week 4 assign man fin
silpac1850
BUS650_Chapter_10.pdf
Learning Objectives
After studying this chapter, you should be able to:
• Describe the characteristics of common cash dividends.
• Explain how dividend policy functions in perfect capital markets.
• Show how imperfections in capital markets impact dividend policy.
• Summarize how dividend policy is put into practice.
Associated Press10
Dividend Policy: Distributions to Shareholders
byr80601_10_c10_285-310.indd 285 1/24/13 3:58 PM
CHAPTER 10Introduction
Introduction Figure 10.0: Chapter 10 in focus
?? Dividend Decision
Reinvest residual cash
Preferred Stock Common Stock
Investments
The Financial Balance Sheet
$
In Chapter 10, we explore the effect of a firm’s dividend policy in perfect and imperfect markets.
Our study of the capital budgeting process in Chapters 6, 7, and 8 covered the NPV crite- rion for identifying projects expected to increase corporate shareholders’ wealth.
In Chapter 9, we analyzed the considerations managers should make when selecting the mix of debt and equity used to finance investment projects. Again, this analysis was pre- sented within the framework of maximizing shareholders’ wealth. In this chapter, we discuss dividend policy, or the distribution of residual cash to shareholders, an act upon which shareholders’ wealth ultimately depends. Figure 10.1 depicts where the dividend decision occurs in terms of the financial balance sheet’s model of business activity.
Figure 10.1: The dividend decision and the financial balance sheet
Goods and services
$
$
$ $
The dividend decision
Reinvested residual cash
Products and service markets
Investments made by the firm
Fixed claims
Residual claims
Fix ed
pa ym
en ts
Resid ual ca
sh flo w
After companies satisfy their fixed claims, they must decide how much residual cash flow to distribute to shareholders and how much to reinvest on behalf of shareholders.
byr80601_10_c10_285-310.indd 286 1/24/13 3:58 PM
CHAPTER 10Introduction
To understand the importance of dividends, let’s consider the fundamental equation for value:
(10.1) Value 5 a`t 5 1
CFt
11 1 r2 t
This equation expresses value as the sum of future cash flows, discounted at a risk-adjusted required return. This formula may be applied to stocks by recognizing that the cash flows distributed to shareholders come in the form of dividends.
(10.2) Value 5 a`t 5 1
Dt
11 1 r2 t
Now, suppose a fictitious stock included in its corporate charter an iron-clad, irrevocable promise never to pay a dividend to stockholders. What would be the value of a share of this stock? According to Equation (10.2), the value would be zero. Despite the firm’s profitability, it would be forced by its own charter to retain all residual cash flows, never distributing funds to shareholders. Because the present value of an infinite stream of zeros is zero, such a firm would be worthless to shareholders. For those who argue that money could still be made via price appreciation, consider who would be willing to purchase a valueless stock (especially at a higher price). Such an investment strategy is known as the “next-bigger-fool” strategy. It will eventually break down when there are no buyers will- ing to make a bad investment, leaving the shareholder with a worthless security.
Yet, you may be aware of firms that pay no dividends and sell for relatively high prices. For example, Apple (Ticker: AAPL) quit paying dividends in 1995. In 2012, the company’s share price was a whopping $585.00, and investors must have anticipated the reinstitution of dividend payments. It turns out they were right. In March 2012, Apple announced a $2.65 dividend and the repurchase of $10 billion of stock.
This discussion points out two important facts about dividend policy: First, dividends are essential to stock value, and second, large future dividends may occur even if current dividends are small or nonexistent.
In our assessment of dividend policy in this chapter, we will assume that the firm has identified its investment projects and established its mix of debt and equity financing. Thus, capital budgeting is done, capital structure has been targeted, and we may isolate the dividend decision. Because we know our target capital structure, we also know how much equity financing is needed to fund the firm’s promising investment projects. This will allow us to focus more closely on the distribution of residual cash to shareholders.
Before we dive into our analysis of dividend policy, we will quickly examine two basic types of dividends: regular and special dividends. Following this discussion, we will return to the format used to analyze capital structure, first exploring dividend policy anal- ysis within a perfect capital market. After we have established how the process functions in this ideal environment, we will once again introduce market imperfections. Finally, we will look at dividend policy in practice.
byr80601_10_c10_285-310.indd 287 1/24/13 3:58 PM
CHAPTER 10Section 10.1 Overview of Cash Dividends
Pre-Test
1. Regular cash dividends can be thought of as a quasi-fixed cost. a. True b. False
2. When capital markets are perfect, then shareholder wealth is unchanged by a firm’s dividend policy.
a. True b. False
3. A residual dividend policy is when dividends take priority over project fund- ing, and residual cash after dividends are paid is used to finance positive NPV projects.
a. True b. False
4. The ex-dividend date is two days after the date of record. a. True b. False
Answers 1. a. True. The answer can be found in Section 10.1. 2. a. True. The answer can be found in Section 10.2. 3. b. False. The answer can be found in Section 10.3. 4. b. False. The answer can be found in Section 10.4.
10.1 Overview of Cash Dividends
Corporate law gives the firm’s board of directors the authority to declare dividends. This is generally done at quarterly board meetings, with large corporations usu-ally paying dividends four times a year. Regular dividends are generally paid on approximately the same dates year after year. Most U.S. firms that pay dividends follow the constant dollar dividend policy, in which the company pays the same dollar amount every year unless the dividend increases. This policy represents an implicit promise to shareholders to continue paying dividends, year after year, at or above the current regu- lar dividend level. Over time, companies following the constant dollar policy will have a dividend payout that follows a stair-step pattern, which can be observed in Figure 10.2. The graph shows Procter & Gamble’s (Ticker: PG) quarterly dividend history from 1970 to 2012. As you can see, only in Q1 of 1983 did the amount of the dividend fall, but since then it has steadily increased.
byr80601_10_c10_285-310.indd 288 1/24/13 3:58 PM
CHAPTER 10Section 10.1 Overview of Cash Dividends
Figure 10.2: Procter & Gamble’s quarterly dividend history: 1970–2012
Date
D iv
id e n
d
2 01
2
2 01
0
2 0
0 8
2 0
0 6
2 0
0 4
2 0
0 2
2 0
0 0
19 9 8
19 9 6
19 9 4
19 9 2
19 9 0
19 8 8
19 8 6
19 8 4
19 8 2
19 8 0
19 7 8
19 76
19 74
19 7 2
19 7 0
0.0
0.1
0.2
0.3
0.4
0.5
0.6
Q4Q3Q2Q1KEY:
As this graph shows, Procter & Gamble has an almost uninterrupted history of dividend increases.
Data from Yahoo Finance: http://finance.yahoo.com/q/hp?a506&b51&c51985&d509&e58&f52012&g5v&s5pg&ql51.
