2816453.ppt

Copyright © 2011 Pearson Prentice Hall. All rights reserved.
Dividend Policy
Chapter 16

16-2
Introduction
• When a firm generates cash from
operations, what can the firm do with the
cash?
1. Use the cash to fund new investments,
2. Use the cash to pay off some of its debt,
and/or
3. Distribute the cash back to the firm’s
shareholders either as a cash dividend or as
stock repurchases.

16-3
Introduction (cont.)
• This chapter provides answers to three questions
regarding a firm’s dividend policy:
1. What are the pros and cons of the methods
the firm can use to distribute cash?
2. Why should the firm’s shareholders care
about the firm’s dividend policy given that
they can generate cash when they need it by
selling some of their shares?
3. What cash distribution policies do most firms
use in practice?

16.1 How Do
Firms Distribute
Cash to their
Shareholders?

16-5
How Do Firms Distribute Cash to
their Shareholders?
• Cash distributions can take two basic
forms:
1. Cash dividend
2. Share repurchase

16-6
How Do Firms Distribute Cash to
their Shareholders? (cont.)
• With cash dividend, cash is paid directly
to the shareholders.
• With a share repurchase, a company
uses cash to buy back its own shares from
the market place, thereby reducing the
number of outstanding shares.

16-7
Figure 16.1 (Cont.)

16-8
Figure 16.1 (Cont.)

16-9
Cash Dividends
• A firm’s dividend policy determines how
much cash it will distribute to its
shareholders and when these distributions
will be made.
• Dividends are generally described in terms
of dividend payout ratio, which indicates
the amount of dividends paid relative to
the company’s earnings.

16-10
Dividend Payment Procedures
• Generally, companies pay dividends on a
quarterly basis. There are several dates
that are important with regard to dividend
payment:
• (a) Announcement date: It is the date on
which dividend is formally declared by the
board of directors.

16-11
(cont.)
• (b) Date of record: Investors who own stock on
this date receive the dividend. However, this date
was pushed forward two days to ex-dividend
date.
(c) Ex-dividend date: This is two days before the
date of record and any investor who buys shares
after the ex-dividend date is not entitled to
dividend.

16-12
(cont.)
• (d) Payment date: This is the date on
which dividend checks are mailed to the
investors.

16-13
(cont.)
Date Explanation Calendar Date
Announcement Date Dividend is declared. March 15
Ex-Dividend Date Shares begin trading
ex-dividend.
May 17
Record Date Dividend will be paid to
shareholders who own
the stock on this date.
May 19
Payment Date Dividends are
distributed to the
shareholders of record
on the record date.
May 27

16-14
Stock Repurchases (Stock Buyback)
• Stock repurchase is when a firm uses its
cash to repurchase some of its own stock.
• This results in a reduction in the firm’s
cash balance as well as the number of
shares of stock outstanding. Firms use one
of three methods to purchase the shares:
Open market repurchase, tender offer, and
direct purchase.

16-15
How do Firms Repurchase Their
Shares?
• Open Market Repurchase
– Here the firm acquires the stock on the market,
often buying a relatively small number of
shares everyday. This will put upward pressure
on share prices. This is the most widely used
method for stock repurchase.

16-16
How do Firms Repurchase Their
Shares? (cont.)
• Direct Purchase from a large investor
– Here the firm purchases the stock from one or
more major stockholders on a negotiated basis.
This method is not used frequently.

16-17
Personal Tax Considerations –
Dividend Versus Capital Gains Income
• Historically, tax laws have favored capital
gains income over dividend income.
• However, the 2006 Tax Act lowered the tax
rate on dividends and long-term capital
gains (stock held for more than 1 year) to
15% for most people.

16-18
Personal Tax Considerations – Dividend
Versus Capital Gains Income (cont.)
• To qualify for the lower tax rate on
dividends, the stock must be held for more
than 60 days during the 120-day period
that begins 60 days before the ex-dividend
date.
• If not, dividends will be taxed as ordinary
income.

16-19
Non-Cash Distributions: Stock
Dividends and Stock Splits
• A stock dividend is a pro-rata distribution
of additional shares of stock to the firm’s
current stockholders. These distributions
are generally defined in terms of a fraction
paid per share.
– For example, a firm might pay a stock dividend
of .20 shares of stock per share or 2 shares for
every 10 held.

16-20
Non-Cash Distributions: Stock
Dividends and Stock Splits (cont.)
• Stock split is essentially a very large
stock dividend. For example, a 2-for-1 split
would entail receiving two new shares for
every old share currently held.
• With a 2-for-1 split, the number of shares
will double and the share price will drop in
half.

