chapter 13. dividend policy and internal financing

Chapter 13

Dividend Policy and Internal Financing

Stock Returns:

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Stock Returns:

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Capital GainCapital Gain

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Stock Returns:

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Capital GainCapital Gain DividendDividend YieldYield

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Stock Returns:

Dilemma: Should the firm use retained earnings for:

a) Financing profitable capital a) Financing profitable capital investments?investments?

b) Paying dividends to stockholders?b) Paying dividends to stockholders?

If we retain earnings for profitable If we retain earnings for profitable investments,investments,


Po PoPo Po+Return =Return =

If we retain earnings for profitable If we retain earnings for profitable investments, investments, dividend yield will be zero,dividend yield will be zero,



If we retain earnings for profitable If we retain earnings for profitable investments, dividend yield will be zero, investments, dividend yield will be zero, but the stock price will increase, resulting but the stock price will increase, resulting in a higher capital gain.in a higher capital gain.



If we pay dividends, If we pay dividends,



If we pay dividends, If we pay dividends, stockholders receive stockholders receive an immediate cash reward for investing,an immediate cash reward for investing,



If we pay dividends, stockholders receive If we pay dividends, stockholders receive an immediate cash reward for investing, an immediate cash reward for investing, but the capital gain will decrease, since but the capital gain will decrease, since this cash is not invested in the firm.this cash is not invested in the firm.



So, dividend policy really involves 2 decisions:

How much of the firm’s earnings How much of the firm’s earnings should be should be distributed to distributed to shareholders as dividendsshareholders as dividends, and, and

How much should be How much should be retained for retained for capital investment?capital investment?

Is Dividend Policy Important?

Three viewpoints:Three viewpoints:

1) 1) Dividends are IrrelevantDividends are Irrelevant.. If we If we assume perfect markets (no taxes, assume perfect markets (no taxes, no transaction costs, etc.) dividends no transaction costs, etc.) dividends do not matter. If we pay a do not matter. If we pay a dividend, shareholders’ dividend dividend, shareholders’ dividend yield rises, but capital gains yield rises, but capital gains decrease.decrease.

With perfect markets, investors are With perfect markets, investors are concerned only with total returns, concerned only with total returns, and do not care whether returns and do not care whether returns come in the form of come in the form of capital gainscapital gains or or dividend yieldsdividend yields..



With perfect markets, investors are With perfect markets, investors are concerned only with total returns, concerned only with total returns, and do not care whether returns and do not care whether returns come in the form of capital gains or come in the form of capital gains or dividend yields.dividend yields.



With perfect markets, investors are With perfect markets, investors are concerned only with total returns, concerned only with total returns, and do not care whether returns and do not care whether returns come in the form of capital gains or come in the form of capital gains or dividend yields.dividend yields.

Therefore, one dividend policy is as Therefore, one dividend policy is as good as another.good as another.



2) High Dividends are Best

Some investors may prefer a Some investors may prefer a certain certain dividenddividend now over a now over a risky expected risky expected capital gaincapital gain in the future. in the future.

3) Low Dividends are Best

Dividends are Dividends are taxed immediatelytaxed immediately. . Capital gains are not taxed until the Capital gains are not taxed until the stock is sold.stock is sold.

Therefore, Therefore, taxes on capital gains can taxes on capital gains can be deferred indefinitelybe deferred indefinitely..

Do Dividends Matter?

Other Considerations:Other Considerations:

1) Residual Dividend Theory1) Residual Dividend Theory: : The firm pays a dividend only if it has The firm pays a dividend only if it has

retained earnings left after financing retained earnings left after financing all profitable investment all profitable investment opportunities.opportunities.

This would maximize capital gains for This would maximize capital gains for stockholders and minimize flotation stockholders and minimize flotation costs of issuing new common stock.costs of issuing new common stock.


2) Clientele Effects2) Clientele Effects: : Different investor clienteles prefer different Different investor clienteles prefer different

dividend payout levels.dividend payout levels. Some firms, such as utilities, pay out over Some firms, such as utilities, pay out over

70% of their earnings as dividends. These 70% of their earnings as dividends. These attract a clientele that prefers high attract a clientele that prefers high dividends.dividends.