Although not a legally enforceable guarantee, a firm declaring a $0.50 regular dividend in the current year is promising its shareholders that it can maintain the regular dividend at or above that level in the future. Regular dividends, therefore, are a quasi-fixed cost. They are fixed in that, like interest payments, they represent an obligation of the corporation. They are quasi in that, unlike interest payments, there is no legal contract that forces the firm to make payment. If the firm chooses not to make an interest payment, it is an act of default, whereas choosing to forego an expected regular dividend payment is not. How- ever, there is a penalty associated with the inability to maintain a regular dividend at its expected level: the ire of investors. This disappointment is often reflected in declining of share prices.
Special dividends, on the other hand, carry no implicit promise. Boards declaring a spe- cial dividend are careful to designate it as such. A special dividend might be caused by a special cash flow–generating event. For instance, corporations that have sold a division may find themselves with a large excess cash flow on hand. They could declare a special dividend to put this excess cash in the hands of their stockholders. Sometimes a special dividend is part of a recapitalization plan. For example, Domino’s Pizza issued a $13.50 per
byr80601_10_c10_285-310.indd 289 1/24/13 3:58 PM
CHAPTER 10Section 10.2 Dividend Policy in Perfect Capital Markets
share special dividend after completing a $1.85 billion debt issue in 2012 (PR Newswire, 2012). The distribution was designated a special dividend to ensure that investors would not expect the same windfall the following year.
Now that we have briefly overviewed cash dividends, we can move on to learning how they are distributed in perfect and imperfect markets.
10.2 Dividend Policy in Perfect Capital Markets
Like capital structure, dividend policy is also irrelevant to shareholders in perfect capital markets. A firm is equally valuable whether it pays all of its residual cash to shareholders (a 100% payout), or retains all of its cash flow (a 100% retention, or plowback, rate). Regardless of a firm’s dividend policy, shareholders’ wealth remains unchanged in this environment. This irrelevance can be attributed to the perfect market assumptions discussed in Chapter 9:
1. Perfect markets are frictionless, so corporations may raise new capital without incurring transaction costs. Individuals may also buy (or sell) securities without commissions or tax ramifications.
2. Perfect markets lack information asymmetry. 3. Perfect markets are strong-form efficient; therefore, security prices accurately
reflect value, and agency problems do not exist.
Now, let’s analyze dividend irrelevance within this ideal context.
Imagine a corporation with 1,000 shares of stock issued and outstanding. The corporation has two assets: $100,000 in cash and an identified, proprietary project. This project will cost the firm an initial investment of $100,000 and has a net present value of $20,000. The corporation has no debt in its capital structure, and management has decided to finance the project with 100% equity. Because the firm operates in perfect financial markets, the stock’s price will accurately reflect its value.
Let’s consider two alternatives for funding the project. First, the firm could retain all of its cash and fund the total cost of the project with internal equity. In this case, the firm’s current dividend would be zero because all cash has been retained and reinvested in the project. The second alternative is to distribute all the cash as dividends to current share- holders and sell new stock to raise the equity needed to finance the project. In this case, the firm would pay a dividend of $100 per share and use external equity to fund the project.
Irrelevance predicts that either dividend policy results in the same shareholder wealth. We examine the zero dividend scenario first. If all $100,000 is invested in the project, which has a $20,000 NPV, then the stock’s price will be $120. To see this, recall the formula for net present value:
(10.3) NPV 5 aaNt 5 1
CFt
11 1 r2 tb 2 Initial investment
byr80601_10_c10_285-310.indd 290 1/24/13 3:58 PM
CHAPTER 10Section 10.2 Dividend Policy in Perfect Capital Markets
Recognizing that the sum of discounted future cash flows equals value, we can substitute value for this term in Equation (10.3).
(10.4) NPV 5 Value – Initial investment
In efficient markets, value equals price. We know NPV is $20,000 and the project costs $100,000, so we can make further substitutions and solve for the stock’s price.
(10.5) NPV 5 Price – Initial investment
$20,000 5 Price – $100,000
Price 5 $100,000 1 $20,000 5 $120,000
Thus, with 1,000 shares outstanding, the price per share is $120 per share ($120,000/1,000 shares).
Now, let’s examine the funding plan that includes a dividend. The company distributes $100,000 cash to its shareholders, resulting in a $100 per share dividend ($100,000/1,000 shares), and then raises $100,000 by selling additional stock. Thus, each current share- holder would have $100 in the bank (from the dividend) and a share of stock valued at $20. By distributing all of its cash, the corporation is left with only one asset—the right to pursue the $20,000 NPV project. To raise the $100,000 needed to finance the project, the corporation sells 5,000 shares of new stock to the public for $20 per share, the same rate as currently outstanding stock. Both the new and old stockholders have identical rights representing identical claims. The firm now has 6,000 shares, with a total value of $120,000. Ultimately, the strategy of paying a dividend and raising investment funds by selling stock results in present shareholder wealth of $120 ($100 in cash and a share of stock worth $20)—the same value as the first dividend policy.
Table 10.1 summarizes this result for the two dividend strategies.
Table 10.1: Two dividend strategies compared
Firm paying no dividend Firm paying $100,000 in dividends
Total value $120,000 $120,000
Number of shares 1,000 6,000
Value per share $120 $20
Wealth of “old” shareholders
Number of shares 1,000 1,000
Value of shares $120,000 $20,000
Cash dividend received 0 $100,000
Total wealth $120,000 $120,000
byr80601_10_c10_285-310.indd 291 1/24/13 3:58 PM
CHAPTER 10Section 10.2 Dividend Policy in Perfect Capital Markets
Many retirees supplement their fixed incomes with investments. What are the benefits and risks of this practice?
Associated Press
As you can see in the table, nei- ther the value of the firm nor the wealth of the shareholders has changed. The old shareholders who received the dividend sim- ply converted a portion of their wealth from common stock to cash. Shareholders can reallo- cate their wealth easily by selling shares at $120 to raise cash (in the case of no dividend) or by using cash to buy shares at $20 (in the case of dividend). Ultimately, both policies result in identical wealth for existing stockholders, illustrating that dividend pol- icy is irrelevant to shareholder wealth within the environment of perfect capital markets.
You may object to this conclusion. You may know of individuals who prefer high- dividend-paying securities because they depend on income from their personal invest- ments to meet living expenses. Retirees, for example, often require regular investment income to supplement Social Security payments. Recall, however, that in perfect capital markets there are no transaction costs. Retirees needing current income can, in such mar- kets, manufacture homemade dividends by selling some proportion of their shares. Consider an individual who owns 60 shares of stock worth $7,200 in the firm that elected the no dividend option. If this individual needs $6,000 to pay a hospital bill, he could simply sell 50 shares of stock for $120 each, raising $6,000 in cash. He would still own 10 shares of stock worth $1,200. Had the firm paid a $100 per share dividend and dropped each share’s value to $20, the investor would collect $6,000 in total dividends, pay his hospital bill, and still have $1,200 worth of stock in his portfolio. Either way, his total remaining wealth after paying his hospital bill is $1,200.
