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Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

18-0

CHAPTER

18Dividends and OtherPayouts

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Chapter Outline

18.1 Different Types of Dividends

18.2 Standard Method of Cash Dividend Payment

18.3 Home made Dividend Policy

18.4 Repurchase of Stock18.5 Personal Taxes, Issuance Costs, and Dividends

18.6 Real World Factors Favoring a High Dividend Policy

18.7 The Clientele Effect

18.8 What We Know and Do Not Know About DividendPolicy

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18.1 Different Types of Dividends

Many companies pay a regular cash dividend.Public companies often pay quarterly.

Sometimes firms will throw in an extra cash dividend.

The extreme case would be a liquidating dividend.Often companies will declare stock dividends.

No cash leaves the firm.

The firm increases the number of shares outstanding.

Some companies declare a dividend in kind.Wrigleys Gum sends around a box of chewing gum.

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18.2 Standard Method of Cash

Dividend Payment

Ex-Dividend DateThe second day before

the date of record which is January 28 is

called the Ex-dividend date..

Cash Dividend- Payment of cash by the firm

to its shareholders.

The mechanics of dividend payment:Declaration Date: On January 1(diclaration

date) the board of directors passes a resolution

to pay a dividend of $1 per share on February

16 to all holders.

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18.2 Standard Method of Cash

Dividend Payment

Ex-Dividend Date- Date that determines whether a

stockholder is entitled to a dividend payment; anyone

holding stock before this date is entitled to a dividend.

Record Date- Person who owns stock on this date

received the dividend. The corporation prepares a list on

January 30 of all individuals/shareholders as of this date.

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Procedure for Cash Dividend Payment

15 Jan.Thursday

27 Jan.Tuesday

28Jan.Wenday

30Jan. Fri. 16 Feb.Mon.

Declaration

Date

Cum-

dividend

Date

Ex-

dividend

Date

Record

Date

Payment

Date

Declaration Date: The Board of Directors declares a payment of dividends.

Cum-Dividend Date: The last day that the buyer of a stock is entitled to the

dividend.

Ex-Dividend Date: The first day that the seller of a stock is entitled to the

dividend.Record Date: The corporation prepares a list of all individuals believed to be

stockholders as of 30 January.

Payment Date: The dividend cheques are mailed to shareholders of records.

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Price Behavior around the Ex-Dividend Date

In a perfect world, the stock price will fall by the

amount of the dividend on the ex-dividend date.

$P

$P - div

Ex-dividend

Date

The price drops

by the amount of

the cash

dividend

-t -2 -1 0 +1 +2

Taxes complicate things a bit. Empirically, the price

drop is less than the dividend and occurs within the first

few minutes of the ex-date.

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18.3 The Benchmark Case: An Illustration ofthe Irrelevance of Dividend Policy

A compelling case can be made that dividend

policyis irrelevant.

Dividend policy will have no impact on the valueof the firm because investors can create whatever

income stream they prefer by using homemade

dividends.

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Homemade Dividends

Bianchi Inc. is a $42 stock about to pay a $2 cash dividend.

Bob Investor owns 80 shares and prefers $3 cash dividend.

Bobs homemade dividend strategy:

Sell 2 shares ex-dividend

homemade dividends

Cash from dividend $160

Cash from selling stock $80Total Cash $240

Value of Stock Holdings $40 78 =

$3,120

$3 Dividend

$240

$0$240

$39 80 =

$3,120

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Dividend Policy is Irrelevant

Since investors do not need dividends to convert shares to cash,

dividend policy will have no impact on the value of the firm.

In the above example, Bob Investor began with total wealth of

$3,360:

share

42$

shares80360,3$=

240$

share

39$shares80360,3$ +=

80$160$share

40$shares78360,3$ ++=

After a $3 dividend, his total wealth is still $3,360:

After a $2 dividend, and sale of 2 ex-dividend shares,his totalwealth is still $3,360:

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Irrelevance of Stock Dividends: Example

Shimano USA has 2 million shares currently outstanding at $15 per

share. The company declares a 50% stock dividend. How many

shares will be outstanding after the dividend is paid?