Growth-oriented firms which pay low (or Growth-oriented firms which pay low (or no) dividends attract a clientele that prefers no) dividends attract a clientele that prefers price appreciation to dividends.price appreciation to dividends.


3) Information Effects3) Information Effects: : Unexpected dividend increases Unexpected dividend increases

usually cause stock prices to rise, and usually cause stock prices to rise, and unexpected dividend decreases cause unexpected dividend decreases cause stock prices to fall. stock prices to fall.

Dividend changes convey information Dividend changes convey information to the market concerning the firm’s to the market concerning the firm’s future prospects.future prospects.


4) Agency Costs4) Agency Costs: : Paying dividends may reduce agency Paying dividends may reduce agency

costs between managers and costs between managers and shareholders.shareholders.

Paying dividends reduces retained Paying dividends reduces retained earnings and forces the firm to raise earnings and forces the firm to raise external equity financing.external equity financing.

Raising external equity subjects the firm Raising external equity subjects the firm to scrutiny of regulators (SEC) and to scrutiny of regulators (SEC) and investors and therefore helps monitor the investors and therefore helps monitor the performance of managers.performance of managers.


5) Expectations Theory5) Expectations Theory: : Investors form expectations concerning Investors form expectations concerning

the amount of a firm’s upcoming the amount of a firm’s upcoming dividend.dividend.

Expectations are based on past dividends, Expectations are based on past dividends, expected earnings, investment and expected earnings, investment and financing decisions, the economy, etc.financing decisions, the economy, etc.

The stock price will likely react if the The stock price will likely react if the actual dividendactual dividend is different from the is different from the expected dividendexpected dividend..

Dividend Policies

1) 1) Constant Dividend Payout RatioConstant Dividend Payout Ratio: : if if directors declare a constant payout directors declare a constant payout ratio of, for example, 30%, then for ratio of, for example, 30%, then for every dollar of earnings available to every dollar of earnings available to stockholders, 30 cents would be paid stockholders, 30 cents would be paid out as dividends.out as dividends.

The ratio remains constant over time, The ratio remains constant over time, but the but the dollar value of dividends dollar value of dividends changeschanges as earnings change. as earnings change.

Dividend Policies

2) 2) Stable Dollar Dividend PolicyStable Dollar Dividend Policy:: the firm tries to pay a fixed dollar the firm tries to pay a fixed dollar dividend each quarter.dividend each quarter.

Firms and stockholders prefer Firms and stockholders prefer stable dividends. Decreasing the stable dividends. Decreasing the dividend sends a negative signal! dividend sends a negative signal!

Dividend Policies

3) 3) Small Regular Dividend plus Year-Small Regular Dividend plus Year-End ExtrasEnd Extras

The firm pays a stable quarterly The firm pays a stable quarterly dividend and includes an extra year-dividend and includes an extra year-end dividend in prosperous years.end dividend in prosperous years.

By identifying the year-end dividend By identifying the year-end dividend as “extra,” directors hope to as “extra,” directors hope to avoid avoid signalingsignaling that this is a permanent that this is a permanent dividend.dividend.

Dividend Payments

1) 1) Declaration DateDeclaration Date:: the board of the board of directors declares the dividend, directors declares the dividend, determines the amount of the dividend, determines the amount of the dividend, and decides on the payment date.and decides on the payment date.

Jan.4 Jan.30 Feb.1 Mar. 11Jan.4 Jan.30 Feb.1 Mar. 11

Declare Ex-div. Record PaymentDeclare Ex-div. Record Paymentdividend date date datedividend date date date

Dividend Payments

2) 2) Ex-Dividend DateEx-Dividend Date::



Dividend Payments

2) 2) Ex-Dividend DateEx-Dividend Date:: To receive the To receive the dividend, you have to buy the stock before dividend, you have to buy the stock before the ex-dividend date. On this date, the the ex-dividend date. On this date, the stock begins trading “ex-dividend” and stock begins trading “ex-dividend” and the stock price falls approximately by the the stock price falls approximately by the amount of the dividend.amount of the dividend.