You might assume that investors would prefer a high-payout policy over a homemade dividend. If there is a large clientele with such a preference, the demand for high-payout stocks would drive up their prices. However, in a perfect market, investors with zero divi- dend policies can simply sell shares of stock to generate cash without transaction costs. They won’t pay a premium for stock with characteristics they can duplicate for free; there- fore, in perfect markets homemade dividends can substitute for dividends generated by the firm.
What of investors who prefer to keep their funds invested in the firm’s stock rather than saved in a bank account? Wouldn’t these investors pay a premium to invest with firms that adopt a low payout of cash? Again, the answer is no. Consider the 100% payout policy. An investor with 60 shares of stock in such a firm would receive dividends totaling $6,000 and would own 60 shares of $20 stock for a total wealth of $7,200. If the investor wished to maintain her total investment in the firm, she could purchase 300 shares of the
byr80601_10_c10_285-310.indd 292 1/24/13 3:58 PM
CHAPTER 10Section 10.3 Dividend Policy in Imperfect Capital Markets
newly issued stock for $20 per share. Her total wealth consists of investment in the firm equal to $7,200, and she would own 360 shares (6% of the firm’s equity). Note that this is the same position she would be in had the firm chosen to retain all the cash: There would be 1,000 shares outstanding, she would own 60 (6% of the total) and her investment would be worth $7,200. Again, dividend policy is irrelevant because investors can construct their own dividend policies independent of that adopted by the firm.
Both of the aforementioned scenarios break down once we introduce imperfection into the market. If we allow transaction costs (e.g., brokerage commissions) to enter these exam- ples, then selling shares to construct a homemade dividend becomes costly and reduces the shareholder’s wealth. Clearly, it would be economically preferable for such an indi- vidual to invest in a corporation adopting a higher payout. Thus, just as capital structure irrelevance disappears when perfect market assumptions are relaxed, a breakdown of irrelevance also occurs in dividend policy. We will now relax the perfect market assump- tion to examine dividend policy in a context that more closely resembles the real world.
10.3 Dividend Policy in Imperfect Capital Markets
Once transaction costs enter our example, individuals are no longer neutral regard-ing dividend policy. Those who need steady income from their investments (e.g., retirees) are likely to prefer stocks that pay relatively higher dividends, also known as income stocks. Constructing their own homemade dividends would incur brokerage commissions, effectively lowering their wealth.
Similarly, investors who wish to keep their savings fully invested in stocks may prefer firms that pay little or no dividends. There are firms with numerous promising projects that continually reinvest all their residual cash into positive NPV investments; these firms are known as growth companies. As their assets grow, the claims on the assets gain in value, causing price appreciation or capital gains. Younger investors, saving for retire- ment, often prefer to invest in the securities of such firms. These investors would rather not receive large dividends and then use this cash to buy more of the company’s stock because of the brokerage commission they would have to pay on these transactions.
Market Frictions and Dividend Policy: Transaction Costs and Taxes The existence of two dividend clienteles does not necessarily mean that dividend policy affects firm value. Dividend policy remains irrelevant as long as there are enough high- dividend income and growth stocks to satisfy demand for each. Compare this situation to buying ice cream. Some people prefer chocolate, and others choose vanilla. The price of both flavors will be equal so long as there is no shortage of one flavor. The same holds true for stocks with different dividend policies: Adopting a high or low payout does not lead to an increase in value, as long as demand for such issues is satisfied. Thus, irrel- evance still persists. We saw this in 2012; as yields on government bonds approached zero, there still wasn’t enough excess demand for high dividend paying stocks to shift prices (Jakab, 2012).
byr80601_10_c10_285-310.indd 293 1/24/13 3:58 PM
CHAPTER 10Section 10.3 Dividend Policy in Imperfect Capital Markets
Stocks with different dividend prices are like buying chocolate and vanilla ice cream; some people prefer one over the other. What other examples of comparisons can you think of?
Ingram Publishing/SuperStock
In our example from Section 10.1, the firm adopt- ing a high-dividend payout sought outside equity to fund its investment in the positive NPV proj- ect. This capital was raised by selling new equity, which was done in a frictionless, perfect capital market. However, when firms issue and sell secu- rities, they generally hire investment bankers to assist them in marketing the issue. Investment bankers charge fees for their services, known as flotation costs. These costs represent a leakage of cash from the firm, lowering its value. Recall in our perfect markets example that the firm fund- ing the project by foregoing dividend payments incurred no fees. With flotation or brokerage costs associated with other forms of raising capital, investors are no longer indifferent to dividend policy. Because of transaction costs involved in raising equity capital, firms should first fund all positive NPV projects with operating cash flows and then determine the dividend policy regard- ing the leftover cash. This strategy is known as a residual dividend policy; funds left over after making all profitable investments are distributed to investors.
Taxes represent an important friction in capital markets. Individuals in high personal-tax brack- ets often prefer investments whose returns come in the form of price appreciation (capital gains) rather than current income. To convince yourself
of this, try the following time value problem: Suppose you are in the 50% tax bracket and invest $1,000 for 10 years in an investment that returns 10% per year before taxes. Now try two different scenarios. In the first, imagine that you must pay taxes at the end of each year at the 50% tax rate. In the second case, suppose your investment compounds tax-free for 10 years and then you must pay a 50% tax on your total gain. In which case will you be better off?
Paying taxes each year at a 50% rate effectively lowers your annual return from 10% to 5%. The after-tax value of your 10-year, $1,000 investment is found by using the future value of a single cash flow formula from Chapter 3:
FV 5 $1,000(1.05)10 5 $1,628.89
The tax-deferral feature of capital gains allows the investment to compound at 10% for 10 years; then 50% taxes are assessed against the gain:
FV (before taxes) 5 $1,000(1.10)10 5 $2,593.74
byr80601_10_c10_285-310.indd 294 1/24/13 3:58 PM
CHAPTER 10Section 10.3 Dividend Policy in Imperfect Capital Markets
Information Asymmetry and Dividend Policy: Signaling and Agency Costs Dropping perfect market assumption reintroduces asymmetry between the information available to company insiders and outsiders. Like the signaling feature of debt, dividend pol- icy also allows insiders to give a credible signal to outsiders regarding the firms’ prospects.
Let’s examine the signaling effect within the context of the quasi-fixed nature of regular dividends. Recall from Chapter 9 that a firm’s management can signal higher expected cash flows by taking on a greater proportion of debt. The signal is credible because of the
Capital Gains Controversy
A particular type of capital gain received significant publicity in the early 2000s. Private equity manag- ers were having a considerable portion of their income taxed as carried interest, qualifying them for the 15% long-term capital gain rate. This became a contentious political issue, prompting legislation aimed at preventing the low rate from being applicable to high income. Master investor Warren Buf- fet even got involved when he admitted in 2011 that he paid only 17.4% in income taxes, which was less than his secretary’s rate of more than 30% (Buffet, 2011). He argued that the rich shouldn’t pay a lower tax rate than middle-income citizens, and his admission helped motivate proposed legislation aimed at “limiting the degree to which the most well-off can take advantage of tax expenditures and preferential rates on certain income” (National Economic Council, 2012, p. 2). This legislation, known as “The Buffett Rule” was a hotly-debated topic in the 2012 presidential elections.
