FINC 331-WEEK 7: Cash Collections

Chapter 15 “Dividends” from Finance by Boundless is used under the terms of the Creative Commons Attribution-ShareAlike 3.0 Unported license. © 2014, boundless.com. UMGC has modified this work and it is available under the original license.

(UMGC, 2014)-Retrieved from https://leocontent.umgc.edu/content/dam/equella-content/finc331/Chapter15Dividends.pdf

C h a p te r 15

D iv id en

d s

ht tp s: // w w w .b ou

nd le ss .c om

/ na

nc e/ d iv id en

d s/

D e

ni ng

D iv id en

d s

Th e N at ur e of

D iv id en

d s

D iv id en

d Ir re le va

nc e Th

eo ry

Va lu e of

a Lo

w D iv id en

d

Se ct io n 1

W ha

t ar e D iv id en

d s

79 2

ht tp s: // w w w .b ou

nd le ss .c om

/ na

nc e/ d iv id en

d s/ w ha

t- ar e- d iv id en

d s/

D e

ni ng

D iv id en

d s

D iv id en

d s ar e a p or tio

n of

co m p an

y ea

rn in gs

re gu

la rly

p ai d to

sh ar eh

ol d er s,

p ai d as

so m e x

ed am

ou nt

p er

sh ar e p ric

e.

K E Y P O IN TS

• D iv id en d s ar e p er io d ic al p ay m en ts a co rp or at io n ca n ch oo se

to is su e to it s sh ar eh ol d er s, w it h th e am ou n t of p ay m en t to

ea ch sh ar eh ol d er co m m en su ra te w it h th ei r n u m be r of sh ar es .

T h ey m ay be p ai d as ca sh ,a d d it io n al st oc k, or p ro p er ty .

• D iv id en d s m ay al so be ca te go ri ze d as co m m on st oc k or

p re fe rr ed d iv id en d s; p re fe rr ed st oc k ow n er s ge t th ei r

d iv id en d s p ai d in fu ll fi rs t, be fo re an y co m m on st oc k

d iv id en d s ar e d is tr ib u te d .

• R at io s u si n g d iv id en d va lu e, su ch as d iv id en d s p er sh ar e

(D P S) ,d iv id en d yi el d ,a n d p ay ou t ra ti o h av e h is to ri ca ll y be en

u se d as in d ic at or s of a st oc k' s in ve st m en t st re n gt h an d th e

co m p an y' s ov er al lp er fo rm an ce ,t h ou gh th ei r u se fu ln es s h as

be en co n te st ed .

D iv id en d s ar e p ay m en ts m ad e by a co rp or at io n to it s sh ar eh ol d er

m em be rs on a re gu la r (u su al ly qu ar te rl y) ba si s– th es e ar e es se n ti al ly

th e sh ar eh ol d er 's p or ti on of a co m p an y' s p ro fi ts .A d iv id en d is

al lo ca te d as a fi xe d am ou n t p er sh ar e. T h er ef or e, a sh ar eh ol d er

re ce iv es a d iv id en d in p ro p or ti on to th ei r sh ar eh ol d in g; ow n in g

m or e sh ar es re su lt s in gr ea te r d iv id en d s fo r th e sh ar eh ol d er .W h en

it is ti m e to m ak e d iv id en d p ay m en ts ,c or p or at io n s al w ay s p ay

p re fe rr ed st oc k ow n er s fi rs t, an d th en co m m on st oc k d iv id en d s ar e

al lo ca te d af te r al lp re fe rr ed d iv id en d s ar e p ai d in fu ll .I n th e U n it ed

St at es ,d iv id en d s ar e u su al ly d ec la re d qu ar te rl y by th e co rp or at io n 's

bo ar d of d ir ec to rs ( F ig u re 15 .1 ).

D iv id e n d s p e r sh a re (D P S) re fe rs to th e d ol la r am ou n t

sh ar eh ol d er s ea rn fo r ea ch sh ar e, ca lc u la te d by d iv id in g to ta l

d iv id en d am ou n t by to ta ln u m be r of sh ar es ou ts ta n d in g. D iv id en d

yi el d re fe rs th e ra ti o be tw ee n d iv id en d s p er sh ar e an d th e m ar ke t

p ri ce of ea ch sh ar e, an d it is ex p re ss ed in te rm s of p er ce n ta ge .

79 3

Th is is an

ad fo r Fr an

kl in

A ut om

ob ile

C om

p an

y fr om

a 19

22 is su

e of

th e

B os

to n G lo b e,

p ro m ot in g th e r m 's

p re fe rr ed

st oc

k as

a "s ou

rc e of

re lia b le

in co

m e"

b ec

au se

of its

7% d iv id en

d p ai d in

q ua

rt er ly in te rv al s.

Fi g ur e 15

.1 Fi g 1. H is to ric al d iv id en d

in fo rm

at io n fo r Fr an kl in A ut om

ob ile

C om

p an y

P ay ou t ra ti o is ca lc u la te d by d iv id in g th e co m p an y' s d iv id en d by th e

ea rn in gs p er sh ar e. A p ay ou t ra ti o gr ea te r th an 1 m ea n s th e

co m p an y is p ay in g ou t m or e in d iv id en d s fo r th e ye ar th an it

ea rn ed ,w h il e a lo w p ay ou t ra ti o in d ic at es th at th e co m p an y is

re ta in in g a gr ea te r p ro p or ti on of th ei r ea rn in gs in st ea d of p ay in g

ou t d iv id en d s. T h es e ra ti os h av e h is to ri ca ll y be en u se d as in d ic at or s

of a st oc k' s in ve st m en t st re n gt h an d th e co m p an y' s ov er al l

p er fo rm an ce .

D iv id en d s m ay be al lo ca te d in d if fe re n t fo rm s of p ay m en t, ou tl in ed

be lo w :C as h d iv id en d s ar e th e m os t co m m on .A s th e n am e su gg es ts ,

th es e ar e p ai d ou t as cu rr en cy vi a el ec tr on ic fu n d s tr an sf er or a

p ri n te d p ap er ch ec k. F or ea ch sh ar e ow n ed ,a d ec la re d am ou n t of

m on ey is d is tr ib u te d .T h u s, if a p er so n ow n s 10 0 0 sh ar es an d th e

ca sh d iv id en d is U SD 0 .9 0 p er sh ar e, th e h ol d er of th e st oc k w il lb e

p ai d U SD 90 0 .S to ck d iv id en d s (a ls o kn ow n as sc ri p s) ar e p ay m en ts

in th e fo rm of ad d it io n al st oc k sh ar es of th e co m p an y it se lf or on e of

it s su bs id ia ri es ,a s th e n am e su gg es ts .T h is m ay be a m or e p al at ab le

op ti on fo r co m p an ie s w h o w ou ld p re fe r to u se it s ea rn in gs to w ar d s

gr ow th of th e co m p an y, ra th er th an d iv er ti n g th em in to ca sh

d iv id en d s fo r sh ar eh ol d er s. P ro p er ty d iv id en d s or d iv id en d s in

sp ec ie (L at in fo r "i n ki n d ") ar e th os e p ai d ou t in th e fo rm of as se ts

fr om th e is su in g co rp or at io n or an ot h er co rp or at io n ,s u ch as a

su bs id ia ry co rp or at io n .T h ey ar e re la ti ve ly ra re an d ca n ta ke th e

fo rm of se cu ri ti es of ot h er co m p an ie s ow n ed by th e is su er ,o r

p ro d u ct s an d se rv ic es .C om p an ie s m ay al so of fe r re in ve st m en t

p la n s w h er e sh ar eh ol d er s ca n au to m at ic al ly re in ve st d iv id en d s in to

m or e st oc k.

F or p u bl ic co m p an ie s, th er e ar e si x im p or ta n t d at es to re m em be r

re ga rd in g d iv id en d s:

• D ec la ra ti on d at e is th e d ay th e bo ar d of d ir ec to rs an n ou n ce s

it s in te n ti on to p ay a d iv id en d .O n th is d ay ,a li ab il it y is

cr ea te d an d th e co m p an y re co rd s th at li ab il it y on it s bo ok s; it

n ow ow es th e m on ey to th e st oc kh ol d er s. T h e bo ar d w il la ls o

an n ou n ce a d at e of re co rd an d a p ay m en t d at e.

• In -d iv id en d d at e is th e la st d ay ,w h ic h is on e tr ad in g d ay

be fo re th e ex -d iv id en d d at e, w h er e th e st oc k is sa id to be cu m

d iv id en d (' w it h [i n cl u d in g] d iv id en d ') .I n ot h er w or d s, ex is ti n g

h ol d er s of th e st oc k an d an yo n e w h o bu ys it on th is d ay w il l

re ce iv e th e d iv id en d ,w h er ea s an y h ol d er s se ll in g th e st oc k

lo se th ei r ri gh t to th e d iv id en d .A ft er th is d at e th e st oc k

be co m es ex -d iv id en d .

• E x- d iv id en d d at e (t yp ic al ly tw o tr ad in g d ay s be fo re th e re co rd

d at e fo r U .S .s ec u ri ti es ) is th e d ay on w h ic h al ls h ar es bo u gh t

an d so ld n o lo n ge r co m e at ta ch ed w it h th e ri gh t to be p ai d th e

m os t re ce n tl y d ec la re d d iv id en d .T h is is an im p or ta n t d at e fo r

an y co m p an y th at h as m an y st oc kh ol d er s, in cl u d in g th os e th at

tr ad e on ex ch an ge s, as it m ak es re co n ci li at io n of w h o is to be

p ai d th e d iv id en d ea si er .E xi st in g h ol d er s of th e st oc k w il l

79 4

re ce iv e th e d iv id en d ev en if th ey n ow se ll th e st oc k, w h er ea s

an yo n e w h o n ow bu ys th e st oc k w il ln ot re ce iv e th e d iv id en d .

It is re la ti ve ly co m m on fo r a st oc k' s p ri ce to d ec re as e on th e

ex -d iv id en d d at e by an am ou n t ro u gh ly eq u al to th e d iv id en d

p ai d .T h is re fl ec ts th e d ec re as e in th e co m p an y' s as se ts

re su lt in g fr om th e d ec la ra ti on of th e d iv id en d .T h e co m p an y

d oe s n ot ta ke an y ex p li ci t ac ti on to ad ju st it s st oc k p ri ce ;i n an

ef fi ci en t m ar ke t, bu ye rs an d se ll er s w il la u to m at ic al ly p ri ce

th is in .

• B oo k cl os u re d at e is w h en co m p an y w il li d ea ll y te m p or ar il y

cl os e it s bo ok s fo r fr es h tr an sf er s of st oc k.

• R ec or d d at e re fe rs to th e d at e th at sh ar eh ol d er s m u st be

re gi st er ed on re co rd in or d er to re ce iv e th e d iv id en d .

Sh ar eh ol d er s w h o ar e n ot re gi st er ed as of th is d at e w il ln ot

re ce iv e th e d iv id en d .

• P ay m en t d at e is th e d ay w h en th e d iv id en d s w il la ct u al ly be

d is tr ib u te d to th e sh ar eh ol d er s of a co m p an y or cr ed it ed to

br ok er ag e ac co u n ts .

So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /d iv id en d s/ w ha t- a re -

d iv id en d s/ d ef in in g -d iv id en d s/

C C -B Y -S A

B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e

Th e N at ur e of

D iv id en

d s

D iv id en

d s ar e at tr ac

tiv e to

m an

y in ve

st or s b ec

au se

th ey

ar e se

en as

st ea

d y st re am

s of

in co

m e fr om

lo w

ris k

in ve

st m en

ts .

K E Y P O IN TS

• D iv id en d s of fe r co n si st en t re tu rn s on re la ti ve ly lo w ri sk

in ve st m en ts .W h il e co m p an ie s ex p er ie n ci n g ra p id gr ow th ar e

u n li ke ly to of fe r d iv id en d s, es ta bl is h ed co m p an ie s w it h st ab le

bu si n es s an d le ss ro om to gr ow d o p ay d iv id en d s to

sh ar eh ol d er s.

• A fi rm 's d iv id en d d ec is io n m ay al so se rv e as a si gn al in g

d ev ic e ab ou t a fi rm 's fu tu re p ro sp ec ts .D u e to in fo rm at io n

as ym m et ry be tw ee n in ve st or s an d th e fi rm m an ag er s,

in ve st or s w il ll oo k to in d ic at or s li ke d iv id en d d ec is io n s,

w h ic h m ay gi ve cl u es ab ou t w h at th e fi rm m an ag er s fo re ca st

fo r th e fi rm .

• C ri ti cs of d iv id en d s co n te n d th at co m p an y p ro fi ts ar e be tt er

u se d re in ve st ed ba ck in to th e co m p an y fo r re se ar ch ,

d ev el op m en t, an d ca p it al ex p an si on .

T h e n at u re of d iv id en d s m ay ap p ea lt o in ve st or s be ca u se th ey of fe r

co n si st en t re tu rn s on re la ti ve ly lo w ri sk in ve st m en ts .W h il e

co m p an ie s ex p er ie n ci n g ra p id gr ow th ar e u n li ke ly to of fe r

79 5

d iv id en d s, es ta bl is h ed co m p an ie s w it h st ab le bu si n es s an d le ss

ro om to gr ow d o p ay d iv id en d s to sh ar eh ol d er s. D es p it e th e lo w

ea rn in gs gr ow th of th es e st oc ks ,s h ar eh ol d er s ge t th e be n ef it of

kn ow in g th at th e va lu e of th ei r in it ia li n ve st m en t is li ke ly to re m ai n

st ab le .T h ey ca n st il lp ro fi t of fa st ea d y st re am of d iv id en d

p ay m en ts .

A fi rm 's d iv id e n d d e ci si o n m ay al so se rv e as a si gn al in g d ev ic e

w h ic h gi ve s cl u es ab ou t a fi rm 's fu tu re p ro sp ec ts .D u e to

in fo rm at io n as ym m et ry be tw ee n in ve st or s an d th e fi rm m an ag er s,

in ve st or s w il ll oo k to in d ic at or s li ke d iv id en d d ec is io n s. St u d ie s

h av e sh ow n th at st oc k p ri ce s te n d to in cr ea se w h en an in cr ea se in

d iv id en d s is an n ou n ce d an d te n d to d ec re as e w h en a d ec re as e or

om is si on is an n ou n ce d .M an ag er s h av e m or e in fo rm at io n th an

in ve st or s ab ou t th e fi rm ,a n d su ch in fo rm at io n m ay in fo rm th ei r

d iv id en d d ec is io n s. W h en m an ag er s la ck co n fi d en ce in th e fi rm 's

ab il it y to ge n er at e ca sh fl ow s in th e fu tu re th ey m ay ke ep d iv id en d s

co n st an t or p os si bl y ev en re d u ce th e am ou n t of d iv id en d s p ai d ou t.

