Dividend Policy

Professor XXXXXCourse Name / Number

2

Dividend Fundamentals

Announcement

date

The day the firm announces the dividend, dividend record, and payment

dates

Date of record All persons recorded as stockholders on this date receive the declared dividend.

Relevant dates for dividend payments

Ex dividend date

The persons that buy the stock before ex dividend date will receive the current

dividend.

Several business days before date of record

3

Maximum Amount a Firm Can Pay in Cash Dividends

Alpha Corporation’s Stockholders’ Equity

Common stock at par $100,000

Additional paid-in capital 200,000

Retained earnings 140,000

Total stockholders’ equity $440,000

Where legal capital defined as par value of common stock,

maximum payout is $340,000 (Paid-in capital + RE).

In states where legal capital includes all paid-in capital, maximum payout is $140,000 (only

Retained Earnings).

4

Types of Dividends

Types of dividend policies

– Constant payout ratio policy– Constant nominal payments

(standard worldwide)– Low regular and extra dividend

Stock repurchase

s

– Buying shares on the market

– Tender Offer to Shareholders

– Private Negotiation (Green Mail)

Stock dividends and stock

splits

– Stock dividend: payment of a dividend in the form of stock

– Stock splits affect firm’s shares similarly to stock dividends.

Cash dividends

– Regular Cash Dividend– Special Cash Dividend– National differences in payment

methods

5

Patterns In Dividend Policies Worldwide

Pronounced industry patterns

– The same worldwide– Profitable firms in mature industries

tend to pay out much larger fractions of their earnings.

Distinct national patterns

– Companies in common law countries have higher payouts than those from civil law countries.

– US companies are now near global average.

Within industries, dividend payout tends to be directly related to asset intensity and the presence

of regulation.

Almost all firms maintain constant nominal dividend payments per share for long periods of time.

8

Aggregate Dividend Payout Ratio for U.S. Corporate Sector

0

10

20

30

40

50

60

70

80

90

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 2000

%

Source: Statistical Abstract of United States, U.S department of Commerce, various issues (1972-2001)

9

Dividend Payout Ratios For Selected U.S. Industries

Industry

Payout Ratio

Industry

Payout Ratio

Biotechnology

0%

Household non-durables

41% Airlines 0 Industrial metals 46

Computer software 2 Pharmaceuticals 47

Semiconductors 7 Banking 47

Computer hardware 14 Basic chemicals 48

Commcl Transportation 15 Foods & non-alcohol bev 51

Prop & cas Insurance 20 Autos & auto parts 42

Aerospace & defense 28 Electric utilities 65

Paper & forest products 28 Alcohol bev & tobacco 70

Telecommunications 39 Oil & gas product & mktg 75 41

Source: Standard & Poors Industry Reports, various issues (2001)

10

Patterns Observed In Dividend Policies Worldwide

The stock market reacts positively to dividend increases and negatively to decreases or cuts.

It is unclear how dividends affect the required return on a firm's common stock.

Taxes influence dividend payouts, but the net effect is ambiguous.

– Firms paid dividends before and after income tax.– Empirical evidence shows that tax increases lead to

higher payouts, rather than lower.

11

Models Of Dividend Payments

Several competing theories are advanced to explain observed patterns in dividend policies.

The Agency Cost / Contracting Model The Signaling Model

Mainstream favorite: the agency cost/contracting model

The signaling model of dividends: firms pay dividends to “burn money,” separate from weaker

rivals

12

The Agency Cost / Contracting Model Of Dividend Payments

Dividends exist to overcome agency problems between managers and shareholders.

Managers “commit” to paying out free cash flow as dividends.

Based on ownership structure: private and closely held firms rarely pay dividends; big public

firms have high payouts.

Based on investment opportunity set: mature firms have high payout; high-growth firms have low

payouts.

13

Dividend Policy Irrelevance In A World Without Market Imperfections

Miller & Modigliani (1961) showed dividend policy cannot impact firm value in a world without market

frictions.

Miller & Modigliani showed this the same way that they proved that capital structure was irrelevant.

Value is determined solely by investment policy and profitability of the firm’s assets.

Investors can sell shares to mimic the dividend policy.

14

Dividend Policy Irrelevance In A World Without Market Imperfections

An example....

Adams Constructionand Feldon

Home Builders

Two identical companies, except their dividend policy. Both have 4 millions shares

outstanding.

Both companies have assets worth $40 million.

Expected net cash inflow is $6 million next year.

Adams Construction

Feldon Home Builders

Return on investment 15% 15%

Price per share $10 $10

Both firms anticipate an investment opportunity next year that will require $6 million. How will the two firms finance this

opportunity?

15

Adams Construction

Pays out 100% of next year’s cash inflows as dividends. Earns and distributes $1.50/share

Will raise $6 million in a new equity offering to finance the new investment opportunity

600,000 shares at $10 each

Today Tomorrow

Assets worth $40 million

4 million shares$10 per share

Assets worth $46million

4.6 million shares$10 per share

Adams Construction original shareholders earn 15% return in the form of dividend.

16

Feldon Home Builders

Retains next year’s $6 million cash inflows; invest $6 million in the new investment opportunity

Today Tomorrow

Assets worth $40 million

4 million shares$10 per share

Assets worth $46million

4 million shares$11.5 per share

Shareholders earn required return of 15% in the form of stock price increase.

Firm value for both firms is the same, regardless of the dividend payout policy!

17

Real-World Influences On Dividends

Personal taxes on dividends

– Should discourage payments– Empirical evidence is ambiguous.– Dividends paid before 1936 (no taxes)

and after 1936 (dividends taxed)– Some evidence of positive relation

between payout and tPS

Security issuance

costs

– Should discourage payments.– If costly to issue new stocks and bonds,

firm should retain cash.

Investor trading costs

– This factor argues in favor of dividends.– Cost of selling shares for income has

fallen steadily.

18

Real-World Influences On Dividends

Dividends might be a “residual” after funding investments.

But dividends are most stable of all CF series.

Dividends may convey information in markets with info asymmetries.

– But what specific information? Isn’t there a cheaper way to signal?

– Latest empirical evidence: dividends signal the past, not the future.

19

How Do Corporations Set Dividend Payments?Managers believe investors value steady dividend

payments.

Managers seem to have target payout ratio, but only over time.

– Will allow payout to vary in the short term to keep $ dividends the same.

– Will only raise $ dividend if permanent earnings increase.– Will only cut $ dividend if firm facing financial disaster.

Managerial reluctance to change nominal dividend payment gives rise to partial adjustment model.

We can explain inter-industry differences in dividend payout.

We know that ownership matters greatly and roughly how.

We are convinced that dividends exist because of flaws in human ability to communicate and

commit, not flaws in how markets work.

Dividends convey information. Initiations and increases convey good news, decreases convey

catastrophic news.

Common law countries have higher payouts than civil law.

What Do We Know About Dividends?

Exactly how do taxes impact dividends?

Exactly what information is conveyed by dividends?

Most puzzling: why has fraction of firms paying dividends declined in the US, but not

elsewhere?

What Don’t We Know About Dividends?