1 Dividend Policy 11/19/07

2 Learning Objectives Factors that influence dividend policy Factors that influence dividend policy How dividends are paid How dividends are paid Major dividend theories Major dividend theories Alternatives to cash dividends Alternatives to cash dividends Stock Dividends Stock Dividends Stock Splits Stock Splits Stock Repurchases Stock Repurchases

3 Factors that affect Dividend Policy Company projects low growth, has excess funds, may = large dividends (PG & E) Company projects low growth, has excess funds, may = large dividends (PG & E) Management expects high growth, high need for cash; may = high retained earnings and low or no dividends (high tech firms) Management expects high growth, high need for cash; may = high retained earnings and low or no dividends (high tech firms) Stockholders’ preferences Stockholders’ preferences Capital gains vs ordinary income

4 Factors that affect dividend policy Restrictions on dividend payments Restrictions on dividend payments Bond indenture agreements Lack of retained earnings Availability of cash Availability of cash

5 Dividend Payment Procedures On August 25, 2002 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to shareholders of record September 9, Dividend will be paid on Sept. 15, 2002 Each dividend must be declared (approved) by the Board of Directors. This is usually done at the quarterly Board meetings.

6 Date that dividend is announced by the Board of Directors. A dividend payable is recorded on the books. Debit retained earnings Date that dividend is announced by the Board of Directors. A dividend payable is recorded on the books. Debit retained earnings On August 25, 2002 Southside Bankshares announced a quarterly dividend of $1 per share for shareholders of record as of Sept. 9, 2002, and payable to shareholders on Sept. 15, AugustAugustSeptemberSeptember Declaration Date Dividend Payment Procedures

7 All owners of record will receive the dividend. On August 25, 2002 Southside Bankshares announced a quarterly dividend of $1 per share for share holders of record as of September 9, 2002, and to be paid on September 15, AugustAugustSeptemberSeptember Declaration Date Date of Record Dividend Payment Procedures

8 To allow time for the official list of stockholders to be updated, stockholders must buy stock before the ex-dividend date which is 2 business days prior to date of record. On August 25, 2002 Southside Bankshares announced a quarterly dividend of $1 per share for shareholders of record September 9, 2002, and to be paid on September 15, AugustAugustSeptemberSeptember Declaration Date Date of Record Ex-Dividend Date Dividend Payment Procedures

9 On August 25, 2002 Southside Bankshares announced a quarterly dividend of $1 per share for shareholders of record September 9, 2002, and to be paid on September 15, AugustAugustSeptemberSeptember Declaration Date Ex-Dividend Date Date of Record Date that the dividend is paid out in cash to the stockholders. Payment Date Dividend Payment Procedures

10 Dividend determination methods Dividend Rate. Most companies use a fixed dollar amount per share. This amount is determined by the Board of Directors Dividend Rate. Most companies use a fixed dollar amount per share. This amount is determined by the Board of Directors Dividends tend to stay the same or increase slightly each year; shows stability, positive future Dividends tend to stay the same or increase slightly each year; shows stability, positive future Decreases in dividends can severely impact the stock price Decreases in dividends can severely impact the stock price

11 Leading Dividend Theories Clientele Dividend Theory Clientele Dividend Theory  Some investors, such as elderly people on fixed incomes, tend to prefer to receive dividend income.  Others, such as young investors often prefer growth, and tend to like their income in the form of capital gains rather than as dividend income.

12 Alternatives to Cash Dividends Stock Dividends Stock Dividends  Existing shareholders receive additional shares of stock instead of cash dividends  Stock dividends represent a distribution of stock of less than 25% of total shares outstanding  Done usually if the firm wants to conserve cash  The number of shares is expressed as a percentage of current stock holdings. e.g. if there is a 10% stock dividend, you would receive one additional share for every 10 that you currently own.