C on ve rs el y, m an ag er s th at h av e ac ce ss to in fo rm at io n th at in d ic at es

ve ry go od fu tu re p ro sp ec ts fo r th e fi rm ar e m or e li ke ly to in cr ea se

d iv id en d s.

In ve st or s ca n u se th is kn ow le d ge ab ou t m an ag er s' be h av io r to

d et er m in e th ei r d ec is io n to bu y or se ll th e fi rm 's st oc k, bi d d in g th e

p ri ce u p in th e ca se of a p os it iv e d iv id en d su rp ri se or se ll in g it d ow n

w h en d iv id en d s d o n ot m ee t ex p ec ta ti on s. T h is ,i n tu rn ,m ay

in fl u en ce th e d iv id en d d ec is io n as m an ag er s kn ow th at st oc k

h ol d er s cl os el y w at ch d iv id en d an n ou n ce m en ts lo ok in g fo r go od or

ba d n ew s. M an ag er s te n d to av oi d se n d in g a n eg at iv e si gn al to th e

m ar ke t ab ou t th e fu tu re p ro sp ec ts of th ei r fi rm .T h is al so te n d s to

le ad to a d iv id en d p ol ic y of a st ea d y, gr ad u al ly in cr ea si n g p ay m en t

(F ig u re 15 .2 ).

O n th e ot h er h an d ,c ri ti cs of d iv id en d s co n te n d th at co m p an y

p ro fi ts ar e be st re -i n ve st ed ba ck in to th e co m p an y fo r re se ar ch an d

d ev el op m en t, ca p it al ex p an si on ,a n d so fo rt h .T h ei r vi ew is th at an

ea ge rn es s to re tu rn p ro fi ts to sh ar eh ol d er s m ay si gn al to in ve st or s

th at th e m an ag em en t d oe s n ot h av e id ea s fo r th e fi rm 's fu tu re

p ro sp ec ts .

79 6

S to ck

p ric

es m ay

b e

in fo rm

ed b y a r m 's

d iv id en

d d ec

is io ns

.

Fi g ur e 15

.2 S to ck

p ric es

sh ow

n in a tic ke r in

To ky o, Ja p an

So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /d iv id en d s/ w ha t- a re -

d iv id en d s/ th e- n a tu re -o f- d iv id en d s/

C C -B Y -S A

B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e

D iv id en

d Ir re le va

nc e Th

eo ry

U nd

er p er fe ct

m ar ke

t co

nd iti on

s, st oc

kh ol d er s w ou

ld ul tim

at el y b e in d i er en

t b et w ee

n re tu rn s fr om

d iv id en

d s

or re tu rn s fr om

ca p ita

lg ai ns

.

K E Y P O IN TS

• D iv id en d ir re le va n ce co m es fr om M od ig li an i- M il le r' s ca p it al

ir re le va n ce m od el ,w h ic h w or ks u n d er sp ec if ic m ar ke t

co n d it io n s– n o ta xe s, n o tr an sa ct io n co st s, an d n o fl ot at io n

co st s. In ve st or s an d fi rm s m u st h av e id en ti ca lb or ro w in g an d

le n d in g ra te s an d th e sa m e in fo rm at io n on th e fi rm 's

p ro sp ec ts .

• F ir m s th at p ay m or e d iv id en d s of fe r le ss st oc k p ri ce

ap p re ci at io n .H ow ev er ,t h e to ta lr et u rn fr om bo th d iv id en d s

an d ca p it al ga in s to st oc kh ol d er s sh ou ld be th e sa m e, so

st oc kh ol d er s w ou ld u lt im at el y be in d if fe re n t be tw ee n th e tw o

ch oi ce s.

• If d iv id en d s ar e to o sm al l, a st oc kh ol d er ca n si m p ly ch oo se to

se ll so m e p or ti on of th ei r st oc k fo r ca sh an d vi ce ve rs a.

E co n om is ts M od ig li an ia n d M il le r p u t fo rt h a th eo ry th at on ly th e

fi rm 's ab il it y to ea rn m on ey an d ri sk in es s of it s ac ti vi ty ca n h av e an

im p ac t on th e va lu e of th e co m p an y; th e va lu e of a fi rm is

u n af fe ct ed by h ow th at fi rm is fi n an ce d .I t d oe s n ot m at te r if th e

79 7

fi rm 's ca p it al is ra is ed

by is su in g st oc k or

se ll in g d eb t, n or d oe s

it m at te r w h at th e

fi rm 's d iv id en d p ol ic y

is .D iv id en d

ir re le va n ce fo ll ow s

fr om th is ca p it al

st ru ct u re ir re le va n ce

(F ig u re 15 .3 ).

M od ig li an i- M il le r gr ou n d ed th ei r th eo ry on a se t of as su m p ti on s:

• N o ti m e la g an d tr an sa ct io n co st s ex is t.

• Se cu ri ti es ca n be sp li t in to an y p ar ts (i .e ., th ey ar e d iv is ib le ).

• N o ta xe s an d fl ot at io n co st s.

• F in an ci al le ve ra ge d oe s n ot af fe ct th e co st of ca p it al .

• B ot h m an ag er s an d in ve st or s h av e ac ce ss to th e sa m e

in fo rm at io n .

• F ir m 's co st of eq u it y is n ot af fe ct ed in an y w ay by d is tr ib u ti on

of in co m e be tw ee n d iv id en d an d re ta in ed ea rn in gs .

• D iv id en d p ol ic y h as n o im p ac t on fi rm 's ca p it al bu d ge t

U n d er th es e fr ic ti on le ss p er fe ct ca p it al m ar ke t as su m p ti on s,

d iv id en d ir re le va n ce fo ll ow s fr om th e M od ig li an i- M il le r th eo re m .

E ss en ti al ly ,f ir m s th at p ay m or e d iv id en d s of fe r le ss st oc k p ri ce

ap p re ci at io n th at w ou ld be n ef it st oc k ow n er s w h o co u ld ch oo se to

p ro fi t fr om se ll in g th e st oc k. H ow ev er ,t h e to ta lr et u rn fr om bo th

d iv id en d s an d ca p it al ga in s to st oc kh ol d er s sh ou ld be th e sa m e. If

d iv id en d s ar e to o sm al l, a st oc kh ol d er ca n si m p ly ch oo se to se ll

so m e p or ti on of h is st oc k. T h er ef or e, if th er e ar e n o ta x ad va n ta ge s

or d is ad va n ta ge s in vo lv ed w it h th es e tw o op ti on s, st oc kh ol d er s

w ou ld u lt im at el y be in d if fe re n t be tw ee n re tu rn s fr om d iv id en d s or

re tu rn s fr om ca p it al ga in s.

Si n ce th e p u bl ic at io n of th e p ap er s by M od ig li an ia n d M il le r,

n u m er ou s st u d ie s h av e sh ow n th at it d oe s n ot m ak e an y d if fe re n ce

to th e w ea lt h of sh ar eh ol d er s w h et h er a co m p an y h as a h ig h

d iv id en d yi el d or if a co m p an y u se s it s ea rn in gs to re in ve st in th e

co m p an y an d ac h ie ve s h ig h er gr ow th .H ow ev er ,t h e im p or ta n ce of a

fi rm 's d iv id en d d ec is io n is st il lc on te st ed ,w it h a n u m be r of th eo ri es

ar gu in g fo r d iv id en d re le va n ce .

So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /d iv id en d s/ w ha t- a re -

d iv id en d s/ d iv id en d -i rr el ev a n ce -t he or y/

C C -B Y -S A

B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e

79 8

M er to n M ill er ,o

ne of

th e co

-a ut ho

rs of

th e ca

p ita

l irr el ev

an ce

th eo

ry w hi ch

im p lie d

d iv id en

d irr el ev

an ce

.

Fi g ur e 15

.3 M er to n

M ill er

Va lu e of

a Lo

w D iv id en

d Lo

w d iv id en

d p ay

ou ts

ca n b e in te rp re te d in

a nu

m b er

of w ay

s, in cl ud

in g:

as a le ad

in g in d ic at or

of fu tu re

gr ow

th or

a si gn

of in st ab

ili ty .

K E Y P O IN TS

• A re la ti ve ly lo w p ay ou t co u ld m ea n th at th e co m p an y is

re ta in in g m or e ea rn in gs to w ar d d ev el op in g th e fi rm in st ea d

of p ay in g st oc kh ol d er s, w h ic h h in ts at fu tu re gr ow th .F u tu re

ca p it al ga in s al so h av e ta x ad va n ta ge s. T h es e ar e al lf ac to rs in

fa vo r of in ve st in g in st oc ks w it h lo w d iv id en d s.

• If a st oc k h as a lo w d iv id en d yi el d ,t h is im p li es th at th e

st oc k' s m ar ke t p ri ce is co n si d er ab ly h ig h er th an th e d iv id en d

p ay m en ts a sh ar eh ol d er ge ts fr om ow n in g th e st oc k. T h is m ay

in d ic at e an ov er va lu ed st oc k or la rg er d iv id en d s in th e fu tu re .

• A h is to ry of lo w or fa ll in g yi el d s m ay in d ic at e th at th e fi rm 's

ca sh si tu at io n is n ot st ab le .T h ey ca n n ot af fo rd to gi ve h ig h er

d iv id en d s be ca u se th ey d o la ck ca sh on h an d .A s a re su lt ,

th er e is so m e m ea su re of ri sk in vo lv ed w it h th es e lo w

d iv id en d in ve st m en ts .

T h e va lu e of a d iv id en d is ex p re ss ed as so m e p er ce n ta ge p ro p or ti on

of th e n u m be r of sh ar es h el d .A re la ti ve ly lo w p ay ou t co u ld m ea n

th at th e co m p an y is re ta in in g m or e ea rn in gs to w ar d d ev el op in g th e

fi rm in st ea d of p ay in g st oc kh ol d er s. So m e in ve st or s w ou ld p re fe r

th is lo w p ay ou t be ca u se it h in ts at fu tu re gr ow th .F u rt h er m or e,

re ta in ed ea rn in gs le ad to lo n g- te rm ca p it al ga in s, w h ic h h av e

ta xa ti on ad va n ta ge s ov er h ig h d iv id en d p ay ou ts ,a cc or d in g to th e

T ax at io n P re fe re n ce T h eo ry .T ax es on ca p it al ga in s ar e d ef er re d in to

th e fu tu re w h en th e st oc k is ac tu al ly so ld ,a s op p os ed to

im m ed ia te ly li ke ca sh d iv id en d s. F u rt h er m or e, ca p it al ga in s ar e

ta xe d at lo w er ra te s th an d iv id en d s. T h er ef or e, ta xa ti on be n ef it is

an ot h er p oi n t in fa vo r of lo w d iv id en d p ay ou ts (F ig u re 15 .4 ).

H ow ev er ,u n d er d iv id en d ir re le va n ce th eo ry ,t h e ac tu al va lu e of a

d iv id en d is in co n se qu en ti al to in ve st or s. If th e d iv id en d is to o lo w ,

th ey ca n si m p ly se ll of fp ar t of th ei r p or tf ol io to ge n er at e m or e

in co m e fo r th em se lv es .T h e co n fl ic ti n g th eo ri es on d iv id en d p ol ic y

co m p li ca te in te rp re ta ti on s of lo w d iv id en d s in re al li fe .

D iv id en d va lu e m u st al so be co n si d er ed in re la ti on to ot h er

m ea su re s of th e fi rm ,s u ch as th ei r ea rn in gs an d st oc k p ri ce .

79 9

A cc

or d in g to

th e cl ie nt el e e

ec t,

r m s o

er in g lo w

d iv id en

d p ay

ou t

w ill at tr ac

t ce

rt ai n in ve

st or s w ho

ar e

lo ok

in g fo r a lo ng

te rm

in ve

st m en

t an

d w ou

ld lik e to

av oi d ta xe

s.

Fi g ur e 15

.4 In ve st or

p re fe re nc es

fo r lo w d iv id en d p ay ou ts

If a st oc k h as a lo w d iv id e n d yi e ld ,t h is im p li es th at th e st oc k' s

m ar ke t p ri ce is co n si d er ab ly h ig h er th an th e d iv id en d p ay m en ts a

sh ar eh ol d er ge ts fr om ow n in g th e st oc k. T h er e ar e a n u m be r of

w ay s to in te rp re t th is ra ti o. A h is to ry of lo w or fa ll in g yi el d s m ay

in d ic at e th at th e fi rm 's ca sh si tu at io n is n ot st ab le .T h ey ca n n ot

af fo rd to gi ve h ig h er d iv id en d s be ca u se th ey d o la ck ca sh on h an d .

T h is in st ab il it y ca n be se en in ca lc u la ti n g th e d iv id e n d co ve r,

w h ic h is ca lc u la te d as D C = E P S/ D P S. A ra ti o of 2 or h ig h er is

co n si d er ed sa fe — in th e se n se th at th e co m p an y ca n w el la ff or d th e

d iv id en d — bu t an yt h in g be lo w 1. 5 is ri sk y. If th e ra ti o is u n d er 1, th e

co m p an y is u si n g it s re ta in ed ea rn in gs fr om a p re vi ou s ye ar to p ay

th is ye ar 's d iv id en d ,w h ic h si gn al s th e ri sk of in st ab il it y an d p oo r

p er fo rm an ce of th e fi rm .S ig n s of ri sk w il ld et er in ve st or s,

p ar ti cu la rl y if th ey ar e lo ok in g fo r ca sh d iv id en d s as a st ea d y so u rc e

of in co m e.

C on ve rs el y, a lo w d iv id en d yi el d ca n be co n si d er ed ev id en ce th at

th e fi rm is ex p er ie n ci n g ra p id gr ow th or th at fu tu re d iv id en d s m ig h t

be h ig h er .I n ve st or s w h o p re fe r a "g ro w th in ve st m en t" st ra te gy m ay

p re fe r a st oc k w it h lo w to n o d iv id en d yi el d s, as th at is on e of

se ve ra li n d ic at or s fo r a fi rm ex p er ie n ci n g qu ic k gr ow th .

