Cash Dividends

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Dividends and Payout Policy

Dividend policy is an important subject in corporate finance, and dividends are a major cash outlay for

many corporations. At first glance, it may seem obvious that a firm would always want to give as much as

possible back to its shareholders by paying dividends. It might seem equally obvious, however, that a firm

could always invest the money for its shareholders instead of paying it out. Should the firm pay out money

to its shareholders, or should the firm take that money and invest it for its shareholders?

Can the wrong dividend policy bankrupt a firm? The following anecdote suggests that dividend

policy can play a role in a company’s downfall.

The automobile industry was quite prosperous in the 1920s, but was hit hard by the depression. Studebaker

Corporation, which was relatively weak to begin with, suffered more than other automotive manufacturers.

Part of the reason for its financial problems was the belief by the firm’s president that dividends alone could

increase the value of the stock. He implemented a dividend policy that increased the dividend payout ratio

from 43 percent in the early 1920s to 91 percent in 1929. However, the dividend was held constant in 1930

and 1931 even as sales and earnings decreased. This led to a payout ratio of 500 percent(!) in 1930 and 350

percent in 1931. In 1932, the company lost $8.7 million, but still paid $1 million in dividends! The firm’s

financial health was damaged significantly by the generous dividend policy and filed for reorganization in

March 1933. Tragically, the firm’s president took it very personally and shot himself three months later.

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Cash Dividends

• Regular cash dividend = cash payments made directly to stockholders as part of a firm's normal operations (usually each quarter)

• Extra cash dividend = paid over and above the regular dividend (may not be repeated in the future)

• Special cash dividend = similar to extra dividend, but definitely won’t be repeated

• Liquidating dividend = some or all of the business has been sold

The most common type of dividend is a cash dividend. Later in the module, we discuss dividends paid in

stock instead of cash.

The basic types of cash dividends are these:

1. Regular cash dividend – normal dividends, usually paid on a quarterly basis.

• Commonly, public companies pay regular cash dividends four times a year.

2. Extra cash dividend – paid over and above the regular dividend, may or may not be repeated

3. Special dividend – one-time dividend paid over and above the regular dividend, won’t be repeated

• Special dividend is similar, but the name usually indicates that this dividend is viewed as a truly unusual or one-time.

4. Liquidating dividend

• The payment of a liquidating dividend usually means that some or all of the business has been liquidated

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Dividend Payment • Declaration Date – Board declares the dividend and it

becomes a liability of the firm

• Ex-dividend Date – Occurs two business days before date of record

– If you buy stock on or after this date, you will not receive the upcoming dividend

– Stock price generally drops by approximately the amount of the dividend

• Date of Record – holders of record are determined, and they will receive the dividend payment

• Date of Payment – checks are mailed

The Board of Directors declares dividends, after which the dividends become a liability of the firm.

To make sure that dividend checks go to the right people, brokerage firms and stock exchanges establish

an ex-dividend date. Ex-dividend date – occurs two days prior to the date of record; if you purchase the

stock on or after the ex-dividend date, you will not receive the dividend. If you buy the stock before this

date, you are entitled to the dividend. If you buy on this date or after, the previous owner will get the

dividend.

Date of record—firm prepares the list of stockholders who will receive dividends.

Date of payment – checks are mailed

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Dividend Payment

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The Ex-Dividend Day Price Drop

The value of the stock is the PV of expected future dividends (eg. Dividend growth model)

You may wonder if it would be advantageous to buy a stock on the day before the ex-dividend date.

If you bought the stock prior to the ex-dividend date, you would pay $10 per share. This would entitle you

to receive the $1 dividend, which will be mailed on the payment date. What is the value of your investment

after the stock goes ex-dividend? You have the $1 dividend plus a share of stock that is now worth $9. In a

perfect world, this would result in a no-arbitrage opportunity. However, you would owe taxes on the

dividend received. Consequently, if the stock price falls by the full amount of the dividend, you are worse

off because you will have $1 dividend + $9 for the stock – taxes paid on the dividend < $10. Therefore, if

the marginal investor is in a positive tax bracket (which is always the case), then the stock price should fall

by less than the dividend amount to compensate the investor for the taxes that must be paid on the dividend.

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Does Dividend Policy Matter?

