Dividends

Chapter 14

© 2003 South-Western/Thomson Learning

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Background

Dividends as a Basis for Value Help determine the value of stocks

• Individual investors buy stocks expecting return from dividends and the eventual selling price of stock

• Today’s price represents the present value of those future expected cash flows

• From the whole market view• The price of a stock today is the present value of the

infinite stream of dividends

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Understanding the Dividend Decision The Discretionary Nature of Dividends

Board of Directors has authority to determine the dividend payout

• Payout can range from nothing to everything

The Dividend Decision A firm’s earnings belong to the stockholders

• Management makes the dividend decision on behalf of the stockholders

• Paying dividends gives stockholders an immediate cash payment—current income

• Retaining earnings for reinvestment offers a potentially higher stock price in the future—deferred income

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The Dividend Controversy—Irrelevance

Does the payment of dividends now or increasing the dividend payment impact the stock price? Do stockholders prefer current or deferred

income?

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The Dividend Controversy—Irrelevance Arguments concerning dividend policy

Dividend irrelevance• Value of eliminated dividends is offset by growth-created

value in the future• The increased return on the retained earnings offsets the

reduction or elimination of dividends• Thus, the current stock price is independent of changes

in early dividends

• Investors can tailor their income stream by selling shares of a growing stock that doesn’t pay dividends or by buying shares of stock of a company that pays more dividends than an investor needs

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The Dividend Controversy— Irrelevance—Example

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Q: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?

A: Their original value of AJAX shares was $10 per share 10,000 shares, or $100,000, which they wish to maintain. But, they were generating an annual dividend of 10,000 shares $0.50 or $5,000 before AJAX eliminated the dividend. After one year of 5% growth, AJAX’s shares should be selling for $10.50. Thus, by selling 476 shares ($5,000 $10.50) they can generate $5,000 in cash. Their remaining 9,524 shares would be worth $10.50 each for a total of $100,002.

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The Dividend Controversy—Irrelevance

Transaction Costs Can make tailoring an income stream

impractical The more significant the transactions costs,

the less valid the irrelevance theory becomes

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The Dividend Controversy—Irrelevance 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

• Reduces retained earnings Firms prefer not paying dividends if it avoids

selling new stock• Retained earnings cost less than new equity

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Dividend Preference

Investors prefer immediate cash to uncertain future benefits Not a time value of money argument but

rather a certainty issue Flaw—if investors are worrying about not

receiving the future cash flow, why invest in that firm in the first place?

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Dividend Aversion

Investors prefer future capital gains to current dividends because of lower tax rates Dividends are taxed at higher ordinary income tax

rates This argument hinges on current level of ordinary

income vs. capital gain tax rates Capital gains taxes are not paid until stock is sold If stock is passed along to heirs, taxes on capital

gains occurring during decedent’s life can be avoided

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Other Theories and Ideas

The Clientele Effect Investors choose stocks for dividend policy—

any change in payments is disruptive• Retirees may desire stocks with high dividends• Young professionals may desire stocks will little

or no dividends

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Other Theories and Ideas

The Residual Dividend Theory Dividends are paid from earnings only after all viable

projects are funded

The Signaling Effect of Dividends Cash dividends signal management’s confidence in

the future• A continuing payment of dividends when earnings are low

can signal management’s confidence about the future• A decrease in dividends can signal management’s lack of

confidence concerning the future

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Other Theories and Ideas

The Expectations Theory 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 Dividends can’t be paid by an insolvent firm

and must come from current or prior earnings Protects creditors

Loan indentures and covenants may limit dividend payments to protect creditors’ interests

The cumulative feature of preferred stock limits dividend payments

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Dividend Policy

Payout ratio States dividends as a fraction of earnings:

dividend per share EPS Stability

A stable dividend is one that is non-decreasing

A dividend with a stable growth rate is one that increases at a more or less constant growth rate

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Alternative Dividend Policies

Target Payout Ratio Firm selects a long-run target payout ratio

• Actual payout ratio is set below target allowing for flexibility in earnings

Stable Dividends Per Share A constant dividend is paid regardless of earnings

• Dividend may change if firm consistently does well or poorly

Small Regular Dividend with a Year-End Extra if Earnings Permit Gives firm the ability to lower dividend (by omitting the

extra year-end dividend) without a negative informational effect

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The Mechanics of Dividend Payments Key Dates

Declaration Date: Date on which the board authorizes the dividend

Date of Record: You must be an owner by this date to have access to the declared dividend

Payment Date: Date the dividend payment will be mailed

Ex-Dividend Date: If you buy the stock on or after this day you will not receive the pending dividend

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Figure 14.1: 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 a cash dividend

payment the stockholder receives additional shares of stock

• Company can either buy the shares on the open market or issue new shares to the stockholder

• IRS treats reinvested dividends as taxable income

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Stock Splits and Dividends

Stock Split Current stockholder is issued new shares

proportionate to his current holdings No change in ownership control occurs

Stock Dividend Same as a stock split but called a stock dividend if the

number of shares is less than or equal to 20% of original shares outstanding

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Stock Splits and Dividends

A firm with 100,000 shares outstanding executes a 2-for-1 split. Each stockholder will now have twice as many shares as they had before. The firm will now have 200,000 shares outstanding. Each share is worth half as much as before the split.E

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Stock Splits and Dividends

Accounting Treatment Stock split changes par value and the

number of shares• Capital accounts are unaffected

Stock dividend causes money to be shifted from Retained Earnings to stock account

• Gives the appearance of a sale at market price

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Stock Splits and Dividends

Rationale for Stock Splits and Stock Dividends Splits keep stock prices in a trading range

• Between $30 and $80 Stock dividends are an attempt at signaling

• Sends a positive message

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Stock Repurchases

Alternative to Dividend A firm with cash can either pay a dividend or

repurchase some of its own outstanding stock

• Repurchasing stock reduces number of shares outstanding and increases EPS

• Remaining shares will rise in value if market uses same P/E ratio after the repurchase

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Stock Repurchases

Johnson Company currently has 2,500,000 outstanding shares of common stock and Net Income of $5 million. The firm’s P/E ratio is 10. Thus, Johnson’s EPS is $5,000,000 2,500,000 or $2.00 per share; and the firm’s market price is $2.00 x 10 or $20. Johnson has $1 million in cash available for distribution to stockholders. If the firm distributes it as a dividend, the firm will pay a

dividend of $0.40 per share, or $1,000,000 2,500,000 shares.

If the firm instead buys back its own shares, it will be able to retire 50,000 shares, or $1,000,000 $20. There would then be 2,450,000 shares outstanding and EPS would be $5,000,000 2,450,000 or $2.04 per share. If the firm’s P/E ratio remains unchanged, the firm’s stock price should rise to $20.40, or $2.04 x 10.

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Stock Repurchases

Method of Repurchasing Shares Buy shares on open market Make a tender offer Negotiated deal with a large investor

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Other Repurchase Issues

Opportunistic Repurchase Repurchases are appropriate when a stock is

temporarily undervalued or the firm has excess cash

Repurchases to Dispose of Excess Cash Firm may have excess cash which can be

distributed as dividend• However, firm may suffer from signaling effect

A stock repurchase effectively distributes the cash without a signaling effect

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Other Repurchase Issues

Taxes An occasional stock repurchase may benefit

stockholders because they pay capital gains taxes rather than ordinary income taxes

Repurchases to Restructure Capital By borrowing money and using the cash to

repurchase stock, a firm can raise its debt ratio