So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /d iv id en d s/ w ha t- a re -

d iv id en d s/ va lu e- of -a -l ow -d iv id en d /

C C -B Y -S A

B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e

80 0

A cc

ou nt in g C on

si d er at io ns

In ve

st or

P re fe re nc

es

S to ck

D iv id en

d s ve

rs us

C as

h D iv id en

d s

S ig na

lin g

C lie nt el e

Se ct io n 2

D iv id en

d P ol ic y

80 1

ht tp s: // w w w .b ou

nd le ss .c om

/ na

nc e/ d iv id en

d s/ d iv id en

d -p ol ic y/

A cc

ou nt in g C on

si d er at io ns

A cc

ou nt in g fo r d iv id en

d s d ep

en d s on

th ei r p ay

m en

t m et ho

d (c as

h or

st oc

k) .

K E Y P O IN TS

• C as h d iv id en d s ar e p ay m en ts ta ke n d ir ec tl y fr om th e fi rm 's

in co m e. T h is is fo rm al ly ac co u n te d fo r by m ar ki n g th e

am ou n t d ow n as a li ab il it y fo r th e fi rm .T h e am ou n t is

tr an sf er re d in to a se p ar at e d iv id en d s p ay ab le ac co u n t an d

th is is d eb it ed on p ay m en t d ay .

• A cc ou n ti n g fo r st oc k d iv id en d s is es se n ti al ly a tr an sf er fr om

re ta in ed ea rn in gs to p ai d -i n ca p it al .

• U n li ke ca sh d iv id en d s, st oc k d iv id en d s d o n ot co m e ou t of th e

fi rm 's in co m e, so th e fi rm is ab le to bo th m ai n ta in th ei r ca sh

an d of fe r d iv id en d s. T h e fi rm 's n et as se ts re m ai n th e sa m e, as

d oe s th e w ea lt h of th e in ve st or .

A cc ou n ti n g fo r d iv id en d s d ep en d s on th ei r p ay m en t m et h od (c as h

or st oc k) .O n th e d ec la ra ti on d ay ,t h e fi rm 's B oa rd of D ir ec to rs

an n ou n ce s th e is su an ce of st oc k d iv id en d s or p ay m en t of ca sh

d iv id en d s. C as h d iv id en d s ar e p ay m en ts ta ke n d ir ec tl y fr om th e

fi rm 's in co m e. T h is is fo rm al ly ac co u n te d fo r by m ar ki n g th e

am ou n t d ow n as a li ab il it y fo r th e fi rm .T h e am ou n t is p la ce d in a

se p ar at e d iv id en d s p ay ab le ac co u n t.

T h e ac co u n ti n g eq u at io n fo r th is is si m p ly :

R et ai n ed E ar n in gs = N et In co m e − D iv id en d s

R et ai n ed ea rn in gs ar e p ar t of th e ba la n ce sh ee t (a n ot h er ba si c

fi n an ci al st at em en t) u n d er "s to ck h ol d er s eq u it y (s h ar eh ol d er s'

eq u it y) ." It is m os tl y af fe ct ed by n et in co m e ea rn ed d u ri n g a p er io d

of ti m e by th e co m p an y le ss an y d iv id en d s p ai d to th e co m p an y' s

ow n er s/ st oc kh ol d er s. T h e re ta in ed ea rn in gs ac co u n t on th e ba la n ce

sh ee t is sa id to re p re se n t an "a cc u m u la ti on of ea rn in gs " si n ce n et

p ro fi ts an d lo ss es ar e ad d ed /s u bt ra ct ed fr om th e ac co u n t fr om

p er io d to p er io d .

O n th e d at e of p ay m en t, w h en d iv id en d ch ec ks ar e m ai le d ou t to

st oc kh ol d er s, th e d iv id en d s p ay ab le ac co u n t is d eb it ed an d th e

fi rm 's ca sh ac co u n t is cr ed it ed .

St oc k d iv id en d s ar e p ar se d ou t as ad d it io n al st oc ks to sh ar eh ol d er s

on re co rd .U n li ke ca sh d iv id en d s, th is d oe s n ot co m e ou t of th e

fi rm 's in co m e. T h e fi rm is ab le to bo th m ai n ta in th ei r ca sh an d gi ve

d iv id en d s to in ve st or s. H er e, th e fi rm 's n et as se ts re m ai n th e sa m e.

If a fi rm au th or iz es a 15 % st oc k d iv id en d on D ec 1s t, d is tr ib u ta bl e

on F eb 29 ,a n d to st oc kh ol d er s of re co rd on F eb 1, th e st oc k

cu rr en tl y h as a m ar ke t va lu e of $ 15 an d a p ar va lu e of $ 4. T h er e ar e

15 0 ,0 0 0 sh ar es ou ts ta n d in g an d th e fi rm w il li ss u e 22 ,5 0 0

80 2

ad d it io n al sh ar es .T h e va lu e of th e d iv id en d is (1 50 ,0 0 0 )( 15 % )( 15 ) =

$ 33 7, 50 0 .

T h e d ec la ra ti on of th is d iv id en d d eb it s re ta in ed ea rn in gs fo r th is

va lu e an d cr ed it s th e st oc k d iv id en d d is tr ib u ta bl e ac co u n t fo r th e

n u m be r of n ew st oc k is su ed (1 50 ,0 0 0 *. 15 = 22 ,5 0 0 ) at p ar va lu e.

W e m u st al so co n si d er th e d if fe re n ce be tw ee n m ar ke t va lu e an d p ar

(s ta te d ) va lu e an d re co rd th at as cr ed it fo r ad d it io n al p ai d -i n -

ca p it al (F ig u re 15 .5 ). O n th e d ay of is su an ce ,t h e st oc k d iv id en d s

d is tr ib u ta bl e ac co u n t is d eb it ed an d st oc k is cr ed it ed $ 90 ,0 0 0 .

E X A M P LE

C as h d iv id en d ex am p le :F ir m A 's B oa rd of D ir ec to rs d ec la re d a

d iv id en d on D ec em be r 1, 20 11 of $ 10 0 ,0 0 0 p ay ab le to

sh ar eh ol d er s of re co rd on F eb 1, 20 12 an d p ay ab le on F eb 29 ,

20 12 .T h is $ 10 0 ,0 0 0 go es d ow n as a li ab il it y on th e fi rm 's

ac co u n ti n g sh ee t.

So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /d iv id en d s/ d iv id en d -

p ol ic y/ a cc ou n ti n g -c on si d er a ti on s/

C C -B Y -S A

B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e

80 3

Th is sh

ow s th e b al an

ce sh

ee t fo r a st oc

k d iv id en

d on

d ec

la ra tio

n d at e.

Fi g ur e 15

.5 A cc ou nt in g fo r st oc k d iv id en d s

In ve

st or

P re fe re nc

es Th

e si gn

i ca

nc e of

in ve

st or s'

d iv id en

d p re fe re nc

es is

a co

nt es

te d to p ic

in n

an ce

th at

ha s se

rio us

im p lic at io ns

fo r d iv id en

d p ol ic y.

K E Y P O IN TS

• E le m en ts of d iv id en d p ol ic y in cl u d e: p ay in g a d iv id en d vs

re in ve st m en t in co m p an y, h ig h vs lo w p ay ou t, st ab le vs

ir re gu la r d iv id en d s, an d fr eq u en cy of p ay m en t.

• So m e ar e of th e op in io n th at th e fu tu re ga in s ar e m or e ri sk y

th an th e cu rr en t d iv id en d s, so in ve st or s p re fe r d iv id en d

p ay m en ts ov er ca p it al ga in s. O th er s co n te n d th at d iv id en d

p ol ic y is u lt im at el y ir re le va n t, si n ce in ve st or s ar e in d if fe re n t

be tw ee n se ll in g st oc k an d re ce iv in g d iv id en d s.

• A ss u m in g d iv id en d re le va n ce ,c om in g u p w it h a d iv id en d

p ol ic y is ch al le n gi n g fo r th e fi rm s be ca u se d if fe re n t in ve st or s

h av e d if fe re n t vi ew s on p re se n t ca sh d iv id en d s an d fu tu re

ca p it al ga in s.

• Im p or ta n ce of th e co n te n t an d th e st ab il it y of a d iv id en d

p ol ic y ar e su bj ec t to m u ch ac ad em ic d eb at e.

T h e ro le of in ve st or p re fe re n ce s fo r d iv id en d s an d th e va lu e of a

fi rm ar e p ie ce s of th e d iv id en d p u zz le ,w h ic h is th e su bj ec t of m u ch

ac ad em ic d eb at e. A ss u m in g d iv id en d re le va n ce ,c om in g u p w it h a

d iv id en d p ol ic y is ch al le n gi n g fo r th e d ir ec to rs an d fi n an ci al

m an ag er of a co m p an y be ca u se d if fe re n t in ve st or s h av e d if fe re n t

vi ew s on p re se n t ca sh d iv id en d s an d fu tu re ca p it al ga in s. In ve st or

p re fe re n ce s ar e fi rs t sp li t be tw ee n ch oo si n g d iv id en d p ay m en ts

n ow ,o r fu tu re ca p it al ga in s in li eu of d iv id en d s. F u rt h er el em en ts of

th e d iv id en d p ol ic y al so in cl u d e: 1. H ig h ve rs u s lo w p ay ou t, 2. St ab le

ve rs u s ir re gu la r d iv id en d s, an d 3. F re qu en cy of p ay m en t. C as h

d iv id en d s p ro vi d e li qu id it y, bu t th e bo n u s sh ar e w il lb ri n g ca p it al

ga in s to th e sh ar eh ol d er s. T h e in ve st or ’s p re fe re n ce be tw ee n th e

cu rr en t ca sh d iv id en d an d th e fu tu re ca p it al ga in h as be en vi ew ed in

ki n d .

M an y p eo p le h ol d th e op in io n th at th e fu tu re ga in s ar e m or e ri sk y

th an th e cu rr en t d iv id en d s, as th e "B ir d -i n -t h e- h an d T h eo ry "

su gg es ts .T h is vi ew is su p p or te d by bo th th e W al te r an d G or d on

m od el s, w h ic h fi n d th at in ve st or s p re fe r th os e fi rm s w h ic h p ay

re gu la r d iv id en d s, an d su ch d iv id en d s af fe ct th e m ar ke t p ri ce of th e

sh ar e. G or d on 's d iv id en d d is co u n t m od el st at es th at sh ar eh ol d er s

d is co u n t th e fu tu re ca p it al ga in s at a h ig h er ra te th an th e fi rm 's

ea rn in gs ,t h er eb y ev al u at in g a h ig h er va lu e of th e sh ar e. In sh or t,

w h en th e re te n ti on ra te in cr ea se s, th ey re qu ir e a h ig h er d is co u n ti n g

ra te .

In co n tr as t, ot h er s (s ee D iv id en d Ir re le va n ce T h eo ry ) ar gu e th at th e

in ve st or s ar e in d if fe re n t be tw ee n d iv id en d p ay m en ts an d th e fu tu re

ca p it al ga in s. T h er ef or e, th e co n te n t of a fi rm 's d iv id en d p ol ic y h as

n o re al ef fe ct on th e va lu e of th e fi rm .

80 4

In ve st or p re fe re n ce s p la y an u n ce rt ai n ro le in th e "d iv id en d p u zz le ,"

w h ic h re fe rs to th e p h en om en on of co m p an ie s th at p ay d iv id en d s

be in g re w ar d ed by in ve st or s w it h h ig h er va lu at io n s, ev en th ou gh

ac co rd in g to m an y ec on om is ts ,i t sh ou ld n ot m at te r to in ve st or s

w h et h er or n ot a fi rm p ay s d iv id en d s. T h er e ar e a n u m be r of fa ct or s,

su ch as p sy ch ol og y, ta xe s, an d in fo rm at io n as ym m et ri es ti ed in to

th is p u zz le ,w h ic h fu rt h er co m p li ca te th e m at te r (F ig u re 15 .6 ).

So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /d iv id en d s/ d iv id en d -

p ol ic y/ in ve st or -p re fe re n ce s/

C C -B Y -S A

B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e

S to ck

D iv id en

d s ve

rs us

C as

h D iv id en

d s

In ve

st or s'

p re fe re nc

e fo r st oc

k or

ca sh

d ep

en d s on

th ei r

in cl in at io ns

to w ar d fa ct or s su

ch as

liq ui d ity ,t ax

si tu at io n,

an d e

xi b ili ty .

K E Y P O IN TS

• C as h d iv id en d s p ro vi d e st ea d y p ay m en ts of ca sh th at ca n be

u se d to re in ve st in a co m p an y, if th e sh ar eh ol d er d es ir es .

• H ol d er s of st oc k d iv id en d s ca n se ll th ei r st oc k fo r (h op ef u ll y)

h ig h ca p it al ga in s in th e fu tu re ,o r th ey ca n se ll it of f

im m ed ia te ly to ge t ca sh ,m u ch li ke a ca sh d iv id en d .T h is

fl ex ib il it y is se en by so m e as a be n ef it of st oc k d iv id en d .

• C as h d iv id en d s ar e im m ed ia te ly ta xa bl e as in co m e, w h il e

st oc k d iv id en d s ar e on ly ta xe d w h en th ey ar e ac tu al ly so ld by

th e sh ar eh ol d er .

• If an in ve st or is in te re st ed in lo n g- te rm ca p it al ga in s, h e or

sh e w il ll ik el y p re fe r st oc k d iv id en d s. If an in ve st or n ee d s a

re gu la r so u rc e of in co m e, ca sh d iv id en d s w il lp ro vi d e

li qu id it y.

• F ir m s ca n ch oo se to is su e st oc k d iv id en d s if th ey w ou ld li ke

to d ir ec t th ei r ea rn in gs to w ar d th e d ev el op m en t of th e fi rm

bu t w ou ld st il ll ik e to ap p ea se st oc kh ol d er s w it h so m e fo rm of

p ay m en t.

80 5

In ve

st m en

t p re fe re nc

es ar e

sp lit

b et w ee

n ch

oo si ng

d iv id en

d p ay

ou ts

or fu tu re

ca p ita

lg ai ns

.

Fi g ur e 15

.6 S to ck

m ar ke t

K E Y P O IN TS

(c on t. )

• E st ab li sh ed fi rm s w it h li tt le m or e ro om to gr ow d o n ot h av e

p re ss in g n ee d s fo r al lt h ei r ca sh ea rn in gs ,s o th ey ar e m or e

li ke ly to gi ve ca sh d iv id en d s.

