Chapter 17 Dividends and Payout Policy 17-1 McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc All rights reserved Chapter Outline • Dividend Payments • Dividend Theory • Does Dividend Policy Matter? • Factors Favoring a Low Dividend Payout • Factors Favoring a High Dividend Payout • Experience with Dividend Policies 17-2 Chapter Outline • Dividend Payments • Dividend Theory • Does Dividend Policy Matter? • Factors Favoring a Low Dividend Payout • Factors Favoring a High Dividend Payout • Experience with Dividend Policies 17-3 Dividends and Retained Earnings Net Income Dividends 17-4 Retained Earnings Dividends and Retained Earnings Net Income Dividends Retained Earnings The decision as to how many dividend dollars to allocate from the net income is the firm’s Dividend Policy 17-5 Cash Dividends • Regular 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 17-6 Cash Dividends • Special cash dividend – similar to extra dividend, but definitely will not be repeated • Liquidating dividend – some or all of the business has been sold 17-7 Vocabulary for Dividend Payments Declaration Date – Board declares the dividend, and it becomes a liability of the firm Ex-dividend Date • • • Occurs two business days before date of record If you buy stock on or after this date, you will not receive the dividend Stock price generally drops by about the amount of the dividend 17-8 Vocabulary for Dividend Payments Date of Record – Holders of record are determined, and they will receive the dividend payment Date of Payment – checks are mailed 17-9 Timing of Dividend Payments 17-10 What We Know (and Do Not Know) • Corporations “smooth” dividends • Dividends provide valuable information to the market • Corporations rarely change their dividend policy 17-46 What We Know (and Do Not Know) • Firms should follow a sensible dividend policy: Don’t 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 17-47 Putting the Pieces 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 17-48 Management View of Dividend Policy: Survey Results Agree or Strongly Agree: • 93.8% Try to avoid reducing dividends per share • 89.6% Try to maintain a smooth dividend from year to year • 41.7% Pay dividends to attract investors subject to “prudent man” restrictions 17-49 Management View of Dividend Policy: Survey Results Important or Very Important • 84.1% Maintaining consistency with historic dividend policy • 71.9% Stability of future earnings • 9.3% Flotation costs to issue new equity 17-50 Ethics Issues  Should a company initiate a dividend policy exclusively to reduce the taxes paid by some of their shareholders?  Should the management of a company announce the increase payment of dividends when they have knowledge of significant cash flow problems? 17-51 Quick Quiz 17-52  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 relevance?  What is the information content of dividend changes?  What are stock dividends, and how they differ from cash dividends?  How are share repurchases an alternative to dividends, and why might investors prefer them? Comprehensive Problem A company’s stock is priced at $50 per share, and it plans to pay a $2 cash dividend  Assuming perfect capital markets, what will the per share price be after the dividend payment?  If the average tax rate on dividends is 25%, what will the new share price be? 17-53 Comprehensive Problem A company’s stock is priced at $50 per share, and it plans to pay a $2 cash dividend  Assuming perfect capital markets, what will the per share price be after the dividend payment? In a perfect market, new price = $50-$2 = $48.00  If the average tax rate on dividends is 25%, what will the new share price be? In an imperfect market, new price = 48 + 2*.25 = $48.50 17-54 Terminology • Dividend Policy • Cash Dividend • Stock Dividend • Bonus Dividend • Stock Split • Stock Repurchase • Signaling Effect • Clientele Effect 17-55 Terminology • Declaration Date • Ex-dividend Date • Date of Record • Date of Payment 17-56 Key Concepts and Skills • Define the types of dividends • Describe how and when dividends are paid • Why are dividends paid (or not paid, for that matter)? • Explain how cash and stock dividends differ • How can stock repurchases be used as an alternative to dividend payments? 17-57 What are the most important topics of this chapter? Dividend Policy is the decision by management to pay dividends versus keeping retained earnings Dividends are typically paid quarterly in the form of cash Alternatives to cash dividends are stock dividends and repurchasing 17-58 What are the most important topics of this chapter? Firms have reasons for high or low dividend payouts often involving “information” Investors have separate reasons for high or low dividend payouts often involving taxes or cash needs 17-59 Questions? 