1. Dividends
Chapter 14
© 2003 South-Western/Thomson Learning

2. Background Dividends as a Basis for Value
Help determine the value of stocks
Individual investors buy stocks expecting return from dividends and the eventual selling price of stock
Today’s price represents the present value of those future expected cash flows
From the whole market view
The price of a stock today is the present value of the infinite stream of dividends

3. Understanding the Dividend Decision
The Discretionary Nature of Dividends
Board of Directors has authority to determine the dividend payout
Payout can range from nothing to everything
The Dividend Decision
A firm’s earnings belong to the stockholders
Management makes the dividend decision on behalf of the stockholders
Paying dividends gives stockholders an immediate cash payment—current income
Retaining earnings for reinvestment offers a potentially higher stock price in the future—deferred income

4. The Dividend Controversy—Irrelevance
Does the payment of dividends now or increasing the dividend payment impact the stock price?
Do stockholders prefer current or deferred income?

5. The Dividend Controversy—Irrelevance
Arguments concerning dividend policy
Dividend irrelevance
Value of eliminated dividends is offset by growth-created value in the future
The increased return on the retained earnings offsets the reduction or elimination of dividends
Thus, the current stock price is independent of changes in early dividends
Investors can tailor their income stream by selling shares of a growing stock that doesn’t pay dividends or by buying shares of stock of a company that pays more dividends than an investor needs

6. The Dividend Controversy—Irrelevance
Transaction Costs
Can make tailoring an income stream impractical
The more significant the transactions costs, the less valid the irrelevance theory becomes

7. The Dividend Controversy—Irrelevance
Income Taxes
Dividends are taxed as ordinary income
Appreciation is taxed as a capital gain
The View from Within the Company
Dividends represent a cash outflow
Reduces retained earnings
Firms prefer not paying dividends if it avoids selling new stock
Retained earnings cost less than new equity

8. Dividend Preference
Investors prefer immediate cash to uncertain future benefits
Not a time value of money argument but rather a certainty issue
Flaw—if investors are worrying about not receiving the future cash flow, why invest in that firm in the first place?

9. Dividend Aversion
Investors prefer future capital gains to current dividends because of lower tax rates
Dividends are taxed at higher ordinary income tax rates
This argument hinges on current level of ordinary income vs. capital gain tax rates
Capital gains taxes are not paid until stock is sold
If stock is passed along to heirs, taxes on capital gains occurring during decedent’s life can be avoided

10. Other Theories and Ideas
The Clientele Effect
Investors choose stocks for dividend policy—any change in payments is disruptive
Retirees may desire stocks with high dividends
Young professionals may desire stocks will little or no dividends

11. Other Theories and Ideas
The Residual Dividend Theory
Dividends are paid from earnings only after all viable projects are funded
The Signaling Effect of Dividends
Cash dividends signal management’s confidence in the future
A continuing payment of dividends when earnings are low can signal management’s confidence about the future
A decrease in dividends can signal management’s lack of confidence concerning the future

12. Other Theories and Ideas
The Expectations Theory
Dividends that fail to fulfill stockholders’ expectations send a negative message even if the payment is good

13. Legal and Contractual Restrictions
Dividends can’t be paid by an insolvent firm and must come from current or prior earnings
Protects creditors
Loan indentures and covenants may limit dividend payments to protect creditors’ interests
The cumulative feature of preferred stock limits dividend payments

14. Dividend Policy Payout ratio Stability
States dividends as a fraction of earnings: dividend per share  EPS
Stability
A stable dividend is one that is non-decreasing
A dividend with a stable growth rate is one that increases at a more or less constant growth rate

15. Alternative Dividend Policies
Target Payout Ratio
Firm selects a long-run target payout ratio
Actual payout ratio is set below target allowing for flexibility in earnings
Stable Dividends Per Share
A constant dividend is paid regardless of earnings
Dividend may change if firm consistently does well or poorly
Small Regular Dividend with a Year-End Extra if Earnings Permit
Gives firm the ability to lower dividend (by omitting the extra year-end dividend) without a negative informational effect

16. The Mechanics of Dividend Payments
Key Dates
Declaration Date: Date on which the board authorizes the dividend
Date of Record: You must be an owner by this date to have access to the declared dividend
Payment Date: Date the dividend payment will be mailed
Ex-Dividend Date: If you buy the stock on or after this day you will not receive the pending dividend

17. Dividend Reinvestment Plans
Large companies offer automatic dividend reinvestment plans (DRIPs) to stockholders
Instead of receiving a cash dividend payment the stockholder receives additional shares of stock
Company can either buy the shares on the open market or issue new shares to the stockholder
IRS treats reinvested dividends as taxable income

18. Stock Splits and Dividends
Current stockholder is issued new shares proportionate to his current holdings
No change in ownership control occurs
Stock Dividend
Same as a stock split but called a stock dividend if the number of shares is less than or equal to 20% of original shares outstanding

19. Stock Splits and Dividends
Accounting Treatment
Stock split changes par value and the number of shares
Capital accounts are unaffected
Stock dividend causes money to be shifted from Retained Earnings to stock account
Gives the appearance of a sale at market price

20. Stock Splits and Dividends
Rationale for Stock Splits and Stock Dividends
Splits keep stock prices in a trading range
Between $30 and $80
Stock dividends are an attempt at signaling
Sends a positive message

21. Stock Repurchases Alternative to Dividend
A firm with cash can either pay a dividend or repurchase some of its own outstanding stock
Repurchasing stock reduces number of shares outstanding and increases EPS
Remaining shares will rise in value if market uses same P/E ratio after the repurchase

22. Stock Repurchases Method of Repurchasing Shares
Buy shares on open market
Make a tender offer
Negotiated deal with a large investor

23. Other Repurchase Issues
Opportunistic Repurchase
Repurchases are appropriate when a stock is temporarily undervalued or the firm has excess cash
Repurchases to Dispose of Excess Cash
Firm may have excess cash which can be distributed as dividend
However, firm may suffer from signaling effect
A stock repurchase effectively distributes the cash without a signaling effect

24. Other Repurchase Issues
Taxes
An occasional stock repurchase may benefit stockholders because they pay capital gains taxes rather than ordinary income taxes
Repurchases to Restructure Capital
By borrowing money and using the cash to repurchase stock, a firm can raise its debt ratio