0. Dividends and Other Payouts

1. Three Key Issues: How much to be distributed Forms of dividend
How stable dividend should be

2. Objectives of Dividend Policy
Adequate provision of funds
Return to shareholders
Maximization of shareholders wealth

3. Dividend Vs Capital Gain

4. Three Dividend Theories
Dividend Irrelevance Theory
Bird in the Hand Theory
Tax Preference Theory

5. Definition
The dividend policy involves the allocation of profits between dividend payments to shareholders and retention for reinvestment in the company • Cash dividends are usually paid twice a year– an interim dividend and a final dividend.

6. Different Types of Dividends
Many companies pay a regular cash dividend.
Public companies often pay quarterly.
Sometimes firms will throw in an extra cash dividend.
The extreme case would be a liquidating dividend.
Often companies will declare stock dividends.
No cash leaves the firm.
The firm increases the number of shares outstanding.
Some companies declare a dividend in kind.
Wrigley’s Gum sends around a box of chewing gum.

7. Standard Method of Cash Dividend Payment
Cash Dividend - Payment of cash by the firm to its shareholders.
Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend.
Record Date - Person who owns stock on this date received the dividend. 5

8. Procedure for Cash Dividend Payment
25 Oct.
1 Nov.
2 Nov.
6 Nov.
7 Dec. …
Declaration Date
Cum-dividend Date
Ex-dividend Date
Record Date
Payment Date
Declaration Date: The Board of Directors declares a payment of dividends.
Cum-Dividend Date: The last day that the buyer of a stock is entitled to the dividend.
Ex-Dividend Date: The first day that the seller of a stock is entitled to the dividend.
Record Date: The corporation prepares a list of all individuals believed to be stockholders as of 6 November.

9. Price Behavior around the Ex-Dividend Date
In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date.
-t … … $P
$P - div
The price drops by the amount of the cash dividend
Ex-dividend Date
Taxes complicate things a bit. Empirically, the price drop is less than the dividend and occurs within the first few minutes of the ex-date.

10. Homemade Dividends
Bianchi Inc. is a $42 stock about to pay a $2 cash dividend.
Bob Investor owns 80 shares and prefers $3 cash dividend.
Bob’s homemade dividend strategy:
Sell 2 shares ex-dividend
homemade dividends
Cash from dividend $160
Cash from selling stock $80
Total Cash $240
Value of Stock Holdings $40 × 78 =
$3,120
$3 Dividend
$240 $0
$39 × 80 =
$3,120

11. Dividend Policy is Irrelevant
Since investors do not need dividends to convert shares to cash, dividend policy will have no impact on the value of the firm.
In the above example, Bob Investor began with total wealth of $3,360:
share 42 $
shares 80
360 , 3 =
After a $3 dividend, his total wealth is still $3,360:
240 $
share 39
shares 80
360 , 3 + =
After a $2 dividend, and sale of 2 ex-dividend shares,his total wealth is still $3,360: 80 $
160
share 40
shares 78
360 , 3 + = 19

12. Firms Without Sufficient Cash to Pay a Dividend
Investment Bankers
The direct costs of stock issuance will add to this effect.
Cash: stock issue
Firm
Stock
Holders
Cash: dividends
Taxes
In a world of personal taxes, firms should not issue stock to pay a dividend.
Gov.

13. Firms With Sufficient Cash to Pay a Dividend
The above argument does not necessarily apply to firms with excess cash.
Consider a firm that has $1 million in cash after selecting all available positive NPV projects.
The firm has several options:
Select additional capital budgeting projects (by assumption, these are negative NPV).
Acquire other companies
Purchase financial assets
Repurchase shares

14. Repurchase of Stock
Instead of declaring cash dividends, firms can rid itself of excess cash through buying shares of their own stock.
Recently share repurchase has become an important way of distributing earnings to shareholders.

15. Stock Repurchase versus Dividend
Consider a firm that wishes to distribute $100,000 to its shareholders.
$10 =
/100,000
$1,000,000
Price per share
100,000
outstanding
Shares
1,000,000
Value of Firm
Equity
850,000
assets
Other
Debt
$150,000
Cash
sheet
balance
Original A.
&
Liabilities
Assets 15

16. Stock Repurchase versus Dividend
If they distribute the $100,000 as cash dividend, the balance sheet will look like this: $9 =
00,000
$900,000/1
share
per
Price
100,000 g
outstanding
Shares
900,000
Firm of
Value
Equity
850,000
assets
Other
Debt
$50,000
Cash
dividend
cash $1
After B.
& s
Liabilities
Assets 16

17. Stock Repurchase versus Dividend
If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:
Assets Li
abilities
&
Equity C.
After stock repurchase
Cash
$50,000
Debt
Other assets
850,000
900,000
Value of Firm
Shares outstanding =
90,000
Price per
share
$900,000 /
$10 17

18. Share Repurchase Lower tax (but the IRS is watching) Tender offers
If offer price is set wrong, some stockholders lose.
Open-market repurchase
Targeted repurchase
Repurchase as investment
Recent studies has shown that the long-term stock price performance of securities after a buyback is significantly better than the stock price performance of comparable companies that do not repurchase.

