1 Dividend Policy and Internal Financing Chapter 17.

2 Learning Objectives Learning Objectives  Describe the tradeoff between paying dividends and retaining the profits within the company.  Explain the relationship between a corporation’s dividend policy and the market price of its common stock.  Describe practical considerations that may be important to the firm’s dividend policy.  Distinguish between the types of dividend policy corporations frequently use.  Specify the procedures a company follows in administering the dividend payment.  Describe why and how firm might choose to pay non-cash dividends (stock dividends and stock splits) instead of cash dividends.  Explain the purpose and procedures related to stock repurchases.

3 Dividend Policy and Internal Financing Dividend Policy Dividend Payout Ratio = Dividend per Share Earnings per Share

4 Dividend Policy and Internal Financing Dividend Policy Dividend Payout Ratio = Dividend per Share Earnings per Share A firm calculates and reports Earnings per Share

5 Dividend Policy and Internal Financing Dividend Policy Dividend Payout Ratio = Dividend per Share Earnings per Share A firm calculates and reports earn Earnings per Share Management will reinvest part of earnings per share in the company and pay part as dividend

6 Dividend Policy and Internal Financing Dividend Policy Dividend Payout Ratio = Dividend per Share Earnings per Share A firm calculates and reports earn Earnings per Share Management will reinvest part of earnings per share in the company and pay part as dividend Income Statement 1 Million Shares Outstanding Sales$3,000,000 Net Income$1,000,000 Dividends Paid Addition to RE

7 Dividend Policy and Internal Financing Dividend Policy Dividend Payout Ratio = Dividend per Share Earnings per Share Income Statement Sales$3,000,000 Net Income$1,000,000 Dividends Paid Addition to RE 1 Million Shares Outstanding EPS = $1.00 Stockholders earn Earnings per Share Management will reinvest part of earnings per share in the company and pay part as dividend

8 Dividend Policy and Internal Financing Dividend Policy Dividend Payout Ratio = Dividend per Share Earnings per Share Income Statement Sales$3,000,000 Net Income$1,000,000 Dividends Paid Addition to RE 1 Million Shares Outstanding If have a 50% dividend payout each share of stock will receive a 50¢ dividend Stockholders earn Earnings per Share Management will reinvest part of earnings per share in the company and pay part as dividend

9 Dividend Policy and Internal Financing Dividend Policy Dividend Payout Ratio = Dividend per Share Earnings per Share Income Statement Sales$3,000,000 Net Income$1,000,000 Dividends Paid500,000 Addition to RE$500,000 1 Million Shares Outstanding If have a 50% dividend payout each share of stock will receive a 50¢ dividend $500,000 paid to stockholders and $500,000 is reinvested in the firm Stockholders earn Earnings per Share Management will reinvest part of earnings per share in the company and pay part as dividend

10 Dividend Policy and Internal Financing Dividend Policy Dividend Payout Ratio = Dividend per Share Earnings per Share Income Statement 1 Million Shares Outstanding If it has a 0% dividend payout, all earnings are reinvested in the firm Sales$3,000,000 Net Income$1,000,000 Dividends Paid Addition to RE Stockholders earn Earnings per Share Management will reinvest part of earnings per share in the company and pay part as dividend

11 Dividend Policy and Internal Financing Dividend Policy Dividend Payout Ratio = Dividend per Share Earnings per Share Income Statement 1 Million Shares Outstanding If have a 0% dividend payout, all earnings are reinvested in the firm $0 paid to stockholders and $1,000,000 is reinvested in the firm Sales$3,000,000 Net Income$1,000,000 Dividends Paid 0 Addition to RE$1,000,000 Stockholders earn Earnings per Share Management will reinvest part of earnings per share in the company and pay part as dividend

12 Can Dividend Policy Affect Share Price Three Theories of Dividends  Irrelevance  Dividends Increase Stock Price  Dividends Decrease Stock Price

13 Can Dividend Policy Affect Share Price If the world was perfect (in perfect markets)  No brokerage fees  No floatation costs of issuing shares  No taxes  Equal access to information  Manager's act in shareholders' best interests View 1: Irrelevance View 1: Irrelevance Dividend Policy does not affect stock price

14 Can Dividend Policy Affect Share Price If the world was perfect (in perfect markets)  No brokerage fees  No floatation costs of issuing shares  No taxes  Equal access to information  Manager's act in shareholders' best interests View 1: Irrelevance View 1: Irrelevance Dividend Policy does not affect stock price 52 WeeksYldVol Net HiLoStockSymDiv%PE100sHiLoCloseChg s42½29MKPSMK ¼-1 When dividend of $1.75 is paid. the stock price falls by exactly the same amount.