Critical Thinking Question
1. Do you think that wealthy individuals should be allowed to pay a lower tax rate using the capital gains rate? Why or why not?
In this second scenario, you see a capital gain of $1,593.74 on your original investment. The taxes on the gain must be paid ($1,593.75 3 0.50 5 $796.87), leaving you with $1,796.87 after tax. The deferral feature of capital gains results in $167.98 greater wealth.
The attractiveness of capital gains for this highly taxed individual lies in its tax-deferral feature. Dividends are taxed in the year they are paid, whereas capital gains are not recog- nized for tax purposes until the security is sold at its appreciated value. In 2012, the capital gain has an even greater advantage because it is taxed at a maximum rate of 15%, rather than the ordinary income maximum rate of 35%. Nevertheless, the benefit of tax-deferred compounding exists regardless of the rates.
Many investors pay little or no taxes on their investment income. Investors such as low- income retirees, college endowments, and pension plans pay no taxes on current income and may be indifferent between capital gains and dividends. Does the existence of tax cli- entele necessarily lead to a prescribed dividend policy that will optimize the value of the firm? The answer is no. It is the ice cream story once more—as long as demand for firms with a particular dividend policy does not outstrip supply, investors will be unwilling to pay a premium price based on the firm’s dividend strategy.
Transaction costs, therefore, lead to one breakdown of the irrelevance proposition: The costs associated with raising external equity should be avoided if possible. Thus, market frictions lead us toward a residual dividend policy.
byr80601_10_c10_285-310.indd 295 1/24/13 3:58 PM
CHAPTER 10Section 10.4 Dividend Policy in Practice
penalty associated with false signaling—a higher likelihood of bankruptcy. Similarly, for firms using a constant dollar dividend policy, declaring a higher regular dividend signals to investors that the board, under advisement of management, believes the corporation can maintain its dividend at the new level indefinitely into the future. If management expects a firm’s cash flows to be higher in the future, they may signal to outsiders the improved prospects by increasing the regular dividend.
If management increases the regular dividend without expecting better prospects, then they have sent a false signal. There is some likelihood of the firm not being able to meet its new, higher dividend payment. If the company performs poorly, managers may have to lower the dividend. Shareholders respond negatively to dividend decreases by lowering their share valuations. Sometimes the response is dramatic enough to cost managers their jobs. This penalty for false signaling lends credibility to a dividend increase.
Other policies do not share the constant dollar policy’s signal reliability. If the company follows a different type of dividend policy—such as a pure residual dividend policy or a payout ratio target policy—then investors cannot infer a signal from a dividend increase. Under the pure residual policy, dividends go up and down as earnings and investment need changes. With a target payout ratio policy, a dividend increase follows higher earn- ings, but there is no assurance from managers that earnings will continue to be high, so there is no signal. Investors prefer the constant dollar policy because it allows managers to reliably signal a company’s future prospects.
A second outcome of introducing information asymmetry into our economic environment is the potential for agency problems. In Chapter 9, we introduced the agency cost of free cash flow argument, which predicts that firms often waste money when cash on hand is in excess of that needed to fund all positive NPV projects. The potential for agency costs does not go unnoticed by investors. They see the potential for waste within firms that produce cash flows in excess of their internal needs, yet fail to pay out this cash to residual claimants. In order to lower the potential for waste, firms should pay dividends at the highest possible level without limiting the cash needed to fund anticipated promising investment projects.
Now that we have examined how market inefficiencies affect dividend policy, we can more thoroughly examine the process in action.
10.4 Dividend Policy in Practice
Three propositions that are at odds with dividend irrelevance have been presented:1. The residual dividend policy prescribes funding all positive NPV projects first and then determining the dividend payment.
2. Signaling with dividends prescribes paying regular dividends at a level that can be maintained by the firm.
3. The agency costs of free cash flow policy prescribe paying the highest possible dividend after funding all positive NPV projects.
byr80601_10_c10_285-310.indd 296 1/24/13 3:58 PM
CHAPTER 10Section 10.4 Dividend Policy in Practice
Taken together, these three propositions suggest that managers take the following actions when implementing dividend policy:
Step 1. Forecast the cash needed to fund the firm’s investment projects for several years in the future.
Step 2. Forecast the residual cash flows the firm will generate for several years in the future.
Step 3. Using the information from steps 1 and 2, subtract the cash needed for invest- ment projects each year from the cash flows anticipated that year in order to determine each year’s free cash flow. This effectively implements the residual dividend policy’s recommendations.
Step 4. Taking into account the variability of the year-to-year expected free cash flow, establish a maintainable regular dividend, thereby implementing the recommendations of the signaling hypothesis.
Step 5. Large free cash flows left in a particular year after the payment of a regular divi- dend and not needed to fund future investment projects should be disgorged. This can be accomplished by setting the regular dividend at its highest maintainable level or by using a special dividend, thereby implementing the recommendations of the agency costs of free cash flow argument.
Table 10.2 applies these recommendations to a hypothetical firm. The company portrayed follows a constant dollar dividend policy but supplements the regular dividend with a special dividend after Year 3, when cash flow generation is high.
Table 10.2: Implementing dividend policy for a hypothetical firm (100,000 shares outstanding)
Dividend policy implementation Year 1 Year 2 Year 3 Year 4
Step 1. Forecast residual cash needed to fund the firm’s investments for several years.
$200,000 $300,000 $100,000 $250,000
Step 2. Forecast residual cash flows produced by the firm.
$350,000 $400,000 $450,000 $400,000
Step 3. Subtract cash flows needed from those produced.
$150,000 $100,000 $350,000 $150,000
Step 4. Establish a maintainable regular dividend.
$125,000 $125,000 $150,000 $150,000
Price per share $1.25/share $1.25/share $1.50/share $1.50/share
Step 5. Pay out large sums of residual cash using a special dividend.
After-dividend residual cash flow $25,000a 0 $200,000 0
Special dividend $200,000
Price per share $2.00/share
a Carried over to Year 2 to fund maintainable regular dividend of $1.25/share.
byr80601_10_c10_285-310.indd 297 1/24/13 3:58 PM
CHAPTER 10Section 10.4 Dividend Policy in Practice
Note that certain predictions are possible when we consider firms’ application of these steps in the real world. For example, we can expect that firms in high-growth industries, where new and promising projects abound, will adopt a low (or zero) dividend payout. On the other hand, firms in mature industries would have a higher dividend payout ratio. Table 10.3 compares the average dividend payout ratio for 15 diverse industries. Notice how widely payout ratios can vary from one category to the next.