Dividend Payments

3) 3) Date of RecordDate of Record::



Dividend Payments

3) 3) Date of RecordDate of Record:: 2 days after the ex- 2 days after the ex-dividend date, the firm receives the list of dividend date, the firm receives the list of stockholders eligible for the dividend. stockholders eligible for the dividend.

Often, a bank trust department acts as Often, a bank trust department acts as registrar and maintains this list for the registrar and maintains this list for the firm.firm.



Dividend Payments

4) 4) Payment DatePayment Date:: date on which the date on which the firm mails the dividend checks to the firm mails the dividend checks to the shareholders of record.shareholders of record.



Stock Dividends and Stock Splits

Stock dividendStock dividend:: payment of additional payment of additional shares of stock to common stockholders.shares of stock to common stockholders.

ExampleExample: Citizens Bancorporation of : Citizens Bancorporation of Maryland announces a 5% stock Maryland announces a 5% stock dividend to all shareholders of record. dividend to all shareholders of record. For each 100 shares held, shareholders For each 100 shares held, shareholders receive another 5 shares.receive another 5 shares.

Does the shareholders’ wealth increase?Does the shareholders’ wealth increase?


Stock SplitStock Split: : the firm increases the number the firm increases the number of shares outstanding and reduces the of shares outstanding and reduces the price of each share.price of each share.

Example: Joule, Inc. announces a Example: Joule, Inc. announces a 3-for-23-for-2 stock split. For each 100 shares held, stock split. For each 100 shares held, shareholders receive another 50 shares.shareholders receive another 50 shares.

Does this increase shareholder wealth?Does this increase shareholder wealth? Are a stock dividend and a stock split the Are a stock dividend and a stock split the

same?same?


Stock Splits and Stock Dividends are Stock Splits and Stock Dividends are economically the sameeconomically the same: : the number of the number of shares outstanding increases and the price shares outstanding increases and the price of each share drops. The value of the firm of each share drops. The value of the firm does not change.does not change.

ExampleExample: A 3-for-2 stock split is the same : A 3-for-2 stock split is the same as a 50% stock dividend. For each 100 as a 50% stock dividend. For each 100 shares held, shareholders receive another shares held, shareholders receive another 50 shares.50 shares.


Effects on Shareholder WealthEffects on Shareholder Wealth::


Effects on Shareholder WealthEffects on Shareholder Wealth: : these will these will cut the company “pie” into more pieces cut the company “pie” into more pieces but will not create wealth. A 100% stock but will not create wealth. A 100% stock dividend (or a 2-for-1 stock split) gives dividend (or a 2-for-1 stock split) gives shareholders 2 half-sized pieces for each shareholders 2 half-sized pieces for each full-sized piece they previously owned.full-sized piece they previously owned.


Effects on Shareholder WealthEffects on Shareholder Wealth: : these will these will cut the company “pie” into more pieces cut the company “pie” into more pieces but will not create wealth. A 100% stock but will not create wealth. A 100% stock dividend (or a 2-for-1 stock split) gives dividend (or a 2-for-1 stock split) gives shareholders 2 half-sized pieces for each shareholders 2 half-sized pieces for each full-sized piece they previously owned.full-sized piece they previously owned.

For example, this would double the For example, this would double the number of shares, but would cause a $60 number of shares, but would cause a $60 stock price to fall to $30.stock price to fall to $30.


Why bother?Why bother? Proponents argue that these are used to Proponents argue that these are used to

reduce high stock prices to a “more reduce high stock prices to a “more popular” popular” trading rangetrading range (generally $15 to (generally $15 to $70 per share).$70 per share).

Opponents argue that most stocks are Opponents argue that most stocks are purchased by institutional investors who purchased by institutional investors who have millions of dollars to invest and are have millions of dollars to invest and are indifferent to price levels. Plus, stock splits indifferent to price levels. Plus, stock splits and stock dividends are and stock dividends are expensiveexpensive!!