• Dividends matter

– The value of the stock is based on the present value of expected future dividends

• Dividend policy may not matter

– Dividend policy is the decision to pay dividends versus retaining funds to reinvest in the firm

– In theory, if the firm reinvests capital now, it will grow and can pay higher dividends in the future

The question we will be discussing here is whether the firm should pay out cash now or invest the cash

and pay it out later.

In particular, should the firm pay out a large percentage of its earnings now or a small (or even zero)

percentage?

Recall the dividend growth model:

P0 = D1 / (RE – g)

It can be shown that an increase in the future dividend, D1, will reduce earnings retention and

reinvestment. This will reduce the growth rate, g. Therefore, both the numerator and the denominator

increase, and the net effect on P0 is zero.

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• Consider a firm that can either pay out dividends with one of two plans:

– Plan 1: can pay $10,000 per year for each of the next two years, or

– Plan 2: can pay $9,000 this year, reinvest the other $1,000 into the firm and then pay $11,120 next year.

– Investors require a 12% return.

• Compare the market value of the two plans:

▪ Present value of Plan 1 dividends:

PV of constant dividends = $16,900.51

▪ Present value of Plan 2 dividends:

PV growing dividends with reinvestment = $16,900.51

• If the company will earn the required return, then it doesn’t matter when it pays the dividends.

Illustration of Irrelevance

Assuming that the second dividend is a liquidating dividend and the firm ceases to exist after period 2:

PV = 10,000 / 1.12 + 10,000 / 1.122 = 16,900.51

PV = 9,000 / 1.12 + 11,120 / 1.122 = 16,900.51

Recall the dividend growth model: P0 = D1 / (RE – g). In the absence of market imperfections, such as taxes,

transaction costs and information asymmetry, it can be shown that an increase in the future dividend, D1,

will reduce earnings retention and reinvestment. This will reduce the growth rate, g. Therefore, both the

numerator and the denominator increase and the net effect on P0 is zero.

The idea behind the irrelevance argument is that if the firm has a lower payout ratio now, it will reinvest

the capital into the firm, grow the firm faster and pay higher dividends later. On the other hand, if the firm

has a higher payout ratio now, it will reinvest less capital back into the firm and pay lower dividends later.

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Factors Favoring a Low Payout

• Why might a low payout be desirable?

▪ Taxes:

• Individuals in upper income tax brackets might prefer lower dividend payouts, with their immediate tax consequences, in favor of higher capital gains

▪ Flotation costs:

• Low payouts can decrease the amount of capital that needs to be raised, thereby lowering flotation costs

▪ Dividend restrictions:

• bond indentures often contain a provision that limits the level of dividend payments

• Taxes Investors that are in high marginal tax brackets might prefer lower dividend payouts. If the firm reinvests

the capital back into positive NPV investments, then this should lead to an increase in the stock price. The

investor can then sell the stock when she chooses and pay capital gains taxes at that time. Taxes must be

paid on dividends immediately, and even though qualified dividends are currently taxed at the same rate as

capital gains, the effective tax rate is higher because of the timing issue.

Currently, individuals in the higher marginal income tax brackets pay 15% to 20% on capital gains and

dividends, while taxpayers in the lower brackets generally pay nothing. The new tax law keeps the existing

0%, 15% and 20% brackets.

• Flotation costs If a firm has a high dividend payout, then it will be using its cash to pay dividends instead of investing in

positive NPV projects. If the firm has positive NPV projects available, it will need to go to the capital

market to raise money for the projects. There are fees and other costs (flotation costs) associated with

issuing new securities. If the company had paid a lower dividend and used the cash on hand for projects, it

could have avoided at least some of the flotation costs.

• Dividend Restrictions In some cases, a corporation may face restrictions on its ability to pay dividends. Bond indentures often

contain a provision that limits the level of dividend payments.

There is a conflict of interest between stockholders and bondholders. As a result, bond indentures contain

restrictive covenants to prevent the transfer of wealth from bondholders to stockholders. Dividend

restrictions are one of the most common restrictive covenants. They normally require that dividends be

forgone when net working capital falls below a certain level or that dividends only be paid out of net income,

not retained earnings that existed before the bond agreement was signed.

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Factors Favoring a High Payout • Why might a high payout be desirable?

▪ Desire for current income: • Individuals who want current income (eg. retirees) can either invest in

companies that have high dividend payouts or they can sell shares of stock.

