Chapter 4

DIVIDENDS AND OTHER PAYOUTS

Dr. Tran Ngoc Mai

Can the dividend policy bankrupt a firm?
 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
 Part 1.
Different types of Payouts
 Different Types of Payouts

● Dividend usually refers to a cash distribution of earnings.

o Dividend refers to a distribution from earnings
o Liquidating dividend refers to a distribution from capital
● The decision to pay a dividend is made by the board of
directors of the corporation.
● The most common type of dividend is in the form of cash.
 Different Types of Payouts

1. Regular cash dividend

○ Public companies often pay quarterly.
○ Sometimes firms will pay an extra cash dividend.

2. Stock dividends
○ No cash leaves the firm.
○ The firm increases the number of shares outstanding.
 Different Types of Payouts

3. Stock split
○ Example: three for one stock spilt

○ The firm increases the number of shares outstanding.

4. Stock buybacks
○ Company use cash to buy back shares

○ The shares are accounted for as treasury stock

5. Dividend in kind
○ pay owners using products or services of the firm
 Part 2.
Standard Method of Cash Dividend
 2. Standard Method of Cash Dividend

● A dividend is distributable to shareholders of record on a

specific date.

● When a dividend has been declared, it becomes a

liability of the firm and cannot be easily rescinded by the
corporation.

● Expressed as Dividend per share, dividend yield,

dividend payout
 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.
 Procedure for Cash Dividend

25 Oct. 1 Nov. 2 Nov. 5 Nov. 7 Dec.

…
Declaration Date Cum-dividend Ex-dividend Record Date Payment
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.
Payment Date: The dividend checks are mailed to the stockholders.
 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 by the Ex-dividend
amount of 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.
 Part 3.
The Irrelevance of Dividend Policy
19.3 The Irrelevance of Dividend Policy

Which of the following statements is true?

● Dividends are relevant.

● Dividend policy is irrelevant.

19.3 The Irrelevance of Dividend Policy

Which of the following statements is true?

● Dividends are relevant.

● Dividend policy is irrelevant.

 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.
à 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.
 19.3 The Irrelevance of Dividend Policy

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.

What is the market value in two cases?

 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
Example
Shimano USA has 2 million shares currently outstanding at
$15 per share. The company declares a 50% stock dividend.
How many shares will be outstanding after the dividend is
paid?

After the stock dividend what is the new price per share and
what is the new value of the firm?
A 50% stock dividend will increase the number of shares by
50%: 2 million×1.5 = 3 million shares

The value of the firm was $2m × $15 per share = $30 m. After
the dividend, the value will remain the same. Price per share =
$30m/ 3m shares = $10 per share
 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.”
 Part 4.
Repurchase of Stock
 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.
Stock Repurchase versus Dividend
 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
 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
 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 per share = $900,000 / 90,000 = $10
 Why Share Repurchase?

● Flexibility for shareholders

● Keeps stock price higher
○ Good for insiders who hold stock options

● Offset to Dilution
● Stock undervaluation
● Tax benefits
 Why Share Repurchase?

- Stock repurchase allows investors to decide if they want the

current cash flow and associated tax consequences
- Given our tax structure, repurchases may be more desirable due
to the options provided stockholders
- The IRS recognizes this and will not allow a stock repurchase for
the sole purpose of allowing investors to avoid taxes
 Part 5.
Personal Taxes, Dividends,
and Stock Repurchases
 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.
 Firms without Sufficient Cash

The direct costs of stock

Investment Bankers 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 pay a dividend.
Gov.
 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
 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.
 Part 6.
Stock Dividends and Stock Splits
 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%

 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.”
 The Clientele Effect

●Clienteles for various dividend payout policies are likely to form in the
following way:

●Some investors prefer low dividend payouts and will buy stock in
those companies that offer low dividend payouts

●Some investors prefer high dividend payouts and will buy stock in
those companies that offer high dividend payouts

●Implications?
 The Clientele Effect

●What do you think will happen if a firm changes its policy

from a high payout to a low payout?

●What do you think will happen if a firm changes its policy

from a low payout to a high payout?

●If this is the case, does dividend policy matter?

 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.
 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.
 1. What are the different types of dividends, and
how is a dividend paid?
2. What is the clientele effect, and how does it
affect dividend policy irrelevance?
Quick Quiz 3. What is the information content of dividend
changes?
4. What are stock dividends, and how do they
differ from cash dividends?
5. How are share repurchases an alternative to
dividends, and why might investors prefer
them?
 Cash discounts:
A. increase the amount of total credit offered. B. increase
profit margins on sales.
C. speed up the collection of receivables. D. are a
means of charging lower prices to credit customers.

Quick Quiz ●never give up a positive NPV project to increase a dividend

1
 3) The date before which a new purchaser of
stock is entitled to receive a declared dividend,
but on or after which she does not receive the
dividend, is called the _____ date.
A. ex-rights B. ex-dividend
B. C. record D. payment
Quick Quiz ●never give up a positive NPV project to increase a dividend

1
4) A cash payment made by a firm to its owners
when some of the firm's assets are sold off is
called a:
A. liquidating dividend.
B. B.regular cash dividend.
C. extra cash dividend.
D. share repurchase.