13 Stock Dividend A stock dividend is recorded at the current market price of the stock A stock dividend is recorded at the current market price of the stock For example, if the market price of the stock is $21, and the par value of the stock is $1, then stock dividend of 20,000 shares would be recorded as: For example, if the market price of the stock is $21, and the par value of the stock is $1, then stock dividend of 20,000 shares would be recorded as: Retained Earnings 420,000 Retained Earnings 420,000 Common Stock (at $1 par) 20,000 Capital in excess of par400,000

14 Stock Dividends Impact on Balance Sheet (Market price $21 per share) BEFORE 10% Stock DIVIDEND Common Stock (200,000 shares, $1 par)$200,000 Capital in Excess of Par $1,800,000 Retained Earnings $10,000,000 TOTAL COMMON STOCK EQUITY $12,000,000 AFTER 10% STOCK DIVIDEND (Stock price = $21) Common Stock (220,000 shares, $1 par)$220,000 Capital in Excess of Par $2,200,000 Retained Earnings $9,580,000 TOTAL COMMON STOCK EQUITY $12,000,000

15 Alternatives to Cash Dividends Stock Splits Stock Splits  If total shares will increase by more than 25%, the company will usually declare a stock split.  Expressed as a ratio to original shares. Link to Reuters e.g. a 2-1 split means that each investor will end up with twice as many shares as they had prior to the split.

16 Stock split Typically signals good news, in that the company expects to grow and increase stock price Typically signals good news, in that the company expects to grow and increase stock price Keeps stock price affordable for the greatest number of potential investors Keeps stock price affordable for the greatest number of potential investors Gives something of value to the shareholder without using up cash Gives something of value to the shareholder without using up cash Has no impact on the capital structure of the company Has no impact on the capital structure of the company

17 BEFORE SPLIT Common Stock (200,000 shares, $1 par) $200,000 Capital in Excess of Par $1,800,000 Retained Earnings $10,000,000 TOTAL COMMON STOCK EQUITY $12,000,000 AFTER THE 2 to 1 STOCK SPLIT Common Stock (400,000 shares, $.50 par) $200,000 Capital in Excess of Par $1,800,000 Retained Earnings $10,000,000 TOTAL COMMON STOCK EQUITY $12,000,000 Stock Splits Impact on Balance Sheet

18 Impact of Stock Splits and Dividends on Stock Price The book argues that no significant economic event has taken place and that the price of the stock will drop in proportion to the size of the increase in shares The book argues that no significant economic event has taken place and that the price of the stock will drop in proportion to the size of the increase in shares I disagree. Stock splits especially are an indication that the company believes the stock price will continue to grow. I disagree. Stock splits especially are an indication that the company believes the stock price will continue to grow. As a result, shareholder wealth typically increases as the result of a split As a result, shareholder wealth typically increases as the result of a split

19 Impact of Stock Split on Shareholder Before Split Before Split 100 shares x $10 = $1,000 value After 2 for 1 Split After 2 for 1 Split  Per book argument (no increase in value)  200 shares x $5 = $1,000 value  Investor positive reaction (value increases to $11.00 per share prior to split)  200 shares x $5.50 = $1,100 value

20 Stock Repurchases A firm buys back its own stock on the open market A firm buys back its own stock on the open market A very common occurrence recently A very common occurrence recently By reducing the number of shares outstanding, earnings per share are increased By reducing the number of shares outstanding, earnings per share are increased Rather than payout a dividend, which would have immediate tax consequences for the investor, a stock repurchase increases the share price Rather than payout a dividend, which would have immediate tax consequences for the investor, a stock repurchase increases the share price Stock repurchase reverses the impact of dilution Stock repurchase reverses the impact of dilution

21 Stock Repurchase Effect Serves as a perfect replacement for a dividend payment to shareholders Serves as a perfect replacement for a dividend payment to shareholders Example: stock worth $60 per share pays $4 dividend. Shareholder has a Stock worth $60 and must pay tax on the $4 dividend Example: stock worth $60 per share pays $4 dividend. Shareholder has a Stock worth $60 and must pay tax on the $4 dividend If dividend money used to repurchase stock instead, shareholder ends up with stock worth $64 with no immediate recognition of income If dividend money used to repurchase stock instead, shareholder ends up with stock worth $64 with no immediate recognition of income