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Chapter

19

Dividends and Other Payouts

McGraw-Hill/Irwin

Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

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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Chapter Outline
19.1
19.2
19.3

Different Types of Payouts


Standard Method of Cash Dividend Payment
The Benchmark Case: An Illustration of the Irrelevance of
Dividend Policy
19.4 Repurchase of Stock
19.5 Personal Taxes, Dividends, and Stock Repurchases
19.6 Real-World Factors Favoring a High Dividend Policy
19.7 The Clientele Effect: A Resolution of Real-World Factors?
19.8 What We Know and Do Not Know about Dividend Policy
19.9 Putting It All Together
19.10 Stock Dividends and Stock Splits
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19.1 Different Types of Payouts

Many companies pay a regular cash 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.

Public companies often pay quarterly.


Sometimes firms will pay an extra cash dividend.
The extreme case would be a liquidating dividend.

Wrigleys Gum sends a box of chewing gum.

Other companies use stock buybacks.


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19.2 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.

1 Nov.

2 Nov.

5 Nov.

7 Dec.

Declaration
Date

ExCumdividend dividend
Date
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 5 November.
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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
Exby the amount of
dividend
Date
the cash
Taxes complicate things a bit. Empirically, the
dividend.
price drop is less than the dividend and occurs
within the first few minutes of the ex-date.
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19.3 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.
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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.
Bobs 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

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Dividend Policy Is Irrelevant

In the above example, Bob Investor began with a


total wealth of $3,360:
$42
$3,360 80 shares
share
After a $3 dividend, his total wealth is still $3,360:
$39
$3,360 80 shares
$240
share
After a $2 dividend and sale of 2 ex-dividend shares, his

total wealth is still $3,360:

$3,360 78 shares

$40
$160 $80
share
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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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19.4 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
A.Original balance sheet

Liabilities & Equity

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= $1,000,000 /100,000 = $10

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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

Other Assets

850,000

Equity

Value of Firm 900,000

0
900,000

Value of Firm 900,000

Shares outstanding = 100,000


Price per share = $900,000/100,000 = $9
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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
C. After stock repurchase

Liabilities& Equity

Cash
$50,000 Debt
0
Other Assets 850,000 Equity
900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding= 90,000
Price pershare = $900,000 / 90,000 = $10
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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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19.5 Personal Taxes, Dividends, and


Stock Repurchases

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 (currently) 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


Investment Bankers

Cash: stock issue


Firm

The direct costs of


stock issuance will
add to this effect.
Stock
Holders

Cash: dividends
Taxes
Gov.

In a world of personal taxes,


firms should not issue stock to
pay a dividend.
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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

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Taxes and Dividends

In the presence of personal taxes:


1.
2.
3.

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.

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19.6 Real-World Factors Favoring High


Dividends

Desire for Current Income


Behavioral Finance

Tax Arbitrage

It forces investors to be disciplined.


Investors can create positions in high dividend
yield securities that avoid tax liabilities.

Agency Costs

High dividends reduce free cash flow.


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19.7 The Clientele Effect

Clienteles for various dividend payout policies


are likely to form in the following way:
Group

High Tax Bracket Individuals


Low Tax Bracket Individuals
Tax-Free Institutions
Corporations

Stock Type
Zero-to-Low payout
Low-to-Medium payout
Medium payout
High payout

Once the clienteles have been satisfied, a corporation is


unlikely to create value by changing its dividend policy.
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19.8 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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19.9 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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19.10 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%


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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.


Common explanation for split is to return price
to a more desirable trading range.

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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?

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