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Learning OutcomesChapter 13

Describe the views that have been proposed to explain why firms follow particular dividend policies and why investors react when firms change dividend policies.

Discuss (a) the types of dividend payments and (b) payment procedures that firms follow in practice.

Discuss factors that firms consider when making dividend policy decisions.

Describe stock dividends and stock splits, and discuss how stock prices are affected by these activities.

Describe stock repurchases and discuss reasons firms use repurchases.

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Dividend Policy

DividendsPayments made to stockholders from the

firm’s earnings, whether those earnings were generated in the current period or in previous periods

Dividends affect capital structure:Retaining earnings increases common equity

relative to debt.Financing with retained earnings is cheaper

than issuing new common equity.

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Dividend Policy and Stock ValueDividend Irrelevance TheoryTheory states that a firm’s dividend policy has no effect

on either its value or its cost of capital

Investors value dividends and capital gains equally

Optimal Dividend PolicyStrikes a balance between current dividends and future

growth that maximizes the firm’s stock price

Dividend Relevance TheoryA firm’s value is affected by its dividend policy

The optimal dividend policy is the one that maximizes the firm’s value

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Investors and Dividend Policy

Information Content, or SignalingSignaling hypothesis says that investors regard dividend

changes as signals of management’s earnings forecasts.

Clientele EffectThe tendency of a firm to attract the type of investor who

likes its dividend policy

Free Cash Flow HypothesisAll else equal, firms that pay dividends from cash flows that

cannot be reinvested in positive net present value projects (free cash flows), have higher values than firms that retain free cash flows.

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Types of Dividend Payments in Practice

Residual Dividend Policy:A policy in which the dividend paid is set equal to the

actual earnings minus the amount of retained earnings necessary to finance the firm’s optimal capital budget

Stable, Predictable Dividend PolicyPayment of a specific dollar dividend each year, or

periodically increasing the dividend at a constant rateThe annual dividend is somewhat predictable by

investors.

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Types of Dividend Payments in Practice

Constant Payout RatioPercentage of earnings, such as 50 percent

Must watch out for reductions, which may seem to signal permanent earnings decline

Low Regular Dividend Plus ExtrasA low regular dividend plus a year-end extra in good

years

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Dividend Payments in Practice

Declaration DateDate on which a firm’s board of directors issues a

statement declaring a dividend

Holder-of-Record DateThe date on which the company opens the ownership

books to determine who will receive the dividend

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Dividend Payments in Practice

Ex-Dividend DateThe date on which the right to the next

dividend no longer accompanies a stock

Usually two business days prior to the holder-of-record date

Payment DateThe date on which the company actually

mails dividend checks

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Dividend Reinvestment Plans (DRIPs)

Plans that enable stockholders to automatically reinvest dividends received back into the stock of the paying firm

Firms either repurchase existing shares or issue new shares that are part of DRIPs

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Factors Influencing Dividend Policy

1. Constraints on dividend payments:• Debt contract restrictions

• Cannot exceed “retained earnings”

• Cash availability

• IRS restrictions on improperly accumulated retained earnings

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Factors Influencing Dividend Policy

2. Investment opportunities• Large capital budgeting projects affect dividend-

payout ratios.

3. Alternative sources of capital

4. Ownership dilution

5. Effects of dividend policy on rS

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Stock Dividends and Stock Splits

Both stock dividends and stock splits increase the number of shares outstanding, so “the pie is divided into smaller pieces.”

Unless the stock dividend or stock split conveys information, or is accompanied by another event like higher dividends, the stock price falls so as to keep each investor’s wealth unchanged.

But splits/stock dividends may help firm reach an “optimal price range.”

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Balance Sheet Effects of a Stock Split

Before a Stock Split Common stock (5 million shares outstanding, $1 par value) $ 5.0Additional paid-in capital 10.0Retained earnings 285.0Total common stockholders’ equity $300.0Book value per share = $300/5 $ 60.0

After a 2-for-1 Stock SplitCommon stock (10 million shares outstanding, $0.50 par value) $ 5.0Additional paid-in capital 10.0Retained earnings 285.0Total common stockholders’ equity $300.0

Book value per share = $300/10 $ 30.0

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Balance Sheet Effects of Stock DividendsBefore a Stock Split of Stock Dividend

Common stock (5 million shares outstanding, $1 par value) $ 5.0Additional paid-in capital 10.0Retained earnings 285.0Total common stockholders’ equity $300.0Book value per share = $300/5 $ 60.0

After a 20 Percent Stock DividendCommon stock (6 million shares outstanding, $1 par value)a $ 6.0Additional paid-in capitalb 99.0Retained earningsb 195.0Total common stockholders’ equity $300.0

Book value per share = $300/6 $ 50.0a Shares outstanding are increased by 20 percent, from 5 million to 6 million.b A transfer equal to the market value of the new shares is made from the retained

earnings account to the additional paid-in capital and common stock accounts:Transfer = [(5,000,000 shares)(.020)]$90 = $90,000,000

Of this $90 million, $1,000,000 = ($1 par)(1,000,000 shares) goes in the Common stock account and the remaining $89 million goes in the Paid-in capital account.

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Reasons for Stock Repurchases

To distribute excess funds to stockholders

To adjust the firm’s capital structure

To acquire shares needed for employee options or compensation

To protect against a takeover attempt

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Advantages of Stock Repurchases1. A company can use a stock repurchase to distribute excess

cash (free cash flows) without increasing the amount of the dividends that might otherwise be paid during the year.

2. A repurchase is an effective method to immediately change the firm’s capital structure when the proportion of equity is substantially higher than the target capital structure prescribes.

3. When a firm expects managers and other employees to exercise stock options that have been paid to them as compensation in previous years, a repurchase can be used to minimize the “dilution effect” associated with exercising the options.

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Advantages of Stock Repurchases4. Stockholders do not have to sell their shares to

the company during a repurchase period.

5. Many investors believe that a stock repurchase program is a signal from management that the firm’s stock is undervalued in the financial markets, and thus it is a bargain to purchase.

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Disadvantages of Stock Repurchases

1. The company might pay too much for stock that is repurchased.

2. The interval between one stock repurchase and another one generally is irregular, which means that participating investors cannot rely on the cash that they receive from stock repurchases.

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Capital Structures and Dividend Policies Around the World

Companies in Italy and Japan use more debt than companies in the United States or Canada, but companies in the United Kingdom use less than any of these.

Different accounting practices make comparisons difficult.

Gap has narrowed in recent years.

Dividend-payout ratios vary greatly also.

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Capital Structures and Dividend Policies Around the World

Tax codes generally favor use of debt in developed countries.

In countries where capital gains are not taxed, investors should show a preference for stocks compared with countries that have capital gains taxes.

Investor preferences should lead to relatively low equity capital costs in those countries that do not tax capital gains.

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Capital Structures and Dividend Policies Around the World

What about risk, especially bankruptcy costs?Foreign banks are closely linked to corporations

that borrow from them, and have substantial influence over the management of the debtor firms

Equity monitoring costs are comparatively low in the United States

These low monitoring costs indicate that U.S. firms should have more equity and less debt than firms in countries like Japan and Germany