15 Can Dividend Policy Affect Share Price Assumes Perfect Markets  No brokerage fees  No floatation costs of issuing shares  No taxes  Equal access to information  Manager's act in shareholders' best interests View 1: Irrelevance View 1: Irrelevance Dividend Policy does not affect stock price 52 WeeksYldVol Net HiLoStockSymDiv%PE100sHiLoCloseChg s42½29MKPSMK ¼-1 When dividend of $1.75 is paid. the stock price falls by exactly the same amount. $34.25 – $1.75 = $32.50

16 Can Dividend Policy Affect Share Price If the world was perfect (in perfect markets)  No brokerage fees  No floatation costs of issuing shares  No taxes  Equal access to information  Manager's act in shareholders' best interests View 1: Irrelevance View 1: Irrelevance Dividend Policy does not affect stock price Dividends are Irrelevant Since:  No net gain to investor

17 Can Dividend Policy Affect Share Price Assumes Perfect Markets  No brokerage fees  No floatation costs of issuing shares  No taxes  Equal access to information  Manager's act in shareholders' best interests View 1: Irrelevance View 1: Irrelevance Dividend Policy does not affect stock price Dividends are Irrelevant Since:  No net gain to investor  Without receiving dividend, an investor can sell shares of stock costlessly and create their own "dividend"

18 Can Dividend Policy Affect Share Price Assumes Perfect Markets  No brokerage fees  No floatation costs of issuing shares  No taxes  Equal access to information  Manager's act in shareholders' best interests View 1: Irrelevance View 1: Irrelevance Dividend Policy does not affect stock price Dividends are Irrelevant Since:  No net gain to investor  Without receiving dividend, an investor can sell shares of stock costlessly and create their own "dividend"  If the firm pays a large dividend, but needs cash to invest can sell additional shares of stock costlessly.

19 Can Dividend Policy Affect Share Price Theory states:  Dividends are more predicable that capital gains, so investors prefer dividends--"Bird in the Hand theory” View 2: High Dividends Increase Stock Value

20 Can Dividend Policy Affect Share Price Theory states:  Dividends are more predicable that capital gains, so investors prefer dividends--"Bird in the Hand theory"  To be indifferent, investors will require a higher rate on capital gains than dividends View 2: High Dividends Increase Stock Value

21 Can Dividend Policy Affect Share Price Theory states:  Dividends are more predicable that capital gains, so investors prefer dividends-- "Bird in the Hand theory”  To be indifferent, investors will require a higher rate on capital gains than dividends  Critics of this theory  Point out cash flows of overall firm are not affected by dividends  If investors want cash, they should leave money in a bank account View 2: High Dividends Increase Stock Value

22 Can Dividend Policy Affect Share Price Theory states:  Dividends are more predicable that capital gains, so investors prefer dividends--"Bird in the Hand theory”  Investors will require a higher rate on capital gains than dividends  Critics of this theory  Point out cash flows of overall firm are not affected by dividends  If investors want cash, they should leave money in a bank account  Many investment advisors believe this theory; most finance professors do not View 2: High Dividends Increase Stock Value

23 Can Dividend Policy Affect Share Price Based on Tax Effects:  Individual investors must pay taxes on dividends as the dividends are received View 3: Low Dividends Increase Stock Value

24 Can Dividend Policy Affect Share Price Based on Tax Effects:  Individual investors must pay taxes on dividends as the dividends are received defer  Individual investors can defer taxes on capital gains until they sell the stock View 3: Low Dividends Increase Stock Value Before 1987, Capital Gains were taxed at a lower rate than dividends. Once again, capital gain taxes are lower than current income taxes today.

