dividend pplicy

18-1

Dividend Policy

Prepared By:

Prof.Chhaya Patel

Smt.K.K.Patel MBA/MCA College, Palasar (818)

18-2

Dividend Policy

Passive Versus Active Dividend

Policies

Factors Influencing Dividend Policy

Dividend Stability

Stock Dividends and Stock Splits

Stock Repurchase

Administrative Considerations

18-3

Dividends as a

Passive Residual

The firm uses earnings plus the additional

financing that the increased equity can support to

finance any expected positive-NPV projects.

Any unused earnings are paid out in the form of

dividends. This describes a passive dividend

policy.

Can the payment of cash dividends affect

shareholder wealth?

If so, what dividend-payout ratio will

maximize shareholder wealth?

18-4

Irrelevance of Dividends

M&M contend that the effect of dividend

payments on shareholder wealth is

exactly offset by other means of

financing.

The dividend plus the “new” stock price

after dilution exactly equals the stock

price prior to the dividend distribution.

A. Current dividends versus retention

of earnings

18-5

Irrelevance of Dividends

M&M and the total-value principle ensures

that the sum of market value plus current

dividends of two firms identical in all

respects other than dividend-payout ratios

will be the same.

Investors can “create” any dividend policy

they desire by selling shares when the

dividend payout is too low or buying shares

when the dividend payout is excessive.

B. Conservation of value

18-6

Relevance of Dividends

Uncertainty surrounding future company

profitability leads certain investors to

prefer the certainty of current dividends.

Investors prefer “large” dividends.

Investors do not like to manufacture

“homemade” dividends, but prefer the

company to distribute them directly.

A. Preference for dividends

18-7


Capital gains taxes are deferred until the

actual sale of stock. This creates a timing

option.

Capital gains are preferred to dividends,

everything else equal. Thus, high dividend-

yielding stocks should sell at a discount to

generate a higher before-tax rate of return.

Certain institutional investors pay no tax.

B. Taxes on the investor

18-8


Corporations can typically exclude 70% of dividend

income from taxation. Thus, corporations generally

prefer to receive dividends rather than capital gains.

The result is clienteles of investors with different

dividend preferences. In equilibrium, there will be

the proper distribution of firms with differing

dividend policies to exactly meet the needs of

investors.

Thus, dividend-payout decisions are irrelevant.

B. Taxes on the investor (continued)

18-9

Other Dividend Issues

Flotation costs

Transaction costs and

divisibility of securities

Institutional restrictions

Financial signaling

18-10

Empirical Testing

of Dividend Policy

Tax Effect

Dividends are taxed more heavily (in PV terms) than

capital gains, so before-tax returns should be higher

for high-dividend-paying firms.

Empirical results are mixed -- recently the evidence

is largely consistent with dividend neutrality.

Financial Signaling

Expect that increases (decreases) in dividends lead

to positive (negative) excess stock returns.

Empirical results are consistent with these

expectations.

18-11

Implications for

Corporate Policy

Establish a policy that will maximize

shareholder wealth.

Distribute excess funds to shareholders

and stabilize the absolute amount of

dividends if necessary (passive).

Payouts greater than excess funds

should occur only in an environment

that has a net preference for dividends.

18-12

Implications for

Corporate Policy

There is a positive value associated

with a modest dividend. Could be due

to institutional restrictions or

signaling effects.

Dividends in excess of the passive

policy does not appear to lead to

share price improvement because of

taxes and flotation costs.

18-13

Factors Influencing

Dividend Policy

Capital Impairment Rule -- many states prohibit

the payment of dividends if these dividends

impair “capital” (usually either par value of

common stock or par plus additional paid-in

capital).

Incorporation in some states (notably Delaware)

allows a firm to use the “fair value,” rather than

“book value,” of its assets when judging whether

a dividend impairs “capital.”

Legal Rules

18-14

Factors Influencing

Dividend Policy

Insolvency Rule -- some states prohibit the

payment of cash dividends if the company is

insolvent under either a “fair market

valuation” or “equitable” sense.

Undue Retention of Earnings Rule -- prohibits

the undue retention of earnings in excess of

the present and future investment needs of

the firm.

Legal Rules

18-15

Factors Influencing

Dividend Policy

Funding Needs of the Firm

Liquidity

Ability to Borrow

Restrictions in Debt Contracts (protective covenants)

Control

Other Issues to Consider

18-16

Dividend Stability

Stability -- maintaining the position of the firm’s

dividend payments in relation to a trend line.

Do

lla

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er

Sh

are

3

4

2

1

Earnings per share

Dividends

per share

Time

50% of earnings

paid out as dividends

18-17

Dividend Stability

Dividends begin at 50% of earnings, but are stable and

increase only when supported by growth in earnings.

