Chapter 14 Dividend Policy

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Chapter 14Dividend Policy
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Influencing the Value of the Firm

• Investment Decisions
• Determines the level of future earnings and
  future potential dividends
• Financing Decisions
• Influences the cost of capital, which can
  determine the number of acceptable investment
  opportunities
• Dividend Decisions
• Influences the amount of equity capital in a
  firms capital structure and the cost of capital
  - Distribution Decision
• Interdependent Maximize shareholder
  wealth

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Dividend Policy

• Does the payment of cash dividends affect
  stockholder wealth, and if it can, what is the
  optimal dividend payout that will optimize
  stockholder wealth?

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Types of Regulations on Dividends

• Capital Impairment Restriction
• Dividends cant be paid out of capital
• Net Earnings Restriction
• Dividends must be paid out of present and past
  earnings
• Insolvency Restriction
• Dividends cant be paid when a firm is insolvent

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Other Factors Affecting Dividends

• Many firms pay out a relatively stable amount of
  their earnings to shareholders in the form of
  dividends.
• Reluctance to reduce dividends
• Need to maintain bond ratings
• Restrictive covenants in bond indentures, loan
  agreements, lease contracts, etc.
• IRS Code prohibits excessive accumulation of
  profits (Sections 531-537)
• A tax is imposed on excessive accumulations

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Determinants of Dividend Policy

• Legal constraints
• Restrictive covenants
• Shareholder preference
• Clientele effect
• Tax considerations
• Personal Tax Rates
• Liquidity and CF considerations
• Need for cash

• Earnings stability
• Growth prospects
• Inflation
• Protection against dilution
• Borrowing capacity access to capital markets
• Informational Content
• Variations in payout

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Schools of Thought Regarding Dividend Policy

• Dividend Irrelevance
• Dividends do not matter and are a mere financing
  detail
• Bird-In-Hand
• Dividends matter and pay out a large amount
• Tax Avoidance
• Why pay ordinary taxes on dividends while
  individuals can pay at a lower rate on capital
  gains? - The Taxpayer Relief Act of 1997

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Irrelevance of Dividends

• Assumptions
• No taxes No Transactions costs
  No Issuance costs on new securities
• Fixed investment policy
• Wealth of a shareholder is not affected by
  dividend policy
• Dividend can have informational content
• Signaling effect
• Clientele effect

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Relevance of Dividends - Bird-Hand - High Payout

• Risk aversion - Prefer Dividends Now
• Resolution of Uncertainty and Informational
  Content (Think of retirees.)
• Transaction (brokerage) costs make it expensive
  for stockholders to sell part of their holdings
  to substitute for cash dividends
• Reduction of Agency costs
• Payment of dividends can reduce agency costs
  between shareholders and management
• Legal List
• Many practitioners believe that dividends are
  important

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Relevance of Dividends - Tax Avoidance School -
Low Dividend Payout

• Individual capital gains will be taxed at a
  maximum of 20 for assets held more than 12
  months
• 1997 Taxpayer Relief Act
• High Issuance Costs for External Equity make it
  expensive
• Good Investment Opportunities
• Dot.com type companies

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Passive Residual Policy

• Suggests that a firm should retain its earnings
  as long as it has investment opportunities that
  promise higher rates of return than the required
  rate.
• Dividends can fluctuate significantly
• Depends on the firms investment
  opportunities
• In practice dividends can be smoothed
• Smoothed Residual Dividend Policy
• Growth firms will have low dividend payout

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Stable Dividend Policies

• Reluctance to reduce dividends
• Firms act as if dividend policy is important
• Increases in dividends tend to lag earnings
• Desirability
• Informational content
• Many shareholders depend on dividends
• Stability tends to reduce uncertainty
• Signal of well being of firm
• Legally desirable Legal list

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• Constant Payout Ratio
• Pays a constant of earnings as dividends
• Fluctuating dividends - Very few firms use this
  method!
• Small Regular Dividends Plus Extras
• Stockholders can depend on regular payout
• Accommodates changing earnings and investment
  requirements
• Small Firms and Dividends
• Tend to pay out a smaller of earnings
• Rapid growth and limited access to capital
  markets
• Gompertz Growth Curve
• Multinational Firms Dividends
• Primary means of transferring funds to parent
  co.
• Tax Effects Exchange Political risk
  Funds availability
• Financing needs Exchange controls

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How are Dividends Paid ?

• Declaration Date - e.g. 2/1
• Board of Directors announce a dividend
• Record Date - e.g. 2/15
• Shareholders of record will receive dividends
• Ex-dividend Date 4 business days before record
  date Stock trades ex-dividends 2/11
• Payment Date - e.g. 3/1
• Dividend checks mailed

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Dividend Reinvestment Plan - DRIP

• Two types of DRIPS
• Existing Stock purchased on open market
• Newly Issued Stock - raises additional equity
• Cash dividend reinvested automatically into
  additional shares
• No brokerage commissions
• Investors are still liable for income taxes on
  dividends reinvested even though they received no
  cash. Key disadvantage.
• DRIP Web-site http/www.stock-drips.com/

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Stock DividendsPayment of additional shares of
C/S

• Usually stated as a of shares outstanding
• Increases the number of shares outstanding
• Accounting transaction Pre-dividend market
  value
• Par value credited to C/S
• Additional value credited to contributed
  capital
• Market price of C/S should decline in proportion
  to the of new shares issued
• Stock splits are similar to stock dividends
• Increase shares and reduce price - but no
  accounting entries other than increasing the
  number of shares.

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Reasons for Declaring a Stock Dividend

• Broaden the ownership of the firms 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

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Stock Repurchase

• Methods of Repurchase
• By a tender offer
• In the open market
• By negotiation with large holders
• Becomes Treasury Stock
• In recent years, larger amount than dividends
• Reduces the number of shares outstanding
• Increases EPS
• Should Be Announced
• So investors know the reason for additional
  trading
• So investors can wait for anticipated price
  increase

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Advantages to Firm

• Reduction of Takeover Risk
• Drains excess cash from the firm
• Greater financial flexibility for the firm when
  substituting for regular dividends
• Signal effect may be positive
• Co. expects higher earnings and CF
• Permits change in the Capital Structure - Static
  Tradeoff Theory
• Treasury stock can be resold in the open market
  if the firm needs additional funds
• Reduces Agency Costs between Stockholders and
  Managers.

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• Advantages for Stockholders
• Converts dividend income into capital gains for
  shareholders - lower tax rate
• Stockholders have a choice. They can sell or
  decline to sell. Not so with regular dividends
• Repurchases may remove a large block of stock
  which is overhanging the market

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• Disadvantages to Firm
• Company may overpay for the stock
• Trigger IRS scrutiny
• Tax avoidance
• SEC may become concerned
• Some current stockholders may be unaware

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Conclusion

• Determinants of Dividend Policy
• Dividend Irrelevance
• Bird-In-Hand
• Tax Avoidance
• Passive Residual
• Stable Dividend
• DRIP
• Stock Repurchase