25 Can Dividend Policy Affect Share Price Based on Tax Effects:  Individual investors must pay taxes on dividends as the dividends are received defer  Individual investors can defer taxes on capital gains until they sell the stock. View 3: Low Dividends Increase Stock Value  However, corporations may exclude 70% of dividends from corporate income taxes, so they may actually prefer a higher level of dividends

26 Can Dividend Policy Affect Share Price Based on Tax Effects:  Individual investors must pay taxes on dividends as the dividends are received defer  Individual investors can defer taxes on capital gains until they sell the stock View 3: Low Dividends Increase Stock Value  However, corporations may exclude 70% of dividends from corporate income taxes, so they may actually prefer a higher level of dividends  Investors prefer the dividend policy that gives the highest after-tax return

27 Residual Dividend Theory Recognizes that floatation costs are involved in issuing new stock are very high

28 Residual Dividend Theory Companies with investment opportunities which require capital would prefer to use internal funds rather than issue new stock Recognizes that floatation costs are involved in issuing new stock are very high

29 Residual Dividend Theory Residual Dividend Method  Accept all investments with positive net present values Companies with investment opportunities which require capital would prefer to use internal funds rather than issue new stock Recognizes that floatation costs are involved in issuing new stock are very high

30 Residual Dividend Theory Residual Dividend Method  Accept all investments with positive net present values  Use retained earnings to finance investments to the extent possible Companies with investment opportunities which require capital would prefer to use internal funds rather than issue new stock Recognizes that floatation costs are involved in issuing new stock are very high

31 Residual Dividend Theory Residual Dividend Method  Accept all investments with positive net present values  Use retained earnings to finance investments to the extent possible  If earnings left over after making investments, pay a dividend with the residual Companies with investment opportunities which require capital would prefer to use internal funds rather than issue new stock Recognizes that floatation costs are involved in issuing new stock are very high

32 Residual Dividend Theory Residual Dividend Method  Accept all investments with positive net present values  Use retained earnings to finance investments when possible  If retained earnings left over after making investments, pay a dividend with the residual  If there are no residual funds, pay no dividend Companies with investment opportunities which require capital would prefer to use internal funds rather than issue new stock Recognizes that floatation costs are involved in issuing new stock are very high

33 Residual Dividend Theory Residual Dividend Method  Accept all investments with positive net present values  Use retained earnings to finance investments when possible  If retained earnings left over after making investments, pay a dividend with the residual  If there are no residual funds, pay no dividend Companies with investment opportunities which require capital would prefer to use internal funds rather than issue new stock Recognizes that floatation costs when issuing new stock are very high Residual Theory minimizes floatation costs

34 The Clientele Effect There are all kinds of investors, some like dividends, others do not. According to clientele effect, investors who prefer dividends over capital gains will gravitate to high dividend paying firms. Others will choose to invest in no or low dividend paying firms. As an investor’s circumstances and or outlook for dividends changes, he will sell one kind of shares to invest in another kind. Recognizes that investors are not all alike

35 The Information Effect Changes in dividends may provide a signal of firm's financial condition Dividend Increase - May signal managers expect higher earnings in the future Earnings UP 10% 50¢ Dividend Increase

36 The Information Effect Changes in dividends may provide a signal of firm's financial condition Earnings OFF 10% 25¢ Dividend Cut Dividend Decrease - May signal managers expect earnings downturn

37 The Information Effect Changes in dividends may provide a signal of firm's financial condition Earnings OFF 10% 25¢ Dividend Cut Dividend Decrease - May signal managers expect earnings downturn In practice, stock price usually rises with a unexpected dividend increase and falls with a dividend decrease

38 Drop Agency Costs

39 Expectations Theory Investors have expectations of managers' actions

40 Expectations Theory Investors have expectations of managers' actions If managers announce a dividend at the level that investors expect, stock price will not be affected

41 Expectations Theory Investors have expectations of managers' actions If managers announce a dividend at the level that investors expect, stock price will not be affected $2.25/share $2.25 share? Investor Manager

42 Expectations Theory Investors have expectations of managers' actions If managers announce a dividend at the level that investors expect, stock price will not be affected $2.25/share $2.25 share? Investor Manager

