Dividends

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Dividends

• Chapter 14

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Background

• Dividends as a Basis for Value
• Help determine the value of stocks
• Individual investors buy stocks expecting return
  from dividends and the eventual selling price of
  stock
• Todays price represents the present value of
  those future expected cash flows
• From the whole market view
• The price of a stock today is the present value
  of the infinite stream of dividends

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Understanding the Dividend Decision

• The Discretionary Nature of Dividends
• Board of Directors has authority to determine the
  dividend payout
• Payout can range from nothing to everything
• The Dividend Decision
• A firms earnings belong to the stockholders
• Management makes the dividend decision on behalf
  of the stockholders
• Paying dividends gives stockholders an immediate
  cash paymentcurrent income
• Retaining earnings for reinvestment offers a
  potentially higher stock price in the
  futuredeferred income

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The Dividend ControversyIrrelevance

• Does the payment of dividends now or increasing
  the dividend payment impact the stock price?
• Do stockholders prefer current or deferred income?

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The Dividend ControversyIrrelevance

• Arguments concerning dividend policy
• Dividend irrelevance
• Value of eliminated dividends is offset by
  growth-created value in the future
• The increased return on the retained earnings
  offsets the reduction or elimination of dividends
• Thus, the current stock price is independent of
  changes in early dividends
• Investors can tailor their income stream by
  selling shares of a growing stock that doesnt
  pay dividends or by buying shares of stock of a
  company that pays more dividends than an investor
  needs

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The Dividend ControversyIrrelevanceExample
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The Dividend ControversyIrrelevance

• Transaction Costs
• Can make tailoring an income stream impractical
• The more significant the transactions costs, the
  less valid the irrelevance theory becomes

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The Dividend ControversyIrrelevance

• Income Taxes
• Dividends are taxed as ordinary income
• Appreciation is taxed as a capital gain
• The View from Within the Company
• Dividends represent a cash outflow
• Reduces retained earnings
• Firms prefer not paying dividends if it avoids
  selling new stock
• Retained earnings cost less than new equity

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Dividend Preference

• Investors prefer immediate cash to uncertain
  future benefits
• Not a time value of money argument but rather a
  certainty issue
• Flawif investors are worrying about not
  receiving the future cash flow, why invest in
  that firm in the first place?

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Dividend Aversion

• Investors prefer future capital gains to current
  dividends because of lower tax rates
• Dividends are taxed at higher ordinary income tax
  rates
• This argument hinges on current level of ordinary
  income vs. capital gain tax rates
• Capital gains taxes are not paid until stock is
  sold
• If stock is passed along to heirs, taxes on
  capital gains occurring during decedents life
  can be avoided

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Other Theories and Ideas

• The Clientele Effect
• Investors choose stocks for dividend policyany
  change in payments is disruptive
• Retirees may desire stocks with high dividends
• Young professionals may desire stocks will little
  or no dividends

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Other Theories and Ideas

• The Residual Dividend Theory
• Dividends are paid from earnings only after all
  viable projects are funded
• The Signaling Effect of Dividends
• Cash dividends signal managements confidence in
  the future
• A continuing payment of dividends when earnings
  are low can signal managements confidence about
  the future
• A decrease in dividends can signal managements
  lack of confidence concerning the future

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Other Theories and Ideas

• The Expectations Theory
• Dividends that fail to fulfill stockholders
  expectations send a negative message even if the
  payment is good

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Legal and Contractual Restrictions

• Dividends cant be paid by an insolvent firm and
  must come from current or prior earnings
• Protects creditors
• Loan indentures and covenants may limit dividend
  payments to protect creditors interests
• The cumulative feature of preferred stock limits
  dividend payments

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Dividend Policy

• Payout ratio
• States dividends as a fraction of earnings
  dividend per share ? EPS
• Stability
• A stable dividend is one that is non-decreasing
• A dividend with a stable growth rate is one that
  increases at a more or less constant growth rate

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Alternative Dividend Policies

• Target Payout Ratio
• Firm selects a long-run target payout ratio
• Actual payout ratio is set below target allowing
  for flexibility in earnings
• Stable Dividends Per Share
• A constant dividend is paid regardless of
  earnings
• Dividend may change if firm consistently does
  well or poorly
• Small Regular Dividend with a Year-End Extra if
  Earnings Permit
• Gives firm the ability to lower dividend (by
  omitting the extra year-end dividend) without a
  negative informational effect

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The Mechanics of Dividend Payments

• Key Dates
• Declaration Date Date on which the board
  authorizes the dividend
• Date of Record You must be an owner by this
  date to have access to the declared dividend
• Payment Date Date the dividend payment will be
  mailed
• Ex-Dividend Date If you buy the stock on or
  after this day you will not receive the pending
  dividend

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Figure 14.1 The Dividend Declaration and
Payment Process
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Dividend Reinvestment Plans

• Large companies offer automatic dividend
  reinvestment plans (DRIPs) to stockholders
• Instead of receiving a cash dividend payment the
  stockholder receives additional shares of stock
• Company can either buy the shares on the open
  market or issue new shares to the stockholder
• IRS treats reinvested dividends as taxable income

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Stock Splits and Dividends

• Stock Split
• Current stockholder is issued new shares
  proportionate to his current holdings
• No change in ownership control occurs
• Stock Dividend
• Same as a stock split but called a stock dividend
  if the number of shares is less than or equal to
  20 of original shares outstanding

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Stock Splits and Dividends
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Stock Splits and Dividends

• Accounting Treatment
• Stock split changes par value and the number of
  shares
• Capital accounts are unaffected
• Stock dividend causes money to be shifted from
  Retained Earnings to stock account
• Gives the appearance of a sale at market price

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Stock Splits and Dividends

• Rationale for Stock Splits and Stock Dividends
• Splits keep stock prices in a trading range
• Between 30 and 80
• Stock dividends are an attempt at signaling
• Sends a positive message

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Stock Repurchases

• Alternative to Dividend
• A firm with cash can either pay a dividend or
  repurchase some of its own outstanding stock
• Repurchasing stock reduces number of shares
  outstanding and increases EPS
• Remaining shares will rise in value if market
  uses same P/E ratio after the repurchase

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Stock Repurchases
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Stock Repurchases

• Method of Repurchasing Shares
• Buy shares on open market
• Make a tender offer
• Negotiated deal with a large investor

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Other Repurchase Issues

• Opportunistic Repurchase
• Repurchases are appropriate when a stock is
  temporarily undervalued or the firm has excess
  cash
• Repurchases to Dispose of Excess Cash
• Firm may have excess cash which can be
  distributed as dividend
• However, firm may suffer from signaling effect
• A stock repurchase effectively distributes the
  cash without a signaling effect

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Other Repurchase Issues

• Taxes
• An occasional stock repurchase may benefit
  stockholders because they pay capital gains taxes
  rather than ordinary income taxes
• Repurchases to Restructure Capital
• By borrowing money and using the cash to
  repurchase stock, a firm can raise its debt ratio