Dividend Policy

Recall: Stock Returns

Return =

P1 - Po + D1
Po

Recall: Stock Returns

Return =

P1 - Po
Po

P1 - Po + D1
Po
D1
+
Po

Recall: Stock Returns

Return =

P1 - Po
Po

P1 - Po + D1
Po
D1
+
Po

Capital Gain

Recall: Stock Returns

Return =

P1 - Po
Po

P1 - Po + D1
Po
D1
+
Po

Capital Gain

Dividend Yield

Dilemma: Should the firm use

retained earnings for:
a) Financing profitable capital
investments?
b) Paying dividends to stockholders?

Return =
If

P1 - Po
Po

D1
Po

we retain earnings for profitable

investments,

Return =
If

P1 - Po
Po

D1
Po

we retain earnings for profitable

investments, dividend yield will be zero,

Return =
If

P1 - Po
Po

D1
Po

we retain earnings for profitable

investments, dividend yield will be zero,
but the stock price will increase, resulting
in a higher capital gain.

Return =
If

P1 - Po
Po

we pay dividends,

D1
Po

Return =
If

P1 - Po
Po

D1
Po

we pay dividends, stockholders receive

an immediate cash reward for investing,

Return =
If

P1 - Po
Po

D1
Po

we pay dividends, stockholders receive

an immediate cash reward for investing,
but the capital gain will decrease, since
this cash is not invested in the firm.

So, dividend policy really

involves 2 decisions:
How

much of the firms earnings

should be distributed to
shareholders as dividends, and
How much should be retained for
capital investment.

Is Dividend Policy Important?

Three viewpoints:
1) Dividends are Irrelevant. If we assume
perfect markets (no taxes, no
transactions costs, etc.) dividends do not
matter. If we pay a dividend,
shareholders dividend yield rises, but
capital gains decrease.

D1
Po =
kc - g
Dividend

irrelevance: In perfect markets,

an increase in dividends

D1
Po =
kc - g
Dividend

irrelevance: In perfect markets,

an increase in dividends

D1
Po =
kc - g
Dividend

irrelevance: In perfect markets,

an increase in dividends means less
money will be invested, so the growth rate
declines.

D1
Po =
kc - g
Dividend

irrelevance: In perfect markets,

an increase in dividends means less
money will be invested, so the growth rate
declines.

D1
Po =
kc - g
Dividend

irrelevance: In perfect markets,

an increase in dividends means less
money will be invested, so the growth rate
declines.
The increase in D1 is offset by the
decrease in g.

D1
Po =
kc - g
Dividend

irrelevance: In perfect markets,

an increase in dividends means less
money will be invested, so the growth rate
declines.
The increase in D1 is offset by the
decrease in g.
Consequently, dividend policy does not
affect stock price.

Return =

Dividend

P1 - Po
Po

D1
Po

irrelevance: In perfect
markets, investors do not care if
returns come in the form of dividend
yields or capital gains.

Return =

Dividend

P1 - Po
Po

D1
Po

irrelevance: In perfect
markets, investors do not care if
returns come in the form of dividend
yields or capital gains.

Return =

Dividend

P1 - Po
Po

D1
Po

irrelevance: In perfect
markets, investors do not care if
returns come in the form of dividend
yields or capital gains.

2) High Dividends are Best

Some

investors may prefer a certain

dividend now over a risky expected
capital gain in the future.

2) High Dividends are Best

Some

investors may prefer a certain

dividend now over a risky expected
capital gain in the future.

Return =

P1 - Po
Po

D1
Po

3) Low Dividends are Best

Dividends

are taxed immediately.

Capital gains are not taxed until the
stock is sold.
Therefore, taxes on capital gains can
be deferred indefinitely.

Do Dividends Matter?
Other Considerations:
1) Residual Dividend Theory:
The firm pays a dividend only if it has
retained earnings left after financing all
profitable investment opportunities.
This would maximize capital gains for
stockholders and minimize flotation
costs of issuing new common stock.

Do Dividends Matter?
2) Clientele Effects:
Different investor clienteles prefer
different dividend payout levels.
Some firms, such as utilities, pay out
over 70% of their earnings as dividends.
These attract a clientele that prefers high
dividends.
Growth-oriented firms which pay low (or
no) dividends attract a clientele that
prefers price appreciation to dividends.

Do Dividends Matter?
3) Information Effects:
Raising a firms dividend usually causes
the stock price to rise and decreasing the
dividend causes the stock price to fall.
Dividend changes convey information to
the market concerning the firms future
prospects.

Do Dividends Matter?
4) Agency Costs:
Paying dividends may reduce agency costs
between managers and shareholders.
Paying dividends reduces retained earnings
and forces the firm to raise external equity
financing.
Raising external equity subjects the firm to
scrutiny of regulators (SEC) and investors
and therefore helps monitor the
performance of managers.

Do Dividends Matter?
5) Expectations Theory:
Investors form expectations concerning
the amount of a firms upcoming dividend.
Expectations are based on past dividends,
expected earnings, investment and
financing decisions, the economy, etc.
The stock price will likely react if the
actual dividend is different from the
expected dividend.

Dividend Policies
1) Constant Payout Ratio Policy: if
directors declare a constant payout ratio
of, for example, 30%, then for every
dollar of earnings available to
stockholders, 30 cents would be paid out
as dividends.
the ratio remains constant over time, but
the dollar value of dividends changes as
earnings change.

Dividend Policies
2) Stable Dollar Dividend Policy: the firm
tries to pay a fixed dollar dividend each
quarter.
firms and stockholders prefer stable
dividends. Decreasing the dividend sends
a negative signal!

