Copyright ©2003 South-Western/Thomson Learning

Chapter 15Dividend Policy

Introduction

• This chapter examines the factors that

influence a company’s choice of

dividend policy. It includes:

– Importance of firm’s dividend policy

– Corporate dividend policies

– Mechanics of dividend payments

– Stock splits/dividends

– Share repurchase plans

Importance of Dividend Policy

One of Several Decisions Influencing Value of the Firm:

• Investment Decisions (Ch 10)– Determine the level of future earnings and future potential

dividends• Financing Decisions (Ch 12)

– Influence the cost of capital, which can determine the number of acceptable investment opportunities

• Dividend Decisions (Ch 15)– Influence the amount of equity capital (via retained earnings)

in a firm’s capital structure and the cost of capital– Influence stock price and types of investors

Determinants of Dividend Policy

• Variations in payout(p. 520-521)

• Legal constraints• Restrictive

covenants• Tax considerations• Liquidity and CF

considerations

• Borrowing capacity & access to capital markets

• Earnings stability• Growth prospects• Shareholder

preference• Protection against

dilution

Argument for Irrelevance of Dividends

• Modigliani and Miller (Ch 13) argue that value of firm is solely dependent upon investment decisions.

• Therefore, value of the firm not affected by dividend policy.

• But, MM recognize dividends can have:– Informational content– Signaling effect– Clientele effect

Argument for Relevance of Dividends

Most finance experts believe div. policy is relevant:• Shareholder preferences (div’s vs. capital gain):

– Risk aversion--“bird in the hand”concept– Taxes—pay (15%) now versus deferral – Transaction costs—higher with deferral– “Never spend the principal” attitude

• Management preferences (cash is good):– Issuance/agency costs– Maintenance of cash reserves– Cost of external capital

• Common stock valuation—PV of future cash flows• Meet investor return objectives (Handouts)• Informational content

Conclusion

• When establishing an optimal dividend policy, a firm must balance: – Shareholder preferences – Investment opportunities– Cost of retained earnings versus external

capital

Dividend Policies

• Passive residual policy

• Stable dollar dividend policy

• Constant payout policy

• Small quarterly payments plus year-end extra

Will cover on next slides

Passive Residual Policy

• A firm should retain its earnings as long as it has investment opportunities that promise higher rates of return than the investor’s required return on equity (k).

• Dividends can fluctuate significantly or can be insignificant over time.– Depends on the firm’s investment opportunities

• In practice, dividends can be smoothed.• Growth firms will have low-dividend payouts

and yields. Ex: Dell (0% yield), Microsoft (1.2%)

• See Table, 15.3, p. 524

Stable Dollar Dividend Policies

• Most firms prefer stable div. policy—relatively small with annual growth

• Reluctance to reduce dividends—investors hate cuts; also a negative “signal”

• Increases in dividends tend to lag earnings.• Desirability of stable div policy:

– Information content– Many shareholders depend on dividends.– Stability tends to reduce uncertainty.– Legally desirable– “Legal list” – Helps stock price valuation

• See pp. 530-531

Other Dividend Payment Policies

• Constant Payout Ratio– Pays a constant percent of earnings as dividends– But, dividends fluctuate

• Small Regular Dividends Plus Extras– Stockholders can depend on regular dividends– Accommodates changing earnings and investment

requirements – GM in prior years—see p. 533, next slide

Note: GM has paid an annual dividend since 1915

• Small Firms and Dividends– Tend to pay out a smaller percent of earnings– Rapid growth and limited access to capital markets

Multinational Firms & Dividends

• Primary means of transferring funds from

foreign subs to parent company

• Key factors:

– Tax

– Foreign Exchange

– Political risk

– Funds availability

– Financing needs

Mechanics of Paying Dividends

• Declaration Date– Board of directors announce a dividend.

• Record Date– Shareholders of record will receive dividends.

• Ex-dividend Date – 2 business days before record date

– Stock trades ex-dividend, stock price usually declines

• Payment Date– 4 weeks after the record date

– Dividend checks mailed or direct deposited

• See Fig. 15.4, p. 534

Dividend Reinvestment Plan

• Cash dividend reinvested

automatically into additional shares

• Purchase new or existing shares

– Purchasing new shares raises new equity

capital for the firm.

• No brokerage commissions

• But, income tax liability

Stock Dividends/Splits: Payment of additional shares of C/S

• Stock splits similar to stock dividends.• Increases the number of shares

outstanding• Accounting transaction

– Transfer pre-dividend market value from retained earnings to other stockholders equity accounts (see pp. 535-536)

• Market price of C/S should decline in proportion to the number of new shares issued (Ex: bottom, p. 536)—no increase in S/H value

Reasons for Declaring a Stock Dividend or Split

• Broaden the ownership of the firm’s shares

• May result in an effective increase in cash dividends – Provided the level of cash dividends is not

reduced

• Reduction in share price may broaden the appeal of the stock to investors.– Resulting in a real increase in market value– Interpreted as “bullish” signal

Stock Repurchase

• Tender offer in the open market or by

negotiation with large holders

• Becomes treasury stock

• Reduces the number of shares

outstanding

• Increases EPS

• Usually announced in advance

Stock Repurchase Pros and Cons

• Advantages:– Substitutes for a cash dividend

– Converts dividend income into capital gain

– Increases existing S/H ownership of company/cash flow

– Increases stock price

– More flexible--does not lock management into a policy

– Important signal of higher expected earnings/cash flow

• Disadvantages:– Some shareholders may want cash dividends

– Tax/IRS implications

– Firm may overpay

– Firm admits inv. opportunities are limited

• Ex: P. 538

Summary

• Relevance of Dividends• Dividend Policies

– Passive residual policy– Stable dollar dividend policy– Constant payout policy– Small quarterly payments plus year-end extra

• How dividends are paid• Other forms of dividends:

– Stock dividends and splits– Share repurchases– Application: Ex: p. 535-538

Chapter 15 Homework Problems

Homework Problems• # 1, 2, 3, 4, 5, 6, 7, 8• Assignment 4 B: Ch 15, problems 7, 8

Next Class• Chapter 9: Capital Budgeting and Cash Flow

Analysis• Chapter 10: Capital budgeting Decision Criteria• Chapter 23: Valuation of Merger, pp.775-776• Review for mid-term