16-21
Rationale for a Stock Dividend or
Stock Split
• One rationale for splits and stock dividends
is that there is an optimal price range for
the firm’s stock. Also, beyond a certain
price range, there might be lower demand
for shares from investors.
• If the price exceeds that optimal range, it
can be brought back to the optimal range
by doing a stock split or paying stock
dividend.

16.2 Does
Dividend Policy
Matter?

16-23
Does Dividend Policy Matter?
• Modigiliani and Miller suggest that without
taxes and transaction costs, cash
dividends and share repurchases are
equivalent and the timing of the
distribution is unimportant.
• This is known as the Modigiliani and Miller
dividend irrelevancy proposition.

16-24
The Irrelevance of the Distribution
Choice
• The distribution choice is irrelevant under
the following assumptions:
1. There are no taxes.
2. No transaction costs are incurred in either
buying or selling shares of stock.
3. The firm’s operating and investment policies
are fixed.

16-25
The Irrelevance of the Distribution
Choice (cont.)
• The dividend irrelevancy proposition can
be illustrated in two ways:
1.Timing of dividend distributions does not affect
firm value.
2.In the absence of taxes and transaction costs,
a cash dividend is equivalent to a share
repurchase.

16-26
Why Dividend Policy is Important?
• Transactions are costly
– Since taxes are incurred when dividends are
received and transactions costs are incurred
when buying and selling shares, investors will
prefer to select companies whose dividend
policy match up with their own preferences.
Because firms with different dividends attract
different dividend clienteles, it is important
that dividend policy remain somewhat stable.

16-27
(cont.)
• The Information Conveyed by Dividend
and Share Repurchase Announcement
– Investors and stock market are constantly
trying to decipher the information released by
firms to better understand what they imply
about firm values.
– Firms tend to increase their dividends when
dividends can be sustained in the future. In
such cases, dividend increase is clearly good
news.

16-28
(cont.)
• Share repurchases are also viewed very
favorably as it reveals that the firm has
generated more money than it currently
needs. Share repurchases may also reveal
that the equity is currently underpriced.
• The empirical evidence indicates that
dividends and share repurchases do in fact
convey favorable information to investors.

16-29
(cont.)
• The Information Conveyed by Stock
Dividends and Stock Splits
– The announcement of stock dividends and
stock splits also tend to generate positive stock
returns. This increase is harder to explain as
stock dividends and stock splits do not affect
firm’s cash flows.
– Some researchers have suggested that firms
have a preferred trading range and stock splits
help bring stock prices to that trading range.

16-30
(cont.)
• A second possibility is that stock splits and
stock dividends tend to attract attention.
Naturally, firm would like to attract
attention only when the prospects are
favorable.
• Thus even though there is no direct effect
on cash flows, the market reacts favorably.

16.3 Cash
Distribution
Policies in
Practice

16-32
Cash Distribution Policies in Practice
• Stable Payout
– In a survey of CEOs, most CEOs recognized the
importance of maintaining consistency and
stability in dividend policy.
– See figure 16-3, panel a and b.

16-33
Stock Repurchase Decisions
• Figure 16-4 reveals that stock repurchase
decisions are driven by executive’s feeling
that the stock is a good investment
relative to its true value and that there are
a lack of good investment opportunities to
invest in.

16-34

16-35
Dividends versus Repurchases
• Table 16-3 provides a summary of factors
influencing the payout policy.
• Flexibility emerges as a major factor in the
choice of repurchases as opposed to
dividends.

16-36
Residual Dividend Policy
• With a residual dividend policy, the firm
first finances its investments using its own
earnings. Dividends are paid out of the
residual earnings that are not needed to
finance new investment opportunities.
• While this policy minimizes the cost of
financing, it can lead to unstable dividends
for shareholders.

16-37
Other Factors Playing a Role in
How Much to Distribute
• Liquidity Position
– Because dividend payments and stock
repurchases are made with cash, and not with
retained earnings, the firm must have cash
available for payouts to be made.

16-38
Other Factors Playing a Role in How
Much to Distribute (cont.)
• Lack of Other Sources of Financing
– Many small or new companies may not have
access to the capital markets, and must
depend upon internally generated funds to fund
their investment opportunities. As a result, the
dividend pay out ratio for such firms is
generally lower.

16-39
Other Factors Playing a Role in How
Much to Distribute (cont.)
• Earnings Predictability
– A company’s payout ratio depends to some
extent on the predictability of a firm’s profits
over time. Firms with stable earnings will
typically pay out a larger portion of its
earnings.

16-40
Key Terms
• Cash dividend
• Date of record
• Declaration date
• Dividend clienteles
• Dividend payout ratio
• Dividend policy
• Ex-dividend date

16-41
Key Terms (cont.)
• Open market repurchases
• Payment date
• Residual dividend payout policy
• Stock dividend
• Stock repurchase
• Stock split
• Tender offer

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