• Trust funds and endowments may prefer current income because they may be restricted from selling stock

▪ Uncertainty resolution: • No guarantee that the higher future dividends will materialize

▪ Tax and legal benefits from high dividends: • Corporate investors—taxable exclusion of at least 70% of dividends received

from other corporations.

• Tax-exempt investors—tax-exempt investors do not care about the differential tax treatment between dividends and capital gains.

Desire for Current Income

• Individuals that want current income can either invest in companies that have high dividend payouts or they can sell shares of stock. An advantage to dividends is that you don’t have to pay commission.

• Trust funds and endowments may prefer current income because they may be restricted from selling stock to meet expenses if it will reduce the fund below the initial principal amount.

Tax and Other Benefits from High Dividends

• Corporate investors – at least 50% of dividends received from other corporations does not have to be included in taxable income (but there is no such exclusion for capital gains)

• Tax-exempt investors – tax-exempt investors do not care about the differential tax treatment between dividends and capital gains. And, in many cases, tax-exempt institutions have a fiduciary responsibility

to invest money prudently. The courts have found that it is not prudent to invest in firms without an

established dividend policy

Conclusion

• Differences in tax laws and regulations cause some groups to prefer dividends.

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• Asymmetric information – managers have more information about the health of the company than investors

• Changes in dividends convey information

▪ Dividend increases • Management believes it can be sustained • Expectation of higher future dividends, increasing

present value • Signal of a healthy, growing firm

▪ Dividend decreases • Management believes it can no longer sustain the

current level of dividends • Expectation of lower dividends indefinitely; decreasing

present value • Signal of a firm that is having financial difficulties

Dividends and Signals

Changes in dividends may be important signals if the market anticipates that the change will be maintained

through time. If the market believes that the change is just a rearrangement of dividends through time, then

the impact will be small. The reaction to the information contained in dividend changes is called the

information content effect.

Selling stock to raise funds for dividends also creates a “bird-in-the-hand” situation for the shareholder.

Again, we are back to “all else equal.” Can a higher dividend make a stock more valuable? If a firm must

sell more stock or borrow more money to pay a higher dividend now, it must return less to the stockholder

in the future. The uncertainty over future income (the firm’s business risk) is not affected by dividend policy.

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Clientele Effects

• Investor preference: - If a firm changes its policy, it will just have different investors.

- Some investors prefer low dividend payouts

- Some investors prefer high payouts

- Investors will buy stock in companies that meet their dividend preferences

• What do you think will happen if a firm changes its policy from a high payout to a low payout? … or vice versa?

Some investors prefer low dividend payouts and will buy stock in those companies that offer low dividend

payouts.

Some investors prefer high dividend payouts and will buy stock in those companies that offer high dividend

payouts.

In our earlier discussion, we saw that some groups (wealthy individuals, for example) have an incentive to

pursue low-payout (or zero-payout) stocks. Other groups (corporations, for example) have an incentive to

pursue high-payout stocks. Companies with high payouts will thus attract one group, and low-payout

companies will attract another. These different groups are called clienteles.

The clientele effect says that dividend policy is irrelevant because investors that prefer high payouts will

invest in firms that have high payouts, and investors that prefer low payouts will invest in firms with low

payouts. When a firm chooses a particular dividend policy, the only effect is to attract a particular clientele.

If a firm changes its dividend policy, then it just attracts a different clientele.

If a firm changes its payout policy, it will not affect the stock value, it will just end up with a different set

of investors. This is true as long as the “market” for dividend policy is in equilibrium. In other words, if

there is excess demand for companies with high dividend payouts, then a low payout company may be able

to increase its stock value by switching to a high payout policy. This is only possible until the excess demand

is met.

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Stock Repurchase • Company buys back shares of its own stock

– Open market = company buys its own stock in the open market

– Tender offer = company states a purchase price and a desired number of shares to be bought

– Targeted repurchase = firm repurchases shares from specific individual shareholders

• Similar to a cash dividend in that it returns cash from the firm to the stockholders

• This is another argument for dividend policy irrelevance in the absence of taxes or other imperfections.

A firm may choose to buy back outstanding shares instead of paying a cash dividend (or instead of

increasing a regular dividend). If we assume no market imperfections, then stockholder wealth is unaffected

by the choice between share repurchases and cash dividends.

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• Stock repurchase allows investors to decide if they want the current cash flow and associated tax consequences.