A 50% stock dividend will increase the number of shares by 50%:

2 million1.5 = 3 million shares

After the stock dividend what is the new price per share and what is

the new value of the firm?

The value of the firm was $2m $15 per share = $30 m. After thedividend, the value will remain the same.

Price per share = $30m/ 3m shares = $10 per share

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Dividends and Investment Policy

Firms should never forgo positive NPV projects

to increase a dividend.

Recall that on of the assumptions underlying thedividend-irrelevance arguments was The

investment policy of the firm is set ahead of time

and is not altered by changes in dividend policy.

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18.4 Repurchase of Stock

Instead of declaring cash dividends, a firm may

use excess cash to repurchase shares of its own

stock.Recently share repurchase has become an

important way of distributing earnings to

shareholders.

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18.4 Repurchase of Stock

Three ways of Share Repurchase:Open Market Purchases

Firms may simply purchase their own stock like other

investors.The firm does not reveal itself as buyer

Tender Price

The firm announces to all of its shareholders to buy a fixed

number of share at specified price.Targeted repurchase

Firms may repurchase share from specified individualstockholder are called targeted repurchase.

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Stock Repurchase versus Dividend

$10=/100,000$1,000,000=Price per share

100,000=outstandingShares1,000,000Value of Firm1,000,000Value of Firm

1,000,000Equity850,000assetsOther

0Debt$150,000Cash

sheetbalanceOriginalA.Equity&LiabilitiesAssets

Consider a firm that wishes to distribute $100,000 to its

shareholders.

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$9=00,000$900,000/1=shareperPrice

100,000=goutstandingShares

900,000FirmofValue900,000FirmofValue

900,000Equity850,000assetsOther

0Debt$50,000Cash

dividendcashshareper$1AfterB.Equity&sLiabilitiesAssets

If they distribute the $100,000 as cash dividend, the balance

sheet will look like this:

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Assets L iabil i ties & EquityC. After stock repurchase

Cash $50,000 Debt 0

Other assets 850,000 Equity 900,000

Value of Firm 900,000 Value of Firm 900,000

Shares outstanding= 90,000

Price pershare = $900,000/ 90,000= $10

If they distribute the $100,000 through a stock repurchase, the

balance sheet will look like this:

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Stock Repurchase versus DividendWhy some firms choose repurchase over dividend?

FlexibilityFirms view dividend as a commitment to their shareholders.

Repurchases do not represent a similar commitment.

Executive CompensationExecutives are given stock options a part of theircompensation.

Offset dilutionExercise of stock option increases the number of shareoutstanding causes dilution of stock.

Firms buy back shares of stock to offset this dilution.

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Stock Repurchase versus DividendWhy some firms choose repurchase over dividend?

Repurchase as investment

Recent studies has shown that the long-term stock

price performance of securities after a buyback is

significantly better than the stock price performance

of comparable companies that do not repurchase.

Taxes

Repurchases provide a tax advantage over dividend.

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18.5 Personal Taxes, Issuance Costs,and Dividends

To get the result that dividend policy is irrelevant, weneeded three assumptions:

No taxes

No transactions costsNo uncertainty

In the United States, both cash dividends and capitalgains are taxed at a maximum rate of 15 percent.

Since capital gains can be deferred, the tax rate ondividends is greater than the effectiverate on capitalgains.

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Firms Without Sufficient Cashto Pay a Dividend

In a world of personal taxes,

firms should not issue stock

to pay a dividend.

FirmStock

Holders

Cash: stock issue

Cash: dividends

Gov.

Taxes

Investment Bankers The direct costs ofstock issuance willadd to this effect.

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Firms With Sufficient Cash toPay a Dividend

The above argument does not necessarily apply to firms

with excess cash.

Consider a firm that has $1 million in cashafter

selecting all available positive NPV projects.