Table 10.3: Payout ratios for selected industries, 1999–2012
Industry name Average payout ratio Average # of firms
Advertising 26.32% 33
Aerospace/Defense 25.49% 64
Apparel 20.12% 56
Biotechnology 5.88% 104
Computer Software & Services 14.55% 365
Computer & Peripherals 12.24% 139
Electric Utilities 54.89% 71
Electronics 9.22% 171
Internet 0.67% 268
Medical Services 4.24% 177
Paper & Forest Products 47.41% 42
Petroleum (Integrated) 33.59% 31
Tobacco 53.63% 12
Water Utility 88.03% 15
Wireless Networking 4.31% 66
Source: http://pages.stern.nyu.edu/~adamodar/.
As predicted, the industries with the most growth (Internet, Medical Services, Wireless Networking, Biotechnology, and Electronics) have the lowest payout ratios. We expect firms in these industries to need significant investment funds, so they would retain and reinvest any cash flow generated. More mature firms, and those with little need for con- stant competitive innovation (Tobacco, Electric and Water Utilities), have the highest pay- out ratios.
Expectations and Dividend Policy Another prediction we can make is that firms lowering their regular dividend will expe- rience a fall in stock prices when the announcement is made. One might also antici- pate that corporations announcing an increase in their regular dividend will see their share value increase. These predictions are based on the signaling effect of the dividend
byr80601_10_c10_285-310.indd 298 1/24/13 3:58 PM
CHAPTER 10Section 10.4 Dividend Policy in Practice
announcement. If the change in the regular dividend signals new information to the mar- ket, an impact on price will be forthcoming as investors evaluate the content of the signal. However, we must keep in mind that investors may have already formed expectations about future dividends when they value stocks. In some cases, the market is expecting a firm to lower its dividend, perhaps because of recent and ongoing difficulties. If a firm subsequently lowers its dividend, but by less than the amount expected, the market may actually perceive this as good news (positive signal) that circumstances are better than investors originally thought. On the other hand, a corporation raising its dividend less than expected could find that share prices decline due to investors’ disappointment in the relatively low increase. Therefore, the wealth effect (share price change) of a dividend change is a function of the actual change versus the expected change. In other words, it’s the unexpected part of the dividend announcement that has an impact on value.
An erratic pattern of paying dividends could be full of unexpected changes that surprise investors. Managers seek to avoid irregularity by setting a regular dividend at a reason- able maintainable rate. Many managers also avoid issuing regular dividend increases in large, randomly occurring jumps. Rather, they tend to adopt a smooth stream of steadily but moderately increasing dividend payments. Such a stream can absorb the shock of earnings reversals that occur from time to time. This type of payment schedule is known as smooth-stream dividend strategy and can be viewed as an attempt to minimize divi- dend disappointments. An example of the smooth-stream dividend strategy in practice is shown for Hershey in Table 10.4.
Table 10.4: Hershey’s annual dividend, EPS, and payout ratio, 1990–2011 (adjusted for stock splits)
Year Dividend EPS Payout ratio
1990 0.25 0.55 45.4%
1991 0.24 0.61 38.5%
1992 0.26 0.68 38.1%
1993 0.29 0.72 39.9%
1994 0.31 0.76 41.1%
1995 0.34 0.85 40.5%
1996 0.38 1.00 38.0%
1997 0.42 1.12 37.7%
1998 0.46 1.15 40.2%
1999 0.50 1.05 47.8%
2000 0.54 1.18 45.8%
2001 0.58 0.72 81.0%
2002 0.63 1.42 44.4%
2003 0.72 1.70 42.5%
(continued)
byr80601_10_c10_285-310.indd 299 1/24/13 3:58 PM
CHAPTER 10Section 10.4 Dividend Policy in Practice
Year Dividend EPS Payout ratio
2004 0.84 2.25 37.1%
2005 0.93 1.99 46.7%
2006 1.03 2.34 44.0%
2007 1.14 0.93 122.2%
2008 1.19 1.36 87.6%
2009 1.19 1.90 62.7%
2010 1.28 2.21 57.9%
2011 1.38 2.74 50.4%
Source: http://finance.yahoo.com/q/hp?s5HSY&a506&b51&c51985&d509&e58&f52012&g5v.
Notice that even though Hershey’s dividends increase smoothly, the dividend payout ratio (Dividends/EPS) is somewhat erratic, ranging from 38% to 122%. We must also point out that firms are so reluctant to reduce dividends—due to the negative response from investors—they may continue to pay dividends even if they exceed current earnings. This was the case in 2007 for Hershey.
The Process of Paying Dividends When a corporate board declares payment of dividends, the announcement includes a date of record. On that date, the corporation reviews its stock transfer books to deter- mine who owns shares and is entitled to the dividend proceeds. The dividend announce- ment also specifies a dividend payment date. This date is a few weeks after the date of record, the payment delay being necessary to allow paperwork and check writing to be completed.
The date of record is preceded by the ex-dividend date. Only investors who purchase a share of stock prior to the ex-dividend date are entitled to the dividend. For example, when shares are bought a few days after the ex-dividend date, the old owner will receive the dividend payment, even though the stock has changed hands. Brokerage firms specify an ex-dividend date in order to assure investors that their names will appear as stockhold- ers on the corporate books by the date of record. Because it normally takes a few days to settle a stock purchase or sale, the ex-dividend date precedes the date of record by about two business days.
Figure 10.3 illustrates a dividend payment time line. Point A is the April 1 announcement of a dividend payable on May 19. Point C is the date of record, May 5, and Point B is the ex-dividend date, May 1. The dividend checks are mailed on the payment date of May 19.
Table 10.4: Hershey’s annual dividend, EPS, and payout ratio, 1990–2011 (adjusted for stock splits) (continued)
byr80601_10_c10_285-310.indd 300 1/24/13 3:58 PM
CHAPTER 10Section 10.4 Dividend Policy in Practice
Figure 10.3: Dividend payment timeline
April 1 May 1 May 5April 1
A = dividend announcement date B = ex-dividend date C = date of record D = payment date
May 19
A DB C
The dividend payment process has four key dates: (1) announcement date, (2) ex-dividend date, (3) date of record, and (4) payment date.
In the timeline, anyone holding stock by the ex-dividend date will receive the May 19 dividend check, even if they subsequently sell their shares. Those who buy the stock on or after May 1 will receive no dividend because the transaction occurred after the date-of- record deadline. This means that if you bought shares on May 2, you would not be entitled to a dividend, whereas had you purchased shares two days earlier, you would receive the dividend check. This may seem unfair until you realize that, theoretically, the stock’s price drops on the ex-dividend date by the amount of the dividend. Thus, by purchasing the stock on May 2, you pay less than if had you purchased the stock two days earlier. Those who sell their shares on May 2 will receive their dividend for stock they no longer own, but they receive less on the sale of their stock than they would have had they sold earlier and foregone the right to collect the dividend. In this way, the dividend payment system works out fairly for all parties.
