Chapter 16 Dividend Policy

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Chapter 16 Outline16.1 Distributions to Shareholders

• Dividends• Cash dividends• Stock dividends• Stock splits• Share repurchases

16.2 Why Do Companies Pay Cash Dividends?

• Residual Theory• Agency costs• “Bird in the hand”• Signaling• Taxes

16.3 Dividend Policy in Practice

• Dividend Ratios• What do we know

about dividends?

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A corporation has no legal obligation to make any type of distribution to common shareholders, whether this is a distribution of cash or a distribution of shares.

A company’s board of directors declares a dividend, and only then does a dividend become a contractual commitment of the company.

Shareholders cannot force the members of the board to declare a dividend, and there may be legal restrictions on whether or not the company can declare a dividend.

16.1 Distributions to Shareholders

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Cash DividendsThe dividend payout ratio is dividends as a percentage of earnings, as shown in the graph for the stocks that comprise the S&P 500 Index. Aggregate Dividends and

Profits, 1871 Through 2010

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Dividend Payout RatioWe can draw a few conclusions from the graph:

The payout rate is normally around 40 to 60%, but increased to over 100% during economic downturns, when profits dropped dramatically but dividends remained relatively stable.

The payout rate has been trending downward over time.

The median payout for the most recent 10 years is 35.5%.

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We can also look at dividends from another perspective. Consider the dividend yield of stocks in the S&P 500 Index, as shown in the graph.The dividend yield is the ratio of the dividend to the price of the stock; with the price of the stock in the denominator.

Dividend Yield

Dividend Yields of Stocks in the S&P 500 Index, 1871

Through 2010

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On the declaration date, the board specifies: The amount of the dividend, generally stated as an

amount per share of stock The record date or date of record, which is the date

used to determine the shareholders who will receive the dividend

The payment date or payable date, which is the day the dividend is actually paid by the company.

The Mechanics of Cash Dividends

Declaration date

Ex-dividend

dateRecord date

Payment date

| | | |

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Because shares of stock are traded in markets on a continual basis, it can take a day or so to determine who actually owns the shares at a point in time; in this case, who the holder of record is on a particular day.

The holder of record is resolved by the markets, which specify the ex-dividend date as two trading days prior to the record date.

Holder of Record

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How this works is as follows: If you buy the stock on the ex-dividend date or later, you do

not get the forthcoming, declared dividend. If you buy the stock before the ex-dividend date and own it at

least until the day before the ex-dividend date, you will receive the forthcoming dividend.

This explains why we typically see a drop in the share price of a dividend-paying stock from the day before to the ex-dividend date: If you buy the stock on the day before the ex-dividend date, you receive the dividend; if you buy the stock on the ex-dividend date, you do not receive the dividend.

Holder of Record

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Timeline of IBM’s Cash Dividend Paid November 8, 2010

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If the investor does not want to receive a dividend, many corporations offer the option of using the cash dividend proceeds to buy new shares by way of a dividend reinvestment plan (DRIP or DRP).

Why wouldn’t an investor want a cash dividend?

Dividend Reinvestment Plans

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DRIPs are popular with both investors and companies. For the company, it means that it can issue shares on a regular basis continuously at no cost, whereas investors perceive that it is paying a regular dividend.

DRPS, continued

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A stock dividend is generally defined as any share distribution, but typically we use the term “stock dividend” when the number of shares issued is less than 25% of the outstanding shares.

If a company declares a 10% stock dividend, each investor will get 10% more shares.

Stock Dividends

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In terms of accounting, a company paying a stock dividend transfers the value of the shares from retained earnings into the capital stock account.

As a result, a company cannot issue a stock dividend if there are no available retained earnings.

Stock Dividends

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A stock dividend will likely have the effect of reducing the share price proportionately.

If a company had 10 million shares outstanding and a share price of $20, and then pays a 15% stock dividend, the expected share price after the dividend is the total market value of the company, divided by the new number of shares: ($20 × 10,000,000) ÷ (10,000,000 × 1.15) = $17.9 per share.

Stock Dividends

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A stock split is similar (but not identical) to a stock dividend.

Typically, when a company has a goal of issuing more than 25% additional shares, it uses a stock split; however, there is no rule or restriction with regard to this.

We refer to a stock split in terms of shares after compared to shares before. Examples: 2:1 3:2 4:1

Stock Splits

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Related to the stock split is the reverse stock split. Like the stock split that we have already discussed,

a company might try to lift its stock price by undergoing a reverse stock split, in which the company issues fewer shares for the existing outstanding shares.

Why reverse stock split? The typical stock split reduces the share price, so the logic is that the reverse stock split will increase the share price

Reverse Stock Split

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Effect on… Cash Dividend

Stock Dividend

Stock Split

Cash flow Cash outflow for the total amount of dividends

No cash flow No cash flow

Retained earnings

Reduce by the amountof the dividends

Reduce by the value of the shares distributed

No effect

Taxable incomeof investor

Dividend income

No taxable income

No taxable income

Summary of Dividends

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A share repurchase (or stock repurchase) is an outright purchase of the company’s own shares, either through open market purchases through a broker or through a tender offer in which shareholders can elect to sell their shares.

Share Repurchases

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To see the effect of a repurchase on share price, consider that the value of a share of stock is the present value of future cash flows.

If a company is expected to pay a dividend next period of D1, has a market value of the shares at the end of next period P1, and has S0 shares outstanding, the present value of a share of stock is:

Share Repurchases

or, using notation:

Why Repurchase?

