1. FIN 360: Corporate Finance
Topic 13: Distributions to Shareholders
Larry Schrenk, Instructor

2. Topics
Dividends
Stock Repurchases
Stock Splits

3. Different Types of Dividends
Many companies pay a regular cash dividend.
Public companies often pay quarterly.
Sometimes firms will pay an extra cash dividend.
The extreme case would be a liquidating dividend.
Companies will often declare stock dividends.
No cash leaves the firm.
The firm increases the number of shares outstanding.
Some companies declare a dividend in kind.
Wrigley’s Gum sends a box of chewing gum.
Dundee Crematoria offers shareholders discounted cremations.

4. Procedure for Cash Dividend
25 Oct.
1 Nov.
2 Nov.
5 Nov.
7 Dec. …
Declaration Date
Cum-Dividend Date
Ex-Dividend Date
Record Date
Payment Date
Declaration Date: The Board of Directors declares a payment of dividends.
Cum-Dividend Date: Buyer of stock still receives the dividend.
Ex-Dividend Date: Seller of the stock retains the dividend.
Record Date: The corporation prepares a list of all individuals believed to be stockholders as of this date.

5. Price Behavior
In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date.
-t … … $P
$P - div
The price drops by the amount of the cash dividend.
Ex-Dividend Date

6. Irrelevance of Dividend Policy
A compelling case can be made that dividend policy is irrelevant.
Since investors do not need dividends to convert shares to cash; they will not pay higher prices for firms with higher dividends.
In other words, dividend policy will have no impact on the value of the firm because investors can create whatever income stream they prefer by using homemade dividends.

7. Homemade Dividends
Bianchi Inc. is a $42 stock about to pay a $2 cash dividend.
Bob Investor owns 80 shares and prefers a $3 dividend.
Bob’s homemade dividend strategy:
Sell 2 shares ex-dividend
homemade dividends
Cash from dividend $160
Cash from selling stock $80
Total Cash $240
Value of Stock Holdings $40 × 78 =
$3,120
$3 Dividend
$240 $0
$39 × 80 =
$3,120

8. Dividend Policy is Irrelevant
In the above example, Bob Investor began with a total wealth of $3,360:
After a $3 dividend, his total wealth is still $3,360:
After a $2 dividend and sale of 2 ex-dividend shares, his total wealth is still $3,360: 19

9. Dividends and Investment Policy
Firms should never forgo positive NPV projects to increase a dividend (or to pay a dividend for the first time).
Recall that one of the assumptions underlying the dividend-irrelevance argument is: “The investment policy of the firm is set ahead of time and is not altered by changes in dividend policy.”

10. Repurchase of Stock
Instead of declaring cash dividends, firms can rid themselves of excess cash through buying shares of their own stock.
Recently, share repurchase has become an important way of distributing earnings to shareholders.

11. Stock Repurchase versus Dividend
Consider a firm that wishes to distribute $100,000 to its shareholders.
$10 =
/100,000
$1,000,000
Price per share
100,000
outstanding
Shares
1,000,000
Value of Firm
Equity
850,000
Assets
Other
Debt
$150,000
Cash
sheet
balance
Original A.
&
Liabilities 15

12. Stock Repurchase versus Dividend
If they distribute the $100,000 as a cash dividend, the balance sheet will look like this: $9 =
00,000
$900,000/1
share
per
Price
100,000
outstanding
Shares
900,000
Firm of
Value
Equity
850,000
Assets
Other
Debt
$50,000
Cash
dividend
cash $1
After B.
&
Liabilities 16

13. Stock Repurchase versus Dividend
If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:
Assets
Liabilities
&
Equity C.
After stock repurchase
Cash
$50,000
Debt
Other Assets
850,000
900,000
Value of Firm
Shares outstanding =
90,000
Price per
share
$900,000 /
$10 17

14. Share Repurchase Flexibility for Shareholders Keeps Stock Price Higher
Good for insiders who hold stock options
As an Investment of the Firm
Tax Benefits

15. Personal Taxes, Issuance Costs, and Dividends
To get the result that dividend policy is irrelevant, we needed three assumptions:
No taxes
No transactions costs
No uncertainty
In the United States, both cash dividends and capital gains are taxed at a maximum rate of 15 percent.
Since capital gains can be deferred, the tax rate on dividends is greater than the effective rate on capital gains.
The dividend and capital gains tax rates are subject to change at the discretion of Congress.

16. Firms with Sufficient Cash
The above argument does not necessarily apply to firms with excess cash.
Consider a firm that has $1 million in cash after selecting all available positive NPV projects.
Select additional capital budgeting projects (by assumption, these are negative NPV).
Acquire other companies
Purchase financial assets
Repurchase shares

17. Taxes, Issuance Costs, and Dividends
In the presence of personal taxes:
A firm should not issue stock to pay a dividend.
Managers have an incentive to seek alternative uses for funds to reduce dividends.
Though personal taxes mitigate against the payment of dividends, these taxes are not sufficient to lead firms to eliminate all dividends.

18. Real-World Factors Favoring High Dividends
Desire for Current Income
Behavioral Finance
It forces investors to be disciplined.
Tax Arbitrage
Investors can create positions in high dividend yield securities that avoid tax liabilities.
Agency Costs
High dividends reduce free cash flow.

19. The Clientele Effect
Clienteles for various dividend payout policies are likely to form in the following way:
Group
Stock Type
High Tax Bracket Individuals
Zero-to-Low Payout
Low Tax Bracket Individuals
Low-to-Medium Payout
Tax-Free Institutions
Medium Payout
Corporations
High Payout
Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy.

20. What We Know and Do Not Know
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.

21. Stock Dividends Pay 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%

22. Stock Splits
Stock splits–essentially the same as a stock dividend except it is expressed as a ratio
For example, a 2 for 1 stock split is the same as a 100% stock dividend.
Stock price is reduced when the stock splits.
Common explanation for split is to return price to a “more desirable trading range.”
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