In the previous paragraph we said “theoretically, the stock’s price drops on the ex- dividend date by the amount of the dividend.” In reality, a company’s stock price may not drop by the exact dividend amount following the ex-dividend date, due to the new infor- mation continually fed into the market. The stock price could actually rise if, for example, the firm announced an oil discovery after the close of trading the previous day. This posi- tive news would more than offset the decline caused by the stock going ex-dividend. Even if there is no new information arriving in the market place that day, the price drop on the ex-dividend rate may be smaller than the dividend per share. This is because investors, on average, need to pay tax on a dividend, so the drop will approximately equal (Dividend) 3 (1 – t), where t is the average tax rate.
Stock Repurchases Firms considering issuing a special dividend will often opt for a stock repurchase instead. Similar to the dividend, the repurchase distributes excess cash to existing shareholders, lowering the potential for agency costs. Once stock is repurchased, it becomes known as treasury stock. Treasury stock is held by the corporation and may be reissued to the public without going through the costly registration requirements associated with issu- ing completely new shares. Many firms also use treasury stock to fund executive bonuses
byr80601_10_c10_285-310.indd 301 1/24/13 3:59 PM
CHAPTER 10Section 10.4 Dividend Policy in Practice
Guess is just one company that decided to repurchase its own stock in the secondary market. Do you think it is fair for companies to do this?
PR Newswire/Associated Press
and employee retirement plans. For this reason, some firms repurchase stock to provide them with shares to fund such programs. Sometimes companies choose to retire the stock, permanently reducing the number of shares outstanding. Stock repurchases can also be used as a takeover defense when a large block of stock is repurchased at a premium from a potential acquirer. These targeted repurchases, called greenmail transactions, were used in the 1980s but are uncommon now.
We will discuss three methods for accomplishing share repurchases: open market pur- chases, fixed-price tender offers, and Dutch Auctions.
In an open market purchase, the corporation buys its own stock in the secondary market, but must publicly announce in advance their intention to repurchase shares. In June 2012, the clothing company Guess announced in a press release that it would “repurchase, from time-to-time and as market and business conditions war- rant, up to $500 million of its common stock” (Guess, 2012). This announcement is typical of open market share buyback programs, with no definite period or price range specified. When the share price drops, the company could become a buyer, and other investors never know if they are selling to the com- pany or other outside investors. Also, there is no assurance that the repurchase plan will ever be completed. In fact, there is evidence that companies actually purchase only about 78% of the announced target number of shares (Stephens & Weisbach, 1998). In the two weeks after the stock market crash of 1987, about 600 companies (9.3% of all listed com- panies in the U.S.) announced open market repurchase programs. Over the following five months, only about 40% of those firms decreased their shares outstanding, while one- third actually saw an increase (Netter & Mitchell, 1989).
Share repurchases are sometimes interpreted as positive signals that the firm’s stock is undervalued. The reasoning behind this signal follows: Managers are looking for posi- tive NPV projects, or projects whose costs are less than their value. With their superior information, managers who choose to repurchase shares send a signal that they consider the firm’s stock to be priced below value, and view the purchase as a positive NPV invest- ment. Knowing that repurchases might be viewed as a signal of the firm’s value, what pre- vents managers from abusing repurchases for corporate gain? There are rules that prevent companies from using open market repurchases to manipulate share prices. For example, the maximum amount of stock that can be bought on a single day is 5% of the average trading volume for the previous month. Additionally, all shares purchased by a firm on a
byr80601_10_c10_285-310.indd 302 1/24/13 3:59 PM
CHAPTER 10Section 10.4 Dividend Policy in Practice
single day must be purchased through a single brokerage firm. (Share buybacks by corpo- rate issuers are governed by the Securities Exchange Act of 1934 under Rule 10b-18, titled Purchases of Certain Equity Securities by the Issuer and Others.)
As opposed to an open market purchase, a tender offer is a formal offer to buy all shares tendered, up to a given total. Firms generally use the tender offer method when repur- chasing a large number of shares. The repurchase price (or bid price) is explicitly stated in the tender offer announcement and exceeds the current market price. Thus, the term bid premium is used to describe the percentage by which the tender offer price exceeds the share’s market price as of the date of the offer’s announcement. Typical bid premiums are 15% to 20% above the preannouncement share price. There is no obligation on the part of the stockholder to tender their shares; if they wish, they can continue to hold them. If more shares are tendered than the number sought by the firm, the tender offer is oversub- scribed, and the corporation has the option of purchasing some or all of the excess shares.
Finally, a Dutch Auction repurchase allows the firm to set a price range it will consider for the shares. Shareholders submit offers with the number of shares they wish to sell at a price within the specified range. When the auction period ends, the company looks at all the offers and creates a supply curve. It then chooses the lowest price that allows it to repurchase the desired number of shares and pays everyone who submitted an offer at or below that price. Let’s consider an example. Company A wants to repurchase 1 million shares for a price between $25 and $30 per share. Table 10.5 shows the range of bids sub- mitted by investors, with the number of bids submitted in the left column, and the price per share for those bids in the middle column. The right column totals up the number of shares, starting at the lowest number and working up to the 1,000,000 goal (similar to what the firm managers will do). The company will reach its target number of shares once it purchases those through the $27.75 price. Therefore the firm will offer this price to all investors submitting offers at or below $27.75, no matter what their actual offer was.
Table 10.5: A Dutch Auction example
Number of shares Price per share Total number of shares (1,000,000 goal)
150,000 $26.00 150,000
250,000 $27.00 400,000
350,000 $27.25 750,000
200,000 $27.50 950,000
50,000 $27.75 1,000,000
150,000 $28.00 1,150,000
On June 28, 2012, AOL (the old America On-Line), announced a Dutch Auction repur- chase. The press release gave the following details: the repurchase was to distribute the proceeds from the sale of AOL patents to Microsoft. Shareholders had until August 2, 2012, to submit their offer to tender shares at a price between $27 and $30 per share. AOL allocated $400 million for the repurchase, but reserved the right to terminate or extend the repurchase (AOL.com, 2012).
byr80601_10_c10_285-310.indd 303 1/24/13 3:59 PM
CHAPTER 10Section 10.4 Dividend Policy in Practice
Stock repurchases via Dutch Auction are different than purchasing shares through the secondary market in that there is more flexibility in the share price. What are some other differences?
Associated Press
A major function of stock repur- chases is to lower the number of outstanding shares. In this respect they differ from special dividends. Because there are fewer outstanding shares, future regular dividends may increase after a repurchase. For exam- ple, if a corporation forecasts that $1,000,000 is available for regular dividends each year for the foreseeable future and has 1,000,000 shares outstanding, then the firm could maintain a $1 per share annual dividend. Let’s assume the firm has suf- ficient additional free cash to either pay a special dividend or repurchase 200,000 shares. If the firm pays a special dividend with this cash, it will continue to pay the $1 per share dividend.
On the other hand, if the excess cash is used to repurchase shares, then only 800,000 shares will be outstanding, and the corporation could theoretically pay a $1.25 per share regular dividend ($1,000,000 distributed among 800,000 shares).
