Chapter 11 Dividends and Share Repurchase: Theory and Practice

Procedural Aspects of Paying Dividends Date of record Entitled to the dividends Ex-dividend date 3 business days before the date of record Capital impairment rule

Dividend Payout Irrelevance Dividends as a residual Pay out only excess cash Strictly a financing decision Smooth out actual payments MM position Argue for irrelevance Dividends versus terminal value Stockholder is indifferent between dividends and retention of earnings Homemade dividends

Arguments for Dividend Payout Mattering Unimportance of corporate income taxes Taxes on the investor and negative dividend effect Tax wedge Financing/dividend forgone indifference Irrelevance under uncertainty Intercorporate dividend exclusion Dividends effect on value Dividend neutrality Clienteles of investors Completing markets Positive dividend effect Behavioral reasons

Impact of Other Imperfections Flotation costs Favors the retention of earnings Stock financing is lumpy Transaction costs and divisibility of securities Restricts the arbitrage process Divisibility problems Institutional restrictions Seek stocks paying reasonable dividends

Financial Signaling Cash dividends speak louder than words Occur if the dividend is more or less than expected Price of the stock may react to unanticipated changes in dividends

Empirical Testing and Implications for Payout Ex-dividend day tests Behavior of common stock prices Dividend-yield approach Relationship between dividend yields and stock returns Financial signaling studies At the time of the dividend change find that there is a significant earnings change

Implications for Corporate Policy Tax effect consistent with dividend neutrality Signaling effect Optimal dividend policy Maximize shareholder wealth Excess cash

Share Repurchase Increased in importance relative to dividends Substitute for cash dividends Employee stock options and share repurchase Means to compensate employees Employees with existing stock options prefer share repurchase

Method of Repurchase Fixed-price tender offer Formal offer to stockholders to purchase so many shares at a set price Dutch-auction tender offer Dominant form of tender offer Open-market purchase SEC rules Disclose intentions

Repurchasing as Part of a Dividend Decision Fewer shares remaining outstanding EPS rise Dividends per share rise Market price per share should rise Equilibrium formula Personal tax effect Signaling effect Differs with the method of repurchase

Stock Dividends No reduction of par value Accounting treatment differences Small-percentage stock dividend Large-percentage stock dividend

Stock Splits Number of shares is increased through a proportional reduction in the par value May increase cash dividends Place the stock in a more-popular trading range Informational or signaling effect Asymmetric information Perceived earnings Not the stock dividend nor split itself Reverse stock split Reduce the number of shares Usually a negative signal

Managerial Considerations as to Dividend/Share-Repurchase Policy Funds needs of the firm Ability to borrow Control Nature of stockholders Liquidity Restrictions Dividend stability Target-payout ratios Assessment of any valuation information

Some Final Observations Dividend in excess of residual implies a favorable effect on shareholder wealth Lack of clear empirical evidence Many companies believe dividend payout affects share price Repurchase of stock When sizable amount of excess funds exists Increasingly more important