• Given our tax structure, repurchases may be more desirable due to the options provided stockholders.

• The IRS recognizes this and will not allow a stock repurchase for the sole purpose of allowing investors to avoid taxes.

Real-World Considerations

One of the most important market imperfections related to cash dividends versus share repurchases is the

differential tax treatment of dividends versus capital gains. When a company does a share repurchase, the

investor can choose whether to sell their shares and take the capital gain (loss) and the associated tax

consequences. When a company pays dividends, the investor does not have a choice and taxes must be paid

immediately.

The IRS understands the tax differences between the two methods for returning cash to stockholders and

prohibits stock repurchase plans solely for the purpose of allowing investors to avoid taxes.

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Tax Effects of Dividends and Stock Repurchases

• Cash dividends: – No investor control over timing or size

– Taxed as ordinary income

• Repurchase: – Allows investors to decide if they want a current

cash flow

– Taxed only if: • They choose to sell AND

• They reap a capital gain on the sale

– Gain may qualify as lower taxed capital gains if shares owned more than one year.

When a company pays dividends, the investor does not have a choice, and taxes must be paid immediately.

Historically, the lower tax rate on capital gains favored repurchases over dividends.

When a company does a share repurchase, the investor can choose whether to sell his/her shares and take

the capital gain (loss) and the associated tax consequences.

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Information Content of Dividends & Repurchases

• Changes in the dividend signal management’s view concerning the firm’s future prospects

• Stock repurchases signal that management believes the current stock price is low

• Tender offers send a more positive signal than open market repurchases because the company is stating a specific stock price

• Stock prices often increase when repurchases are announced

An increase in dividends sends a signal that prospects are good and that the firm will be able to maintain

the higher dividend. A decrease in dividends is usually an indication that the firm can no longer sustain the

current dividend level. Note the Wall Street aphorism: “Earnings declines are tolerable for a while, but the

market never forgives a dividend cut.”

Repurchase announcements are often viewed by market participants as favorable signals of future firm

prospects and/or as evidence that management believes that shares are currently undervalued. As a

consequence, share prices tend to rise when a buyback is announced.

Tender offers are viewed more favorably than open market repurchases because tender offers specify a

share price.

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“America West Airlines announced that its Board of Directors has authorized the purchase of up to 2.5 million shares of its Class B common stock on the open market as circumstances warrant over the next two years …”

“Following the approval of the stock repurchase program by the company’s Board of Directors earlier today. W. A. Franke, chairman and chief officer said ‘The stock repurchase program reflects our belief that America West stock may be an attractive investment opportunity for the Company, and it underscores our commitment to enhancing long-term shareholder value.”

“The shares will be repurchased with cash on hand, but only if and to the extent the Company holds unrestricted cash in excess of $200 million to ensure that an adequate level of cash and cash equivalents is maintained.”

Example: Repurchase Announcement

A quick search of stock repurchase announcements following the terrorist attacks on September 11 found

at least nine companies that specifically cited a desire to support American financial markets and confidence

in the long-term prospects of the economy and the company as reasons for the repurchase. Some of these

companies were Cisco, E-Trade, and Pfizer. At least fourteen other major companies made repurchase

announcements in the week that followed the attacks. These announcements were for new or continuing

repurchases without specifically mentioning the attacks or support for the markets. These companies

include Intel, Federal Express, and PeopleSoft.

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• Corporations “smooth” dividends.

• Dividends provide information to the market.

• Firms should follow a sensible dividend policy:

– Don’t forgo positive NPV projects just to pay a dividend.

– Avoid issuing stock to pay dividends.

– Consider share repurchase when there are few better uses for the cash.

What We Know and Do Not Know

A. Dividends and Dividend Payers

Dividends are large in the aggregate; however, the number of firms that pay a dividend has declined over

time. This suggests that dividend payments are concentrated in a relatively small set of (larger, older) firms.

This issue remains even after controlling for the increased use of repurchases, although not to the same

extent following the tax cut on dividends in 2003.

B. Corporations Smooth Dividends

Because of the information content of dividend changes, managers may prefer to maintain a more stable

dividend policy. This reduces the uncertainty surrounding expected future dividends and should decrease

the risk attributed to the cash flows from the stock.

In July, 1995, Venture Corporation, a high-volume discount retailer, announced the suspension of its

quarterly dividend following a period of poor earnings performance. The price of the stock (which had

already fallen over the preceding months) fell by approximately one-third on the day of the announcement.