17-60 [...]... Announcement “America West Airlines announced that its Board of Directors has authorized the purchase of up to 2.5 million shares of its Class B common stock on the open market as circumstances warrant over the next two years … Following the approval of the stock repurchase program by the company’s Board of Directors earlier today W A Franke, chairman and chief officer said ‘The stock repurchase program reflects... many firms do NOT follow the “Residual Theory of Dividends” What is going on? It appears that there are other factors at play when it comes to a firm’s dividend policy 17-27 M & M’s “Information Content of Dividends” Modigliani and Miller (M & M) postulate that the payment of dividends, the nonpayment of dividends, or the change of pattern to the past payment of dividends all signal important information... 17-33 Illustration of Irrelevance Consider a firm that can either pay out dividends of $10,000 per year for each of the next two years or can pay $9,000 this year, reinvest the other $1,000 into the firm and then pay $11,120 next year (Investors require a 12% return.) 17-34 Illustration of Irrelevance Consider a firm that can either pay out dividends of $10,000 per year for each of the next two years... 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 17-31 Does Dividend Policy Matter? Maybe “YES” Dividends may matter – the value of the stock is based on the present value of expected future dividends 17-32 Does Dividend Policy Matter? Maybe... own shares of stock • Tender offer – company states a purchase price and a desired number of shares • Open market – buys its own common stock in the open market 17-16 Stock Repurchase A company buys back its own shares of stock • Similar to a cash dividend in that it returns cash from the firm to the stockholders • This is another argument for dividend policy irrelevance in the absence of taxes or... allow a stock repurchase for the sole purpose of allowing investors to avoid taxes 17-18 Information Content of Stock Repurchases • Stock repurchases send a positive signal that management believes the current price is low • Tender offers send a more positive signal than open market repurchases because the company is stating a specific price • The stock price often increases when repurchases are announced...Bonus Dividends Bonus Dividend – The payment of additional dollars to each shareholder (above the “regular” dividend payment) This is another name for extra cash dividends 17-11 Stock Dividends • Pay additional shares of stock instead of cash • Increases the number of outstanding shares 17-12 Stock Dividends • Small stock dividend Less than 20 to 25% If... excess of $200 million to ensure that an adequate level of cash and cash equivalents is maintained.” 17-20 Chapter Outline • Dividend Payments • Dividend Theory • Does Dividend Policy Matter? • Factors Favoring a Low Dividend Payout • Factors Favoring a High Dividend Payout • Experience with Dividend Policies 17-21 Dividend Policy Theory The “Residual Theory of Dividends” Given three pieces of information,... and Signals Asymmetric information – Managers have more information about the health of the company than investors 17-29 Dividends and Signals Changes in dividends convey information: Dividend increases: • Management believes it can be sustained • Expectation of higher future dividends, increasing present value • Signal of a healthy, growing firm 17-30 Dividends and Signals Changes in dividends convey... Optimal Capital Structure: D/E = 65/.35 3 The total cash needed for future projects: $2,150,000 17-23 Dividend Policy Theory Residual Theory of Dividends Estimate the equity needed for purchasing: $2,150,000 ( 35) = $752,500 Now construct the division of estimated profits to retained earning and dividends: 17-24 Dividends and Retained Earnings Estimated Net Income $3,000,000 The residual is paid out as ... for Dividend Payments Date of Record – Holders of record are determined, and they will receive the dividend payment Date of Payment – checks are mailed 17-9 Timing of Dividend Payments 17-10... Modigliani and Miller (M & M) postulate that the payment of dividends, the nonpayment of dividends, or the change of pattern to the past payment of dividends all signal important information to the... 17-15 Stock Repurchase A company buys back its own shares of stock • Tender offer – company states a purchase price and a desired number of shares • Open market – buys its own common stock in the