If a fi rm d ec id es to p ar ce lo u t

d iv id en d s to sh ar eh ol d er s, th ey

h av e a ch oi ce in th e fo rm of

p ay m en t: ca sh or st oc k. C as h

d iv id en d s ar e th os e p ai d ou t in

cu rr en cy ,u su al ly vi a el ec tr on ic

fu n d s tr an sf er or by p ap er

ch ec k. T h is is th e m os t co m m on

m et h od of sh ar in g co rp or at e

p ro fi ts w it h th e sh ar eh ol d er s of

a co m p an y. St oc k or sc ri p d iv id en d s ar e th os e p ai d ou t in th e fo rm

of ad d it io n al st oc k sh ar es of ei th er th e is su in g co rp or at io n or

an ot h er co rp or at io n .C as h d iv id en d s p ro vi d e in ve st or s w it h a

re gu la r st re am of in co m e. St oc k d iv id en d s, u n li ke ca sh d iv id en d s,

d o n ot p ro vi d e li qu id it y to th e in ve st or s; h ow ev er ,t h ey d o en su re

ca p it al ga in s to th e st oc kh ol d er s. T h er ef or e, if in ve st or s ar e n ot

in te re st ed in a lo n g- te rm in ve st m en t, th ey w il lp re fe r re gu la r ca sh

p ay m en ts ov er p ay m en ts of ad d it io n al st oc k (F ig u re 15 .7 ).

C os ts of ta xe s ca n al so p la y a ro le in ch oo si n g be tw ee n ca sh or st oc k

d iv id en d s. C as h d iv id en d s ar e im m ed ia te ly ta xa bl e u n d er m os t

co u n tr ie s' ta x co d es as in co m e, w h il e st oc k d iv id en d s ar e n ot

ta xa bl e u n ti ls ol d fo r ca p it al ga in s (i fs to ck w as th e on ly ch oi ce fo r

re ce iv in g d iv id en d s) .T h is ca n be se en as a h u ge be n ef it of st oc k

d iv id en d s, p ar ti cu la rl y fo r in ve st or s of a h ig h in co m e ta x br ac ke t. A

fu rt h er be n ef it of th e st oc k d iv id en d is it s p er ce iv ed fl ex ib il it y.

Sh ar eh ol d er s h av e th e ch oi ce of ei th er ke ep in g th ei r sh ar es in h op es

of h ig h ca p it al ga in s, or se ll in g so m e of th e n ew sh ar es fo r ca sh ,

w h ic h is so m ew h at li ke re ce iv in g a ca sh d iv id en d .

If th e p ay m en t of st oc k d iv id en d s in vo lv es th e is su in g of n ew

sh ar es ,i t in cr ea se s th e to ta ln u m be r of sh ar es w h il e lo w er in g th e

p ri ce of ea ch sh ar e w it h ou t ch an gi n g th e m ar ke t ca p it al iz at io n of

th e sh ar es h el d .I t h as th e sa m e ef fe ct as a st oc k sp li t: th e to ta lv al u e

of th e fi rm is n ot af fe ct ed .I ft h e p ay m en t in vo lv es th e is su in g of

n ew sh ar es ,i t in cr ea se s th e to ta ln u m be r of sh ar es w h il e lo w er in g

th e p ri ce of ea ch sh ar e w it h ou t ch an gi n g th e m ar ke t ca p it al iz at io n ,

or to ta lv al u e, of th e sh ar es h el d .A s su ch ,r ec ei vi n g st oc k d iv id en d s

d oe s n ot in cr ea se a sh ar eh ol d er 's st ak e in th e fi rm ;b y co n tr as t, a

sh ar eh ol d er re ce iv in g ca sh d iv id en d s co u ld u se th at in co m e to

re in ve st in th e fi rm an d in cr ea se th ei r st ak e.

F or th e fi rm ,d iv id en d p ol ic y d ir ec tl y re la te s to th e ca p it al st ru ct u re

of th e fi rm ,s o ch oo si n g be tw ee n st oc k d iv id en d s an d ca sh d iv id en d s

80 6

W he

n ch

oo si ng

b et w ee

n ca

sh or

st oc

k d iv id en

d s,

th e tr ad

e- o

is b et w ee

n liq

ui d ity

in th e sh

or t- te rm

or in co

m e

fr om

ca p ita

lg ai ns

in th e lo ng

-t er m .

Fi g ur e 15

.7 In co m e fr om

D iv id en d s

is an im p or ta n t co n si d er at io n .A fi rm th at is st il li n it s st ag es of

gr ow th w il lm os t li ke ly p re fe r to re ta in it s ea rn in gs an d p u t th em

to w ar d fi rm d ev el op m en t, in st ea d of se n d in g th em to th ei r

sh ar eh ol d er s. T h e fi rm co u ld al so ch oo se to ap p ea se in ve st or s w it h

st oc k d iv id en d s, w h ic h w ou ld st il la ll ow it to re ta in it s ea rn in gs .

C on ve rs el y, a fi rm th at is al re ad y qu it e st ab le w it h lo w gr ow th is

m u ch m or e li ke ly to ch oo se p ay m en t of d iv id en d s in ca sh .T h e

n ee d s an d ca sh fl ow of th e fi rm ar e n ec es sa ry p oi n ts of

co n si d er at io n in ch oo si n g a d iv id en d p ol ic y.

So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /d iv id en d s/ d iv id en d -

p ol ic y/ st oc k- d iv id en d s- ve rs u s- ca sh -d iv id en d s/

C C -B Y -S A

B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e

S ig na

lin g

D iv id en

d d ec

is io ns

ar e fr eq

ue nt ly

se en

b y in ve

st or s as

re ve

al in g in fo rm

at io n ab

ou t a r m 's

p ro sp

ec ts ;t he

re fo re

r m s ar e ca

ut io us

w ith

th es

e d ec

is io ns

.

K E Y P O IN TS

• Si gn al in g is th e id ea th at on e ag en t co n ve ys so m e

in fo rm at io n ab ou t it se lf to an ot h er p ar ty th ro u gh an ac ti on .I t

to ok ro ot in th e id ea of as ym m et ri c in fo rm at io n ;i n th is ca se ,

m an ag er s kn ow m or e th an in ve st or s, so in ve st or s w il lf in d

"s ig n al s" in th e m an ag er s' ac ti on s to ge t cl u es ab ou t th e fi rm .

• F or in st an ce ,w h en m an ag er s la ck co n fi d en ce in th e fi rm 's

ab il it y to ge n er at e ca sh fl ow s in th e fu tu re th ey m ay ke ep

d iv id en d s co n st an t, or p os si bl y ev en re d u ce th e am ou n t of

d iv id en d s p ai d ou t. In ve st or s w il ln ot ic e th is an d ch oo se to

se ll th ei r sh ar e of th e fi rm .

• In ve st or s ca n u se th is kn ow le d ge ab ou t si gn al to in fo rm th ei r

d ec is io n to bu y or se ll th e fi rm 's st oc k, bi d d in g th e p ri ce u p in

th e ca se of a p os it iv e d iv id en d su rp ri se ,o r se ll in g it d ow n

w h en d iv id en d s d o n ot m ee t ex p ec ta ti on s.

• F ir m s ar e aw ar e of th is si gn al in g ef fe ct ,s o th ey w il lt ry n ot to

se n d a n eg at iv e si gn al th at se n d s th ei r st oc k p ri ce d ow n .

80 7

A d iv id en d d ec is io n m ay h av e an in fo rm at io n si gn al in g ef fe ct th at

fi rm s w il lc on si d er in fo rm u la ti n g th ei r p ol ic y. T h is te rm is d ra w n

fr om ec on om ic s, w h er e si gn al in g is th e id ea th at on e ag en t co n ve ys

so m e in fo rm at io n ab ou t it se lf to an ot h er p ar ty th ro u gh an ac ti on .

Si gn al in g to ok ro ot in th e id ea of as ym m et ri c in fo rm at io n ,w h ic h

sa ys th at in so m e ec on om ic tr an sa ct io n s, in eq u al it ie s in ac ce ss to

in fo rm at io n u p se t th e n or m al m ar ke t fo r th e ex ch an ge of go od s an d

se rv ic es (F ig u re 15 .8 ). A n in fo rm at io n as ym m et ry ex is ts if fi rm

m an ag er s kn ow m or e ab ou t th e fi rm an d it s fu tu re p ro sp ec ts th an

th e in ve st or s.

W h en in ve st or s h av e in co m p le te in fo rm at io n ab ou t th e fi rm

(p er h ap s d u e to op aq u e ac co u n ti n g p ra ct ic es ) th ey w il ll oo k fo r

ot h er in fo rm at io n in ac ti on s li ke th e fi rm 's d iv id en d p ol ic y. F or

in st an ce ,w h en m an ag er s la ck co n fi d en ce in th e fi rm 's ab il it y to

ge n er at e ca sh fl ow s in th e fu tu re th ey m ay ke ep d iv id en d s co n st an t,

or p os si bl y ev en re d u ce th e am ou n t of d iv id en d s p ai d ou t.

C on ve rs el y, m an ag er s th at h av e ac ce ss to in fo rm at io n th at in d ic at es

ve ry go od fu tu re p ro sp ec ts fo r th e fi rm (e .g .a fu ll or d er bo ok ) ar e

m or e li ke ly to in cr ea se d iv id en d s.

In ve st or s ca n u se th is kn ow le d ge ab ou t m an ag er s' be h av io r to

in fo rm th ei r d ec is io n to bu y or se ll th e fi rm 's st oc k, bi d d in g th e

p ri ce u p in th e ca se of a p os it iv e d iv id en d su rp ri se ,o r se ll in g it

d ow n w h en d iv id en d s d o n ot m ee t ex p ec ta ti on s. T h is ,i n tu rn ,m ay

in fl u en ce th e d iv id en d d ec is io n as m an ag er s kn ow th at st oc k

h ol d er s cl os el y w at ch d iv id en d an n ou n ce m en ts lo ok in g fo r go od or

ba d n ew s. A s m an ag er s te n d to av oi d se n d in g a n eg at iv e si gn al to

th e m ar ke t ab ou t th e fu tu re p ro sp ec ts of th ei r fi rm ,t h is al so te n d s

80 8

A m od

el d ev

el op

ed b y M er to n M ill er

an d K ev

in R oc

k in

19 85

su gg

es ts

th at

d iv id en

d an

no un

ce m en

ts co

nv ey

in fo rm

at io n to

in ve

st or s re ga

rd in g th e r m 's

fu tu re

p ro sp

ec ts .M

an y ea

rli er

st ud

ie s ha

d sh

ow n th at

st oc

k p ric

es te nd

to in cr ea

se w he

n an

in cr ea

se in

d iv id en

d s is an

no un

ce d an

d te nd

to d ec

re as

e w he

n a

d ec

re as

e or

om is si on

is an

no un

ce d .M

ill er

an d R oc

k p oi nt ed

ou t th at

th is is lik el y

d ue

to th e in fo rm

at io n co

nt en

t of

d iv id en

d s.

Fi g ur e 15

.8 A co m p an y' s d iv id en d d ec is io n m ay

si gn al w ha t m an ag em

en t

b el ie ve s is th e fu tu re p ro sp ec ts of th e r m an d its

st oc k p ric e.

to le ad to a d iv id en d p ol ic y of a st ea d y, gr ad u al ly in cr ea si n g

p ay m en t.

So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /d iv id en d s/ d iv id en d -

p ol ic y/ si g n a li n g /

C C -B Y -S A

B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e

C lie nt el e

C ha

ng e in

a r m 's

d iv id en

d p ol ic y m ay

ca us

e lo ss

of ol d cl ie nt el e an

d ga

in of

ne w

cl ie nt el e,

b as

ed on

th ei r

d i er en

t d iv id en

d p re fe re nc

es .

K E Y P O IN TS

• T h e cl ie n te le ef fe ct is th e id ea th at th e ty p e of in ve st or s

at tr ac te d to a p ar ti cu la r ki n d of se cu ri ty w il la ff ec t th e p ri ce of

th e se cu ri ty w h en p ol ic ie s or ci rc u m st an ce s ch an ge .

• C u rr en t cl ie n te le m ig h t ch oo se to se ll th ei r st oc k if a fi rm

ch an ge s th ei r d iv id en d p ol ic y an d d ev ia te s co n si d er ab ly fr om

th e in ve st or 's p re fe re n ce s. C h an ge s in p ol ic y ca n al so le ad to

n ew cl ie n te le ,w h os e p re fe re n ce s al ig n w it h th e fi rm 's n ew

d iv id en d p ol ic y.

• In eq u il ib ri u m ,t h e ch an ge s in cl ie n te le se ts w il ln ot le ad to

an y ch an ge in st oc k p ri ce .

• T h e re al w or ld im p li ca ti on of th e cl ie n te le ef fe ct li es in th e

im p or ta n ce of d iv id en d p ol ic y st ab il it y, ra th er th an th e

co n te n t of th e p ol ic y it se lf .

T h e C li e n te le E ff e ct

T h e cl ie n te le ef fe ct is th e id ea th at th e ty p e of in ve st or s at tr ac te d to

a p ar ti cu la r ki n d of se cu ri ty w il la ff ec t th e p ri ce of th e se cu ri ty w h en

p ol ic ie s or ci rc u m st an ce s ch an ge .T h es e in ve st or s ar e kn ow n as

80 9

d iv id e n d cl ie n te le .F or in st an ce ,s om e cl ie n te le w ou ld p re fe r a

co m p an y th at d oe sn 't p ay d iv id en d s at al l, bu t in st ea d in ve st s th ei r

re ta in ed ea rn in gs to w ar d gr ow in g th e bu si n es s. So m e w ou ld in st ea d

p re fe r th e re gu la r in co m e fr om d iv id en d s ov er ca p it al ga in s. O f

th os e w h o p re fe r d iv id en d s ov er ca p it al ga in s, th er e ar e fu rt h er

su bs et s of cl ie n te le ;f or ex am p le ,i n ve st or s m ig h t p re fe r a st oc k th at

p ay s a h ig h d iv id en d ,w h il e an ot h er su bs et m ig h t lo ok fo r a ba la n ce

be tw ee n d iv id en d p ay ou t an d re in ve st m en t in th e co m p an y (F ig u re

15 .9 ).

C li en te le m ay ch oo se to se ll th ei r st oc k if a fi rm ch an ge s it s d iv id en d

p ol ic y, an d d ev ia te s co n si d er ab ly fr om it s p re fe re n ce s. O n th e ot h er

h an d ,t h e fi rm m ay at tr ac t a n ew cl ie n te le gr ou p if it s n ew d iv id en d

p ol ic y ap p ea ls to th e gr ou p 's d iv id en d p re fe re n ce s. T h es e ch an ge s in

d em og ra p h ic s re la te d to a st oc k' s ow n er sh ip d u e to a ch an ge of

d iv id en d p ol ic y ar e ex am p le s of th e "c li en te le ef fe ct ."