19. Personal Taxes, Issuance Costs, and Dividends
To get the result that dividend policy is irrelevant, we needed three assumptions:
No taxes
No transactions costs
No uncertainty
In the United States, both cash dividends and capital gains are taxed at a maximum rate of 15 percent.
Since capital gains can be deferred, the tax rate on dividends is greater than the effective rate on capital gains.

20. Bonus shares are dividends paid in the form of additional shares
Bonus shares are dividends paid in the form of additional shares. 4 main motivations for bonus issues: 1.do not require the use of cash (liquidity) 2.growth firms have many positive NPV projects, so a bonus issue can be used to supplement a low dividend 3.signal ability to pay future dividends 4.improve market liquidity of shares

21. Real World Factors Favoring a High Dividend Policy
Desire for Current Income
Resolution of Uncertainty
Tax Arbitrage
Agency Costs

22. Desire for Current Income
The homemade dividend argument relies on no transactions costs.
To put this in perspective, mutual funds can repackage securities for individuals at very low cost: they could buy low-dividend stocks and with a controlled policy of realizing gains, pay their investors at a specified rate.

23. Resolution of Uncertainty
It would be erroneous to conclude that increased dividends can make the firm less risky.
A firm’s overall cash flows are not necessarily affected by dividend policy—as long as capital spending and borrowing do not change.
Thus, it is hard to say how the risks of the overall cash flows can be changed with a change in dividend policy.

24. Tax Arbitrage
Investors can create positions in high dividend-yield securities that avoid tax liabilities.
Thus, corporate managers need not view dividends as tax-disadvantaged.

25. Agency Costs Agency Cost of Debt Agency Costs of Equity
Firms in financial distress are reluctant to cut dividends. To protect themselves, bondholders frequently create loan agreements stating dividends can only be paid if the firm has earns, cash flow and working capital above pre-specified levels.
Agency Costs of Equity
Managers will find it easier to waste funds if they have a low dividend payout.

26. Real World Factors Reasons for Low Dividend Reasons for High Dividend
Personal Taxes
High Issuing Costs
Reasons for High Dividend
Information Asymmetry
Dividends as a signal about firm’s future performance
Lower Agency Costs
capital market as a monitoring device
reduce free cash flow, and hence wasteful spending
Bird-in-the-hand: Theory or Fallacy?
Uncertainty resolution
Desire for Current Income

27. The Clientele Effect: A Resolution of Real- World Factors?
Clienteles for various dividend payout policies are likely to form in the following way:
Group
Stock
High Tax Bracket Individuals
Zero to Low payout stocks
Low Tax Bracket Individuals
Low-to-Medium payout
Tax-Free Institutions
Medium Payout Stocks
Corporations
High Payout Stocks
Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy.

28. Establishing Dividend Policy
Residual Dividend Model
Low Regular Dividend Plus Extra
Constant payout ratio
Stable dividend

29. Factors Influencing Dividend Policy
Other Issues to Consider
Funding Needs of the Firm
Liquidity
Ability to Borrow
Restrictions in Debt Contracts (protective covenants)
Control

30. Factors Influencing Dividend Policy
Internal
profitability
liquidity and
capacity to attract external financing
institutional
inability to pay dividends from legal capital
possible restrictive loan covenants
taxation system – maximize after-tax return for the majority of
shareholders
market factors
asymmetric information
transaction costs
agency costs

31. Factors Influencing Dividend Policy
Nature of business Age of company Liquidity position of the company Need for additional capital Nature of ownership Dividend policy of other companies Redemption of debts Investment opportunities Financing policy of the company State of present economy Legal issues laid by the government Taxation policy Public opinion

32. Dividend Stability
Stability -- maintaining the position of the firm’s dividend payments in relation to a trend line. 4
50% of earnings
paid out as dividends
Earnings per share 3
Dollars Per Share 2
Dividends
per share 1
Time

33. Dividend Stability
Dividends begin at 50% of earnings, but are stable and increase only when supported by growth in earnings. 4
50% dividend-payout
rate with stability
Earnings per share 3
Dollars Per Share 2 1
Dividends per share
Time

34. Valuation of Dividend Stability
Information content -- management may be able to affect the expectations of investors through the informational content of dividends. A stable dividend suggests that the company expects stable or growing dividends in the future.
Current income desires -- some investors who desire a specific periodic income will prefer a company with stable dividends to one with unstable dividends.
Institutional considerations -- a stable dividend may permit certain institutional investors to buy the common stock as they meet the requirements to be placed on the organizations “approved list.”

35. What We Know and Do Not Know About Dividend Policy
Corporations “Smooth” Dividends.
Dividends Provide Information to the Market.
Firms should follow a sensible dividend policy:
Don’t forgo positive NPV projects just to pay a dividend.
Avoid issuing stock to pay dividends.
Consider share repurchase when there are few better uses for the cash.