Do

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rs P

er

Sh

are

3

4

2

1

Earnings per share

Dividends per share

Time

50% dividend-payout

rate with stability

18-18

Valuation of

Dividend Stability

Information content -- management may be able to affect the expectations of investors through the informational content of dividends. A stable dividend suggests that the company expects stable or growing dividends in the future.

Current income desires -- some investors who desire a specific periodic income will prefer a company with stable dividends to one with unstable dividends.

Institutional considerations -- a stable dividend may permit certain institutional investors to buy the common stock as they meet the requirements to be placed on the organizations “approved list.”

18-19

Types of Dividends

Extra dividend

A nonrecurring dividend paid to

shareholders in addition to the regular

dividend. It is brought about by special

circumstances.

Regular Dividend

The dividend that is normally expected to

be paid by the firm.

18-20

Stock Dividends

and Stock Splits

Small-percentage stock dividends

Typically less than 25% of previously

outstanding common stock.

Assume a company with 400,000 shares of $5 par

common stock outstanding pays a 5% stock

dividend. The pre-dividend market value is $40.

How does this impact the shareholders’ equity

accounts?

Stock Dividend -- A payment of additional

shares of stock to shareholders. Often used

in place of or in addition to a cash dividend.

18-21

B/S Changes for the Small-

Percentage Stock Dividend

$800,000 ($5 x 20,000 new shares)

transferred (on paper) “out of” retained

earnings.

$100,000 transferred “into” common stock

account.

$700,000 ($800,000 - $100,000) transferred

“into” additional paid-in-capital.

“Total shareholders’ equity” remains

unchanged at $10 million.

18-22

Small-Percentage

Stock Dividends

Before 5% Stock Dividend

Common stock

($5 par; 400,000 shares) $ 2,000,000

Additional paid-in capital 1,000,000

Retained earnings 7,000,000

Total shareholders’ equity $10,000,000

After 5% Stock Dividend

Common stock

($5 par; 420,000 shares) $ 2,100,000




18-23

Stock Dividends,

EPS, and Total Earnings

Assume that investor SP owns 10,000 shares and the

firm earned $2.50 per share.

Total earnings = $2.50 x 10,000 = $25,000.

After the 5% dividend, investor SP owns 10,500 shares

and the same proportionate earnings of $25,000.

EPS is then reduced to $2.38 per share because of the

stock dividend ($25,000 / 10,500 shares = $2.38 EPS).

After a small-percentage stock dividend, what

happens to EPS and total earnings of

individual investors?

18-24

Stock Dividends

and Stock Splits

Typically 25% or greater of previously outstanding

common stock.

The material effect on the market price per share causes

the transaction to be accounted for differently.

Reclassification is limited to the par value of additional

shares rather than pre-stock-dividend value of additional

shares.

Assume a company with 400,000 shares of $5 par common

stock outstanding pays a 100% stock dividend. The pre-

stock-dividend market value per share is $40. How does

this impact the shareholders’ equity accounts?

Large-percentage stock dividends

18-25

B/S Changes for the Large-

Percentage Stock Dividend

$2 million ($5 x 400,000 new

shares) transferred (on paper)

“out of” retained earnings.

$2 million transferred “into”

common stock account.

18-26

Large-Percentage

Stock Dividends

Before 100% Stock Dividend

Common stock

($5 par; 400,000 shares) $ 2,000,000




After 100% Stock Dividend

Common stock

($5 par; 800,000 shares) $ 4,000,000




18-27

Stock Dividends

and Stock Splits

Similar economic consequences as a 100% stock

dividend.

Primarily used to move the stock into a more

popular trading range and increase share demand.


common stock splits 2-for-1. How does this impact

the shareholders’ equity accounts?

Stock Split -- An increase in the number of

shares outstanding by reducing the par value

of the stock.

18-28

Stock Splits

Before 2-for-1 Stock Split

Common stock

($5 par; 400,000 shares) $ 2,000,000




After 2-for-1 Stock Split

Common stock

($2.50 par; 800,000 shares) $ 2,000,000




18-29

Value to Investors of Stock

Dividends or Stock Splits

Effect on investor total wealth

Effect on investor psyche

Effect on cash dividends

More popular trading range

Informational content

18-30

Stock Dividends

and Stock Splits

Used to move the stock into a more popular trading

range and increase share demand.

Usually signals negative information to the market

upon its announcement (consistent with empirical

evidence).


common stock splits 1-for-4. How does this impact

the shareholders’ equity accounts?

Reverse Stock Split -- A stock split in which the

number of shares outstanding is decreased.

