Financial Management

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? 2002, Prentice Hall, Inc.
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Stock Returns

• P1 - Po D1
• Po
• P1 - Po D1
• Po Po

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Dilemma Should the firm use retained earnings
for

• a) Financing profitable capital investments?
• b) Paying dividends to stockholders?

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• If we retain earnings for profitable investments,
  dividend yield will be zero, but the stock price
  will increase, resulting in a higher capital
  gain.

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• 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.

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So, dividend policy really involves 2 decisions

• How much of the firms earnings should be
  distributed to shareholders as dividends, and
• How much should be retained for capital
  investment?

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Is Dividend Policy Important?

• 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.

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• 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.
• Therefore, one dividend policy is as good as
  another.

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2) High Dividends are Best

• Some investors may prefer a certain dividend now
  over a risky expected capital gain in the future.

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3) 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.

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Do Dividends Matter?

• 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.

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Do Dividends Matter?

• 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.

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Do Dividends Matter?

• 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 firms future prospects.

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Do Dividends Matter?

• 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.

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Do Dividends Matter?

• 5) Expectations Theory
• Investors form expectations concerning the amount
  of a firms 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.

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Yr-to-Yr Dividend Pmt Patterns

• A) 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.

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Yr-to-Yr Dividend Pmt Patterns

• B) 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!

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Yr-to-Yr Dividend Pmt Patterns

• C) 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.

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Dividend Payment Procedures
Jan.4 Jan.30 Feb.1
Mar. 11
Declare Ex-div. Record
Payment dividend date date
date

• 1) Declaration Date the board of directors
  declares the dividend, determines the amount of
  the dividend, and decides on the payment date.

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Dividend Payment Procedures
Jan.4 Jan.30 Feb.1
Mar. 11
Declare Ex-div. Record
Payment dividend date date
date

• 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.

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Dividend Payment Procedures
Jan.4 Jan.30 Feb.1
Mar. 11
Declare Ex-div. Record
Payment dividend date date
date

• 3) Date of Record 2 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.

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Dividend Payment Procedures
Jan.4 Jan.30 Feb.1
Mar. 11
Declare Ex-div. Record
Payment dividend date date
date

• 4) Payment Date date on which the firm mails
  the dividend checks to the shareholders of record.

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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 5 shares.
• Does the shareholders wealth increase?

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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?

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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.

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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 2
  half-sized pieces for each full-sized piece they
  previously owned.
• For example, this would double the number of
  shares, but would cause a 60 stock price to fall
  to 30.

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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!

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Stock Dividend Example

• shares outstanding 1,000,000
• net income 6,000,000
• P/E 10
• 25 stock dividend.
• An investor has 120 shares. Does the value of
  the investors shares change?

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• 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

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Stock DividendsIn-class Problem

• shares outstanding 250,000
• net income 750,000
• stock price 84
• 50 stock dividend.
• What is the new stock price?

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Hint

• stock price
• P/E net income
• shares

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• 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)

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Stock Repurchases

• Stock Repurchases may be a good substitute for
  cash dividends.
• If the firm has excess cash, why not buy back
  common stock?

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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.

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Stock Repurchases

• Repurchases may be used to avoid a hostile
  takeover.
• Example T. Boone Pickens attempted raids on
  Phillips Petroleum and Unocal in 1985. Both were
  unsuccessful because the target firms undertook
  stock repurchases.

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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.