Chapter 13

Dilemma: Should the firm use retained earnings for: a) Financing profitable capital investments? b) Paying dividends to stockholders?

So, dividend policy really involves 2 decisions: n How much of the firm’s earnings should be distributed to shareholders as dividends, and n How much should be retained for capital investment?

Is Dividend Policy Important? Three viewpoints: 1) Dividends are Irrelevant. If we assume perfect markets (no taxes, no transaction costs, etc.) dividends do not matter. If we pay a dividend, shareholders’ dividend yield rises, but capital gains decrease.

2) High Dividends are Best n Some investors may prefer a certain dividend now over a risky expected capital gain in the future.

3) Low Dividends are Best n Dividends are taxed immediately. Capital gains are not taxed until the stock is sold. n Therefore, taxes on capital gains can be deferred indefinitely.

Do Dividends Matter? Other Considerations: 1) Residual Dividend Theory: n The firm pays a dividend only if it has retained earnings left after financing all profitable investment opportunities. n This would maximize capital gains for stockholders and minimize flotation costs of issuing new common stock.

Do Dividends Matter? 2) Clientele Effects: n Different investor clienteles prefer different dividend payout levels. n Some firms, such as utilities, pay out over 70% of their earnings as dividends. These attract a clientele that prefers high dividends. n Growth-oriented firms which pay low (or no) dividends attract a clientele that prefers price appreciation to dividends.

Do Dividends Matter? 3) Information Effects: n Unexpected dividend increases usually cause stock prices to rise, and unexpected dividend decreases cause stock prices to fall. n Dividend changes convey information to the market concerning the firm’s future prospects.

Dividend Policies 1) Constant Dividend Payout Ratio: if directors declare a constant payout ratio of, for example, 30%, then for every dollar of earnings available to stockholders, 30 cents would be paid out as dividends. n The ratio remains constant over time, but the dollar value of dividends changes as earnings change.

Dividend Policies 2) Stable Dollar Dividend Policy: the firm tries to pay a fixed dollar dividend each quarter. n Firms and stockholders prefer stable dividends. Decreasing the dividend sends a negative signal!

Dividend Policies 3) Small Regular Dividend plus Year- End Extras n The firm pays a stable quarterly dividend and includes an extra year- end dividend in prosperous years. n By identifying the year-end dividend as “extra,” directors hope to avoid signaling that this is a permanent dividend.

Stock Dividends and Stock Splits n Stock dividend: payment of additional shares of stock to common stockholders. n Example: Citizens Bancorporation of Maryland announces a 5% stock dividend to all shareholders of record. For each 100 shares held, shareholders receive another 5 shares. n Does the shareholders’ wealth increase?

Stock Dividends and Stock Splits n Stock Split: the firm increases the number of shares outstanding and reduces the price of each share. n Example: Joule, Inc. announces a 3-for-2 stock split. For each 100 shares held, shareholders receive another 50 shares. n Does this increase shareholder wealth? n Are a stock dividend and a stock split the same?

Stock Dividends and Stock Splits n Stock Splits and Stock Dividends are economically the same: the number of shares outstanding increases and the price of each share drops. The value of the firm does not change. n Example: A 3-for-2 stock split is the same as a 50% stock dividend. For each 100 shares held, shareholders receive another 50 shares.

Stock Dividends and Stock Splits n Effects on Shareholder Wealth: these will cut the company “pie” into more pieces but will not create wealth. A 100% stock dividend (or a 2-for-1 stock split) gives shareholders 2 half-sized pieces for each full-sized piece they previously owned. n For example, this would double the number of shares, but would cause a $60 stock price to fall to $30.

Stock Dividends and Stock Splits n Why bother? n Proponents argue that these are used to reduce high stock prices to a “more popular” trading range (generally $15 to $70 per share). n Opponents argue that most stocks are purchased by institutional investors who have millions of dollars to invest and are indifferent to price levels. Plus, stock splits and stock dividends are expensive!

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

Stock Repurchases Methods: n Buy shares in the open market through a broker. n Buy a large block by negotiating the purchase with a large block holder, usually an institution (targeted stock repurchase). n Tender offer: offer to pay a specific price to all current stockholders.