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Remove cash without generating expectations for future distributions

Information or signaling effects Offsetting the exercise of executive stock

options Leveraged recapitalizations Repurchase dissidents’ shares (a.k.a. greenmail) Take the company private

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Open market repurchaseTender offer

Traditional tender offer Dutch Auction tender offer

Repurchase Methods

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In a Dutch auction tender offer, shareholders submit bids for the price they are willing to sell their shares; the company will pay the minimum price necessary to acquire the stated number of shares.

Repurchase Methods

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Explanations of why companies pay dividends include the following:

Residual cash flow Agency costs “Bird in the hand” Signaling Taxes

16.2 Why Do Companies Pay Cash Dividends?

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Residual theory of dividends - theory that the dividends paid out should be the residual cash flow that remains after the company has taken care of all of its investment requirements.

Faced with significant costs attached to raising new money, cash-poor growth companies have little incentive to pay a dividend because all they are doing is compounding their financing problems.

Residual Theory

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Similarly, companies that face volatile earnings, so that their cash fluctuates significantly from year to year, will attempt to “store” cash from one period to another. As a result, companies maintain their dividend payments conservatively and at a level that minimizes the need to constantly access the capital markets.

BOTTOM LINE: companies will pay dividends if they do not need additional capital and they have cash flows remaining after all profitable investment projects. If dividends are paid based on residual cash flows, we should see profitable, mature companies paying dividends, but also observe that high-growth companies do not.

Residual Theory

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The announcement of a dividend increase is generally associated with the increase in the share price. The fear is that senior management may waste

corporate resources by overinvesting in poor (that is, negative NPV) projects because it is not “their” money but the shareowners’.

Agency Costs

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This idea of the bird in the hand argument is that a “bird in the hand” (that is, a cash dividend) is worth more than “two in the bush” (twice as much in capital gains). Dividends are more stable than capital gains

and, as a result, more highly valued.

The “Bird in the Hand” Argument

Management usually knows more than external investors, so the company has to have some way of signaling to investors that their press releases can be believed because investors tend to view such information with a great deal of skepticism.

One way of doing this is to increase the dividend only when the company believes that it will not have to cut it in the future.

Signaling

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Describing how taxes affect financial policy is very difficult because different classes of investors have different tax brackets, so with taxes the general rule is that “one size does not fit all.”

Corporations pay little or no tax on dividend income if it is from another corporation. This is because of the dividends received deduction, which

provides a deduction for 70, 80, or 100% of dividends received.

As a result, there is a preference by corporate owners of equity for dividend income.

Taxes

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For individuals, the preference for dividend versus capital gains income depends on whether the dividends are considered qualifying dividends and whether the price appreciation is short or long term.

The current tax system, with individual investors, corporations, and institutional investors facing different tax rates on dividends, gives rise to tax clienteles.

Taxes

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The dividends of most companies follow some pattern, though these patterns may be in terms of a steady payout ratio, a constant dividend per share, or a constantly growing dividend per share.

There is no requirement that a company follow a consistent pattern in its dividend, but many shareholders acquire stock with the expectation of dividends following a pattern.

16.3 Dividend Policy in Practice

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We can classify many companies’ dividends as falling into one of these patterns:

Dividend Policy in Practice

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Dividend per share Dollar amount of dividend per share of stock

Dividend yield Return on stock in the form of a cash dividend

Dividend payout Proportion of earnings paid out in the form of cash dividends

Dividend coverage Number of times a dividend could be paid based on earnings

Dividend Ratios

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Johnson & Johnson’s Dividend

1962

1967

1972

1977

1982

1987

1992

1997

2002

2007

2012

$0.0$0.5$1.0$1.5$2.0$2.5$3.0

DPS

Per s

hare

1962

1967

1972

1977

1982

1987

1992

1997

2002

2007

2012

0%20%40%60%80%

Dividend payout

Perc

enta

ge o

f ear

n-in

gs

1962

1967

1972

1977

1982

1987

1992

1997

2002

2007

2012

0%1%2%3%4%

Dividend yield

Yiel

d

Source of data: Standard & Poor’s Compustat

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Observation 1: Dividends follow earnings. We observe that many companies do not vary their

dividend each period based on their performance, but rather smooth the dividends over time so that they grow from year to year at a constant rate.

Observation 2: Dividends are sticky. We observe that companies are reluctant to cut

dividends when earnings decline, perhaps because of the anticipated market reaction to a dividend cut.

What Do We Know about Dividends?

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Johnson & Johnson: EPS & DPS

1962

1966

1970

1974

1978

1982

1986

1990

1994

1998

2002

2006

2010

$0$1$2$3$4$5$6

EPS DPS

Amou

nt p

er s

hare

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Corporations may distribute funds to owners by paying dividends or buying back shares in a share repurchase.

Corporations may also provide shareholders with additional shares either through a stock dividend or a stock split, but both of these transactions are merely slicing the equity “pie” into more pieces.

Investors tend to react favorably to dividend initiations and increases and react unfavorably to dividend cuts or omissions. We gauge investors’ reaction to these dividend decisions by looking at the stock price movements associated with dividend policy changes.

Summary

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There are various theories and explanations for why companies pay dividends: Residual theory - companies pay dividends when they have no

profitable investment opportunities) Agency theory - by paying dividends, companies have to go to the

capital market more often, and are therefore monitored more often

The “bird in the hand” explanation - investors prefer the certain cash flow of dividends to the uncertain price appreciation s

Signaling - by committing to paying more dividends, the company’s management is signaling that the company will be able to sustain this dividend into the future

The dividend tax clientele explanation - some investors prefer dividends because of their tax situation, whereas others do not

Summary

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We observe that companies that do pay dividends do so on a regular basis, either with dividends increasing at a relatively constant rate or a dividend payout rate that is consistent over time. However, in tough economic periods, some

companies do cut their dividend and wait to restore their dividend until the economy—and company—has recovered.

Summary