Ch. 17: Dividends and Payout Policy

Dividend Policy

• Manages can allocate Net Income between
  • Retained earnings (reinvestment)
  • Dividends
    • Regular cash dividend: tends to be sticky
    • Extra cash dividend
    • Special cash dividend
    • Liquidating dividend: some or all of business has been sold
• Vocabulary
  • Declaration date: board declares dividend, which becomes a firm liability
  • Ex-dividend date
    • Two business days prior to date of record
    • Must own shares prior to this date to receive dividend
    • Stock price generally drops by the amount of the dividend on this day
  • Date of record: holders of record are determined
  • Date of payment: checks are mailed

Stock Dividends

• Pay additional shares of stock instead of cash
• Increases the number of shares outstanding

Stock Splits

• Essentially, the same as a stock dividend. 2 for 1 split is the same as a 100% stock dividend.
• Reduces stock price.
• Commonly used to return price to a more desirable trading range.

Stock Repurchase

• A company buys back its own shares of outstanding stock
  • Tender offer: company states a purchase price and desired number of shares
  • Open market: buys stock in the open market
• Similar to a cash dividend in that it returns cash to the stockholders
• Allows investors to decide if they want the current cash flow and associated tax consequences (option value)
• Contains information
  • Manager believes current stock price is undervalued
  • Tender offer sends a signal about a specific price

Dividend Theory

• Residual Theory of Dividends
  • Example
    • Suppose that estimated profits are $3M with $2.15M in cash needed for future projects. The optimal debt-to-equity ratio for the firm is .65/.35.
    • Firm needs to raise $2,150,000(.35) = $752,500 in equity.
    • This amount is retained, and the remainder of earnings is paid out as a dividend.
• Does dividend policy matter?
  • Example
    • Consider a firm that can either pay out dividends of $10,000 per year for each of the next two years or can pay $9,000 this year, reinvest the other $1,000 into the firm and then pay $11,120 next year. Investors require a 12% return.
    • The price of the stock is the same in both cases.
  • In the absence of market imperfections (taxes, transaction costs, and information asymmetry), $R = D1/P0 + g$.
• When might dividend policy matter?
  • Low payout
    • High taxes on dividends, low taxes on capital gains
    • High floatation costs
    • Dividends restrictions in debt contracts
  • High payout
    • Desire for current income (retirees)
    • Uncertainty resolution
    • Taxes: Dividend exclusion for corporations
  • Clientele effects
• In practice
  • Corporations smooth dividends
  • Dividends tend to signal firm prospects
  • Corporations rarely change their dividend policy
  • 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