Ch 17 Dividends and Payout Policy

• 1. Cash dividends and payment

• 1) Def: a payment made out of a firm’s earnings to shareholders (owners)

• 2) Types

• Regular cash dividends

• Extra cash dividends

• Special dividends

• Liquidating dividends

• 3) Dividend Payment: A Chronology• (1) Declaration date: Resolution date to pay a

dividend• (2) Ex-dividend date: Two business day before

the date of record. Shareholders listed until this date would receive dividends.

• (3) Date of record: Declared dividends are distributable.

• (4) Payment date: Mailing date

• Usually, stock price drops after ex-dividend date.

• 2. Does dividend policy matter?• 1) Irrelevance

• Ex) Fin 314 is all equity firm. Managers decide to dissolve the firm. The liquidation would generate $10,000 in each of next two years. The proceed from liquidation would be distributed as dividends. There are 100 shares. Dividend per share is $100. A rate of return is 10%.

• Policy 1: Equal dividend to each year -

• P=$100/(1.1)+$100/(1.1^2) =173.5

Policy 2: Non-equal dividend -• The firm decides to pay $11,000 (=100* $110) in the first

year. But it has only $10,000. Thus issuing 10 new stocks at $100, the firm raise $1000. Here the firm promised 10% return to new stock holders in the second year. In the first year, dividend per share is $110 for old stock holders. In the second year, new shareholder would receive 1000*(1+0.1) =$1,100. Thus only 8,900(=10,000-1,100) is left for old shareholders in the second year. Dividend for old shareholders in the second year is 89.

• P = 1100/(1.1)+89/(1.1^2) = 173.55

• Thus dividend policy may be irrelevant.

• 3) Homemade dividends.• Regardless of dividend policy of a firm, investors are able

to set up their portfolio generating certain amounts of dividends.

• 3. Real world factors favoring a low payout: tax and flotation cost.

• 1) Dividend is considered as ordinary gains. Plausible tax rate on dividend is higher than on capital gains due to deferment. new tax rate on dividend payment is lower than corporate tax rate. A firm will have an incentive to pay out any excess cash.

• 2) Flotation cost of issuing new stocks for dividend payment or Covenant from debts.

• 4. Real world factors favoring a high payout: • 1) Discounted value of near dividends is higher

than the present value of the distant dividends.• 2) Stock paying dividends sells at a higher price

due to desire for current income. • 3) Tax-free institutions or tax benefit over

dividends received by corporation (70% exclusion).

• 4) Tax-exempt investors in zero tax brackets.

• 5. Information Content Effect• When dividends unexpectedly increase

(decrease), it would signal expected future cash flow of dividends and generally increase (decrease) the stock price.

• 6. Clientele Effect• Different groups of investors desire

different levels of dividends. Regardless of dividend policy, it would determine the stock price.

• 7. Establishing a Dividend Policy

• 1) Residual Dividend Approach: a policy under which a firm pays dividends only after meeting its investment needs while maintaining a desired debt-equity ratio.

• Ex) A firm has $1000 earnings and a debt-equity ratio of 0.5. The firm decided to reinvest a portion of earnings.

• If a project costs $900, in order to maintain debt-equity ratio, the needed equity is $600(=$900*2/3) and newly needed debt is $300(=$900*1/3).

• Thus dividend would be $400 (=1000-600). • It implies that firms with more investment opportunities

would pay less dividends whereas firms with fewer investment opportunities would pay more dividends.

• 2) Dividend Stability• Cyclical dividend policy: dividends would vary throughout

the year.• Stable dividend policy: dividends are fixed. It is common.

• 3) A Comprise Dividend Policy• A policy based on five 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 to equity ratio.• - Maintain a target dividend payout ratio.

• Using this approach, the regular dividend would most likely be relatively small fraction of earnings. Extra dividends would be granted when earnings are expected to be high.

• Survey results regarding dividend policy: • - Managers are reluctant to cut dividends and try

to maintain the dividends.• - In making dividend decisions, they are very

concerned about earnings stability, future earnings levels and investment opportunities not taxes or flotation costs.

• - Attracting institutional or individual investors

• 8. Stock repurchase: Alternative to cash dividends.• 1) Stock repurchase: to repurchase its own stocks. It

has the similar effects as cash dividends under no commission, no tax and imperfections.

• Ex) All equity firm A has excess cash of $300,000. Its net income is $49,000. The number of shares is 100,000. The market value of equity is $1 million. Price per share is $10. EPS =49000/100000=0.49. PE = 10/0.49 =20.4.

•

Excess Cash 300000 Debt 0Other Asset 700000 Equity 1000000

Toatl 1000000 Total 1000000

• Ex-1) assume to pay $300,000 as cash dividends.

• Stock price =(1000000-300000)/100000 = 7.• Shareholder wealth per share = $3 (dividend) +

$7 (price). No change. • EPS = 49000/1000000=0.49. No change. • PE = 7/0.49 =14.3. Reduced.

Excess Cash 0 Debt 0Other Asset 700000 Equity 700000

Toatl 700000 Total 700000

• Ex-2) repurchase of 30,000 shares at $10 per share.

• Price = 700,000/70000=$10. No change.

• Shareholder wealth = $10. No change.

• EPS = 49,000/70000= 0.7. Improved.

• PE = 10/0.7 = 14.3. No change.

Excess Cash 0 Debt 0Other Asset 700000 Equity 700000

Toatl 700000 Total 700000

• 2) Tax difference and reason.

• A dividend is taxed as ordinary incomes. But In a repurchase, a shareholder pays tax only when he or she sells securities and obtains capital gains

• Common reasons of stock repurchase:

• (1) stock is undervalued.

• (2) To improve EPS.

• 9. Stock dividends and stock split• 1) Stock dividend: a payment made by a firm to its owners

in the form of stock, diluting the value of each share outstanding. Stock dividends of less than 20 to 25% is called a small stock dividend. Stock dividend greater than 20 to 25% is called a large stock dividend.

• Ex) 20% stock dividend: one new share every five shares.

• 2) Stock split: an increase in a firm’s share outstanding without any change in owners’ equity.

• Ex) Three to one stock split: one old share would split into three new shares.

• Both stock dividend and stock split would have the same effects: increased number of shares and reduced price per share.

• Ex) Firm B has 10,000 shares. Price is $66. Total market value is $660,000.

• Ex-1) 10% stock dividend.• Total number of shares = 10,000*1.1 =11,000.• Excess of 65(=66-1)*1000 is added to capital in excess.

•

Common stock ($1 Par) 10000Capital in excess of par value 200000

Retained earnings 290000Total owners' equity 500000

Common stock ($1 Par) 11000Capital in excess of par value 265000

Retained earnings 224000Total owners' equity 500000

• Total owner’s equity is unaffected but retained earning is reduced.

• Ex-2) Two for one split• Number of shares increases to 20000 from 10000. • Par value would reduce to 0.5.

• Reasons of split: improvement of liquidity of securities.

Common stock ($0.5 Par) 10000Capital in excess of par value 200000

Retained earnings 290000Total owners' equity 500000

• E-3) when 100% stock dividend is declared.

Common stock ($1 par, 20,000 shares outstanding)

$20,000

Capital in excess of par value

$200,000

Retained earnings $280,000

Total owners’ equity $500,000

• 3) Reverse split• A stock split in which a firm’s number of shares

outstanding is reduced.• Reasons: • (1) Less transaction costs after reverse split• (2) Improved liquidity and marketability after

reverse split• (3) Instant respectability by increasing price.• (4) To satisfy the minimum price requirement.• (5) To buy out shareholders who end up less

than a certain number of shares.