0. Week 11 Lecture 11 Ross, Westerfield and Jordan 7e Chapter 18
Dividends and Dividend Policy

1. Last Week.. Capital Structure Effect of Financial Leverage
M&M propositions I and II
Case 1 – No Costs
Case 2 – With Taxes
Case 3 – With Taxes and Bankruptcy Costs
Bankruptcy Costs
Direct & Indirect
Optimal Capital Structure

2. Chapter 18 Outline Cash Dividends and Dividend Payment
Does Dividend Policy Matter?
Some Real-World Factors Favoring a Low Payout
Some Real-World Factors Favoring a High Payout
A Resolution of Real-World Factors
Establishing a Dividend Policy
Stock Repurchase: An Alternative to Cash Dividends
Stock Dividends and Stock Splits

3. Cash Dividends Regular cash dividend Extra cash dividend
– cash payments made directly to stockholders, usually each quarter
Extra cash dividend
– indication that the “extra” amount 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

4. Dividend Payment - Chronology
Declaration Date
Board declares the dividend and it becomes a liability of the firm
Ex-dividend Date
Two business days before date of record
Stock bought on or after this date, will not receive the dividend
Stock price generally drops by about the amount of the dividend
Date of Record
Holders of record are determined
Date of Payment
Cheques are mailed

5. Figure 18.2 - Price Behavior around ex date

6. Example 18.1
Divided Airlines has declared a $2.50 dividend per share payable on Tuesday, May 30, to shareholders of record as of Tuesday, May 9.
An investor buys 100 shares of this company on Tuesday May 2 for $150 each.
What is the ex date? What are the events happening with respect to the dividend and stock price?

7. Example 18.1 continued.. Purchase: Tuesday 2nd of May
Ex date: Friday 5th of May
Saturday 6th do not count
Sunday 7th
Monday 8th of May
Date of record: Tuesday 9th of May
Checks mailed: Tuesday 30th of May
2nd th th 30th
Purchase Ex-date Record date Payment

8. Example 18.1 continued.. Value of stock around ex-dividend date
$ $147.50
-t t
$2.50 ex-dividend price drop
Investor’s wealth at dividend payment date:
$ x 100 shares = $14,750
$2.50 x 100 shares = $250
Total = $15,000

9. Does Dividends and 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
Pay larger dividends and reinvest less vs
Pay smaller dividends and retain funds to reinvest more in the firm
In theory, if the firm reinvests capital now, it will grow and can pay higher dividends in the future

10. Irrelevance Theory
Modigliani and Miller’s (1961) irrelevance theory makes use of home-made dividends and relies on a number of assumptions:
No company taxes, no transaction costs or market imperfections.
No personal taxes
A fixed capital budgeting program
The value of a firm:
is determined by the earning power of the firm’s assets
is not affected how the income is split between dividends and retained earnings.

11. Illustration of Irrelevance
Palm Inc. is a firm with 2 year life and 100 shares
Policy 1: pay out dividends of $100 each year
Policy 2: pay $90 dividend year 1, reinvest the other $10 into the firm and then pay $ next year. Investors require a 12% return.
Which policy is the best?
It doesn’t matter !! Value is the same
Market Value with constant dividend = $16,900.51
PV = 10,000 / ,000 / = 16,900.51
Market Value with reinvestment = $16,900.51
PV = 9000 / ,120 / = 16,900.51

12. Irrelevance of Dividend Policy - Example
Operating CF = $10,000; Net Investment = $8,000
Shares Outstanding = 1,000 Shares;
Price per share = $42. Firm has a finite life.
Bianchi Inc. Policy 1 Policy 2
$2 Div. $3 Div
Dividends 2,000 $3,000
Ex-dividend Price per share $40 $39
New Equity Issued $0 $1,000
Shares Outstanding 1,000 1,025.64
Value of the Firm $40,000 $40,000
($40 x 1000) ($39 x )

13. Homemade Dividend Policy
Investors will not pay higher prices for firms with higher dividend payouts.
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.
Homemade Dividend Policy = Tailored dividend policy created by individual investors to undo corporate dividend policy

14. Homemade Dividend - Example
A company has a choice between 2 dividend policies. Req. rate of return is 10%
The company implements Policy 2 – pay $110 now
Investor X prefers Policy 1 – he wants $100 each year
Homemade Dividend:
X can retain only $100 and reinvest the extra $10.
At 10% it will grow to $11.
In year 2, X receives 89+11= 100, the desired amount.
Policy 1
Policy 2
Year 1
$100
$110
Year 2
$89

15. Homemade Dividends - Example
Bianchi Inc. (slide 12) is a $42 stock about to pay a $2 dividend.
Bob Investor owns 80 shares and prefers $3 dividend.
Bob’s homemade dividend strategy:
Sell 2 shares ex-dividend
if co. pays $2 Dividend
homemade dividends
Cash from dividend $160
Cash from selling stock $80
Total Cash Desired $240
Value of Stock Holdings $40 × 78 =
$3,120
Total Wealth $3,360
same as if co. paid
$3 Dividend
$240 $0
$39 × 80 =
$3,120
$3,360

16. Dividend Policy is Irrelevant
Since investors do not need dividends to convert shares to cash, dividend policy will have no impact on the value of the firm.
In the above example, Bob Investor began with total wealth of $3,360:
80 shares x $42 = $3,360
After a $3 dividend, his total wealth is still $3,360:
$240 + (80 shares x $39) = $3,360
After a $2 dividend, and sale of 2 ex-dividend shares, his total wealth is still $3,360:
$160 + (2 shares x $40) + (78 shares x $40) = $3,360 19

17. Contrary Views Others believe dividend policy is relevant.
They argue that:
investors prefer high dividend policy because dividends are cash, and so are less risky than capital gains that depend on future market sentiment.
Differential tax treatment for dividends and capital gains can either favour or penalise a dividend policy.

