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
19-1
Chapter Outline
19.1 Different Types of Payouts
19.2 Standard Method of Cash Dividend Payment
19.3 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

19-2
19.1 Different Types of Payouts
 Many companies pay a regular cash dividend.
◼ Public companies often pay quarterly.
◼ Sometimes firms will pay an extra cash dividend.
◼ The extreme case would be a liquidating 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.
◼ Wrigley’s Gum sends a box of chewing gum.
 Other companies use stock buybacks.
19-3
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.
19-4
Procedure for Cash Dividend
25 Oct. 1 Nov. 2 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.
Record Date: The corporation prepares a list of all individuals
believed to be stockholders as of 5 November.
19-5
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-date.
19-6
Example
 You purchased 200 shares of ABC stock on July 15th. On July
20th, you purchased another 100 shares and then on July 22st
you purchased your final 200 shares of ABC stock.
 The company declared a dividend of $1.10 a share on July 5th
to holders of record on Friday, July 23rd. The dividend is
payable on July 31st.
 How much dividend income will you receive on July 31st
from ABC?

19-7
Answer
 Dividend received = $1.10  (200 + 100)
= $330

19-8
Exercise
 On May 18th, you purchased 1,000 shares of BuyLo
stock. On June 5th, you sold 200 shares of this stock
for $21 a share.
 You sold an additional 400 shares on July 8th at a
price of $22.50 a share.
 The company declared a $.50 per share dividend on
June 25th to holders of record as of Thursday, July
10th. This dividend is payable on July 31st.
 How much dividend income will you receive on July
31st as a result of your ownership of BuyLo stock?
19-9
Answer
 Dividend received = $.50  (1,000 - 200)
= $400

19-10
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.
19-11
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 $3 Dividend
Cash from dividend $160 $240
Cash from selling stock $80 $0
Total Cash $240 $240
Value of Stock Holdings $40 × 78 = $39 × 80 =
$3,120 $3,120
19-12
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:
$40
$3,360 = 78 shares  + $160 + $80
share
19-13
Example
 Priscilla owns 500 shares of Delta stock. It is
January 1, 2006, and the company recently issued a
statement that it will pay a $1.00 per share dividend
on December 31, 2006, and a $.50 per share
dividend on December 31, 2007. Priscilla does not
want any dividend this year but does want as much
dividend income as possible next year. Her required
return on this stock is 12%. Ignoring taxes, what will
Priscilla's homemade dividend per share be in 2007?

19-14
Answer
 Homemade dividend = ($1.00  1.12) + $.50
= $1.62

19-15
Test your knowledge

 True or False:
 Dividends are irrelevant

 True or False:
 Dividend policy is irrelevant

19-16
Test your knowledge: Answer

 True or False:
 Dividends are irrelevant: Answer - False

 True or False:
 Dividend policy is irrelevant: Answer - True –
absent market imperfections, and maybe even with
market imperfections

19-17
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.”

19-18
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.

19-19
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= $1,000,000 /100,000 = $10

19-20
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 = $900,000/100,000 = $9

19-21
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= 90,000
Price pershare = $900,000 / 90,000 = $10

19-22
Example
A firm has a market value equal to its book value.
Currently, the firm has excess cash of $800 and other
assets of $5,200. Equity is worth $6,000. The firm has
600 shares of stock outstanding and net income of
$700. The firm has decided to spend all of its excess
cash on a share repurchase program. How many
shares of stock will be outstanding after the stock
repurchase is completed?

19-23
Answer

Price per share = $6,000  600 = $10;

Number of shares repurchased = $800  $10 = 80;

New number of shares outstanding = 600 - 80 = 520

19-24
Exercise

A firm has a market value equal to its book value.

Currently, the firm has excess cash of $500 and other
assets of $9,500. Equity is worth $10,000. The firm
has 250 shares of stock outstanding and net income of
$1,400. What will the stock price per share be if the
firm pays out its excess cash as a cash dividend?

19-25
Answer
If they distribute the $500 as a cash dividend, the balance
sheet will look like this:
Assets Liabilities & Equity

Cash $500 Debt 0

Other Assets 9,500 Equity 10,000
Value of Firm 10,000 Value of Firm 10,000
Shares outstanding = 250
Price per share = (10,000-500)/ 250 = $38

19-26
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

19-27
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.
19-28
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 to
Gov.
pay a dividend.
19-29
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 19-30
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.

19-31
19.6 Real-World Factors Favoring High
Dividends
 Desire for Current Income
 Behavioral Finance
◼ It forces investors to be disciplined.
 Tax Arbitrage
◼ Investors can create positions in high dividend
yield securities that avoid tax liabilities.
 Agency Costs
◼ High dividends reduce free cash flow.

19-32
19.7 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.
19-33
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.
19-34
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.

19-35
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%

19-36
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.”

19-37
Example
 Robinsons has 15,000 shares of stock outstanding
with a par value of $1.00 per share and a market
price of $36 a share. The balance sheet shows
$15,000 in the common stock account, $315,000 in
the capital in excess of par account, and $189,000 in
the retained earnings account. The firm just
announced a 3-for-2 stock split. How many shares of
stock will be outstanding after the split?

19-38
Answer
 Number of shares = 15,000  3  2
= 22,500 shares

19-39
Exercise
 Robinson's has 15,000 shares of stock outstanding
with a par value of $1.00 per share and a market
price of $36 a share. The balance sheet shows
$15,000 in the common stock account, $315,000 in
the capital in excess of par account, and $189,000 in
the retained earnings account. The firm just
announced a 3-for-2 stock split. What will the
market price per share be after the split?

19-40
Answer
 Market price per share = $36  2  3
 = $24

19-41
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?
19-42