T h is th eo ry is re la te d to th e d iv id en d ir re le va n ce th eo ry p re se n te d

by M od ig li an ia n d M il le r, w h ic h st at es th at ,u n d er p ar ti cu la r

as su m p ti on ,a n in ve st or ’s re qu ir ed re tu rn an d th e va lu e of th e fi rm

ar e u n re la te d to th e fi rm 's d iv id en d p ol ic y. A ft er al l, cl ie n te le ca n

ju st ch oo se to se ll of ft h ei r h ol d in gs if th ey d is li ke a fi rm 's p ol ic y

ch an ge ,a n d th e fi rm m ay si m u lt an eo u sl y at tr ac t a n ew su bs et of

cl ie n te le w h o li ke th e p ol ic y ch an ge .T h er ef or e, st oc k va lu e is

u n af fe ct ed .T h is is tr u e as lo n g as th e “m ar ke t” fo r d iv id en d p ol ic y is

in eq u il ib ri u m ,w h er e d em an d fo r su ch a p ol ic y m ee ts th e su p p ly .

T h e cl ie n te le ef fe ct 's re al w or ld im p li ca ti on is th at w h at m at te rs is

n ot th e co n te n t of th e d iv id en d p ol ic y, bu t ra th er th e st ab il it y of th e

p ol ic y. W h il e in ve st or s ca n al w ay s ch oo se to se ll sh ar es of fi rm s

w it h u n d es ir ab le d iv id en d p ol ic y, an d bu y sh ar es of fi rm s w it h

at tr ac ti ve d iv id en d p ol ic y, th er e ar e br ok er ag e co st s an d ta x

co n si d er at io n s as so ci at ed w it h th is .A s a re su lt ,a n in ve st or m ay

st ic k w it h a st oc k th at h as a su b- op ti m al d iv id en d p ol ic y be ca u se th e

co st of sw it ch in g in ve st m en ts ou tw ei gh s th e be n ef it th e in ve st or

w ou ld re ce iv e by in ve st in g in a st oc k w it h a be tt er d iv id en d p ol ic y.

A lt h ou gh co m m on ly u se d in re fe re n ce to d iv id en d or co u p on

(i n te re st ) ra te s, th e cl ie n te le ef fe ct ca n al so be u se d in th e co n te xt of

81 0

R et ire

es ar e m or e lik el y to

p re fe r

hi gh

d iv id en

d p ay

ou ts

ov er

ca p ita

lg ai ns

si nc

e th is p ro vi d es

th em

w ith

ca sh

in co

m e.

Th er ef or e,

if a co

m p an

y d is co

nt in ue

d p ay

in g d iv id en

d s,

th e cl ie nt el e e

ec t m ay

ca us

e re tir ee

sh ar eh

ol d er s to

se ll th e

st oc

k in

fa vo

r of

ot he

r in co

m e

ge ne

ra tin

g in ve

st m en

ts .

Fi g ur e 15

.9 C lie nt el e Ty p e

E xa m p le

le ve ra ge (d eb t le ve ls ), ch an ge s in li n e of bu si n es s, ta xe s, an d ot h er

m an ag em en t d ec is io n s.

E X A M P LE

Su p p os e F ir m A h ad be en in a gr ow th st ag e an d d id n ot of fe r

d iv id en d s to it s sh ar eh ol d er s, bu t th ei r p ol ic y ch an ge d to

p ay in g lo w ca sh d iv id en d s. C li en te le in te re st ed in lo n g te rm

ca p it al ga in s m ig h t be al ar m ed ,i n te rp re ti n g th is d ec is io n as a

si gn of sl ow in g gr ow th ,w h ic h w ou ld m ea n le ss st oc k p ri ce

ap p re ci at io n in th e fu tu re .T h is se t of cl ie n te le co u ld ch oo se to

se ll th e st oc k. O n th e ot h er h an d ,d iv id en d p ay m en ts co u ld

ap p ea lt o in ve st or s w h o ar e in te re st ed in re gu la r ad d it io n al

in co m e fr om th e in ve st m en t, an d th ey w ou ld bu y F ir m A 's

st oc k.

So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /d iv id en d s/ d iv id en d -

p ol ic y/ cl ie n te le /

C C -B Y -S A

B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e

81 1

S et tin

g th e Ta

rg et

P ay

ou t R at io

R es

id ua

lD iv id en

d M od

el

M et ho

d of

P ay

m en

t

Se ct io n 3

S et tin

g th e D iv id en

d

81 2

ht tp s: // w w w .b ou

nd le ss .c om

/ na

nc e/ d iv id en

d s/ se

tt in g- th e- d iv id en

d /

S et tin

g th e Ta rg et

P ay

ou t

R at io

C om

p an

ie s d et er m in e w ha

t ki nd

of in ve

st or s th ey

w an

t to

at tr ac

t an

d th e in ve

st m en

t op

p or tu ni tie

s th ey

fa ce

b ef or e se

tt in g th e ta rg et

p ay

ou t ra tio

.

K E Y P O IN TS

• T h e ra ti o is ca lc u la te d by d iv id in g D iv id en d s P ai d by N et

In co m e fo r th e sa m e ac co u n ti n g p er io d ,o r D iv id en d p er

Sh ar e by E ar n in gs p er Sh ar e.

• A h ig h d iv id en d ra ti o ap p ea ls to in ve st or s w h o w an t h ig h

cu rr en t in co m e an d ar e u n co n ce rn ed w it h ca p it al ga in s. A

lo w er ra ti o ap p ea ls to in ve st or s w h o va lu e gr ow th an d ca p it al

ga in s ov er in co m e.

• In ge n er al ,t h e D iv id en d P ay ou t R at io of p u bl ic ly tr ad ed

co m p an ie s h as st ea d il y d ec li n ed ,o n av er ag e, si n ce 19 40 .

S e tt in g th e T a rg e t P a yo u t R a ti o

T h e T ar ge t P ay ou t R at io ,o r D iv id en d P ay ou t R at io ,i s th e fr ac ti on

of n et in co m e a fi rm p ay s to it s st oc kh ol d er s in d iv id en d s. It is

ca lc u la te d by d iv id in g th e d iv id en d s d is tr ib u te d by th e n et in co m e

fo r th e sa m e p er io d .T h e p ar t of th e ea rn in gs n ot p ai d to in ve st or s

in th e fo rm of a d iv id en d is le ft fo r in ve st m en t to p ro vi d e fo r fu tu re

ea rn in gs gr ow th .I n ve st or s se ek in g h ig h cu rr en t in co m e an d li m it ed

ca p it al gr ow th p re fe r co m p an ie s w it h h ig h D iv id en d P ay ou t R at io s.

H ow ev er in ve st or s se ek in g ca p it al gr ow th m ay p re fe r lo w er p ay ou t

ra ti os .T h is is ap p ea li n g to so m e in ve st or s be ca u se a lo w er d iv id en d

im p li es th at m or e ea rn in gs ar e be in g re in ve st ed in th e co m p an y,

w h ic h sh ou ld ca u se th e st oc k p ri ce to ri se .S om e in ve st or s, su ch as

yo u n g p eo p le sa vi n g fo r re ti re m en t, m ay p re fe r h ig h er re tu rn s la te r

th an sm al le r ca sh d is tr ib u ti on s n ow .

81 3

Th e d iv id en

d am

ou nt

a co

m p an

y w ill p ay

ou t ge

ne ra lly

d ep

en d s on

its op

er at io ns

an d ex

p an

si on

p ot en

tia l. O ld er ,e

st ab

lis he

d co

m p an

ie s te nd

to p ay

hi gh

er d iv id en

d s

th an

yo un

ge r, gr ow

in g co

m p an

ie s.

Fi g ur e 15

.1 0 D iv id en d

D iv id e n d R a ti o a n d In ve st m e n t S tr a te g y

T h e T ar ge t P ay ou t R at io d ep en d s on w h at in ve st or s th e

m an ag em en t of a co m p an y ar e tr yi n g to at tr ac t, an d w h at cu rr en t

in ve st or s' ex p ec ta ti on s ar e. It al so d ep en d s on th e gr ow th go al s of

th e co m p an y. If a co m p an y is tr yi n g to gr ow ve ry fa st ,i t m ay p re fe r

to re in ve st it s in co m e in ex p an d in g op er at io n s.

A m or e es ta bl is h ed fi rm w it h an es ta bl is h ed m ar ke t p ro ba bl y d oe s

n ot n ee d to ex p an d it s op er at io n s, an d w ou ld p re fe r to u se it s

ea rn in g to co m p en sa te it s in ve st or s. H ig h gr ow th fi rm s in ea rl y li fe

ge n er al ly h av e lo w or ze ro p ay ou t ra ti os .A s th ey m at u re ,t h ey te n d

to re tu rn m or e of th e ea rn in gs ba ck to in ve st or s (F ig u re 15 .1 0 ).

H is to ri ca l P e rs p e ct iv e

T h e p ay ou t ra te h as gr ad u al ly d ec li n ed fr om 90 % of op er at in g

ea rn in gs in th e 19 40 s to ab ou t 30 % in re ce n t ye ar s. F or sm al le r

gr ow th co m p an ie s, th e av er ag e p ay ou t ra ti o ca n be as lo w as 10 %

So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /d iv id en d s/ se tt in g -t he -

d iv id en d /s et ti n g -t he -t a rg et -p a yo u t- ra ti o/

C C -B Y -S A

B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e

R es

id ua

lD iv id en

d M od

el Th

e R es

id ua

lD iv id en

d M od

el r st

us es

ea rn in gs

to n

an ce

ne w

p ro je ct s,

th en

d is tr ib ut es

th e re m ai nd

er as

d iv id en

d s.

K E Y P O IN TS

• T h e R es id u al D iv id en d M od el im p li es th e Ir re le va n ce of

D iv id en d s T h eo ry ,w h ic h cl ai m s th at in ve st or s ar e in d if fe re n t

be tw ee n re tu rn s in th e fo rm of d iv id en d s or ca p it al ga in s.

• R es id u al D iv id en d s re su lt in a p as si ve ly -c al cu la te d d iv id en d ,

w h ic h ch an ge s ev er y ye ar .

• Si n ce th e R es id u al D iv id en d M od el as su m es d iv id en d s an d

ca p it al ga in s ar e tw o fo rm s of th e sa m e va lu e, it w il ln ot af fe ct

th e m ar ke t va lu e.

D e fi n it io n

T h e R es id u al D iv id en d M od el is a m et h od a co m p an y u se s to

d et er m in e th e d iv id en d it w il lp ay to it s sh ar eh ol d er s.

C om p an ie s w h ic h u se re ta in ed ea rn in gs to fi n an ce n ew p ro je ct s u se

th is m et h od .T h e co m p an y fi rs t d et er m in es w h ic h n ew p ro je ct s it

w an ts to fi n an ce ,d ed ic at es fu n d s to th os e p ro je ct s, an d th en

d is tr ib u te s an y le ft ov er p ro fi ts to it s sh ar eh ol d er s as d iv id en d s.

81 4

T h is m od el ca n le ad to u n p re d ic ta bl e an d in co n si st en t d iv id en d

re tu rn s fo r th e in ve st or .H ow ev er ,t h e co m p an y' s go al is to ge n er at e

fu rt h er p ro fi ts fr om th e p ro je ct s it fu n d s, w h ic h be n ef it s th e

sh ar eh ol d er s ov er al l.

Ir re le va n ce o f D iv id e n d s

T h e R es id u al D iv id en d M od el is an ou tg ro w th of T h e M od ig li an i

an d M il le r T h eo ry th at p os it s th at d iv id en d s ar e ir re le va n t to

in ve st or s. T h is sc h oo lo ft h ou gh t be li ev es th at in ve st or s d o n ot st at e

an y p re fe re n ce be tw ee n cu rr en t d iv id en d s an d ca p it al ga in s. It go es

on to sa y th at d iv id en d p ol ic y d oe s n ot d et er m in e m ar ke t va lu e of a

st oc k. A cc or d in gl y, th e sh ar eh ol d er s ar e in d if fe re n t to th e tw o w ay s

by w h ic h th ei r in ve st m en t gr ow s:

• re ce iv in g a d iv id en d

• sh ar e p ri ce in cr ea si n g d u e to re ta in ed ea rn in gs

W h at in ve st or s w an t ar e h ig h re tu rn s - ei th er in th e fo rm of

d iv id en d s or in th e fo rm of re -i n ve st m en t of re ta in ed ea rn in gs by

th e fi rm (F ig u re 15 .1 1) .

D iv id e n d o r C a p it a l G a in T ra d e -O ff

T h e R es id u al M od el d iv id en d p ol ic y is a p as si ve on e an d ,i n th eo ry ,

d oe s n ot in fl u en ce m ar ke t p ri ce be ca u se th e sa m e w ea lt h is cr ea te d

fo r th e in ve st or re ga rd le ss of th e d iv id en d .T h e fi rm p ay in g ou t

d iv id en d s is ob vi ou sl y ge n er at in g in co m e fo r an in ve st or ;h ow ev er ,

ev en if th e fi rm d iv er ts so m e ea rn in gs fo r in ve st m en t op p or tu n it ie s,

th e in co m e of th e in ve st or s w il lr is e la te r, as su m in g th at th os e

in ve st m en ts ar e p ro fi ta bl e. T h e d iv id en d ,t h er ef or e, fl u ct u at es ev er y

ye ar be ca u se of d if fe re n t in ve st m en t op p or tu n it ie s an d ea rn in g

le ve ls .

So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /d iv id en d s/ se tt in g -t he -

d iv id en d /r es id u a l- d iv id en d -m od el /

C C -B Y -S A

B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e

81 5

C om

p an

ie s us

ua lly

is su

e in ve

st or s a ch

ec k fo r th ei r

d iv id en

d .

Fi g ur e 15

.1 1 W rit in g a ch ec k.

M et ho

d of

P ay

m en

t D iv id en

d s,

w hi ch

ar e d is tr ib ut ed

b as

ed on

ho w

m an

y sh

ar es

ea ch

p er so

n ow

ns ,c

an b e p ai d us

in g ca

sh ,

st oc

k, or

ot he

r co

m p an

y p ro p er ty .

K E Y P O IN TS

• T h e m os t co m m on m et h od of p ay m en t fo r d iv id en d s is ca sh .

T h is ca n be ei th er el ec tr on ic tr an sf er or ch ec k to th e

sh ar eh ol d er ,a n d is ta xe d w h en it is re ce iv ed .

• T h e d iv id en d ca n al so be p ai d as n ew sh ar es of st oc k. T h is

ca n ei th er in vo lv e n ew ly is su ed sh ar es or ol d sh ar es .

• T h e m os t ra re m et h od is to d is tr ib u te p ro p er ty or ot h er as se ts

as th e d iv id en d .