43 Expectations Theory Investors have expectations of managers' actions If managers announce unexpectedly high or low dividend, stock price will be affected

44 Expectations Theory Investors have expectations of managers' actions $2.25/share $3.25 share? Investor Manager If managers announce unexpectedly high or low dividend, stock price will be affected

45 Expectations Theory Investors have expectations of managers' actions $2.25/share $3.25 share? Investor Manager If managers announce unexpectedly high or low dividend, stock price will be affected

46 Expectations Theory Investors have expectations of managers' actions $2.25/share $3.25 share? Investor Manager If managers announce unexpectedly high or low dividend, stock price will be affected If dividend is lower than expected, investors may believe earnings will be lower than expected and stock price will go down

47 Expectations Theory Investors have expectations of managers' actions $2.25/share $1.75 share? Investor Manager If managers announce unexpectedly high or low dividend, stock price will be affected

48 Expectations Theory Investors have expectations of managers' actions $2.25/share $1.75 share? Investor Manager If managers announce unexpectedly high or low dividend, stock price will be affected

49 Expectations Theory Investors have expectations of managers' actions $2.25/share $1.75 share? Investor Manager If managers announce unexpectedly high or low dividend, stock price will be affected If dividend is higher than expected, investors may believe earnings will be higher than expected and stock price will go up

50 Summary of Dividend Theories uTests of dividend policy have not found conclusively that dividends affect stock price uThe majority of managers believe that dividend policy is important uThere are tax disadvantages to paying dividends uAlmost all companies pay regular dividends uDividend Policy is a "puzzle" to academic researchers

51 Dividends in Practice What determines dividends? There may be legal restrictions on dividends  State laws have restrictions on dividends if company is not financially sound  Bond and Preferred Stock contracts may restrict dividends Liquidity Position cash  The firm must have sufficient cash to pay the dividend Sources of Financing  Small firms may be able to easily raise money in the capital markets so they will have low dividends Earnings Predictability  Firms with stable earnings typically pays higher dividends as it expects to have future profits needed to pay dividend

52 Alternative Dividend Policies Constant Dividend Payout Ratio every year firm pays the same percentage of earnings as a dividend to shareholders

53 Alternative Dividend Policies Constant Dividend Payout Ratio every year firm pays the same percentage of earnings as a dividend to shareholders Example: Firm pays a constant 40% dividend annually

54 Alternative Dividend Policies Constant Dividend Payout Ratio every year firm pays the same percentage of earnings as a dividend to shareholders Example: Firm pays a constant 40% dividend annually EPS$2.00$5.00$3.00 Dividend

55 Alternative Dividend Policies Constant Dividend Payout Ratio every year firm pays the same percentage of earnings as a dividend to shareholders Example: Firm pays a constant 40% dividend annually EPS$2.00$5.00$3.00 Dividend$ x.40

56 Alternative Dividend Policies Constant Dividend Payout Ratio every year firm pays the same percentage of earnings as a dividend to shareholders Example: Firm pays a constant 40% dividend annually EPS$2.00$5.00$3.00 Dividend$0.80$ x.40

57 Alternative Dividend Policies Constant Dividend Payout Ratio every year firm pays the same percentage of earnings as a dividend to shareholders Example: Firm pays a constant 40% dividend annually EPS$2.00$5.00$3.00 Dividend$0.80$2.00$ x.40

58 Alternative Dividend Policies Constant Dividend Payout Ratio every year firm pays the same percentage of earnings as a dividend to shareholders Example: Firm pays a constant 40% dividend annually EPS$2.00$5.00$3.00 Dividend$0.80$2.00$1.20 Dollar dividend fluctuates every year

59 Alternative Dividend Policies Stable Dollar Dividend Dividend does not change quickly: small increases in dollar dividend when management is certain higher dividend can be maintained.

