Chapter 16

DIVIDENDS AND OTHER PAYOUTS

Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-1

KEY CONCEPTS AND SKILLS

Differentiate and explain various dividend types
and how they are paid
Grasp and apply the issues surrounding dividend
policy decisions
Comprehend and explain why share repurchases
are an alternative to dividends
Distinguish the difference between cash and stock
dividends

16-2

CHAPTER OUTLINE
16.1
16.2
16.3

Different Types of Dividends

Standard Method of Cash Dividend Payment
The Benchmark Case: An Illustration of the
Irrelevance of Dividend Policy
16.4 Repurchase of Stock
16.5 Personal Taxes, Issuance Costs, and Dividends
16.6 Real World Factors Favoring a High-Dividend Policy
16.7 The Clientele Effect: A Resolution of Real World
Factors?
16.8 What We Know and Do Not Know About Dividend
Policy
16.9 Putting It All Together
16.10 Stock Dividends and Stock Splits
16-3

16.1 DIFFERENT TYPES OF

DIVIDENDS
Many companies pay a regular cash dividend.
Public companies often pay quarterly.
Sometimes firms will pay an extra cash dividend.
The extreme case would be a liquidating dividend.

Companies will often declare stock dividends.

No cash leaves the firm.
The firm increases the number of shares outstanding.

Some companies declare a dividend in kind.

Wrigleys Gum sends a box of chewing gum.
Dundee Crematoria offers shareholders discounted
cremations.
16-4

16.2 STANDARD METHOD OF CASH

DIVIDEND
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 immediately
before this date is entitled to a dividend.
Record Date Date on which company
determines existing shareholders.
16-5

PROCEDURE FOR CASH DIVIDEND

25 Oct.

1 Nov.

2 Nov.

5 Nov.

7 Dec.

Declaration
Date

ExCumdividend dividend
Date
Date

Record
Date

Payment
Date

Declaration Date: The Board of Directors declares a payment

of dividends.
Cum-Dividend Date: Buyer of stock still receives the dividend.
Ex-Dividend Date: Seller of the stock retains the dividend.
Record Date: The corporation prepares a list of all individuals
believed to be stockholders as of 5 November.
16-6

PRICE BEHAVIOR
In a perfect world, the stock price will fall by the
amount of the dividend on the ex-dividend date.

-t -2
-1
0
+1
+2
$P
$P - div
The price drops
Exby the amount of
dividend
Date
the cash
dividend.
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.
16-7

16.3 THE IRRELEVANCE OF

DIVIDEND POLICY
A compelling case can be made that dividend
policy is irrelevant.
Since investors do not need dividends to convert
shares to cash; they will not pay higher prices for
firms with higher dividends.
In other words, dividend policy will have no
impact on the value of the firm because investors
can create whatever income stream they prefer
by using homemade dividends.

16-8

HOMEMADE DIVIDENDS
Bianchi Inc. is a $42 stock about to pay a $2
cash dividend.
Bob Investor owns 80 shares and prefers a $3
dividend.
Bobs homemade dividend strategy:
Sell 2 shares ex-dividend

$2 Dividend
Cash from dividend
$160
Cash from selling stock
$0
Total Cash
160
Value of Stock Holdings $40 80 =
$3,200
Total Value Cash & Stocks $3,360

$3 Dividend
$160
$80
$240
$40 78 =
$3,120
$3,360
16-9

A TEST
True or False: Dividends are irrelevant
True or False: Dividend policy is irrelevant

16-10

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DIVIDEND POLICY IS IRRELEVANT

In the above example, Bob Investor
began with a total wealth of $3,360:

After a $2 dividend, his total wealth is still $3,360:

After a $3 dividend and sale of 2 ex-dividend shares, his

total wealth is still $3,360:

16-11

DIVIDENDS AND INVESTMENT POLICY

Firms should never forgo positive NPV projects to
increase a dividend (or to pay a dividend for the
first time).
Recall that one of the assumptions underlying the
dividend-irrelevance argument is: The
investment policy of the firm is set ahead of time
and is not altered by changes in dividend policy.

16-12

16.4 REPURCHASE OF STOCK

Instead of declaring cash dividends, firms
can rid themselves of excess cash through
buying shares of their own stock.
Recently, share repurchase has become an
important way of distributing earnings to
shareholders.
During the financial crisis of 2007 and
2008 share repurchases and dividends
exceeded reported earnings
16-13

EXAMPLE: STOCK REPURCHASE

VERSUS DIVIDEND
Consider a firm that wishes to distribute $100,000 to its
shareholders.
Assets
A.Original balance sheet

Liabilities & Equity

Cash
$150,000 Debt
0
Other Assets 850,000 Equity
1,000,000
Value of Firm 1,000,000 Value of Firm 1,000,000
Shares outstanding = 100,000
Price per share= $1,000,000 /100,000 = $10