P ro p o rt io n a l P a ym e n t

A d iv id en d is al lo ca te d as a fi xe d am ou n t p er sh ar e. T h er ef or e, a

sh ar eh ol d er re ce iv es a d iv id en d in p ro p or ti on to th ei r sh ar eh ol d in g.

C a sh

C as h d iv id en d s ar e th os e p ai d ou t in cu rr en cy ,u su al ly vi a el ec tr on ic

fu n d s tr an sf er or a p ri n te d p ap er ch ec k. Su ch d iv id en d s ar e a fo rm

of in ve st m en t in co m e an d ar e u su al ly ta xa bl e to th e re ci p ie n t in th e

ye ar th ey ar e p ai d .T h is is th e m os t co m m on m et h od of sh ar in g

co rp or at e p ro fi ts w it h th e

sh ar eh ol d er s of th e co m p an y.

F or ea ch sh ar e ow n ed ,a

d ec la re d am ou n t of m on ey is

d is tr ib u te d .T h u s, if a p er so n

ow n s 10 0 sh ar es an d th e ca sh

d iv id en d is 50 ce n ts p er sh ar e,

th e h ol d er of th e st oc k w il lb e

p ai d 50 d ol la rs .D iv id en d s p ai d

ar e n ot cl as si fi ed as an ex p en se ,

bu t ra th er a d ed u ct io n of

re ta in ed ea rn in gs .D iv id en d s

p ai d d oe s n ot sh ow u p on a

In co m e St at em en t bu t d oe s

ap p ea r on th e B al an ce Sh ee t

(F ig u re 15 .1 2) .

S to ck

St oc k or sc ri p d iv id en d s ar e th os e p ai d ou t in th e fo rm of ad d it io n al

st oc k sh ar es of th e is su in g co rp or at io n or an ot h er co rp or at io n ,s u ch

as it s su bs id ia ry co rp or at io n .T h ey ar e u su al ly is su ed in p ro p or ti on

to sh ar es ow n ed .F or ex am p le ,f or ev er y 10 0 sh ar es of st oc k ow n ed ,

a 5% st oc k d iv id en d w il ly ie ld 5 ex tr a sh ar es .I ft h e p ay m en t

in vo lv es th e is su e of n ew sh ar es ,i t is si m il ar to a st oc k sp li t: it

81 6

C as

h is on

e of

se ve

ra lw

ay s th at

a co

m p an

y ca

n p ay

d iv id en

d s.

Fi g ur e 15

.1 2 D iv id en d

in cr ea se s th e to ta ln u m be r of sh ar es w h il e lo w er in g th e p ri ce of

ea ch sh ar e w it h ou t ch an gi n g th e m ar ke t ca p it al iz at io n ,o r to ta l

va lu e, of th e sh ar es h el d .

P ro p e rt y

P ro p er ty d iv id en d s or d iv id en d s in sp ec ie (L at in fo r "i n ki n d ") ar e

th os e p ai d ou t in th e fo rm of as se ts fr om th e is su in g co rp or at io n or

an ot h er co rp or at io n ,s u ch as a su bs id ia ry co rp or at io n .T h ey ar e

re la ti ve ly ra re an d m os t fr eq u en tl y ar e se cu ri ti es of ot h er co m p an ie s

ow n ed by th e is su er .H ow ev er ,t h ey ca n ta ke ot h er fo rm s, su ch as

p ro d u ct s an d se rv ic es .

In te ri m D iv id e n d s

In te ri m d iv id en d s ar e d iv id en d p ay m en ts m ad e be fo re a co m p an y' s

an n u al ge n er al m ee ti n g an d fi n al fi n an ci al st at em en ts .T h is

d ec la re d d iv id en d u su al ly ac co m p an ie s th e co m p an y' s in te ri m

fi n an ci al st at em en ts .

O th e r

O th er d iv id en d s ca n be u se d in st ru ct u re d fi n an ce .F in an ci al as se ts

w it h a kn ow n m ar ke t va lu e ca n be d is tr ib u te d as d iv id en d s;

w ar ra n ts ar e so m et im es d is tr ib u te d in th is w ay .F or la rg e

co m p an ie s w it h su bs id ia ri es ,d iv id en d s ca n ta ke th e fo rm of sh ar es

in a su bs id ia ry co m p an y. A co m m on te ch n iq u e fo r "s p in n in g of f" a

co m p an y fr om it s p ar en t is to d is tr ib u te sh ar es in th e n ew co m p an y

to th e ol d co m p an y' s sh ar eh ol d er s. T h e n ew sh ar es ca n th en be

tr ad ed in d ep en d en tl y.

So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /d iv id en d s/ se tt in g -t he -

d iv id en d /m et ho d -o f- p a ym en t/

C C -B Y -S A

B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e

81 7

S to ck

S p lit s

S to ck

D iv id en

d s

R ev

er se

S p lit s

S ha

re R ep

ur ch

as es

B en

e ts

of S ha

re R ep

ur ch

as es

D ra w b ac

ks of

S ha

re R ep

ur ch

as es

D iv id en

d R ei nv

es tm

en ts

Se ct io n 4

C as

h D iv id en

d A lte

rn at iv es

81 8

ht tp s: // w w w .b ou

nd le ss .c om

/ na

nc e/ d iv id en

d s/ ca

sh -d iv id en

d -a lte

rn at iv es

-- 2/

S to ck

S p lit s

A st oc

k sp

lit in cr ea

se s th e nu

m b er

of sh

ar es

ou ts ta nd

in g w ith

ou t ch

an gi ng

th e m ar ke

t va

lu e of

th e

r m .

K E Y P O IN TS

• A st oc k sp li t is ex ec u te d by of fe ri n g se ve ra ln ew sh ar es in

ex ch an ge fo r ol d on es .T h is m ay be a 3- fo r- 1 sp li t, fo r

ex am p le :e ac h sh ar e co u ld be tr ad ed in fo r th re e n ew on es .

• A st oc k sp li t d oe s n ot ch an ge th e m ar ke t ca p it al iz at io n of th e

fi rm ,i t m er el y ch an ge s th e n u m be r of sh ar es ou ts ta n d in g.

T h er ef or e th e p ri ce p er sh ar e d ec re as es as th e n u m be r of

sh ar es ou ts ta n d in g in cr ea se s.

• E ac h sh ar eh ol d er re ta in s h is or h er sa m e ow n er sh ip st ak e

be ca u se th e n u m be r of sh ar e s/ h e h ol d s ch an ge s in

p ro p or ti on to th e ch an ge in th e to ta ln u m be r of sh ar es

ou ts ta n d in g.

A st oc k sp li t or st oc k d iv id e in cr ea se s th e n u m be r of sh ar es in a

p u bl ic co m p an y. Su p p os e a co m p an y h as 1, 0 0 0 sh ar es ou ts ta n d in g.

T h e co m p an y m ay w an t to in cr ea se th is n u m be r to 2, 0 0 0 sh ar es

w it h ou t is su in g n ew sh ar es .T h ey w ou ld sp li t th ei r st oc k 2- fo r- 1.

T h at m ea n s th at ev er y sh ar eh ol d er tr ad es in on e ol d sh ar e an d ge ts

tw o n ew sh ar es in re tu rn .

T h e ow n er sh ip st ak e fo r ea ch sh ar eh ol d er re m ai n s co n st an t be ca u se

th e n u m be r of sh ar es h el d ch an ge s in p ro p or ti on to th e n u m be r of

sh ar es ou ts ta n d in g. T h ey ow n th e sa m e p er ce n ta ge of th e

ou ts ta n d in g sh ar es ,t h ou gh th e n om in al n u m be r of sh ar es

in cr ea se s.

T h e p ri ce of th e sh ar es ,h ow ev er ,c h an ge s. Si n ce th e m ar ke t va lu e of

th e co m p an y re m ai n s th e sa m e, th e p ri ce of th e n ew sh ar es ad ju st s

to re fl ec t th e n ew n u m be r of ou ts ta n d in g sh ar es .F or ex am p le ,a

co m p an y th at h as 10 0 ,0 0 0 sh ar es ou ts ta n d in g th at tr ad e at $ 6 h as a

m ar ke t ca p it al iz at io n of $ 60 0 ,0 0 0 .A ft er a 3- fo r- 1 st oc k sp li t th e

m ar ke t ca p it al iz at io n of th e co m p an y re m ai n s u n ch an ge d at

$ 60 0 ,0 0 0 ,b u t th er e ar e n ot 30 0 ,0 0 0 sh ar es tr ad in g at $ 2.

L ow er in g th e p ri ce p er sh ar e

is at tr ac ti ve to so m e

co m p an ie s. B er ks h ir e

H at h aw ay C la ss A sh ar es h av e

n ev er be en sp li t, so th e p ri ce

h as fo ll ow ed th e co m p an y' s

gr ow th ov er ti m e (F ig u re 15 .

13 ). Si n ce th e p ri ce of a C la ss A sh ar e w as ov er $ 12 1, 0 0 0 on M ay 2,

20 12 ,s m al le r in ve st or s m ay h av e ch os en n ot to in ve st in B er ks h ir e

H at h aw ay C la ss A sh ar es be ca u se of ca sh -f lo w or li qu id it y co n ce rn s.

T h er e ar e, h ow ev er ,C la ss B sh ar es th at tr ad e at a lo w er va lu e.

81 9

B er ks

hi re

H at ha

w ay

ha s fa m ou

sl y ne

ve r

ha d a st oc

k sp

lit ,a

nd ha

s ne

ve r p ai d a

d iv id en

d .A

s a re su

lt its

C la ss

A sh

ar es

tr ad

ed at

$1 21

,7 75

.0 0 as

of M ay

2, 20

12 ,

m ak

in g th em

th e hi gh

es t- p ric

ed sh

ar es

on th e N ew

Yo rk

S to ck

E xc

ha ng

e.

Fi g ur e 15

.1 3 B er ks hi re H at ha w ay

So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /d iv id en d s/ ca sh -

d iv id en d -a lt er n a ti ve s- -2 /s to ck -s p li ts -- 2/

C C -B Y -S A

B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e

S to ck

D iv id en

d s

S to ck

d iv id en

d s ar e w he

n a co

m p an

y gi ve

s ea

ch sh

ar eh

ol d er

ad d iti on

al st oc

k in

lie u of

a ca

sh d iv id en

d .

K E Y P O IN TS

• St oc k d iv id en d s ar e n o d if fe re n t th an st oc k sp li ts in p ra ct ic e.

T h ey si m p ly in cr ea se th e n u m be r of sh ar es ou ts ta n d in g, bu t

n ot th e m ar ke t ca p it al iz at io n or th e to ta lv al u e of th e

sh ar eh ol d er s' as se ts .

• St oc k d iv id en d s m ay be p ai d fr om n on -o u ts ta n d in g st oc k or

fr om th e st oc k of an ot h er co m p an y (e .g .i ts su bs id ia ry ).

• C as h d iv id en d s ar e ta xe d w h il e st oc k d iv id en d s ar e n ot .

In li eu of ca sh ,a co m p an y m ay ch oo se to p ay it s d iv id en d in th e

fo rm of st oc k. In st ea d of ea ch sh ar eh ol d er re ce iv in g, sa y $ 2 fo r ea ch

sh ar e, th ey m ay re ce iv e an ad d it io n al sh ar e. A st oc k d iv id en d (a ls o

kn ow n as a sc ri p d iv id en d ) ca n be th e ec on om ic eq u iv al en t of a

st oc k sp li t.

W h en a st oc k d iv id en d is p ai d ,n o sh ar eh ol d er ac tu al ly in cr ea se s th e

va lu es of h is or h er as se ts .T h e to ta ln u m be r of sh ar es ou ts ta n d in g

in cr ea se s in p ro p or ti on to th e ch an ge in th e n u m be r of sh ar es h el d

by ea ch sh ar eh ol d er .I fa 5% st oc k d iv id en d is p ai d ,t h e to ta l

n u m be r of sh ar es ou ts ta n d in g in cr ea se s by 5% ,a n d ea ch

82 0

sh ar eh ol d er w il lr ec ei ve 5 ad d it io n al sh ar es fo r ea ch 10 0 h el d .A s a

re su lt ,e ac h sh ar eh ol d er h as th e sa m e ow n er sh ip st ak e as be fo re th e

st oc k d iv id en d .

In ad d it io n ,t h e va lu e of th e sh ar es h el d d oe s n ot ch an ge fo r ea ch

sh ar eh ol d er .A s th e n u m be r of sh ar es ou ts ta n d in g in cr ea se s, th e

p ri ce p er sh ar e d ro p s be ca u se th e m ar ke t ca p it al iz at io n d oe s n ot

ch an ge .T h er ef or e, ea ch sh ar eh ol d er w il lh ol d m or e sh ar es ,b u t ea ch

h as a lo w er p ri ce so th e to ta lv al u e of th e sh ar es re m ai n s

u n ch an ge d .

T h e st oc k d iv id en d is n ot ,h ow ev er ,e xa ct ly th e sa m e as a st oc k sp li t.

A st oc k sp li t is p ai d by sw it ch in g ou t ol d sh ar es fo r a gr ea te r

n u m be r of n ew sh ar es .T h e co m p an y is es se n ti al ly co n ve rt in g to a

n ew se t of sh ar es an d as ki n g ea ch sh ar eh ol d er to tr ad e in th e ol d

on es .

A st oc k d iv id en d co u ld be p ai d fr om sh ar es n ot -o u ts ta n d in g. T h es e

ar e th e co m p an y' s ow n sh ar es th at it h ol d s: th ey ar e n ot ci rc u la ti n g

in th e m ar ke t, bu t w er e is su ed ju st th e sa m e. T h e co m p an y m ay

h av e go tt en th es e sh ar es fr om sh ar e re p u rc h as es ,o r si m p ly fr om

th em n ot be in g so ld w h en is su ed .

St oc k d iv id en d s m ay al so be p ai d fr om n on -o u ts ta n d in g st o ck or

fr om th e st oc k of an ot h er co m p an y (e .g .i ts su bs id ia ry ).

A n ad va n ta ge of p ay in g st oc k

d iv id en d s in st ea d of ca sh

d iv id en d s to th e sh ar eh ol d er is

d u e to ta x co n si d er at io n s.

C as h d iv id en d s ar e ta xe d ,

w h il e st oc k d iv id en d s ar e n ot

(F ig u re 15 .1 4) .O fc ou rs e,

st oc k d iv id en d s d on 't ac tu al ly

ch an ge th e as se t va lu e of th e

sh ar eh ol d er s so ,i n ef fe ct ,

n ot h in g of su bs ta n ce h as

oc cu rr ed .