60 Alternative Dividend Policies Stable Dollar Dividend Dividend does not change quickly: small increases in dollar dividend when management is certain higher dividend can be maintained. Example: EPS$2.00$2.20$2.10$3.00$2.90$3.10 Dividend

61 Alternative Dividend Policies Stable Dollar Dividend Dividend does not change quickly: small increases in dollar dividend when management is certain higher dividend can be maintained. Example: EPS$2.00$2.20$2.10$3.00$2.90$3.10 Dividend$0.80$0.80$0.80$0.80$0.80$1.20

62 Alternative Dividend Policies Stable Dollar Dividend Dividend does not change quickly: small increases in dollar dividend when management is certain higher dividend can be maintained. Example: EPS$2.00$2.20$2.10$3.00$2.90$3.10 Dividend$0.80$0.80$0.80$0.80$0.80$1.20 Increase dividend in 1996 when EPS levels out around $3.00

63 Alternative Dividend Policies Constant Dividend Payout Stable Dollar Dividend Small regular dividend plus year-end extra payment  Regular dividend is small, if earnings permit pay an extra dividend at end of year Summary

64 Alternative Dividend Policies Constant Dividend Payout Stable Dollar Dividend Small regular dividend plus year-end extra payment  Regular dividend is small, if earnings permit pay an extra dividend at end of year Most popular method is the Stable Dollar Dividend Summary

65 Dividend Payment Procedures Dividends are usually paid quarterly

66 Dividend Payment Procedures Example On August 25, 2004 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to share holders on record September 9, 2004, payable September 15, 1995 Dividends are usually paid quarterly

67 Dividend Payment Procedures Example On August 25, 2004 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to share holders on record September 9, 2004, payable September 15, 1995 Dividends are usually paid quarterly Declaration Date August September Date that dividend is announced

68 Dividend Payment Procedures Example On August 25, 1995 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to share holders on record September 9, 1995, payable September 15, 1995 Dividends are usually paid quarterly Date of Record Declaration Date August September All owners of record will receive the dividend.

69 Dividend Payment Procedures Example On August 25, 2004 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to share holders on record September 9, 2004, payable September 15, Dividends are usually paid quarterly Declaration Date August September Date of Record - 2 days

70 Dividend Payment Procedures Example On August 25, 2004 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to share holders on record September 9, 2004, payable September 15, 2004 Dividends are usually paid quarterly Date of Record Declaration Date Ex-Dividend Date August September ex-dividend date To allow time for the official list of stockholders to be updated, stockholders must buy stock before the ex-dividend date (2 days prior to date of record)

71 Dividend Payment Procedures Example On August 25, 2004 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to share holders on record September 9, 2004, payable September 15, 2004 Dividends are usually paid quarterly Payable Date Date of Record Declaration Date Ex-Dividend Date August September Date that the dividend is paid out to the stockholders.

72 Stock Dividends and Splits Stock Dividends uCompany issues new shares and sends them on a pro rata basis to current shareholders instead of using cash to pay a dividend

73 Stock Dividends and Splits uCompany issues new shares and sends them on a pro rata basis to current shareholders instead of using cash to pay a dividend uNumber of shares increase, no money is collected or paid by the company

74 Stock Dividends and Splits uCompany issues new shares and sends them on a pro rata basis to current shareholders instead of using cash to pay a dividend uNumber of shares increase, no money is collected or paid by the company uWith a 10% stock dividend, an investor will receive one tenth of a share for every share owned.

75 Stock Dividends and Splits uCompany issues new shares and sends them on a pro rata basis to current shareholders instead of using cash to pay a dividend uNumber of shares increase, no money is collected or paid by the company uWith a 10% stock dividend, an investor will receive one tenth of a share for every share owned. Payment Date Ex-Dividend Date August September An investor who is holding 100 shares on the ex-dividend date...

76 Stock Dividends and Splits uCompany issues new shares and sends them on a pro rata basis to current shareholders instead of using cash to pay a dividend uNumber of shares increase, no money is collected or paid by the company uWith a 10% stock dividend, an investor will receive one tenth of a share for every share owned. Payment Date Ex-Dividend Date August September An investor who is holding 100 shares on the ex-dividend date will receive an additional 10 shares on the payable date, for a total holding of 110 shares.

77 Stock Dividends and Splits uCompany issues new shares and sends them on a pro rata basis to current shareholders instead of using cash to pay a dividend uNumber of shares increase, no money is collected or paid by the company uWith a 10% stock dividend, an investor will receive one tenth of a share for every share owned. uIf company issues more than a 25% stock dividend it is considered a stock split vOnly difference between a stock dividend and stock split is accounting treatment on the balance sheet. vNeither stock dividends nor stock splits are taxable.

