What is “dividend policy”?

It’s the decision to pay out earnings versus retaining and reinvesting them.

Do shareholder’s prefer current or deferred income?

Investors preferences for or against dividends? There are three theories:

The dividend irrelevance theory

The Bird-in-the-hand theory

The Tax preference theory

Dividend Irrelevance Theory

Investors are indifferent between dividends and retention-generated capital gains. If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock.

Modigliani-Miller support irrelevance.Theory is based on unrealistic

assumptions (no taxes or brokerage costs), hence may not be true.

Bird-in-the-Hand Theory

Investors think dividends are less risky than potential future capital gains, hence they like dividends.

If so, investors would value high payout firms more highly, i.e., a high payout would result in a high P0.

Tax Preference Theory

Lower tax rates on capital gains Vs cash dividends motivates shareholders against cash dividends.

Taxes are not paid on the gain until a stock is sold.

This could cause investors to prefer firms with low payouts, i.e., a high payout results in a low P0.

Implications of 3 Theories for Managers

Theory Implication

Irrelevance Any payout OK

Bird-in-the-hand Set high payout

Tax preference Set low payout

But which, if any, is correct???

Possible Stock Price Effects

Stock Price ($)

Payout 50% 100%

40

30

20

10

Bird-in-Hand

Indifference

Tax preference

0

Possible Cost of Equity Effects

Cost of equity (%)

Payout 50% 100%

15

20

10

Tax Preference

Indifference

Bird-in-Hand

0

Which theory is most correct?

Empirical testing has not been able to determine which theory, if any, is correct.

Thus, managers use judgment when setting policy.

Analysis is used, but it must be applied with judgment.

What’s the “information content,” or “signaling,” hypothesis?

Managers hate to cut dividends, so won’t raise dividends unless they anticipate higher earnings in the future.

A higher then expected increase is a “signal” to investors that the firms management forecasts good earnings.

A dividend reduction or a smaller than expected increase is a signal that management is forecasting poor earnings.

What’s the “clientele effect”?

Different groups, or clienteles of stockholders, prefer different dividend policies.

Firm’s past dividend policy determines its current clientele of investors.

Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies.

What’s the “residual dividend model”?

Find the retained earnings needed for the capital budget.

Pay out any leftover earnings (the residual) as dividends.

This policy minimizes flotation and equity signaling costs, hence minimizes the WACC.

Using the Residual Model to Calculate Dividends Paid

Dividends = – .Net

income

Targetequityratio

Totalcapitalbudget[ ]))((

Data for SSC

Capital budget: $800,000. Given.

Target capital structure: 40% debt, 60% equity. Want to maintain.

Forecasted net income: $600,000.

How much of the $600,000 should we pay out as dividends?

Of the $800,000 capital budget, 0.6($800,000) = $480,000 must be equity to keep at target capital structure. [0.4($800,000) = $320,000 will be debt.]

With $600,000 of net income, the residual is $600,000 - $480,000 = $120,000 = dividends paid.

Payout ratio = $120,000/$600,000 = 0.20 = 20%.

How would a drop in NI to $400,000 affect the dividend? A rise to

$800,000?

NI = $400,000: Need $480,000 of equity, so should retain the whole $400,000. Dividends = 0.

NI = $800,000: Dividends = $800,000 - $480,000 = $320,000. Payout = $320,000/$800,000 = 40%.

How would a change in investment opportunities affect dividend under the

residual policy?

Fewer good investments would lead to smaller capital budget, hence to a higher dividend payout.

More good investments would lead to a lower dividend payout.

Advantages and Disadvantages of the Residual Dividend Policy

Advantages: Minimizes new stock issues and flotation costs.

Disadvantages: Results in variable dividends, sends conflicting signals, increases risk, and doesn’t appeal to any specific clientele.

Conclusion: Consider residual policy when setting target payout, but don’t follow it rigidly.

Dividend Payment Procedures

Mar 8 Mar 20 Mar 22 Apr 18

Declaration Ex-dividend Record Paymentdate date date date

Share price falls

1.Declaration date: The date on which the board of directors passes a resolution to pay a dividend.

2.Ex-dividend date: The date two business days before the date of record, establishing those individuals entitled to a dividend.

3.Date of record: The date by which a holder must be on record in order to be designated to receive a dividend.

4.Payment date: The date the dividend checks are mailed.

Dividend Payments

1.Stock Dividends

2.Stock Splits

3.Stock Repurchase

Example - Amoeba Products has 2 million shares currently outstanding at a price of $15 per share. The company declares a 50% stock dividend. How many shares will be outstanding after the dividend is paid?

Stock Dividend - Distribution of additional shares to a firm’s

stockholders.

Answer

2 mil x .50 = 1 mil + 2 mil = 3 million shares

Example - cont - After the stock dividend what is the new price per share and what is the new value of the firm?

Answer

Price per share = $30 mil / 3 mil sh = $10 per sh.

The value of the firm before was 2 mil x $15 per share, or $30 mil.

After the dividend the value will remain the same. 3 million x $10 per share, or $30 mil.

Example - Amoeba Products has 2 million shares currently outstanding at a price of $15 per share. The company declares a 3 for 1 stock split.What is the new amount of shares you will own?

Stock Splits - Issue of additional shares to firm’s stockholders.

Answer:

Number of shares = 2 million x 3

= 6 million shares

Example - cont - After the stock split what is the new price per share and what is the new value of the firm?

Answer

Price per share = $15 / 3 = $5 per sh.

The value of the firm before was 2 mil x $15 per share, or $30 mil.

After the stock split the value will remain the same. 6 million x $5 per share, or $30 mil

Stock Repurchases

Reasons for repurchases:As an alternative to distributing cash as

dividends.To dispose of one-time cash from an

asset sale.To make a large capital structure

change.

Repurchases: Buying own stock back from stockholders.

Example:-

ABC Company has after-tax earnings of S5 million and 2,500,000 shares of common stock outstanding. Also suppose the stock trades at a P/E ratio of 10. Then EPS and market price as follows:

EPS = EAT = 5,000,000 = $2.0

Number of shares 2,500,000

Market price = EPS x P/E = $2.0 x 10 =$20.0

Now suppose ABC has $1 million that it can distribute in dividends. If it does so, the dividend per share will be

dividend= $1,000,000 = $0.40 per

2,500,000 shares

However, suppose the company uses the$1 million to buy its own shares instead of paying a dividend. Then it can purchase and retire

$1,000,000 = 50,000 shares

$20

After the repurchase , there will be

2,500,000 – 50,000 = 2,450,000 shares

Left outstanding. If earnings don’t change EPS will then be

EPS = $5,000,000 = $2.04 per share

2,450,000

Finally, if the P/E remains the same, the market price of the remaining shares will be

Market price = EPS x P/E = 2.04 x 10= $ 20.40