Increasing the dividend level through the reduction of shares means that remaining shares increase in value. Investors, realizing this, will demand a higher price for tendering, lead- ing to the bid premium referred to earlier. Although it might appear that repurchasing shares will increase shareholder wealth more than a special dividend, this is not neces- sarily the case. Note that the share repurchase alternative from the previous paragraph increases the dividend by 25%, from $1 to $1.25. The special dividend alternative distrib- utes cash, enabling individual investors to use these funds to buy additional shares. With the special dividend alternative, shareholders in this example have the option of increas- ing their holdings by 25% if they reinvest the disbursement to buy stock in the corpora- tion. In theory, shareholders’ wealth would be identical under either the special dividend or the share repurchase alternative.
Even though shareholder wealth might be theoretically equal in either alternative, in reality this is not the case. We overlooked taxes in this argument. Dividends are taxed as regular income, but share repurchases may be taxed as capital gains. This creates a tax advantage to the repurchase alternative, putting more cash in the pockets of stock- holders, making it preferable to the dividend option. However, when repurchases are made through a tender offer, the firm incurs considerable transaction costs, which tend to offset some of the tax advantages. Tender offer repurchases are therefore generally reserved for instances where the firm intends to buy back a substantial amount of stock, and transaction costs can be spread across numerous shares with minimal impact on shareholders’ wealth.
byr80601_10_c10_285-310.indd 304 1/24/13 3:59 PM
CHAPTER 10Section 10.4 Dividend Policy in Practice
Stock Dividends and Stock Splits In Section 10.1, we discussed two kinds of cash dividends: regular and special. Here, we will cover a different type of dividend: the stock dividend. A stock dividend is the pay- ment of additional stock to shareholders; they change the number of shares of stock that are outstanding, but do not increase the cash flows paid to investors. Let’s look at an example. Assume a company issues a 10% stock dividend, entitling the holder of 100 shares of stock to 10 additional shares (new total of 110 shares). Note that if this company had 2,000 shares outstanding prior to the stock dividend, it would have 2,200 shares out- standing after the stock dividend—a 10% increase overall. The stockholder’s 100 shares represented a 5% ownership interest in the firm’s equity before the dividend, and the 110 shares represents 5% of the equity after the stock dividend. Thus, the shareholder’s pro- portional claim on the firm’s cash flows remains unchanged at 5%.
A stock split increases the number of shares outstanding by replacing old shares with new shares on a proportional basis. A firm offering a two-for-one split doubles the number of shares outstanding, doubling each individual’s shareholdings. Like a stock dividend, a split does not change a shareholder’s ownership interest in the firm. Our example firm, with 2,000 shares before a two-for-one split, would have 4,000 shares outstanding after the split. An owner of 100 shares would end up with 200 shares, both of which represent 5% of the firm’s equity.
If we think of shares of stock as coins, stock dividends and stock splits are like changing how we count our coins. Before a split let’s say we have four dimes. After a two-for-one split, we have eight nickels, and our value remains unchanged. Another way of viewing this is to realize that the value of stock is grounded in its claim on left-hand-side cash flow–producing assets. All splits and stock dividends do is change the units in which we count the claims, not the value of the left-hand-side assets. Thus, if you own claims total- ing 5% of the total left-hand-side value, it is immaterial whether that 5% is counted as 110 shares, 100 shares, or 200 shares; the value is the same. On the other hand, if accompany- ing the split is a signal of increased left-hand-side value, then an increase in shareholder wealth may occur.
Often with a split, dividends effectively increase. In a two-for-one split, a stock that paid a $3 per share dividend prior to the split would be expected to pay a dividend of $1.50 after the split. However, should the firm announce that the dividend following the split was going to be $1.75 per share, it has revealed some positive information about the value of the stock. In this case, stock selling for $40 prior to the two-for-one split may justifi- ably sell for more than $20 afterward. Of course, the same information could arguably be conveyed by not splitting the stock and simply raising the dividend from $3 to $3.50 per share. Splits, in this case, can be seen as a device used to draw more attention to the posi- tive dividend news.
We have described splits that increase the number of shares and reduce share price, but it can happen the other way. A reverse split represents a proportional reduction in shares that leaves ownership interests and value unchanged. If we go back to the idea of exchang- ing coins, reverse splits are like moving from nickels to dimes. Reserve splits reduce the number of shares outstanding and subsequently increase the price per share. For example, a company could offer one share for every two shares tendered, reducing shares out- standing by 50%. Sometimes reverse splits are used to consolidate control of a company. If a company carries out a reverse split where one share is issued for every 500 tendered,
byr80601_10_c10_285-310.indd 305 1/24/13 3:59 PM
CHAPTER 10Post-Test
Field Trip: Stock Splits
Learn more about upcoming stock splits here: http://biz.yahoo.com/c/s.html
Pick one of the better-known firms announcing a split and find its website using a search engine. The corporation’s site should include information about the upcoming split.
Record the firm’s name, its web address, the split terms, and the date. Then read the rationale given for the split.
Reflection Questions
1. What reason does the company give for splitting its stock? 2. How do you think the split will impact the post-split value of shares?
investors with fewer than 500 shares will be paid in cash, and their shares will be added to the company’s Treasury Stock. The result is that only large shareholders will remain as owners of the company.
Stock dividends and splits are so alike that a rule has been adopted to distinguish them: If the number of shares outstanding changes by more than 25%, the change is termed a stock split. Action involving a change of less than 25% is termed a stock dividend.)
Conclusion
Like the capital structure decision, identifying a firm’s optimal dividend policy can be a challenging task. No formula exists to provide the answer, nor is there general agreement on the wisdom of a particular strategy. Managers can feel confident in their decision if they take a few careful and far-sighted considerations when forecast- ing: Minimize transaction costs, limit potential agency problems, and aim to meet the expectations of investors. Most firms, in fact, follow a pattern of slow but steady dividend growth, supplemented by an occasional special dividend.
Post-Test
1. Regular cash dividends can be thought of as a quasi-fixed cost. a. True b. False
2. When capital markets are perfect, then shareholder wealth is unchanged by a firm’s dividend policy.
a. True b. False
3. A residual dividend policy is when dividends take priority over project fund- ing and residual cash after dividends are paid is used to finance positive NPV projects.
a. True b. False
byr80601_10_c10_285-310.indd 306 1/24/13 3:59 PM
CHAPTER 10Key Ideas
4. The ex-dividend date is two days after the date of record. a. True b. False
5. When companies sell a division for cash, they a. will likely increase regular dividends. b. will likely engage in a reverse stock split. c. often pay a special dividend. d. often pay a stock dividend.
6. Which of the following were NOT discussed as supporting the irrelevance of dividend policy in perfect markets?
a. Inclusion of transaction costs b. Ability to create homemade dividends c. Conversion of wealth from common stock to cash d. No premiums on stocks, regardless of payout
7. Fast growing firms with many potential investment projects under consideration probably will
a. appeal to retired investors because of the dividend policy typically adopted by these types of firms.
b. adopt high dividend payout ratios. c. lack enough profit to pay a dividend. d. adopt low payouts and appeal to younger investors.
