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

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– From the whole market view, today’s stock price is the present value of an infinite stream of dividends

Focus on the individual view

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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

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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

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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

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Concept Connection Example 15-3 Tailoring the Income Stream

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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

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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?

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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

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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

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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

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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

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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

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Figure 15.1 The Dividend Declaration and Payment Process

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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

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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

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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

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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

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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

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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

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Other Repurchase Issues

Opportunistic Repurchase– Stock is temporarily undervalued

Repurchase to Dispose of Excess Cash– Distributes cash without a signaling effect

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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

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