So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /d iv id en d s/ ca sh -

d iv id en d -a lt er n a ti ve s- -2 /s to ck -d iv id en d s- -2 /

C C -B Y -S A

B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e

82 1

Th e E is ne

r vs .M

ac om

b er

ca se

w as

a U S

S up

re m e C ou

rt C as

e th at

he lp ed

d et er m in e th e d i er en

ce s in

ta xa

tio n of

ca sh

an d st oc

k d iv id en

d s.

Fi g ur e 15

.1 4 S up re m e C ou rt S ea l

R ev

er se

S p lit s

R ev

er se

sp lit s ar e w he

n a co

m p an

y re d uc

es th e

nu m b er

of sh

ar es

ou ts ta nd

in g b y o

er in g a nu

m b er

of ne

w sh

ar es

fo r ea

ch ol d on

e.

K E Y P O IN TS

• In a re ve rs e st oc k sp li t (a ls o ca ll ed a st oc k m er ge ), th e

co m p an y is su es a sm al le r n u m be r of n ew sh ar es .N ew sh ar es

ar e ty p ic al ly is su ed in a si m p le ra ti o, e. g. 1 n ew sh ar e fo r 2 ol d

sh ar es ,3 fo r 4, et c.

• A re ve rs e sp li t bo os ts th e sh ar e p ri ce ,s o th er e is a st ig m a

at ta ch ed .S om e in ve st or s h av e ru le s ag ai n st tr ad in g sh ar es

be lo w a ce rt ai n va lu e, so a co m p an y in fi n an ci al tr ou bl e m ay

is su e a re ve rs e sp li t to ke ep th ei r sh ar e p ri ce ab ov e th at

th re sh ol d .

• A re ve rs e st oc k sp li t m ay be u se d to re d u ce th e n u m be r of

sh ar eh ol d er s. If a co m p an y co m p le te s re ve rs e sp li t in w h ic h 1

n ew sh ar e is is su ed fo r ev er y 10 0 ol d sh ar es ,a n y in ve st or

h ol d in g le ss th an 10 0 sh ar es w ou ld si m p ly re ce iv e a ca sh

p ay m en t.

B y ow n in g a sh ar e, th e sh ar eh ol d er ow n s a p er ce n ta ge of th e

co m p an y w h os e sh ar e s/ h e ow n s. A sh ar e, h ow ev er ,d oe s en ti tl e th e

sh ar eh ol d er to a sp ec if ic p er ce n ta ge ow n er sh ip ;t h e am ou n t of th e

co m p an y th at th e sh ar eh ol d er ow n s is d ep en d en t of th e n u m be r of

sh ar es ow n ed an d th e n u m be r of sh ar es ou ts ta n d in g. If Ji m ow n s 10

sh ar es of O ra cl e, an d th er e ar e 1, 0 0 0 sh ar es ou ts ta n d in g, Ji m

ef fe ct iv el y ow n s 1% of O ra cl e. If th e n u m be r of sh ar es ou ts ta n d in g

w er e to d ou bl e to 2, 0 0 0 ,J im 's 10 sh ar es w ou ld n ow co rr es p on d to a

0 .5 % ow n er sh ip st ak e. In or d er fo r Ji m 's ow n er sh ip st ak e to re m ai n

co n st an t, th e n u m be r of sh ar es h e h ol d s m u st ch an ge in p ro p or ti on

to ch an ge in ou ts ta n d in g sh ar es :h e m u st ow n 20 sh ar es if th er e ar e

2, 0 0 0 sh ar es ou ts ta n d in g.

T h at is th e p re m is e be h in d a re ve rs e st oc k sp li t. In a re ve rs e st oc k

sp li t (a ls o ca ll ed a st oc k m er ge ), th e co m p an y is su es a sm al le r

n u m be r of n ew sh ar es .N ew sh ar es ar e ty p ic al ly is su ed in a si m p le

ra ti o, e. g. 1 n ew sh ar e fo r 2 ol d sh ar es ,3 fo r 4, et c.

T h e re d u ct io n in th e n u m be r of is su ed sh ar es is ac co m p an ie d by a

p ro p or ti on al in cr ea se in th e sh ar e p ri ce .A co m p an y w it h a m ar ke t

ca p it al iz at io n of $ 1, 0 0 0 ,0 0 0 fr om 1, 0 0 0 ,0 0 0 sh ar es tr ad in g at $ 1

ch oo se s to re d u ce th e n u m be r of ou ts ta n d in g sh ar es to 50 0 ,0 0 0

th ro u gh a re ve rs e sp li t. T h is le ad s to a co rr es p on d in g ri se in th e

st oc k p ri ce to $ 2.

T h er e is a st ig m a at ta ch ed to d oi n g a re ve rs e st oc k sp li t, so it is n ot

in it ia te d w it h ou t ve ry go od re as on an d m ay ta ke a sh ar eh ol d er or

bo ar d m ee ti n g fo r co n se n t. M an y in st it u ti on al in ve st or s an d m u tu al

fu n d s, fo r ex am p le ,h av e ru le s ag ai n st p u rc h as in g a st oc k w h os e

p ri ce is be lo w so m e m in im u m .I n an ex tr em e ca se ,a co m p an y

82 2

w h os e sh ar e p ri ce h as d ro p p ed so lo w

th at it is in d an ge r of be in g d el is te d

fr om it s st oc k ex ch an ge ,m ig h t u se a

re ve rs e st oc k sp li t to in cr ea se it s sh ar e

p ri ce .F or th es e re as on s, a re ve rs e st oc k

sp li t is of te n an in d ic at io n th at a

co m p an y is in fi n an ci al tr ou bl e.

A re ve rs e st oc k sp li t m ay be u se d to

re d u ce th e n u m be r of sh ar eh ol d er s. If a

co m p an y co m p le te s re ve rs e sp li t in

w h ic h 1 n ew sh ar e is is su ed fo r ev er y

10 0 ol d sh ar es ,a n y in ve st or h ol d in g le ss th an 10 0 sh ar es w ou ld

si m p ly re ce iv e a ca sh p ay m en t. If th e n u m be r of sh ar eh ol d er s

d ro p s, th e co m p an y m ay be p la ce d in to a d if fe re n t re gu la to ry

ca te go ri es an d m ay be go ve rn ed by d if fe re n t la w s (F ig u re 15 .1 5) .

So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /d iv id en d s/ ca sh -

d iv id en d -a lt er n a ti ve s- -2 /r ev er se -s p li ts -- 2/

C C -B Y -S A

B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e

S ha

re R ep

ur ch

as es

A sh

ar e re p ur ch

as e is

w he

n a co

m p an

y b uy

s its

ow n

st oc

k fr om

p ub

lic sh

ar eh

ol d er s,

th us

re d uc

in g th e

nu m b er

of sh

ar es

ou ts ta nd

in g.

K E Y P O IN TS

• Si n ce th e m ar ke t ca p it al iz at io n is u n ch an ge d an d th e n u m be r

of sh ar es ou ts ta n d in g d ro p s, a sh ar e re p u rc h as e w il ll ea d to a

co rr es p on d in g in cr ea se in st oc k p ri ce .

• T h e re d u ct io n of th e sh ar es ou ts ta n d in g m ea n s th at ev en if

p ro fi ts re m ai n th e sa m e, th e ea rn in gs p er sh ar e in cr ea se .

• T h er e ar e a n u m be r of m et h od s fo r re p u rc h as in g sh ar es ,t h e

m os t p op u la r of w h ic h is op en -m ar ke t: th e co m p an y bu ys

ba ck sh ar es at th e m ar ke t d ic ta te d p ri ce if th e p ri ce is

fa vo ra bl e.

A n al te rn at iv e to ca sh d iv id en d s is sh ar e re p u rc h as es .I n a sh ar e

re p u rc h as e, th e is su in g co m p an y p u rc h as es it s ow n p u bl ic ly tr ad ed

sh ar es ,t h u s re d u ci n g th e n u m be r of sh ar es ou ts ta n d in g. T h e

co m p an y th en ca n ei th er re ti re th e sh ar es ,o r h ol d th em as tr ea su ry

st oc k (n on -c ir cu la ti n g, bu t av ai la bl e fo r re -i ss u an ce ).

W h en a co m p an y re p u rc h as es it s ow n sh ar es ,i t re d u ce s th e n u m be r

of sh ar es h el d by th e p u bl ic .T h e re d u ct io n of th e sh ar es

82 3

Th e S ec

ur iti es

an d E xc

ha ng

e C om

m is si on

is th e

d ep

ar tm

en t th at

se ts

th e

d i er en

t re gu

la tio

ns re ga

rd in g st oc

k tr ad

in g an

d sp

lit tin

g.

Fi g ur e 15

.1 5 S E C

ou ts ta n d in g m ea n s th at ev en if p ro fi ts re m ai n th e sa m e, th e

ea rn in gs p er sh ar e in cr ea se .R ep u rc h as in g sh ar es w h en a co m p an y' s

sh ar e p ri ce is u n d er va lu ed be n ef it s n on -s el li n g sh ar eh ol d er s an d

ex tr ac ts va lu e fr om sh ar eh ol d er s w h o se ll .

R ep u rc h as in g sh ar es w il ll ea d to a co rr es p on d in g in cr ea se in p ri ce

of th e sh ar es st il lo u ts ta n d in g. T h e m ar ke t ca p it al iz at io n of th e

co m p an y is u n ch an ge d ,m ea n in g th at a re d u ct io n in th e n u m be r of

sh ar es ou ts ta n d in g m u st be ac co m p an ie d by an in cr ea se in st oc k

p ri ce .

T h er e ar e si x p ri m ar y re p u rc h as in g m et h od s:

1. O p en M ar ke t: T h e fi rm bu ys it s st oc k on th e op en m ar ke t

fr om sh ar eh ol d er s w h en th e p ri ce is fa vo ra bl e. T h is m et h od

is u se d fo r al m os t 75 % of al lr ep u rc h as es .

2. Se le ct iv e B u y- B ac ks :T h e fi rm m ak es re p u rc h as e of fe rs

p ri va te ly to so m e sh ar eh ol d er s.

3. R ep u rc h as e P u t R ig h ts :P u t ri gh ts ar e th e ri gh t of th e se ll er

to p u rc h as e at a ce rt ai n p ri ce ,s et ah ea d of ti m e. If th e

co m p an y h as p u t ri gh ts on it s sh ar es ,i t m ay u se th em to

re p u rc h as e sh ar es at th at p ri ce .

4. F ix ed P ri ce T en d er O ff er :T h e fi rm an n ou n ce s a n u m be r of

sh ar es it is lo ok in g fo r an d a fi xe d p ri ce th ey ar e w il li n g to

p ay .S h ar eh ol d er s d ec id e w h et h er or n ot to se ll th ei r sh ar es

to th e co m p an y.

5. D u tc h A u ct io n Se lf -T en d er R ep u rc h as e: T h e co m p an y

an n ou n ce s a ra n ge of p ri ce s at w h ic h th ey ar e w il li n g to

re p u rc h as e. Sh ar eh ol d er vo lu n ta ri ly st at e th e p ri ce at w h ic h

th ey in d iv id u al ly ar e w il li n g to se ll .T h e co m p an y th en

co n st ru ct s th e su p p ly -c u rv e, an d th en an n ou n ce s th e

p u rc h as e p ri ce .T h e co m p an y re p u rc h as es sh ar es fr om al l

82 4

To d d S hi p ya

rd s,

in 19

81 ,w

as th e r st

co m p an

y to

us e th e D ut ch

A uc

tio n m et ho

d of

st oc

k re p ur ch

as in g.

S ha

re re p ur ch

as es

(w hi ch

us es

op en

m ar ke

t re p ur ch

as es

m or e th an

D ut ch

A uc

tio ns

)h av

e in cr ea

se d

fr om

$5 b ill io n in

19 80

to $3

49 b ill io n in

20 05

.

Fi g ur e 15

.1 6 To d d S hi p ya rd s

sh ar eh ol d er s w h o st at ed a p ri ce at or be lo w th at re p u rc h as e

p ri ce (F ig u re 15 .1 6) .

6. E m p lo ye e Sh ar e Sc h em e B u y- B ac k: T h e co m p an y

re p u rc h as es sh ar es h el d by or fo r em p lo ye es or sa la ri ed

d ir ec to rs of th e co m p an y.

So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /d iv id en d s/ ca sh -

d iv id en d -a lt er n a ti ve s- -2 /s ha re -r ep u rc ha se s- -2 /

C C -B Y -S A

B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e

B en

e ts

of S ha

re R ep

ur ch

as es

S ha

re re p ur ch

as es

ar e b en

e ci al

w he

n th e st oc

k is

un d er va

lu ed

,m an

ag em

en t ne

ed s to

m ee

t a n

an ci al

m et ric

,o r th er e is

a ta ke

ov er

th re at .

K E Y P O IN TS

• If m an ag em en t fe el s th e co m p an y is u n d er va lu ed ,t h ey w il l

re p u rc h as e th e st oc k, an d th en re se ll it on ce th e p ri ce of th e

sh ar es in cr ea se s to re fl ec t th e ac cu ra te va lu e of th e fi rm .

• A m em be r of m an ag em en t m ay h av e to m ee t ea rn in gs p er

sh ar e (E P S) m et ri cs w h ic h ca n be in cr ea se d by in cr ea si n g

ea rn in gs or lo w er in g th e n u m be r of ou ts ta n d in g sh ar es .

Sh ar e re p u rc h as es d ec re as e th e n u m be r of ou ts ta n d in g

sh ar es ,a n d th u s in cr ea se E P S.

• T o p re ve n t a fi rm fr om ac qu ir in g en ou gh of a co m p an y' s

st oc k to ta ke it ov er ,t h e ta ke ov er ta rg et m ay bu y ba ck sh ar es ,

of te n at a p ri ce ab ov e m ar ke t va lu e.

A co m p an y m ay se ek to re p u rc h as e so m e of it s ou ts ta n d in g sh ar es

fo r a n u m be r of re as on s. T h e co m p an y m ay fe el th at th e sh ar es ar e

u n d er va lu ed ,a n ex ec u ti ve 's co m p en sa ti on m ay be ti ed to ea rn in gs

p er sh ar e ta rg et s, or it m ay n ee d to p re ve n t a h o st il e ta k e o ve r.