The firm has several options:

Select additional capital budgeting projects (by assumption,

these are negative NPV).Acquire other companies

Purchase financial assets

Repurchase shares

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Taxes, Issuance Costs,

and Dividends

In the presence of personal taxes:

1. A firm should not issue stock to pay a dividend.

2. Managers have an incentive to seek alternative usesfor funds to reduce dividends.

3. Though personal taxes mitigate against the payment

of dividends, these taxes are not sufficient to lead

firms to eliminate all dividends.

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18.6 Real World Factors Favoringa High Dividend Policy

Desire for Current Income

Resolution of Uncertainty

Tax ArbitrageAgency Costs

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Desire for Current Income

The homemade dividend argument relies on no

transactions costs.

To put this in perspective, mutual funds canrepackage securities for individuals at very low

cost: they could buy low-dividend stocks and

with a controlled policy of realizing gains, pay

their investors at a higher rate.

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McGraw-Hill/IrwinCorporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

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Resolution of Uncertainty

It would be erroneous to conclude that increased

dividends can make the firm less risky.

A firms overall cash flows are not necessarilyaffected by dividend policyas long as capital

spending and borrowing are not changes.

Thus, it is hard to see how the risks of the overallcash flows can be changed with a change in

dividend policy.

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Tax Arbitrage

Investors can create positions in high dividend-

yield securities that avoid tax liabilities.

Thus, corporate managers need not viewdividends as tax-disadvantaged.

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Agency Costs

The potential conflict between bondholders andshareholders; bondholders would like shareholders toleave as much cash as possible in the firm to

bondholders.

Conversely, Shareholders would like to keep this extracash for themselves.

Agency Cost of DebtFirms in financial distress are reluctant to cut dividends. To

protect themselves, bondholders frequently create loanagreements stating dividends can only be paid if the firm hasearns, cash flow and working capital above pre-specifiedlevels.

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Agency Costs

The conflict between bondholders and shareholders; the

manager may per sue selfish goal at the expense of

shareholders when firm has plenty of cash flow.

Agency Costs of Equity

Managers will find it easier to squander funds if they have a

low dividend payout.

By paying dividends equal to the amount of surplus cashflows, a firm can reduce managements ability to

squander the funds.

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Information Content of dividends anddividend Signaling

The stock price of a firm will rise when the firmannounces an increase in the dividend & fall when adividend reduction is announced.

A dividend increase is managements signal to themarket the firm is expected to do well.The rise in the share price following the dividend signalis called the information-content effect.This rises an interesting corporate strategy. Increase individends just to make the market think that cash flowwill be higher even though management knows that cashflows will not rise.

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18.7 The Clientele Effect

Different types of shareholders that prefer one kind of

dividend policy due to the difference in tax brackets.

Clienteles for various dividend payout policies are likely

to form in the following way:Group Stock

High Tax Bracket Individuals

Low Tax Bracket IndividualsTax-Free Institutions

Corporations

Zero to Low payout stocks

Low-to-Medium payoutMedium Payout Stocks

High Payout Stocks

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18.8 What We Know and Do Not KnowAbout Dividend Policy

Corporatedividends are substantialDividends are tax disadvantage relative to capital gains;nevertheless, dividends are substantial.

Taxation on dividends is minimal for low tax bracketindividuals or tax free for pension fund.

Corporations Smooth DividendsFirms set long-term target ratios of dividend to earnings.

Low target ratios if many NPV project; i. e. good times.High target ratios if few NPV projects; i. e. bad times.

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18.8 What We Know and Do Not KnowAbout Dividend Policy

Dividends Provide Information to the Market

The price of stock rises when current dividend isincreased or stock purchased is announced.

Conversely, the price of stock falls when its dividend

is cut.Firms should follow a sensible dividend policy:

Dont forgo positive NPV projects just to pay adividend.

Avoid issuing stock to pay dividends.

Consider share repurchase when there are few betteruses for the cash.

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