1. Chapter 14 Dividend Policy © 2001 South-Western College Publishing

2. 2 Influencing the Value of the Firm u Investment Decisions u Determine the level of future earnings and future potential dividends u Financing Decisions u Influence the cost of capital, which can determine the number of acceptable investment opportunities u Dividend Decisions u Influences the amount of equity capital in a firm’s capital structure and the cost of capital No taxes Transactions costs Issuance costs Fixed investment policy

3. 3 Determinants of Dividend Policy u Variations in payout u Legal constraints u Restrictive covenants u Tax considerations u Liquidity and CF considerations u Earnings stability u Growth prospects u Inflation u Shareholder preference u Protection against dilution u u Borrowing capacity & access to capital markets

4. 4 Irrelevance of Dividends u Assumptions No taxes Transactions costs Issuance costs Fixed investment policy u Wealth of a shareholder is not effected by dividend policy u Dividend can have informational content u Signaling effect u Clientele effect

5. 5 Relevance of Dividends u Assumptions u Relaxed assumptions & dividend policy becomes important u Risk aversion u Transaction costs u Taxes

6. 6 Relevance of Dividends u Issuance ( Flotation ) costs u Agency costs u Empirical evidence is mixed u Many practitioners believe that dividends are important ä Informational content ä Expensive external equity

7. 7 Passive Residual Policy u Suggests that a firm should retain its earnings as long as it has investment opportunities that promise higher rates of return than the required rate. u Dividends can fluctuate significantly u Dividends can fluctuate significantly Depends on the firm’s investment opportunities u In practice dividends can be smoothed u Growth firms will have low dividend payout

8. 8 Stable $ Dividend Policies u Reluctance to reduce dividends u Increases in dividends tend to lag earnings u Desirability N Information content N Many shareholders depend on dividends N Stability tends to reduce uncertainty N Legally desirable Legal list

9. 9 Other Dividend Payment Policies u Constant Payout Ratio ä Pays a constant % of earnings as dividends ä Fluctuating dividends u Small Regular Dividends Plus Extras ä Stockholders can depend on regular payout ä Accommodates changing earnings and investment requirements u Small Firms and Dividends ä Tend to pay out a smaller % of earnings ä Rapid growth and limited access to capital markets

10. 10 Multinational Firms & Dividends u Primary means of transferring funds to parent company O Tax O Foreign Exchange O Political risk O Funds availability O Financing needs

11. 11 How are Dividends Paid ? u Declaration Date ä Board of directors announce a dividend u Record Date ä Shareholders of record will receive dividends u Ex-dividend Date ä 2 business days before record date ä Stock trades ex-dividends u Payment Date ä Dividend checks mailed or direct deposited

12. 12 Dividend Reinvestment Plan u Cash dividend reinvested automatically into additional shares u Purchase new or existing shares u Purchasing new shares raises new equity capital for the firm u No brokerage commissions u Income tax liability

13. 13 Stock Dividends Payment of additional shares of C/S u Stock splits are similar to stock dividends u Increases the number of shares outstanding u Accounting transaction u Transfer pre dividend market value from retained earnings to other stockholders equity u Market price of C/S should decline in proportion to the # of new shares issued

14. 14 Reasons for Declaring a Stock Dividend u Broaden the ownership of the firm’s shares u May result in an effective increase in cash dividends u Provided the level of cash dividends is not reduced u Reduction in share price may broaden the appeal of the stock to investors u Resulting in a real increase in market value

15. 15 Stock Repurchase u By a tender offer, in the open market, or by negotiation with large holders u Treasury stock u Reduces the number of shares outstanding u Increases EPS u Usually announced So investors know the reason for additional trading So investors can wait for anticipated price increase

16. 16 Stock Repurchase u Advantages ä Converts dividend income into capital gains ä Greater financial flexibility Timing ä Signal effect u Disadvantages ä Company may over pay for the stock ä Trigger IRS scrutiny Tax avoidance ä Some current stockholders may be unaware