8. If a firm announces that it will decrease the number of shares by exchanging two old shares for one new share, then the firm has
a. initiated a reverse split. b. initiated a 2 for 1 split. c. initiated the equivalent of a 50% stock dividend. d. increased the value of each investor’s wealth because the new share price
should be about double what the old price was.
Answers 1. a. True. The answer can be found in Section 10.1. 2. a. True. The answer can be found in Section 10.2. 3. b. False. The answer can be found in Section 10.3. 4. b. False. The answer can be found in Section 10.4. 5. c. often pay a special dividend. The answer can be found in Section 10.1. 6. a. Inclusion of transaction costs. The answer can be found in Section 10.2. 7. d. adopt low payouts and appeal to younger investors. The answer can be found in Section 10.3. 8. a. initiated a reverse split. The answer can be found in Section 10.4.
Key Ideas
• When capital markets are perfect, dividend policy is irrelevant. • When a corporation raises its regular dividend, the increase carries with it the
implicit promise that the new level of payment can be maintained. • The decision to increase a regular dividend is a signal that the firm can support a
higher payment level.
byr80601_10_c10_285-310.indd 307 1/24/13 3:59 PM
CHAPTER 10Critical Thinking Questions
• Dividend payments tend to lower a corporation’s free cash flow and may, there- fore, lower agency costs.
• Many firms attempt to manage investors’ expectations by adopting a smooth stream dividend strategy.
• An alternative to paying a special dividend is to repurchase shares. • Stock dividends and stock splits change the number of shares of stock that are
outstanding but do not increase the cash flows that are paid to investors.
Critical Thinking Questions
1. Investors and stock analysts are forward-looking. They are concerned with expected future dividends when estimating value. There are occasions when these analysts see a firm’s problems even before management faces up to the difficulties. Explain why a stock’s price might increase when the firm announces it is lowering its dividend and will use the retained cash to retool an inefficient factory.
2. Suppose Bioenergy, Inc. has a market value of $50,000,000 and is 100% equity financed. Its market value per share is $25 because there are 2,000,000 shares outstanding. The firm pays no dividend. At the last shareholders’ meeting, there were complaints about the no-dividend policy. As a director of Bioenergy, what factors should you consider as you contemplate initiating a dividend? [Hint: Discuss why you should analyze (a) the current and expected level of cash flows, (b) the cash needed to fund expected positive NPV investment opportunities, (c) the variability of expected cash flows, (d) other means of financing investment projects and the costs associated with using other sources of capital, and (e) if there have been some wasted funds expended in the firm in the past.]
3. On Thursday, May 3, the board of directors of ACME, Inc. declares a $1.50 per share dividend, payable on Thursday, May 31 to the shareholders of record as of Thursday, May 17. When is the ex-dividend date? Do you think it is a good idea to buy the stock on May 8 and sell it on May 15? Why or why not?
4. Dividend reinvestment plans (DRPs) are in place at many large corporations. DRPs allow stockholders to have their dividends automatically reinvested in the company’s stock. Stockholders avoid brokerage commissions by participating in DRPs, and at times the firm sells the stock to plan participants at a light (3–5%) discount from the current market price. What clientele do you think might find this feature attractive?
5. What kind of dividend policy would you expect growth companies to have? Why?
6. One motive for stock splits is the trading range hypothesis. The argument says that stocks with high prices tend not to be bought by many small investors. Thus, lowering the price per share by way of a stock split makes the stock more attrac- tive to the low-price clientele. More demand for the stock should increase equi- ty’s value. Do you think this is true? Why or why not?
byr80601_10_c10_285-310.indd 308 1/24/13 3:59 PM
CHAPTER 10Key Terms
bid premium The percentage by which the tender offer price exceeds the share’s market price as of the date of the offer’s announcement. Typical bid premiums are 15% to 20% above the preannouncement share price.
constant dollar dividend policy A divi- dend policy where the company pays the same dollar amount every year unless the dividend increases. A company that follows this policy has made an implicit promise to continue to pay dividends, year after year, at or above the current regular dividend level.
date of record The date the corporation uses to determine who owns shares and is entitled to the dividend proceeds.
dividend payment date This date is a few weeks after the date of record, the payment delay being necessary to allow paperwork and check writing to be completed.
dividend policy The distribution of residual cash to shareholders.
ex-dividend date The date on or after which a security begins trading without the dividend included in the contract price.
growth companies Firms with numer- ous projects that continually reinvest their residual cash into positive NPV investments.
income stocks Stocks that pay a relatively high dividend.
open market purchases When a corpora- tion buys its own stock in the secondary market just as any other investor. The firm must publicly announce its intention to repurchase shares in advance.
oversubscribed During a tender offer, each stockholder may elect to tender shares or continue to hold the shares. When more shares are tendered than the number sought by the firm, it has the option of purchasing some or all of the excess shares tendered.
payout ratio Target policy where a percent of earnings is distributed as dividends.
reverse split A proportional reduction in shares that leaves ownership interests and value unchanged.
regular dividends A dividend on com- mon stock that is intended to be paid peri- odically in equal amounts over the course of a year, typically quarterly.
residual dividend policy Dividend policy that distributes any remaining funds to investors after making all profitable invest- ments first.
special dividends A higher than usual payout to stockholders in a company as a share of company profits (may not be continued).
stock dividend The payment per share that a corporation distributes to its stock- holders as the return on their investment.
stock repurchase A firm’s repurchase of outstanding shares of its common stock.
stock split An increase in the number of shares outstanding by replacing old shares with new shares on a proportional basis.
tender offer An acquisition bid made directly to shareholders and not need- ing the approval of the target company’s management.
Key Terms
byr80601_10_c10_285-310.indd 309 1/24/13 3:59 PM
CHAPTER 10Web Resources
Key Formulas
(10.1) Value 5 a`t 5 1
CFt
11 1 r2 t
(10.2) Value 5 a`t 5 1
Dt
11 1 r2 t
(10.3) NPV 5 aaNt 5 1
CFt
11 1 r2 tb 2 Initial investment
(10.4) NPV 5 Value – Initial investment
(10.5) NPV 5 Price – Initial investment
Web Resources
Many investors rely on a company’s dividend yield as a guide to selecting stocks. To learn more about how the “dogs” are selected, go to: http://www.dogsofthedow.com
The Stock Center at Market Edge is a good source of dividend information: http://www.marketedge.com/
An excellent website about corporate finance and valuation has been created by NYU finance professor Aswath Damodaran: http://pages.stern.nyu.edu/~adamodar/
treasury stock Treasury stock is held by the corporation and may be reissued to the public without going through the costly registration requirements that issuing com- pletely new shares entails.
byr80601_10_c10_285-310.indd 310 1/24/13 3:59 PM
