / $20 = 50,000 shares
leaving 2,450,000 shares outstanding
Stock Repurchases
25
The new EPS will be $5,000,000 / 2,450,000 = $2.04 per share.
If the P/E ratio remains unchanged, the stock price will be $2.04 x 10 = $20.40 A price appreciation equal to the dividend
Stock Repurchases
Methods of Repurchasing Shares– Buy on open market – easiest method – Tender offer – buy shares at a set price offered to
interested stockholders– Negotiated deal – buy from a large investor who
owns a block of stock
26
Other Repurchase Issues
Opportunistic Repurchase– Stock is temporarily undervalued
Repurchase to Dispose of Excess Cash– Distributes cash without a signaling effect
27
Other Repurchase Issues
Taxes– Occasional stock repurchases can benefit
stockholders because capital gains tax rates may be lower than ordinary rates
Repurchases to Restructure Capital– Borrowing money to repurchase stock raises
leverage level and debt ratio
28