1. Distribution of Retained Earnings: Dividends and Stock Repurchases

2. Describe the views that have been proposed to explain why firms follow particular dividend policies and why investors react when firms change dividend policies.
Discuss (a) the types of dividend payments and (b) payment procedures that firms follow in practice.
Discuss factors that firms consider when making dividend policy decisions.
Describe stock dividends and stock splits, and discuss how stock prices are affected by these activities.
Describe stock repurchases and discuss reasons firms use repurchases.

3. Dividend Policy Dividends Dividends affect capital structure:
Payments made to stockholders from the firm’s earnings, whether those earnings were generated in the current period or in previous periods
Dividends affect capital structure:
Retaining earnings increases common equity relative to debt.
Financing with retained earnings is cheaper than issuing new common equity.

4. Dividend Policy and Stock Value
Dividend Irrelevance Theory
Theory states that a firm’s dividend policy has no effect on either its value or its cost of capital
Investors value dividends and capital gains equally
Optimal Dividend Policy
Strikes a balance between current dividends and future growth that maximizes the firm’s stock price
Dividend Relevance Theory
A firm’s value is affected by its dividend policy
The optimal dividend policy is the one that maximizes the firm’s value

5. Investors and Dividend Policy
Information Content, or Signaling
Signaling hypothesis says that investors regard dividend changes as signals of management’s earnings forecasts.
Clientele Effect
The tendency of a firm to attract the type of investor who likes its dividend policy
Free Cash Flow Hypothesis
All else equal, firms that pay dividends from cash flows that cannot be reinvested in positive net present value projects (free cash flows), have higher values than firms that retain free cash flows.

6. Types of Dividend Payments in Practice
Residual Dividend Policy:
A policy in which the dividend paid is set equal to the actual earnings minus the amount of retained earnings necessary to finance the firm’s optimal capital budget
Stable, Predictable Dividend Policy
Payment of a specific dollar dividend each year, or periodically increasing the dividend at a constant rate
The annual dividend is somewhat predictable by investors.

7. Types of Dividend Payments in Practice
Constant Payout Ratio
Percentage of earnings, such as 50 percent
Must watch out for reductions, which may seem to signal permanent earnings decline
Low Regular Dividend Plus Extras
A low regular dividend plus a year-end extra in good years

8. Dividend Payments in Practice
Declaration Date
Date on which a firm’s board of directors issues a statement declaring a dividend
Holder-of-Record Date
The date on which the company opens the ownership books to determine who will receive the dividend

9. Dividend Payments in Practice
Ex-Dividend Date
The date on which the right to the next dividend no longer accompanies a stock
Usually two business days prior to the holder-of-record date
Payment Date
The date on which the company actually mails dividend checks

10. Dividend Reinvestment Plans (DRIPs)
Plans that enable stockholders to automatically reinvest dividends received back into the stock of the paying firm
Firms either repurchase existing shares or issue new shares that are part of DRIPs

11. Factors Influencing Dividend Policy
Constraints on dividend payments:
Debt contract restrictions
Cannot exceed “retained earnings”
Cash availability
IRS restrictions on improperly accumulated retained earnings

12. Factors Influencing Dividend Policy
Investment opportunities
Large capital budgeting projects affect dividend-payout ratios.
Alternative sources of capital
Ownership dilution
Effects of dividend policy on rS

13. Stock Dividends and Stock Splits
Both stock dividends and stock splits increase the number of shares outstanding, so “the pie is divided into smaller pieces.”
Unless the stock dividend or stock split conveys information, or is accompanied by another event like higher dividends, the stock price falls so as to keep each investor’s wealth unchanged.
But splits/stock dividends may help firm reach an “optimal price range.” 23

14. Balance Sheet Effects of a Stock Split
Before a Stock Split
Common stock (5 million shares outstanding, $1 par value) $
Additional paid-in capital 10.0
Retained earnings
Total common stockholders’ equity $300.0
Book value per share = $300/5 $ 60.0
After a 2-for-1 Stock Split
Common stock (10 million shares outstanding, $0.50 par value) $
Book value per share = $300/10 $ 30.0 23

15. Balance Sheet Effects of Stock Dividends
Before a Stock Split of Stock Dividend
Common stock (5 million shares outstanding, $1 par value) $
Additional paid-in capital 10.0
Retained earnings
Total common stockholders’ equity $300.0
Book value per share = $300/5 $ 60.0
After a 20 Percent Stock Dividend
Common stock (6 million shares outstanding, $1 par value)a $
Additional paid-in capitalb 99.0
Retained earningsb
Book value per share = $300/6 $ 50.0
a Shares outstanding are increased by 20 percent, from 5 million to 6 million.
b A transfer equal to the market value of the new shares is made from the retained earnings account to the additional paid-in capital and common stock accounts:
Transfer = [(5,000,000 shares)(.020)]$90 = $90,000,000
Of this $90 million, $1,000,000 = ($1 par)(1,000,000 shares) goes in the Common stock account and the remaining $89 million goes in the Paid-in capital account. 23

16. Reasons for Stock Repurchases
To distribute excess funds to stockholders
To adjust the firm’s capital structure
To acquire shares needed for employee options or compensation
To protect against a takeover attempt 23

17. Advantages of Stock Repurchases
A company can use a stock repurchase to distribute excess cash (free cash flows) without increasing the amount of the dividends that might otherwise be paid during the year.
A repurchase is an effective method to immediately change the firm’s capital structure when the proportion of equity is substantially higher than the target capital structure prescribes.
When a firm expects managers and other employees to exercise stock options that have been paid to them as compensation in previous years, a repurchase can be used to minimize the “dilution effect” associated with exercising the options. 23

18. Advantages of Stock Repurchases
Stockholders do not have to sell their shares to the company during a repurchase period.
Many investors believe that a stock repurchase program is a signal from management that the firm’s stock is undervalued in the financial markets, and thus it is a bargain to purchase. 23

19. Disadvantages of Stock Repurchases
The company might pay too much for stock that is repurchased.
The interval between one stock repurchase and another one generally is irregular, which means that participating investors cannot rely on the cash that they receive from stock repurchases. 23

20. Capital Structures and Dividend Policies Around the World
Companies in Italy and Japan use more debt than companies in the United States or Canada, but companies in the United Kingdom use less than any of these.
Different accounting practices make comparisons difficult.
Gap has narrowed in recent years.
Dividend-payout ratios vary greatly also.

21. Capital Structures and Dividend Policies Around the World
Tax codes generally favor use of debt in developed countries.
In countries where capital gains are not taxed, investors should show a preference for stocks compared with countries that have capital gains taxes.
Investor preferences should lead to relatively low equity capital costs in those countries that do not tax capital gains.

22. Capital Structures and Dividend Policies Around the World
What about risk, especially bankruptcy costs?
Foreign banks are closely linked to corporations that borrow from them, and have substantial influence over the management of the debtor firms
Equity monitoring costs are comparatively low in the United States
These low monitoring costs indicate that U.S. firms should have more equity and less debt than firms in countries like Japan and Germany