Dividends and Other

Payouts
Chapter 19

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McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
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Key Concepts and Skills

• Understand dividend types and how they are paid

• Understand the issues surrounding dividend policy

decisions
• Understand why share repurchases are an
alternative to dividends
• Understand the difference between cash and stock
dividends
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Outline
• Different Types of Payouts
• Standard Method of Cash Dividend Payment
• The Benchmark Case: An Illustration of the Irrelevance of
Dividend Policy
• Repurchase of Stock
• Personal Taxes, Dividends, and Stock Repurchases
• Real-World Factors Favoring a High Dividend Policy
• The Clientele Effect: A Resolution of Real-World Factors?
• Stock Dividends and Stock Splits
• What We Know and Do Not Know about Dividend Policy
• Putting It All Together
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Different Types of Payouts

• Many companies pay a regular cash dividend.
• Public companies often pay quarterly dividend.
• Sometimes firms will pay an extra cash dividend.
• The extreme case would be a liquidating dividend.
• Companies 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.
• Other companies use stock buybacks/repurchases.
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Standard Method of Cash Dividend

Cash Dividend - Payment of cash by the firm

to its shareholders

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 – Date on which company

determines existing shareholders
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Procedure for Cash Dividend

25 Oct. 2 Nov. 3 Nov. 5 Nov. 7 Dec.
…

Declaration Cum- Ex- Record Payment

Date dividend dividend Date Date
Date 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.
Ex-dividend date is 2 business days before the record date.
Record Date: The corporation prepares a list of all individuals
believed to be stockholders who will receive dividends.
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Price Behavior
• In a perfect world, the stock price will fall by the
amount of the dividend on the ex-dividend date.
-t …
-2 -1 0 +1 +2 …

$P

$P - div
The price drops Ex-
by the amount of dividend
the cash Date
dividend. Taxes complicate things a bit. Empirically, the
price drop is less than the dividend and occurs
within the first few minutes of the ex-dividend date.
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The Irrelevance of Dividend Policy

• A compelling case can be made that dividend policy
is irrelevant
• 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
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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

$3 Dividend
homemade dividends
Cash from dividend ? $160
Cash from selling stock
? $80
Total Cash $240
?
Value of Stock Holdings
? $40 × 78 =
$3,120
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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:
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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.”
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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.

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Stock Repurchase versus Dividend

Consider a firm that wishes to distribute $100,000 to

its shareholders.

Assets Liabilities & Equity

A.Original balance sheet
Cash $150,000 Debt 0
Other Assets 850,000 Equity 1,000,000
Value of Firm 1,000,000 Value of Firm 1,000,000
Shares outstanding = 100,000
Price per share= ?
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Stock Repurchase versus Dividend

If they distribute the $100,000 as a cash dividend,

the balance sheet will look like this:

Assets Liabilities & Equity

B. After $1 per share cash dividend
Cash $50,000 Debt 0
Other Assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding = 100,000
Price per share = ?
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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 0
Other Assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding = ? shares
Price per share = ?
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Share Repurchase
• Flexibility for shareholders

• Keeps stock price higher

• Good for insiders who hold stock options

• As an investment of the firm (undervaluation)

• Tax benefits
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Personal Taxes, Dividends, and Stock

Repurchases
• To get the result that dividend policy is irrelevant, we
need three assumptions:
• No taxes
• No transactions costs
• No uncertainty
• In the United States, both cash dividends and capital
gains were 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
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Firms without Sufficient Cash

The direct costs of

Investment Bankers
stock issuance will
add to this effect.

Cash: stock issue

Stock
Firm
Holders
Cash: dividends

Taxes
In a world of personal taxes,
firms should not issue stock
Gov. to pay a dividend.
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Firms with Sufficient Cash

• The above “personal tax” 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
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Taxes and Dividends

• In the presence of personal taxes:
1. A firm should not issue stock to pay a dividend.
2. Managers have an incentive to seek alternative
uses for funds to reduce dividends.
3. Though personal taxes mitigate against the
payment of dividends, these taxes are not
sufficient to lead firms to eliminate all dividends.
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Real-World Factors Favoring High

Dividends
• Desire for Current Income
• Behavioral Finance
• It forces investors to be disciplined

• Uncertainty resolution
• No guarantee that the higher future dividends will
materialize
• Agency Costs
• High dividends reduce free cash flow
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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.
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Dividends and Signals

Changes in dividends convey information
• Dividend increases: positive signals
• Management believes it can be sustained

• Expectation of higher future dividends,

increasing present value

• Signal of a healthy, growing firm

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Dividends and Signals

Changes in dividends convey information
• Dividend decreases: negative signals
• 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

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Stock Dividends
• Pay additional shares of stock instead of cash
• Increases the number of shares outstanding
• Small stock dividend
• Less than 20 to 25%
• If you own 100 shares and the company declares a
10% stock dividend, you will receive an additional 10
shares
• Large stock dividend – more than 20 to 25%
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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, but
the number of shares outstanding increases
• Common explanation for split is to return price to
a “more desirable trading range”
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What We Know and Do Not Know

• Corporations “smooth” dividends.
• Fewer companies are paying dividends.
• Dividends provide information to the market.
• Firms should follow a sensible policy:
• Do not 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.
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Putting It All Together

• Aggregate payouts are massive and have increased
over time.
• Dividends are concentrated among a small number of
large, mature firms.
• Managers are reluctant to cut dividends.
• Managers smooth dividends.
• Stock prices react to unanticipated changes in
dividends.
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Quick Quiz
• What are the different types of dividends, and how is
a dividend paid?
• What is the clientele effect, and how does it affect
dividend policy irrelevance?
• What is the information content of dividend changes?
• What are stock dividends, and how do they differ from
cash dividends?
• How are share repurchases an alternative to
dividends, and why might investors prefer them?