1. McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved CHAPTER 18 Dividends and Other Payouts

2. Slide 2 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 18.1 Different Types of Dividends Dividends – Cash Distribution of earnings – Payments made by corporation to its shareholders – Decision to pay made by the board of directors for the corporation Liquidating Dividend – Distribution from Capital

3. Slide 3 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 18.1 Different Types of Dividends Types of Dividends Paid Out: 1.Public companies normally pay a regular cash dividend. –Usually pay quarterly (4 times a year). –Sometimes firms will pay an extra cash dividend (which reduces corporate cash and retained earnings) –The extreme case would be a liquidating dividend (where paid-in capital may be reduced)

4. Slide 4 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 18.1 Different Types of Dividends Types of Dividends Paid Out: 2.Companies will often declare stock dividends. –No cash leaves the firm. –Increases the number of shares outstanding (stock split) –Decreases calue of each share –Usually expressed as ratio

5. Slide 5 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 18.1 Different Types of Dividends Types of Dividends Paid Out: 3.Some companies declare a dividend in kind. –Wrigley’s Gum sends a box of chewing gum. –Dundee Crematoria offers shareholders discounted cremations.

6. Slide 6 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 18.2 Standard Method of Cash Dividend A dividend is distributable to shareholders of record on a specific date Dividend per share – dollar (or RM) per share Dividend Yield – Percentage of the market price Dividend Payment – Percentage of earnings per share

7. Slide 7 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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: Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock immediately before this date is entitled to a dividend. Record Date: The corporation prepares a list of all individuals believed to be stockholders as of 5 November.(Dividend will not be paid to individuals whose notification of purchase is received after this date)

8. Slide 8 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Price Behavior In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date. $P$P $P - div Ex- dividend Date The price drops by the amount of the cash dividend. -t … -2-10+1+2 … Taxes complicate things a bit. Empirically, the price drop is less than the dividend and occurs within the first few minutes of the ex-date.

9. Slide 9 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 18.3 The 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.

10. Slide 10 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Current dividend policy: Old shareholders receive $10,000 at both date 0 and date 1 Dividends ($) 10,000 0 Date 0Date 1 Time

11. Slide 11 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Alternative policy: Old shareholders receive additional $1,000 at date 0 but receives $1,100 less at date 1 Dividends ($) 11,000 0 Date 0Date 1 Time 8,900

12. Slide 12 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Alternative policy: New shareholders pay in $1,000 at date 0 and receive $1,100 in dividend at date 1 Cash flows ($) 1,100 0 Date 0 Date 1 Time - 1,000

13. Slide 13 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin The Value Of The Firm V o = Div o + Div 1 1 + Rs1 V o : Value of the firm Div o & Div 1: Cash flows pay out in dividends Rs : Discount rate

14. Slide 14 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin The Indifference Proposition The values in equations in Current Dividend Policy & Alternative Dividend Policy are the same Therefore, the dividend policy does not affect the value of a share of stock The present value equations are used to show the indifference investors have toward dividend policy Homemade Dividends - The investors’ preference on choosing either policy

15. Slide 15 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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 $240 $39 × 80 = $3,120

16. Slide 16 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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:

17. Slide 17 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Homemade Dividends: A Trade-Off between Dividends per Share at Date 0 and Dividends per Share at Date 1 B A C $11 $9 $11.10 $10 $10.00$8.90 Date 0 Date 1 ($10, $10) Slope = - _1_ 1.1

18. Slide 18 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin A Test Dividends are relevant Dividend policy is irrelevant Managers choosing either to raise or lower the current dividend do not affect the current value of the firm

19. Slide 19 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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.”