78 Rationale for Stock Split or Dividend Are Investors Better Off? Example Katie Corporation announces a 50% stock split. Before the split Katie has 100,000 shares of stock outstanding at a price of $50 per share.

79 Rationale for Stock Split or Dividend Are Investors Better Off? Example Katie Corporation announces a 50% stock split. Before the split Katie has 100,000 shares of stock outstanding at a price of $50 per share. Investors will receive one-half a share for every share outstanding

80 Rationale for Stock Split or Dividend Are Investors Better Off? Example Katie Corporation announces a 50% stock split. Before the split Katie has 100,000 shares of stock outstanding at a price of $50 per share. Investors will receive one-half a share for every share outstanding No new money going into the firm so overall the stock will still be worth $50 x 100,000 = $5 million

81 Rationale for Stock Split or Dividend Are Investors Better Off? Example Katie Corporation announces a 50% stock split. Before the split Katie has 100,000 shares of stock outstanding at a price of $50 per share. Investors will receive one-half a share for every share outstanding No new money going into the firm so overall the stock will still be worth $50 x 100,000 = $5 million Each share will be worth $5 million 150,000 shares = $33.33

82 Rationale for Stock Split or Dividend Are Investors Better Off? Example Katie Corporation announces a 50% stock dividend. Before the dividend Katie has 100,000 shares of stock outstanding at a price of $50 per share. Investors will receive one-half a share for every share outstanding No new money going into the firm so overall the stock will still be worth $50 x 100,000 = $5 million Each share will be worth $5 million 150,000 shares = $33.33 Alternative way to solve: Price before div 1 + % dividend $ = $33.33=

83 Rationale for Stock Split or Dividend Are Investors Better Off? Example Katie Corporation announces a 50% stock split. Before the split Katie has 100,000 shares of stock outstanding at a price of $50 per share. Investors will receive one-half a share for every share outstanding No new money going into the firm so overall the stock will still be worth $50 x 100,000 = $5 million Investors are no better off, have 50% more shares of stock, each share is worth less. Alternative way to solve: Price before div 1 + % dividend $ = $33.33= Each share will be worth $5 million 150,000 shares = $33.33

84 Rationale for Stock Split or Dividend If Investors wealth is not increased, why issue stock dividends? Optimal Price Range  Some managers believe stock price should not be too high an will split the stock or reduce the dividend to reduce the priceInformation  Stock splits and dividends are seen as a signal that the company is growing Cash Dividend Substitute  Companies who do not have cash available to pay a regular dividend may issue a stock dividend instead

85 Stock Repurchases Repurchase as an alternative to dividend  Investors who sell shares receive cash -- must pay taxes on any capital gain.  Investors who do not want cash simple do not sell shares  Company pays excess cash to stockholders. Repurchase as a financing method  Firm may issue debt and then repurchase stock  This would result in a higher debt ratio Repurchase as an investment decision  If management thinks that their stock price is too low, may buy back its own stock Company buys back its own stock from investors

86 Stock Repurchase Procedure Market Purchase  Firm buys its own shares through a broker at the market price.

87 Stock Repurchase Procedure Market Purchase  Firm buys its own shares through a broker at the market price. Tender Offer  Company announces it will repurchase shares at a fixed price. Must announce a price above the current market price to induce shareholders to sell

88 Stock Repurchase Procedure Market Purchase  Firm buys its own shares through a broker at the market price. Tender Offer  Company announces it will repurchase shares at a fixed price. Negotiated Offer  Company negotiates buying stock from specific group of stockholders.  Often done to buy out dissident shareholders.

89 Stock Repurchase Procedure Market Purchase  Firm buys its own shares through a broker at the market price. Tender Offer  Company announces it will repurchase shares at a fixed price. Negotiated Offer  Company negotiates buying stock from specific group of stockholders.  Often done to buy out dissident shareholders. Greenmail Greenmail - Dissident shareholders ask management to buy their shares at an inflated price or dissidents will take over the firm

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