82 5

F or sh ar eh ol d er s, th e p ri m ar y be n ef it is th at th os e w h o d o n ot se ll

th ei r sh ar es n ow h av e a h ig h er p er ce n t ow n er sh ip of th e co m p an y' s

sh ar es an d a h ig h er p ri ce p er sh ar e. T h os e w h o d o ch oo se to se ll

h av e d on e so at a p ri ce th ey ar e w il li n g to se ll at - u n le ss th er e w as a

'p u t' cl au se ,i n w h ic h ca se th ey h ad to se ll be ca u se of th e st ru ct u re of

th e sh ar e, so m et h in g th ey w ou ld h av e al re ad y kn ow n w h en th ey

bo u gh t th e sh ar es .

U n d e rv a lu a ti o n

R ep u rc h as in g sh ar es m ay al so be a si gn al th at th e m an ag er fe el s

th at th e co m p an y' s sh ar es ar e u n d er va lu ed .I n th is ev en t, it w il l

ch oo se to re p u rc h as e sh ar es ,a n d th en re se ll th em in th e op en

m ar ke t on ce th e p ri ce in cr ea se s to ac cu ra te ly re fl ec t th e va lu e of th e

co m p an y.

E x e cu ti ve C o m p e n sa ti o n

In so m e in st an ce s, ex ec u ti ve co m p en sa ti on m ay be ti ed to m ee ti n g

ce rt ai n ea rn in gs p er sh ar e (E P S) m et ri cs .I fm an ag em en t n ee d s to

bo os t th e E P S of th e co m p an y to m ee t th e m et ri c, s/ h e h as tw o

ch oi ce s: ra is e ea rn in gs or re d u ce th e n u m be r of sh ar es .I fe ar n in gs

ca n n ot be in cr ea se d ,t h er e ar e a n u m be r of w ay s to ar ti fi ci al ly bo os t

ea rn in gs (c al le d ea rn in gs m an ag em en t) ,b u t s/ h e ca n al so re d u ce

th e n u m be r of sh ar es by re p u rc h as in g sh ar es (F ig u re 15 .1 7) .S tr ic tl y

sp ea ki n g, th is is a be n ef it to th e m an ag em en t an d ex ec u ti ve s, n ot

th e co m p an y or th e sh ar eh ol d er s. -T h w ar t.

H o st il e T a k e o ve rs

A co m p an y ca n ta ke ov er an ot h er fi rm if it h ol d s en ou gh of th e

ot h er ta ke ov er ta rg et 's sh ar es (t h e bu ye r of th e sh ar es is ca ll ed th e

bi d d er ,a n d th e co m p an y it is tr yi n g to bu y is ca ll ed th e ta ke ov er

ta rg et ). T h e bi d d er is bu yi n g th e ta ke ov er ta rg et 's sh ar es in an

at te m p t to p u rc h as e en ou gh to ow n it .A ss u m in g th e fi rm d oe s n ot

82 6

C E O s,

lik e M ar c B en

io  of

S al es

fo rc e. co

m ,m

ay ha

ve to

m ee

t ce

rt ai n n

an ci al

ta rg et s in

or d er

to ea

rn hi s or

he r b on

us .I fo

ne of

th es

e ta rg et s is E P S ,t he

y m ay

ha ve

an in ce

nt iv e to

tr y to

in cr ea

se E P S ar ti

ci al ly .

Fi g ur e 15

.1 7 M ar c B en io ff

w an t to be ta ke n ov er th is w ay ,t h e ta ke ov er at te m p t is ca ll ed

h os ti le .I n or d er to p re ve n t th is fr om h ap p en in g, th e ta ke ov er ta rg et

n ee d s to p re ve n t th e bi d d er fr om p u rc h as in g en ou gh of th e sh ar es .

T o d o th is ,t h e ta ke ov er ta rg et w il lr ep u rc h as e it s ow n sh ar es fr om

th e u n fr ie n d ly bi d d er ,u su al ly at a p ri ce w el la bo ve m ar ke t va lu e.

F u rt h er m or e, it ca n p re ve n t fu tu re ta ke ov er at te m p ts .C om p an ie s

w it h a lo t of ca sh on th ei r ba la n ce sh ee ts ar e m or e at tr ac ti ve

ta ke ov er ta rg et s be ca u se th e ca sh ca n be u se d to p ay d ow n th e d eb t

in cu rr ed to ca rr y ou t th e ac qu is it io n .S h ar e re p u rc h as es ar e on e w ay

of lo w er in g th e am ou n t of ca sh on th e ba la n ce sh ee t.

So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /d iv id en d s/ ca sh -

d iv id en d -a lt er n a ti ve s- -2 /b en ef it s- of -s ha re -r ep u rc ha se s/

C C -B Y -S A

B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e

D ra w b ac

ks of

S ha

re R ep

ur ch

as es

S ha

re re p ur ch

as es

of te n gi ve

an ad

va nt ag

e to

in si d er s

an d ca

n b e us

ed to

m an

ip ul at e n

an ci al

m et ric

s.

K E Y P O IN TS

• In si d er s ar e m or e li ke ly to kn ow if a fi rm is u n d er va lu ed ,a n d

ar e th er ef or e m or e li ke ly to kn ow w h et h er th ey sh ou ld se ll

th ei r sh ar es in an op en -m ar ke t re p u rc h as e.

• F in an ci al ra ti os th at u se th e n u m be r of sh ar es ou ts ta n d in g

ch an ge w h en sh ar es ar e re p u rc h as ed .E xe cu ti ve s an d

m an ag em en t w h os e co m p en sa ti on is ti ed to th es e m et ri cs

h av e an in ce n ti ve to m an ip u la te th em th ro u gh sh ar e

re p u rc h as es .

• Sh ar e re p u rc h as es ar e of te n n ot co m p le te d .I t is to u gh to

va lu e th e ef fe ct of a sh ar e re p u rc h as e an n ou n ce m en t be ca u se

it is u n kn ow n w h et h er it w il lo cc u r in fu ll .

T h er e ar e a n u m be r of d ra w ba ck s to sh ar e re p u rc h as es .B ot h

sh ar eh ol d er s an d th e co m p an ie s th at ar e re p u rc h as in g th e sh ar es

ca n be n eg at iv el y af fe ct ed .

Sh ar es m ay be re p u rc h as ed if th e m an ag em en t of th e co m p an y fe el s

th at th e co m p an y' s st oc k is u n d er va lu ed in th e m ar ke t. It

82 7

re p u rc h as es th e sh ar es w it h th e in te n ti on of se ll in g th em on ce th e

m ar ke t p ri ce of th e sh ar es in cr ea se to ac cu ra te ly re fl ec t th ei r tr u e

va lu e. N ot ev er y sh ar eh ol d er ,h ow ev er ,h as a fa ir sh ot at kn ow in g

w h et h er th e re p u rc h as e p ri ce is fa ir .T h e re p u rc h as in g of th e sh ar es

be n ef it s th e n on -s el li n g sh ar eh ol d er s an d ex tr ac ts va lu e fr om

sh ar eh ol d er s w h o se ll .T h is gi ve s in si d er s an ad va n ta ge be ca u se

th ey ar e m or e li ke ly to kn ow w h et h er th ey sh ou ld se ll th ei r sh ar es to

th e co m p an y (F ig u re 15 .1 8 ).

F u rt h er m or e, sh ar e re p u rc h as es ca n be u se d to m an ip u la te

fi n an ci al m et ri cs .A ll fi n an ci al ra ti os th at in cl u d e th e n u m be r of

sh ar es ou ts ta n d in g (n ot ab ly ea rn in gs p er sh ar e, or E P S) w il lb e

af fe ct ed by sh ar e re p u rc h as es .S in ce co m p en sa ti on m ay be ti ed to

re ac h in g a h ig h en ou gh E P S n u m be r, th er e is an in ce n ti ve fo r

ex ec u ti ve s an d m an ag em en t to tr y to bo os t E P S by re p u rc h as in g

sh ar es .I n ac cu ra te E P S n u m be rs ar e n ot go od fo r in ve st or s be ca u se

th ey im p ly a d eg re e of fi n an ci al h ea lt h th at m ay n ot ex is t.

F ro m th e in ve st or 's st an d p oi n t, on e d ra w ba ck of sh ar e re p u rc h as es

is th at it 's h ar d to ju d ge h ow it w il la ff ec t th e va lu at io n of th e

co m p an y. C om p an ie s of te n an n ou n ce re p u rc h as es an d th en fa il to

co m p le te th em ,b u t re p u rc h as e co m p le ti on ra te s in cr ea se d af te r

co m p an ie s w er e fo rc ed to re tr oa ct iv el y d is cl os e th ei r re p u rc h as e

ac ti vi ty .I t is d if fi cu lt fo r sh ar eh ol d er s, es p ec ia ll y re la ti ve ly

u n in fo rm ed on es ,t o ju d ge h ow th e an n ou n ce m en t w il la ff ec t th e

va lu e of th ei r h ol d in gs if th er e is n o gu ar an te e th at th e fu ll

an n ou n ce d re p u rc h as e w il lo cc u r.

So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /d iv id en d s/ ca sh -

d iv id en d -a lt er n a ti ve s- -2 /d ra w ba ck s- of -s ha re -r ep u rc ha se s/

C C -B Y -S A

B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e

82 8

M ar th a S te w ar t w as

co nv

ic te d of

in si d er

tr ad

in g,

w hi ch

is no

t th e sa

m e as

in si d er s ch

oo si ng

w he

th er

to se

ll th ei r sh

ar es

in a sh

ar e re p ur ch

as e.

In si d er s ar e

st ill at

an ad

va nt ag

e b ec

au se

th ey

w ill kn

ow no

t to

se ll d ur in g th e sh

ar e

re p ur ch

as e.

Fi g ur e 15

.1 8 M ar th a S te w ar t

D iv id en

d R ei nv

es tm

en ts

D iv id en

d re in ve

st m en

t p la ns

(D R IP s)

au to m at ic al ly

re in ve

st ca

sh d iv id en

d s in

th e st oc

k.

K E Y P O IN TS

• D R IP s h el p sh ar eh ol d er s re in ve st th ei r d iv id en d s in th e

u n d er ly in g st oc k w it h ou t h av in g to w ai t fo r en ou gh m on ey to

bu y a w h ol e n u m be r of sh ar es .I t al so m ay al lo w th em to

av oi d so m e br ok er ag e fe es .

• D R IP s h el p st ab il iz e st oc k p ri ce s by in h er en tl y en co u ra gi n g

lo n g- te rm in ve st m en t in st ea d of ac ti ve -m an ag em en t, w h ic h

m ay ca u se vo la ti li ty .

• D R IP s ar e ge n er al ly as so ci at ed w it h p ro gr am s of fe re d by th e

co m p an y. H ow ev er ,b ro ke ra ge fi rm s m ay of fe r si m il ar

re in ve st m en t p ro gr am s ca ll ed "s yn th et ic D R IP s" .

In so m e in st an ce s, a co m p an y m ay of fe r it s sh ar eh ol d er s an

al te rn at iv e op ti on to re ce iv in g ca sh d iv id en d s. T h e sh ar eh ol d er

ch oo se s to n ot re ce iv e d iv id en d s d ir ec tl y as ca sh ;i n st ea d ,t h e

sh ar eh ol d er 's d iv id en d s ar e d ir ec tl y re in ve st ed in th e u n d er ly in g

eq u it y. T h is is ca ll ed a d iv id en d re in ve st m en t p ro gr am or d iv id en d

re in ve st m en t p la n (D R IP ).

T h e p u rp os e of th e D R IP is to al lo w th e sh ar eh ol d er to im m ed ia te ly

re in ve st h is or h er d iv id en d s in th e co m p an y. Sh ou ld th e

sh ar eh ol d er ch oo se to d o th is on h is or h er ow n ,s /h e w ou ld h av e to

w ai t u n ti le n ou gh ca sh ac cu m u la te s to bu y a w h ol e n u m be r of

sh ar es an d s/ h e w ou ld al so in cu r br ok er ag e fe es ( F ig u re 15 .1 9) .

P ar ti ci p at in g in a D R IP ,h ow ev er ,d oe s n ot m ea n th at th e

re in ve st m en t of th e d iv id en d s is fr ee fo r th e sh ar eh ol d er .S om e

D R IP s ar e fr ee of ch ar ge fo r p ar ti ci p an ts ,w h il e ot h er s d o ch ar ge

fe es an d /o r p ro p or ti on al co m m is si on s.

D R IP s h av e be co m e p op u la r m ea n s of in ve st m en t fo r a w id e va ri et y

of in ve st or s as D R IP s en ab le th em to ta ke ad va n ta ge of d ol la r- co st

av er ag in g w it h in co m e in th e fo rm of co rp or at e d iv id en d s th at th e

co m p an y is p ay in g ou t. N ot on ly is th e in ve st or gu ar an te ed th e

re tu rn of w h at ev er th e d iv id en d yi el d is ,b u t s/ h e m ay al so ea rn

w h at ev er th e st oc k ap p re ci at es to d u ri n g h is or h er ti m e of

ow n er sh ip .H ow ev er ,s /h e is al so su bj ec t to w h at ev er th e st oc k m ay

d ec li n e to ,a s w el l.

82 9

B ro ke

ra ge

r m s lik e C ha

rle s S ch

w ab

ea rn

m on

ey b y ch

ar gi ng

a b ro ke

ra ge

fe e fo r

ex ec

ut in g tr an

sa ct io ns

.T hu

s, p ar tic

ip at in g in

a D R IP

he lp s sh

ar eh

ol d er s av

oi d so

m e

or al lo

ft he

fe es

th ey

w ou

ld oc

cu r if th ey

re in ve

st ed

th e d iv id en

d s th em

se lv es

.

Fi g ur e 15

.1 9 C ha rle s S ch w ab

T h er e is an ad va n ta ge to th e th e co m p an y m an ag in g th e D R IP ,t oo .

D R IP S in h er en tl y en co u ra ge lo n g- te rm in ve st m en t in th e sh ar es ,

w h ic h h el p s to m it ig at e so m e of th e vo la ti li ty as so ci at ed w it h ac ti ve -

tr ad in g. D R IP s h el p to st ab il iz e th e st oc k p ri ce .

T h e n am e "D R IP " is ge n er al ly as so ci at ed w it h p ro gr am s ru n by th e

d iv id en d -p ay in g co m p an y. H ow ev er ,s om e br ok er ag e fi rm s al so

of fe r si m il ar p la n s w h er e sh ar eh ol d er s ca n ch oo se to h av e th ei r ca sh

d iv id en d s re in ve st ed in st oc ks fo r li tt le or n o co st .T h is is ca ll ed a

sy n th et ic D R IP .

So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /d iv id en d s/ ca sh -

d iv id en d -a lt er n a ti ve s- -2 /d iv id en d -r ei n ve st m en ts -- 2/

C C -B Y -S A

B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e

83 0