Dividend Policies
3) Small Regular Dividend plus Year-End
Extras
the firm pays a stable quarterly dividend
and includes an extra year-end dividend
in prosperous years.
By identifying the year-end dividend as
extra, directors hope to avoid signaling
that this is a permanent dividend.

Jan.4
Declare
dividend

Jan.28

Feb.1

Ex-div. Record
date
date

Mar. 11
Payment
date

Dividend Payments
1) Declaration Date: the board of
directors declares the dividend,
determines the amount of the dividend,
and decides on the payment date.

Jan.4
Declare
dividend

Jan.28

Feb.1

Ex-div. Record
date
date

Dividend Payments
2) Ex-Dividend Date:

Mar. 11
Payment
date

Jan.4
Declare
dividend

Jan.28

Feb.1

Ex-div. Record
date
date

Mar. 11
Payment
date

Dividend Payments
2) Ex-Dividend Date: To receive the
dividend, you have to buy the stock
before the ex-dividend date. On this
date, the stock begins trading exdividend and the stock price falls
approximately by the amount of the
dividend.

Jan.4
Declare
dividend

Jan.28

Feb.1

Ex-div. Record
date
date

Dividend Payments
3) Date of Record:

Mar. 11
Payment
date

Jan.4
Declare
dividend

Jan.28

Feb.1

Ex-div. Record
date
date

Mar. 11
Payment
date

Dividend Payments
3) Date of Record: 4 days after the exdividend date, the firm receives the list of
stockholders eligible for the dividend.
often, a bank trust department acts as
registrar and maintains this list for the
firm.

Jan.4
Declare
dividend

Jan.28

Feb.1

Ex-div. Record
date
date

Mar. 11
Payment
date

Dividend Payments
4) Payment Date: date on which the
firm mails the dividend checks to the
shareholders of record.

Stock Dividends and Stock

Splits
Stock

dividend: payment of additional

shares of stock to common stockholders.
Example: Citizens Bancorporation of
Maryland announced a 5% stock
dividend to all shareholders of record on
March 27, 1987. For each 100 shares
held, shareholders received another 5
shares.
Did the shareholders wealth increase?

Stock Dividends and Stock

Splits
Stock

Split: the firm increases the number

of shares outstanding and reduces the price
of each share.
Example: Joule, Inc. announced a 3-for-2
stock split. For each 100 shares held,
shareholders received another 50 shares.
Does this increase shareholder wealth?
Are a stock dividend and a stock split the
same?

Stock Dividends and Stock

Splits
Stock

Splits and Stock Dividends are

economically the same: the number of
shares outstanding increases and the
price of each share drops. The value of
the firm does not change.
Example: A 3-for-2 stock split is the
same as a 50% stock dividend. For each
100 shares held, shareholders receive
another 50 shares.

Stock Dividends and Stock

Splits
Effects

on Shareholder Wealth:

Stock Dividends and Stock

Splits
Effects

on Shareholder Wealth: these will

cut the company pie into more pieces
but will not create wealth. A 100% stock
dividend (or a 2-for-1 stock split) gives
shareholders 2 half-sized pieces for each
full-sized piece they previously owned.

Stock Dividends and Stock

Splits
Effects

on Shareholder Wealth: these will

cut the company pie into more pieces
but will not create wealth. A 100% stock
dividend (or a 2-for-1 stock split) gives
shareholders 2 half-sized pieces for each
full-sized piece they previously owned.
For example, this would double the
number of shares, but would cause a $60
stock price to fall to $30.

 Why

Stock Dividends and Stock

Splits

bother?
Proponents argue that these are used to
reduce high stock prices to a more
popular trading range (generally $15 to
$70 per share).
Opponents argue that most stocks are
purchased by institutional investors who
have $millions to invest and are
indifferent to price levels. Plus, stock
splits and stock dividends are expensive!

Stock Dividend Example

shares

outstanding: 1,000,000
net income = $6,000,000; P/E = 10
25% stock dividend.
An investor has 120 shares. Does the
value of the investors shares
change?

Before the 25% stock dividend:

EPS = 6,000,000/1,000,000 = $6
P/E = P/6 = 10, so P = $60 per share.
Value = $60 x 120 shares = $7,200
After the 25% stock dividend:
# shares = 1,000,000 x 1.25 = 1,250,000.
EPS = 6,000,000/1,250,000 = $4.80
P/E = P/4.80 = 10, so P = $48 per share.
Investor now has 120 x 1.25 = 150 shares.
Value = $48 x 150 = $7,200

Stock Repurchases
Stock

Repurchases may be a good

substitute for cash dividends.
If the firm has excess cash, why not buy
back common stock?

Stock Repurchases
Stock

Repurchases may be a good

substitute for cash dividends.
If the firm has excess cash, why not buy
back common stock?

Stock Repurchases
Repurchases

drive up the stock price,

producing capital gains for
shareholders.
Repurchases increase leverage, and can
be used to move toward the optimal
capital structure.
Repurchases signal positive
information to the market - which
increases stock price.

Stock Repurchases
Repurchases

may be used to avoid a

hostile takeover.
Example: T. Boone Pickens attempted
raids on Phillips Petroleum and Unocal
in 1985. Both were unsuccessful
because the target firms undertook
stock repurchases.

Stock Repurchases
Methods:
Buy shares in the open market through
a broker.
Buy a large block by negotiating the
purchase with a large block holder,
usually an institution. (targeted stock
repurchase)
Tender offer: offer to pay a specific
price to all current stockholders.