18. Low Payout Please Why might a low payout be desirable?
Individuals in upper income tax brackets might prefer lower dividend payouts, given the immediate tax liability, in favor of higher capital gains with the deferred tax liability
Flotation costs – low payouts can decrease the amount of capital that needs to be raised, thereby lowering flotation costs
Dividend restrictions – debt contracts might limit the percentage of income that can be paid out as dividends

19. High Payout Please Why might a high payout be desirable?
1)Desire for current income
Individuals that need current income, i.e. retirees
Groups that are prohibited from spending principal (trusts and endowments)
2)Uncertainty resolution – no guarantee that the higher future dividends will materialize
3)Taxes
Dividend income taxed less for corporation shareholders
Tax-exempt investors don’t have to worry about differential treatment between dividends and capital gains

20. Dividends and Signals
Asymmetric information – managers have more information about the health of the company than investors
Information Content Effect > Changes in dividends convey information > Cause market reaction
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

21. Clientele Effect
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
If a firms changes the dividend policy from low to high or vice versa, it doesn’t matter!!

22. Types of Dividend Policies
Residual dividend policy
Constant growth dividend policy – dividends increased at a constant rate each year
Constant payout ratio – pay a constant percent of earnings each year
Compromise dividend policy
Dividend Reinvestment Plans – DRPs

23. Residual Dividend Policy
Determine capital budget
Determine target capital structure
Finance investments with a combination of debt and equity in line with the target capital structure
Remember that retained earnings are equity
If additional equity is needed, issue new shares
If there are excess earnings, then pay the remainder out in dividends

24. Example – Residual Dividend Policy
Given
Need $5 million for new investments
Target capital structure: D/E = 2/3
Net Income = $4 million
Finding dividend
40% financed with debt (2 million)
60% financed with equity (3 million)
Net Income – equity financing = $1 million, paid out as dividends

25. Dividend Stability
Strict Residual Policy may lead to very unstable dividend payout
Depends on profitable investment opportunities
When earnings are seasonal, quarterly dividends can vary
Eg. Department stores before/after Christmas
Stable dividend policy is in the interest of the firm and its shareholders.
Decrease uncertainty of future dividends

26. Compromise Dividend Policy
Goals, ranked in order of importance
Avoid cutting back on positive NPV projects to pay a dividend
Avoid dividend cuts
Avoid the need to sell equity
Maintain a target debt/equity ratio
Maintain a target dividend payout ratio
Companies want to accept positive NPV projects, while avoiding negative signals

27. Dividend Reinvestment Plans - DRPs
Cash dividends are used to buy additional newly issued shares in the company
Advantages to the Company:
cheap and effective means of raising capital and conserving cash
promotes good shareholder relations
Disadvantages to the company:
administration costs
promotion of the plan
may lead to excessive capital raising

28. Dividend Reinvestment Plans - DRPs
Benefits to Investors
taxation benefits
flexibility
savings program
no transaction costs involved
sometimes offered at a discount
Disadvantages to investors
non-participants get diluted when participants get new shares at a discount.
comprehensive records to be maintained
no control over the reinvestment price

29. Stock Repurchase Company buys back its own shares of stock
Tender offer – company states a purchase price and a desired number of shares
Open market – buys stock in the open market
Similar to a cash dividend in that it returns cash from the firm to the stockholders
Supports the argument for dividend policy irrelevance in the absence of taxes or other imperfections
In a world with taxes, repurchases may be more desirable due to the options provided to stockholders

30. Stock Repurchase vs Dividend
Consider a firm that wishes to distribute $100,000 to its shareholders.
- Pay dividends or Repurchase Shares??..
$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
Assets 15

31. Stock Repurchase vs Dividend
If they distribute the $100,000 as 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
Assets 16

32. Stock Repurchase vs Dividend
If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:
Assets Li
abilities
&
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

33. Stock Dividends
Pay additional shares of stock instead of cash
Increases the number of outstanding shares
Small stock dividend – less than 20 to 25%
Large stock dividend – more than 20 to 25%
If you own 100 shares, at $30 each, and the company declared a 10% stock dividend:
New total shares = old shares x (1+ %) = 110
New price = old $/(1+ %) = $27.27
Same value as before: $3000

34. Stock Splits
Stock splits – essentially the same as a stock dividend except expressed as a ratio
Stock price is reduced when the stock splits
If have 100 $30 each
A 2 for 1 stock split is the same as a 100% stock div.
New nr of shares = old nr. x (new nr./old nr.) = 200
New price = old $ x (old/ new) = $15
Common explanation for split is to return price to a “more desirable trading range”
Reverse split – number of share is reduced
If same data and have a 1 for 2 reverse split:
New nr of shares = old nr. x (new nr./old nr) = 50
New price = old $ x (old/ new) = $60

35. Conclusion
Dividends are important because the value of a share is determined by expectations about future dividends.
There is no ideal dividend policy. Boards must determine the dividend policy that best suits the type of business they are in, and the economic conditions they face.

36. End Chapter 18