Stock Dividend Example

shares outstanding: shares outstanding: 1,000,0001,000,000 net income = net income = $6,000,000$6,000,000; ; P/E = P/E = 1010 25%25% stock dividend. stock dividend. An investor has 120 shares. Does the An investor has 120 shares. Does the

value of the investor’s shares value of the investor’s shares change?change?

Before the 25% stock dividendBefore the 25% stock dividend: : EPS = 6,000,000/1,000,000 = $6EPS = 6,000,000/1,000,000 = $6 P/E = P/6 = 10, so P = $60 per share.P/E = P/6 = 10, so P = $60 per share. Value = $60 x 120 shares = Value = $60 x 120 shares = $7,200$7,200

After the 25% stock dividendAfter the 25% stock dividend:: # shares = 1,000,000 x 1.25 = 1,250,000.# shares = 1,000,000 x 1.25 = 1,250,000. EPS = 6,000,000/1,250,000 = $4.80EPS = 6,000,000/1,250,000 = $4.80 P/E = P/4.80 = 10, so P = $48 per share.P/E = P/4.80 = 10, so P = $48 per share. Investor now has 120 x 1.25 = 150 shares.Investor now has 120 x 1.25 = 150 shares. Value = $48 x 150 = Value = $48 x 150 = $7,200$7,200

Stock DividendsIn-class Problem Stock DividendsIn-class Problem

shares outstanding: shares outstanding: 250,000250,000

net income = net income = $750,000$750,000;;

stock price = stock price = $84$84

50% stock dividend. 50% stock dividend.

What is the new stock price?What is the new stock price?

Hint:

stock pricestock price

P/E =P/E = net income net income

# shares# shares( )

Before the 50% stock dividendBefore the 50% stock dividend: : EPS = 750,000 / 250,000 = EPS = 750,000 / 250,000 = $3$3 P/E = 84 / 3 = P/E = 84 / 3 = 2828..

After the 50% stock dividendAfter the 50% stock dividend:: # shares = 250,000 x 1.50 = # shares = 250,000 x 1.50 = 375,000375,000.. EPS = 750,000 / 375,000 = EPS = 750,000 / 375,000 = $2$2 P/E = P / 2 = 28, so P = P/E = P / 2 = 28, so P = $56$56 per share. per share.

(a 50% stock dividend is equivalent to a (a 50% stock dividend is equivalent to a 3-for-2 stock split)3-for-2 stock split)

Stock Repurchases

Stock Repurchases may be a good Stock Repurchases may be a good substitute for cash dividends.substitute for cash dividends.

If the firm has excess cash, why not If the firm has excess cash, why not buy back common stock?buy back common stock?

Stock Repurchases

Repurchases Repurchases drive up the stock drive up the stock priceprice, producing capital gains for , producing capital gains for shareholders.shareholders.

Repurchases Repurchases increase leverageincrease leverage, and , and can be used to move toward the can be used to move toward the optimal capital structure.optimal capital structure.

Repurchases Repurchases signal positive signal positive informationinformation to the market - which to the market - which increases stock price.increases stock price.

Stock Repurchases

Repurchases may be used to Repurchases may be used to avoid avoid a hostile takeover.a hostile takeover.

ExampleExample: T. Boone Pickens : T. Boone Pickens attempted raids on Phillips attempted raids on Phillips Petroleum and Unocal in 1985. Petroleum and Unocal in 1985. Both were unsuccessful because Both were unsuccessful because the target firms undertook stock the target firms undertook stock repurchases.repurchases.

Stock Repurchases

MethodsMethods:: Buy shares in the Buy shares in the open marketopen market

through a broker.through a broker. Buy a Buy a large blocklarge block by negotiating the by negotiating the

purchase with a large block holder, purchase with a large block holder, usually an institution (targeted stock usually an institution (targeted stock repurchase).repurchase).

Tender offerTender offer: offer to pay a specific : offer to pay a specific price to all current stockholders.price to all current stockholders.

chapter 13. dividend policy and internal financing

Documents

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