1. Chapter 13

2. Dividend Policy and Internal Financing

3. Chapter Objectives
Trade-offs between paying dividends and retaining profits
Relationship between a corporation’s dividend policy and the market price of its common stock
Practical considerations important to dividend policy
Types of dividend policies
Procedures for dividend payout
Non cash dividends
Stock repurchases
Low dividend payments and international capital budgeting opportunities

4. Dividend Policy Two Key Elements: 1. Dividend payout ratio
amount of dividends paid relative to the company’s earnings
2. Dividend stability over time

5. Dividend Tradeoffs
Paying large dividends means simultaneously deciding to retain little profits. Greater reliance on external financing
Paying small dividends corresponds to high profit retention and less need for externally generated equity funds

6. Does Dividend Policy Affect Stock Price?
View 1: Dividend policy is irrelevant
View 2: High dividends increase stock value
View 3: Low dividends increase stock price

7. View 1: Dividend Policy is Irrelevant
Assumption: Investment and borrowing decisions will not be altered by the amount of any dividend payment
Perfect capitals markets are assumed to exist which means:

8. Perfect Capital Markets
Investors can buy and sell stocks without incurring any transaction costs
Companies can issue stock without any cost
No corporate or personal taxes
Complete information is readily available
No conflicts on interest between management and stockholders
Financial distress and bankruptcy are nonexistent

9. Additional Assumptions
There is no relationship between dividend policy and stock value. One dividend policy is as good as another
Investors are concerned only with total returns—they are indifferent whether these returns come from capital gains or dividend income

10. View 2: High Dividends Increase Stock Value
Dividends are more predictable than capital gains—management can control dividends but can not dictate price of stock.
Bird-in-the-hand theory: Dividends are more certain than capital gains.
Trade-off of uncertain capital gains for a “safe” asset (a cash dividend)

11. View 3: Low Dividends Increase Stock Value
Taxpayers seek to maximize after-tax return on investment relative to the risk assumed
Minimize the effective tax rate on the income by deferring the payment of taxes
Stocks that allow tax deferral (low dividends-high capital gains) will possibly sell at a premium.

12. Extensions of Dividend Theory
Residual Dividend Theory
Clientele Effect
Information Effect
Agency
Expectations Theory

13. Residual Dividend Theory
Dividends paid only if profits are not completely used for investment purposes—only when there are “residual earnings” after the financing of new investments.

14. Clientele Effect
Firms draw a certain clientele given their stated dividend policy.
The possibility that clienteles of investors exist might indicate that the dividend policy matters.

15. Information Effect
Dividends are important as a communication tool about future earnings
Information asymmetry
Difference in accessibility to information between management and investors may result in a lower stock price

16. Agency Costs
The stock price of a company with investors who are separate from management may be less than the stock value of a closely held firm.
The Potential difference in price is the cost of the conflict to the owners or agency costs
A firm’s dividend policy may be perceived as a tool to minimize agency costs

17. Expectations Theory
Regardless of the decision, how the market price responds to management’s actions is not determined entirely by the action itself; it is also affected by investors’ expectations about the ultimate decision to be made by management.
If there is a difference between actual and expected dividends, stock price should change

18. Dividend Theories: Conclusions
As a firm’s investment opportunities increase, the dividend payout ratio should decrease
Dividend policy appears to be important
If dividends influence stock price, this influence is based on investors desire to minimize and defer taxes
Management should avoid surprising investors when it comes to the firm’s dividends decision

19. Dividend Considerations
Legal Restrictions
Liquidity Position
Absence or lock of other sources of financing
Earnings predictability
Ownership Control
Inflation

20. Alternative Dividend Policies
Constant dividend payout ratio
Percentage of earnings paid out in dividends is held constant
Stable Dollar Dividend per share
Policy maintains a relatively stable dollar dividend over time. The most common of the dividend policies
Small, regular dividend plus a year-end extra
Pays a small, regular dollar dividend plus a year-end extra dividend in prosperous years.

21. Dividend Payment Procedures
Declaration date
The date when the dividend is formally declared by the board of directors
Date of record
When the stock transfer books are to be closed– the person who owns the stock on this date receives the dividend
Payment date
The date the company mails the dividend check

22. Stock Dividends and Stock Splits
Both increase the number of shares outstanding.
Stock Dividend
Occurs when stock shares, rather than cash, are distributed to the stockholders
Distribution of shares up to 25 percent of the number of share currently outstanding
Stock Split
A stock dividend exceeding 25 percent

23. Rationale for Stock Dividend or Split
Control or influence stock price
Informational content of the announcement
Conserve corporate cash

24. Stock Repurchases
Repurchase or stock buyback is when a firm repurchases its own stock, resulting in a reduction in the number of shares outstanding

25. Rationale for Stock Repurchases
Internal investment opportunity
Modifying capital structure
Impact earnings per share
Elimination of minority ownership
Minimization of the dilution in earnings per share associated with mergers
Reduce costs associated with servicing small stockholders

26. Repurchase Procedure
Option 1 Shares could be bought in the open market at the going market price.
Option 2 A tender offer or a formal offer by the company to buy a specified number of shares at a predetermined and stated price. The tender price is set above the current market price to attract sellers.
Option 3 A negotiated purchase from one or more major stockholders.