Chapter 13 – Dividend Policy and Internal Financing

Stock Returns: P 1 - Po + D 1 P 1 - Po + D 1 Po Po Return =

P 1 - Po + D 1 P 1 - Po + D 1 Po Po P 1 - Po D 1 P 1 - Po D 1 Po Po Po Po + Return = = Stock Returns:

Return = Capital Gain P 1 - Po + D 1 P 1 - Po + D 1 Po Po P 1 - Po D 1 P 1 - Po D 1 Po Po Po Po += Stock Returns:

Return = Capital Gain Dividend Yield += Stock Returns: P 1 - Po + D 1 P 1 - Po + D 1 Po Po P 1 - Po D 1 P 1 - Po D 1 Po Po Po Po

Dilemma: Should the firm use retained earnings for: a) Financing profitable capital investments? b) Paying dividends to stockholders?

If we retain earnings for profitable investments, P 1 - Po D 1 Po Po + Return = Financing Profitable Capital Investments:

If we retain earnings for profitable investments, dividend yield will be zero, P 1 - Po D 1 Po Po + Return = Financing Profitable Capital Investments:

If we retain earnings for profitable investments, dividend yield will be zero, but the stock price will increase, resulting in a higher capital gain. P 1 - Po D 1 Po Po + Return = Financing Profitable Capital Investments:

If we pay dividends, Paying Dividends: P 1 - Po D 1 Po Po + Return =

If we pay dividends, stockholders receive an immediate cash reward for investing, Paying Dividends: P 1 - Po D 1 Po Po + Return =

If 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. P 1 - Po D 1 Po Po + Return = Paying Dividends:

So, dividend policy really involves two decisions:  How much of the firm’s 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 2) High Dividends are Best 3) Low Dividends are Best

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

With perfect markets, investors are concerned only with total returns and do not care whether returns come in the form of capital gains or dividend yields. P 1 - Po D 1 Po Po + Return = Dividends are Irrelevant

Therefore, one dividend policy is as good as another. P 1 - Po D 1 Po Po + Return = Dividends are Irrelevant

High Dividends are Best Some investors may prefer a certain dividend now over a risky expected capital gain in the future.

High Dividends are Best Some investors may prefer a certain dividend now over a risky expected capital gain in the future. P 1 - Po D 1 Po Po + Return =

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 2) Clientele Effects 3) Information Effects 4) Agency Costs 5) Expectations Theory

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.

Other Considerations 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.

Other Considerations 3) Information Effects:  Unexpected dividend increases usually cause stock prices to rise, and unexpected dividend decreases cause stock prices to fall.  Dividend changes convey information to the market concerning the firm’s future prospects.

Other Considerations 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.

Other Considerations 5) Expectations Theory:  Investors form expectations concerning the amount of a firm’s 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 Dividend Payout Ratio: 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.

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 Jan.30 Feb.1 Mar. 11 Declare Ex-div. Record Payment dividend date date 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 “ex-dividend” and the stock price falls approximately by the amount of the dividend. Jan.4 Jan.30 Feb.1 Mar. 11 Declare Ex-div. Record Payment dividend date date date

Dividend Payments 3) Date of Record: Two days after the ex- dividend 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 Jan.30 Feb.1 Mar. 11 Declare Ex-div. Record Payment dividend date date date

Dividend Payments 4) Payment Date: Date on which the firm mails the dividend checks to the shareholders of record. Jan.4 Jan.30 Feb.1 Mar. 11 Declare Ex-div. Record Payment dividend date date date

Stock Dividends and Stock Splits Stock Dividend: Payment of additional shares of stock to common stockholders.  Example: Citizens Bancorporation of Maryland announces a 5% stock dividend to all shareholders of record. For each 100 shares held, shareholders receive another five shares.  Does 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. announces a 3-for-2 stock split. For each 100 shares held, shareholders receive 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 two 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 two half-sized pieces for each full-sized piece they previously owned. Example: This would double the number of shares, but would cause a $60 stock price to fall to $30.

Stock Dividends and Stock Splits Why 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 of dollars to invest and are indifferent to price levels. Plus, stock splits and stock dividends are expensive!

Stock Dividend Example An investor has 120 shares. Does the value of the investor’s shares change?  Shares outstanding: 1,000,000.  Net income = $6,000,000.  P/E = 10.  25% stock dividend.

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 Dividends In-class Problem What is the new stock price?  Shares outstanding: 250,000.  Net income = $750,000.  Stock price = $84.  50% stock dividend.

Hint: stock price stock price P/E = net income P/E = net income # shares # shares ( )

Before the 50% stock dividend:  EPS = 750,000 / 250,000 = $3.  P/E = 84 / 3 = 28. After the 50% stock dividend:  # shares = 250,000 x 1.50 = 375,000.  EPS = 750,000 / 375,000 = $2.  P/E = P / 2 = 28, so P = $56 per share. (A 50% stock dividend is equivalent to a 3-for-2 stock split.)

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 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.