© prentice hall, 2000 1 chapter 15 dividend policy shapiro and balbirer: modern corporate finance:...
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© Prentice Hall, 2000
1
Chapter 15
Dividend Policy
Shapiro and Balbirer: Modern Corporate Finance:
A Multidisciplinary Approach to Value Creation
Graphics by Peeradej Supmonchai
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Learning Objectives Explain the procedures for cash dividends, and
discuss the legal and Internal Revenue Service constraints on dividend payments.
Describe the difference and similarities between stock dividends and stock splits.
Discuss the rationale for share repurchases.
Explain why dividend policy is irrelevant in perfect markets.
Explain how taxes and agency costs make dividend policy relevant.
List the factors that a firm should consider when setting its dividend policy.
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Dividend Payment Procedures
Declaration Date
Holder-of-Record Date
Ex-Dividend Date
Payment Date
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Dividend Payment Procedures - Time Line
Declaration
Date
Ex-dividend
Date
Holder-of-Record
Date
Payment
Date
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Constraints on Dividend Payments
Restrictive covenants in debt and preferred stock agreements
Net profits rule
Capital impairment rule
Insolvency rule
Penalty taxes on retained earnings
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Approaches to Dividend Policy
Pure Residual Policy
Smoothed Residual Policy
Constant Payout Policy
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Dividend Policies in Practice
Most US companies tend to follow the
smoothed residual approach.
Dividend cuts are infrequent.
After-tax earnings are more volatile than
dividends.
Dividend changes lag earnings changes.
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Stock Dividends and Stock Splits
Stock Dividends - Payment of additional shares
to common stockholders. A 10% stock dividend
means that shareholders get 1 additional share
for every 10 they own.
Stock Splits - A proportionate increase in the
number of common shares. A 2:1 stock split
means that stockholders will receive one
additional share for every one they own.
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Reasons for Stock Dividends and Stock Splits
Stock dividends conserve cash while still
maintaining a record of dividends.
Keep share in “popular” trading range in
order to appeal to small investors.
Signals management’s confidence in the
future. However, increases in stock price
will be transitory unless management
delivers results.
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Stock Repurchase
A way for a firm to distribute cash to
shareholders by buying back its own stock.
The share repurchase is essentially a
liquidating dividend for those stockholders
who opt to sell their shares.
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Methods of Share Repurchase
Tender Offer
Open Market Purchases
Private Transactions - Often associated
with greenmail
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Reasons for Share Repurchase
Tax Benefits - Dividends are taxed as
ordinary income; repurchases are taxed
as capital gains. IRS might regard regular
share repurchases as a dividend and tax
them accordingly.
Signal of Management’s Confidence
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MM Dividend Irrelevance Proposition
In perfect capital markets, dividend policy is
irrelevant in the sense that it cannot effect
shareholder value. The effect of any dividend policy
can be offset by management adjusting the sale of
new stock or by investors adjusting their dividend
stream through stock purchases or sales.
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Dividend Irrelevance - MicroGeneral
Balance Sheet (Market Values)
Cash $ 2,000 Debt $ 4,000
Fixed Assets $ 5,000
Growth Opportunities* $ 3,000 Equity $ 6,000
Total Assets $10,000 Value of Firm $10,000
*The value of future opportunities to invest in positive NPV projects
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Dividend Irrelevance - MicroGeneral
MicroGeneral needs $2,000 in cash to invest in
growth opportunities. Each share is worth $60.
Suppose management decides to pay a dividend of
$10 a share for a total of $1,000. Total assets drop
to $9,000 giving the firm a net worth of $5,000. The
new price of the stock is $50 a share, a decline of
$10 a share.
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Dividend Irrelevance - MicroGeneral
Holding capital structure constant, MicroGeneral must
raise $1,000 in new equity by issuing 20 new shares at $50
a share for a total of $1,000. MicroGeneral’s new balance
sheet will look identical to the old except that the equity
account will list 120 shares. MicroGeneral’s old
stockholders’ wealth position remains the same since the
value of their shares ($5,000) plus the dividend of $1,000
equals their original position.
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Signaling With Dividends
Much of the data we have on a firm is
accounting-based. To the extent that this
information is incomplete, dividends may
have communications value if investors
value this information, and the information
cannot be communicated by any other
means
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Bird-in-the-Hand Argument
An argument for paying dividends based on
the idea that since investors are risk-averse,
they prefer a stream of relatively certain
dividends over uncertain capital gains. This
argument confuses the investment and
dividend decision.
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Dividends and Taxes
In the real world, dividends are taxed at a
significantly higher rate than capital gains.
This tax treatment favors retentions (and
capital gains) over dividends.
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Dividends and Taxes - An Example
Suppose that tax on dividend income for the
highest earning individual is 39.6%,
whereas, capital gains are taxed at 20%.
What are the differences in valuation for a
firm that pays no dividends, and one that
pays out all of its earnings in dividends?
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Dividends and Taxes - An Example
Company
A B
Dividend Payout Ratio 0% 100%
Income Available to Shareholder E E
Investors’ After Tax Return 0.80E0.604E
After-Tax Required Return on Equity r r
Market Value of the Equity 0.80E/r 0.604E/r
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The Case for Tax Neutrality of Dividends
Dividends help those investors who need
current income and would incur transaction
costs to sell off part of their holdings. Each
investor, therefore, trades off the trans-
action cost benefits of dividends against the
tax disadvantages.
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The Case for Tax Neutrality of Dividends
Investors sort themselves into three “clienteles”:
those that prefer dividends
those that are indifferent towards dividends
those that are averse to dividends
Thus, companies don’t have to worry about their
payout policy since clienteles will select the payout
policy that serves them best.
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Agency Costs and the Case for Dividends
Dividends eliminate some of the in-
formation asymmetries underlying the
shareholder - manager agency conflict.
Dividend payments reduce management’s
control over free cash flow.
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Setting Dividend Policy
Firms should ask the following questions when establishing dividend policy:
What are our investment opportunities?
What kind of business risk do we face?
Who are our stockholders?
What is our liquidity position?
Is legal listing important to us?
Is control an issue?