18-31

Reverse Stock Splits

Before 1-for-4 Stock Split

Common stock

($5 par; 400,000 shares) $ 2,000,000




After 1-for-4 Stock Split

Common stock

($20 par; 100,000 shares) $ 2,000,000




18-32

Stock Repurchase

Reasons for stock repurchase:

Available for management stock-option plans

Available for the acquisition of other companies

“Go private” by repurchasing all shares from

outside stockholders

To permanently retire the shares

Stock Repurchase -- The repurchase (buyback)

of stock by the issuing firm, either in the open

(secondary) market or by self-tender offer.

18-33

Methods of Repurchase

Fixed-price self-tender offer -- An offer by a firm to

repurchase some of its own shares, typically at a set

price.

Dutch auction self-tender offer -- A buyer (seller)

seeks bids within a specified price range, usually for

a large block of stock or bonds. After evaluating the

range of bid prices received, the buyer (seller)

accepts the lowest price that will allow it to acquire

(dispose of) the entire block.

Open-market purchase -- A company repurchases its

stock through a brokerage house on the secondary

market.

18-34

Repurchasing as

Part of Dividend Policy

Assume:

Earnings after taxes $ 800,000

Number of common shares outstanding 400,000

Earnings per share $ 2

Current market price per share $ 31

Expected dividend per share $ 1

Expected total dividendsto be paid out $ 400,000

18-35

Repurchasing as

Part of Dividend Policy

If dividend is paid, shareholders receive:

Expected dividend per share $ 1

Market price per share $ 30

Total value $ 31

If shares repurchased, shareholders receive:

Dividend per share $ 0

Market price per share* $ 31

Total value $ 31

* Shares repurchased = $400,000 / $31 = 12,903

Original P/E ratio = $30/$2 = 15

“New” EPS = $800,000 / 387,097 = $2.07

“New” market price = $2.07 x 15 = $31

18-36

Summary of Repurchasing

as Part of Dividend Policy

The capital gain arising from the repurchase

(stock rising from $30 to $31) exactly equals

the dividend ($1) that would have otherwise

been paid.

This result holds in the absence of taxes and

transaction costs.

To the taxable investor, capital gains

(repurchases) are favored to dividend income

as the tax on the capital gain is postponed

until the actual sale of the common shares.

18-37

Summary of Repurchasing

as Part of Dividend Policy

Stock repurchases are most relevant for

firms with large amounts of excess cash

that might otherwise generate a significant

taxable transaction to investors.

Firms must be careful not to make regularly

occurring repurchases or the IRS may

consider the capital gains as dividends for

tax purposes.

18-38

Investment or

Financing Decision?

Financing Decision

It possesses capital structure or dividend policy

motivations.

For example, a repurchase immediately changes

the debt-to-equity ratio (higher financial leverage).

Investing Decision

Not really, as stock that is repurchased is held as

treasury stock and does not provide an expected

return like other investments.

18-39

Possible Signaling Effect

Repurchases have a positive signaling effect.

For example, if the stock is undervalued management may tender for shares at a “premium.” This signals that the share prices are undervalued.

Dutch-auction self-tenders have less signaling power likely due to a smaller tender premium.

Open-market purchases have only a modest positive signaling effect likely due to many programs being instituted after significant share price declines.

18-40

Administrative Considerations:

Procedural Aspects

Record Date -- The date, set by the board of directors when a dividend is declared, on which an investor must be a shareholder of record to

be entitled to the upcoming dividend.

The board of directors met on May 8th to declare a dividend payable to shareholders on June 15th

to the shareholders of record on May 31st.

May 8 May 29 May 31 June 15

18-41


Procedural Aspects

Ex-dividend Date -- The first date on which a

stock purchaser is no longer entitled to the

recently declared dividend.

The buyer and seller of the shares have several days to

settle (pay for the shares or deliver the shares). The

brokerage industry has a rule that new shareholders are

entitled to dividends only if they purchase the stock at

least two business days prior to the record date.


18-42


Procedural Aspects

Declaration Date -- The date that the board of

directors announces the amount and date of the

next dividend.

Payment Date -- The date when the corporation

actually pays the declared dividend.


18-43

Dividend

Reinvestment Plans

The firm can use existing stock. A trustee (e.g., a

bank) purchases the stock on the open market and

credits current shareholders with the new shares.

The firm can issue new stock. This method raises

“new” funds for the firm. The plan essentially

reduces the effective dividend-payout ratio.

Some plans offer discounts and eliminate

brokerage costs for current shareholders.

Dividend Reinvestment Plan (DRIP) -- An optional plan

allowing shareholders to automatically reinvest

dividend payments in additional shares of the

company’s stock.

dividend pplicy

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