DIVIDENDS © 2000 South-Western College Publishing Chapter 13 DIVIDENDS © 2000 South-Western College Publishing

DIVIDENDS AS A BASIS FOR VALUE Pricing Models- Stock prices depended entirely on expected future dividends The Individual Perspective where P0 = today's stock price Di = the dividend in the ith year Pn = the selling price of the stock in the nth year k = the expected return on equity. The Whole Market View TM 13-1

THE DIVIDEND DECISION Three Theories: Dividends Are Discretionary Earnings can be paid out as dividends or retained for reinvestment in the business. Both Options Benefit Stockholders Dividend - Immediate Cash - Current Income Retained Earnings - Growth - Deferred Benefit The Dividend Decision Is A Trade-off. THE DIVIDEND CONTROVERSY Whether Paying Dividends or Paying Larger Rather Than Smaller Dividends, Has a Positive, Negative, or Neutral Effect on Stock Price Three Theories: TM 13-2 Slide 1 of 3

I. DIVIDEND IRRELEVANCE PVs Offset in Valuation Model Tailoring the Cash Flow Stream Sell off Shares to Maintain Current Income Works in Perfectly Efficient Capital Markets Problems: Transaction Costs, Income Taxes TM 13-2 Slide 2 of 3

II. DIVIDEND PREFERENCE Argument Is Based On The Uncertainty Of The Future. (Not a time value of money argument.) Bird in the Hand Theory Logical flaw: Why Invest In the Firm In The First Place? III. DIVIDEND AVERSION Based On Taxes: Capital Gains vs Ordinary Income OTHER CONCEPTS The Clientele Effect The Residual Dividend Theory The Signaling Effect of Dividends The Expectations Theory Prefer Not to Pay Dividends No Flotation Costs On Retained Earnings TM 13-2 Slide 3 of 3 The View from Within the Company

CONCLUSION No one knows with certainty whether paying more or less in dividends increases or decreases stock prices Opinions: Practitioners - positive effect Scholars - it can't be proven The majority of U.S. companies pay dividends On average about 50% of earnings TM 13- 3

LEGAL AND CONTRACTUAL RESTRICTIONS ON DIVIDENDS Legal Restrictions Capital Impairment Rule Dividends can't be paid out of capital, they must come from retained earnings. Can't Pay Dividends If Insolvent Protects creditors in bankruptcy proceedings. TM 13-4 Slide 1 of 2

Contractual Restrictions Debt Contracts Restrict Behavior of the Borrowing Company Covenants - Loans Conserve cash and maintain conservative business practices. May restrict or prohibit the payment of common stock dividends under certain conditions. Preferred Stock Cumulative Feature - no common stock dividends until preferred dividends are caught up cumulatively. TM 13-4 Slide 2 of 2

DIVIDEND POLICY Payout Ratio The rationale under which a firm determines what it will pay in dividends. Amount paid and the pattern over time. DEFINITIONS Payout Ratio Payout Ratio = TM 13-5 Slide 1 of 2

Stability - Constancy Over Time COMMON DIVIDEND POLICIES A stable dividend is constant, but is usually increased occasionally. - Nondecreasing - A dividend with a stable growth rate increases by a more or less constant percentage. Signaling effect Keep Dividends From Going Down Stable dividend Goes up or flattens, but doesn't decline COMMON DIVIDEND POLICIES The Target Payout Ratio Stable Dividend Per Share A Small Regular Dividend With A Year End Extra If Earnings Permit TM 13-5 Slide 2 of 2

THE MECHANICS OF DIVIDEND PAYMENTS Four key dates Declaration Date: Board of Directors Authorizes Dividend Date of Record: Dividend payable to owners of record as of the date of record. The Payment Date: Check is mailed. The Ex-dividend Date: Purchase cutoff for receiving dividend - Four business days before date of record TM 13-6 Slide 1 of 2

EXAMPLE DIVIDEND REINVESTMENT PLANS Declaration Date of Payment Date Record Date April 27 May 12 June 1 Ex-Dividend Date May 8 The dividend declared on April 27 is payable on June 1 to owners of record as of May 12. However, to be an owner of record by May 12, an investor must have purchased shares by May 7. Figure 13-1 The Dividend Declaration and Payment Process DIVIDEND REINVESTMENT PLANS Avoids brokerage fees for stockholder and can avoid flotation costs for company. Reinvested Dividend is Taxable TM 13-6 Slide 2 of 2

STOCK SPLITS AND DIVIDENDS Increase the count of shares in the hands of stockholders with no other real effect Stock Splits Issues new shares in numbers proportionate to those already outstanding Stock Dividends When new shares are less than or equal to twenty percent of the original number of shares RATIONALE FOR SPLITS AND DIVIDENDS The Trading Range Argument for Splits Signaling - Giving Something That Doesn't Cost Anything The Effect on Value Logically - No Effect However, a sentiment exists that something is gained, probably because stock splits and dividends generally occur when prices are rising TM 13-7

ACCOUNTING TREATMENT OF STOCK SPLITS AND DIVIDENDS Stockholder's Equity Eagle, Inc. Common Stock (2 million shrs outstdg, $3 par)... $6,000,000 Paid in Excess.................................. 2,000,000 Retained Earnings............................... 4,000,000 Total Common Equity............................$12,000,000 Book Value per share...............................$6.00 Table 13-1 TM 13-8 Slide 1 of 3

After a Two-for-One Stock Split Stockholder's Equity After a Two-for-One Stock Split Eagle, Inc. Common Stock (4 million shrs outstdg, $1.50 par)...$6,000,000 Paid in Excess................................... 2,000,000 Retained Earnings................................ 4,000,000 Total Common Equity.............................$12,000,000 Book Value per share................................$3.00 Table 13-2 TM 13-8 Slide 2 of 3

Stockholder's Equity After a 10% Stock Dividend (at market price of $10) Eagle, Inc. Common Stock (2.2 million shrs outstdg, $3 par)...$6,600,000 Paid in Excess.................................... 3,400,000 Retained Earnings................................. 2,000,000 Total Common Equity............................$12,000,000 Book Value per share...............................$5.45 Table 13-3 TM 13-8 Slide 3 of 3

STOCK REPURCHASE An Alternative To A Dividend Increases the value of the remaining shares The Opportunistic Repurchase Takes advantage of a temporarily depressed price To Dispose Of Excess Cash Better tax treatment possible for shareholders than a special dividend To Restructure Capital Borrow to retire equity and change debt-equity mix Methods of Repurchasing Shares Open Market Tender Offer Negotiated Deal TM 13-11