Subsequent quarterly earnings were “disappointing,” and the firm filed for bankruptcy and was liquidated

a few years later.

At about the same time, Edison Brothers, also a retailer, announced that its dividend would be reduced in

order to “conserve cash for investment opportunities.” The price of the stock fell dramatically, and the

dividend was subsequently reduced again about a year later. Eventually the dividend was eliminated, and

the firm filed for bankruptcy. In both cases, dividend reductions followed periods of poor earnings

performance and were followed by more poor performance. One might say that the “signal” being sent by

the dividend cut was completely accurate!

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• Aggregate payouts are massive and have increased over time.

• Dividends are concentrated among a small number of large, mature firms.

• Managers are reluctant to cut dividends.

• Managers smooth dividends.

• Stock prices react to unanticipated changes in dividends.

Putting It All Together

This section can be summarized by five primary observations:

Aggregate payouts (dividends and repurchases) are massive and have increased in absolute terms over the

years.

Dividends are concentrated among a small number of large, mature firms.

Managers are reluctant to cut dividends, normally doing so only due to firm-specific problems.

Managers smooth dividends, raising them slowly and incrementally as earnings grow.

Stock prices react to unanticipated changes in dividends.

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Pros and Cons of Paying Dividends

1. Cash dividends underscore good results and provide support to stock price

2. Dividends may attract institutional investors

3. Stock price usually increases with a new or increased dividend

4. Dividends absorb excess cash and may reduce agency costs

1. Dividends are taxed to recipients

2. Dividends can reduce internal sources of funding

• May force firm to forgo positive NPV projects

• May require external financing

3. Once established, dividends cuts are hard to make without adversely affecting a firm’s stock price.

Pros Cons

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Stock Dividends

• Distribute additional shares of stock instead of cash

• Increases the number of outstanding shares

• Small stock dividend

– Less than 20 to 25%

– If you own 100 shares and the company declared a 10% stock dividend, you would receive an additional 10 shares

• Large stock dividend – more than 20 to 25%

Stock dividend – dividend paid in shares of stock rather than in cash. Commonly expressed as a percentage,

e.g., a 25% stock dividend means you will receive 1 share for every 4 that you own. As with a cash dividend,

the stock price declines proportionally.

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Stock Splits

• Essentially the same as a stock dividend except expressed as a ratio

– For example, a 2-for-1 stock split means you will have two shares after the split for every one that you owned before the split. (the same as a 100% stock dividend)

• Stock price is reduced when the stock splits

• The total value of owners' equity does not change

• Common explanation for split is to return price to a “more desirable trading range”

Stock split – new outstanding shares issued to existing stockholders, expressed as a ratio, e.g., a 2-for-1

split means you will receive 2 shares for every one that you own. Again, the price drops proportionally.

Splits are usually, but not always, larger than dividends and are treated differently for accounting purposes.

Some Details about Stock Splits and Stock Dividends

• Stock dividend – retained earnings transferred to par value and capital accounts • Stock split – par value adjusted to reflect the split with no effect on retained earnings

Value of Stock Splits and Stock Dividends

• Benchmark case – no change in shareholder wealth

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Reverse Stock Splits

• Reverse Split reduces number of shares outstanding

– For example, a 1-for-5 stock split replaces every 5 shares of stock with one share

• Reasons:

1. Transactions costs may be less for investors

2. Liquidity might be improved

3. Too low a price not considered “respectable”

4. Exchange minimum price per share requirements

Three popular reasons:

• Reduced transaction costs (higher priced stocks have lower commissions on a percentage basis).

• Popular trading range—the price has gotten too low and it affects the stock’s liquidity and marketability.

• Respectability—many people are leery about investing in “penny stocks.”

Two technical reasons:

• Stock exchanges have minimum listing requirements.

• May combine a reverse split and a stock repurchase where the company offers to buy out shareholders

who end up owning shares below some minimum number.

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• A company’s stock is priced at $50 per share, and it plans to pay a $2 cash dividend.

▪ Assuming perfect capital markets, what will the per share price be after the dividend payment?

▪ If the average tax rate on dividends is 25%, what will the new share price be?

Comprehensive Problem

In perfect market, new price = $48.

In imperfect market, new price = 48 + 2 × .25 = $48.50