16-14

EXAMPLE: STOCK REPURCHASE

VERSUS DIVIDEND
If they distribute the $100,000 as a cash dividend, the balance
sheet will look like this:
Assets

Liabilities & Equity

B. After $1 per share cash dividend

Cash

$50,000

Debt

Other Assets

850,000

Equity

Value of Firm 900,000

0
900,000

Value of Firm 900,000

Shares outstanding = 100,000

Price per share = $900,000/100,000 = $9
16-15

EXAMPLE: STOCK REPURCHASE

VERSUS DIVIDEND
If they distribute the $100,000 through a stock repurchase, the
balance sheet will look like this:
Assets
C. After stock repurchase

Liabilities & Equity

Cash
$50,000 Debt
0
Other Assets 850,000 Equity
900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding= 90,000
Price pershare = $900,000 / 90,000 = $10

16-16

SHARE REPURCHASE
Flexibility for shareholders
Keeps stock price higher
Good for insiders who hold stock options

As an investment of the firm

Tax benefits

16-17

16.5 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 20 percent (at least through 2013).
Since capital gains can be deferred, the
tax rate on dividends is greater than the
effective rate on capital gains.
16-18

FIRMS WITHOUT SUFFICIENT

CASH
Investment Bankers

Cash: stock issue

Firm

The direct costs of

stock issuance will
add to this effect.
Stock
Holders

Cash: dividends
Taxes
Gov.

In a world of personal
taxes, firms should not
issue stock to pay a
dividend.
16-19

FIRMS WITH SUFFICIENT CASH

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.
Select additional capital budgeting projects (by
assumption, these are negative NPV).
Acquire other companies
Purchase financial assets
Repurchase shares

16-20

TAXES, ISSUANCE COSTS, AND

DIVIDENDS

In the presence of personal taxes:

1. A firm should not issue stock to pay a dividend.
2. Managers have an incentive to seek alternative uses
for funds to reduce dividends.
3. Though personal taxes mitigate against the payment of
dividends, these taxes are not sufficient to lead firms
to eliminate all dividends.
4. Under current tax law, shareholders generally prefer a
repurchase to a dividend.

16-21

16.6 REAL WORLD FACTORS

FAVORING HIGH DIVIDENDS
Desire for Current Income
Behavioral Finance
It forces investors to be disciplined.
Do investors have sufficient discipline to
optimize their position?

Agency Costs
High dividends reduce free cash flow.

16-22

SIGNALING
Empirically, stock prices increase after dividend
increase announcements
Dividend increases are a signal that the firm is
expected to do well
It is the expectation of good times, or the
information content effect, that raises the price of
the stock on dividend increases, not the increase
in the dividend itself

16-23

16.7 THE CLIENTELE EFFECT

Clienteles for various dividend payout policies
are likely to form in the following way:

Group
High Tax Bracket Individuals
Low Tax Bracket Individuals
Tax-Free Institutions
Corporations

Stock Type
Zero-to-Low payout
Low-to-Medium payout
Medium payout
High payout

Once the clienteles have been satisfied, a corporation is unlikely

to create value by changing its dividend policy.
Stated differently, a firm can boost its stock price by paying
higher dividends only if an unsatisfied clientele exists
16-24

16.8 WHAT WE KNOW AND

DO NOT KNOW
Dividends are large in the aggregate

Number of companies that pays has declined

Many newly listed firms; less likely to pay dividends
Tax policies matter; not a major deterrent

Corporations smooth dividends.

Dividends provide information to the market.
Firms should follow a sensible dividend policy:
Dont 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.
16-25

PUTTING IT ALL TOGETHER

Aggregate payouts are massive and have
increased over time.
Dividends are concentrated among a small
number of large, mature firms.
Managers are reluctant to cut dividends.
Managers smooth dividends.
Stock prices react to unanticipated changes in
dividends.

16-26

16.9 STOCK DIVIDENDS

Pay additional shares of stock instead
of cash
Increases the number of outstanding
shares
Small stock dividend
Less than 20 to 25%
If you own 100 shares and the company
declared a 10% stock dividend, you would
receive an additional 10 shares.

Large stock dividend more than 20 to

25%
16-27

STOCK SPLITS
Stock splits essentially the same as a stock
dividend except it is expressed as a ratio
For example, a 2 for 1 stock split is the same as a 100%
stock dividend.

Stock price is reduced when the stock splits.

Common explanation for split is to return price to
a more desirable trading range.

16-28

QUICK QUIZ
What are the different types of
dividends, and how is a dividend paid?
What is the clientele effect, and how
does it affect dividend policy
irrelevance?
What is the information content of
dividend changes?
What are stock dividends, and how do
they differ from cash dividends?
How are share repurchases an
alternative to dividends, and why might
investors prefer them?
16-29