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Chapter 13
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Dividend Policy and Internal Financing
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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
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Dividend Policy Two Key Elements: 1. Dividend payout ratio
amount of dividends paid relative to the company’s earnings 2. Dividend stability over time
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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
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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
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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:
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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
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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
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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)
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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.
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Extensions of Dividend Theory
Residual Dividend Theory Clientele Effect Information Effect Agency Expectations Theory
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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.
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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.
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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
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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
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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
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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
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Dividend Considerations
Legal Restrictions Liquidity Position Absence or lock of other sources of financing Earnings predictability Ownership Control Inflation
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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.
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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
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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
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Rationale for Stock Dividend or Split
Control or influence stock price Informational content of the announcement Conserve corporate cash
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Stock Repurchases Repurchase or stock buyback is when a firm repurchases its own stock, resulting in a reduction in the number of shares outstanding
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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
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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.
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