Chapter 10 Dividend Policy © 2005 Thomson/South-Western

2 Dividend Policy  Dividends:  Payments made to stockholders from the firm’s earnings, whether those earnings were generated in the current period or in previous periods  Dividends affect capital structure:  Retaining earnings increases common equity relative to debt.  Financing with retained earnings is cheaper than issuing new common equity.

3 Dividend Policy and Stock Value  Dividend Irrelevance Theory  Theory states that a firm’s dividend policy has no effect on either its value or its cost of capital.  Investors value dividends and capital gains equally.  Optimal Dividend Policy:  Strikes a balance between current dividends and future growth that maximizes the firm’s stock price.

4 Dividend Policy and Stock Value  Dividend Relevance Theory  A firm’s value is affected by its dividend policy.  The optimal dividend policy is the one that maximizes the firm’s value.

5 Investors and Dividend Policy  Information Content, or Signaling  Signaling hypothesis says that investors regard dividend changes as signals of management’s earnings forecasts.  Clientele Effect:  The tendency of a firm to attract the type of investor who likes its dividend policy

6 Investors and Dividend Policy  Free Cash Flow Hypothesis  All else equal, firms that pay dividends from cash flows that cannot be reinvested in positive net present value projects (free cash flows), have higher values than firms that retain free cash flows.

7 Dividend Policy in Practice Types of Dividend Payments  Residual Dividend Policy:  A policy in which the dividend paid is set equal to the actual earnings minus the amount of retained earnings necessary to finance the firm’s optimal capital budget  Stable, Predictable Dividend Policy  Payment of a specific dollar dividend each year, or periodically increasing the dividend at a constant rate  The annual dividend is relatively predictable by investors.

8 Dividend Policy in Practice Types of Dividend Payments  Constant Payout Ratio: Percentage of earnings, such as 50 percent. Must watch out for reductions, which may seem to signal permanent earnings decline  Low Regular Dividend Plus Extras: A low regular dividend plus a year-end extra in good years

9 Dividend Policy in Practice Payment Procedures  Declaration Date:  Date on which a firm’s board of directors issues a statement declaring a dividend  Holder-Of-Record Date:  The date on which the company opens the ownership books to determine who will receive the dividend

10 Dividend Policy in Practice Payment Procedures  Ex-Dividend Date:  The date on which the right to the next dividend no longer accompanies a stock  Usually two business days prior to the holder-of- record date  Payment Date:  The date on which the company actually mails dividend checks

11 DRIP Dividend Policy in Practice: Dividend Reinvestment Plans DRIP  Plans that enable stockholders to automatically reinvest dividends received back into the stock of the paying firm  Can either repurchase existing shares or issue new shares

12 Factors Influencing Dividend Policy 1.Constraints on dividend payments:  Debt contract restrictions  Cannot exceed “retained earnings”  Cash availability  IRS restrictions on improperly accumulated retained earnings

13 Factors Influencing Dividend Policy 2.Investment opportunities Large capital budgeting projects affect dividend-payout ratios. 3.Alternative sources of capital 4.Ownership dilution 5.Effects of dividend policy on k S

14 Stock Dividends versus Stock Splits  Stock Dividend: Firm issues new shares in lieu of paying a cash dividend. If 10%, you would get 10 shares for each 100 owned  Stock Split: Firm increases the number of shares outstanding, say 2:1. Firm sends shareholders more shares.

15 Stock Dividends and Stock Splits:  Both stock dividends and stock splits increase the number of shares outstanding, so “the pie is divided into smaller pieces.”  Unless the stock dividend or stock split conveys information, or is accompanied by another event like higher dividends, the stock price falls so as to keep each investor’s wealth unchanged.  But splits/stock dividends may help firm reach an “optimal price range.”

16 Capital Structures and Dividend Policies Around the World  Companies in Italy and Japan use more debt than companies in the United States or Canada, but companies in the United Kingdom use less than any of these.  Different accounting practices make comparisons difficult.  Gap has narrowed in recent years.  Dividend-payout ratios vary greatly also.

17 Reality does not match these conclusions. Logical analysis would indicate that: Capital Structures and Dividend Policies Around the World 1.Tax codes generally favor use of debt in developed countries. 2.In countries where capital gains are not taxed, investors should show a preference for stocks compared with countries that have capital gains taxes. 3.Investor preferences should lead to relatively low equity capital costs in those countries that do not tax capital gains.

18 Capital Structures and Dividend Policies Around the World  What about risk, especially bankruptcy costs?  Foreign banks are closely linked to corporations that borrow from them, and have substantial influence over the management of the debtor firms.  Equity monitoring costs are comparatively low in the United States.  These low monitoring costs indicate that U.S. firms should have more equity and less debt than firms in countries like Japan and Germany

19 End of Chapter 10 Dividend Policy