Chapter 15Dividend Policy

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© 2007 Thomson South-Western

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A firm’s dividend policy refers to the choices its managers make about distributing cash to shareholders. whether to pay shareholders a regular (recurring) cash

dividend how large the cash dividend should be how frequently it should be paid

The dividend payout ratio, calculated by dividing the cash dividend per share by its earnings per share, indicates the percentage of each dollar earned that firms distribute to the owners.

The dividend yield, which equals a stock’s dividend divided by its price, measures the rate of return represented by the dividend payment.

Dividend Policy

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Dividend Trends: Share Repurchase Programs

Companies announcing share repurchase programs state they will buy back some of their own shares, usually through open-market purchases.

Share repurchases give managers an alternative method to distribute cash to shareholders.

The annual value of share repurchases in the United States sometimes exceeds that of dividends, and investors clearly welcome repurchase announcements.

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Dividend Trends: Decline in Payment of Dividends

Decline in the fraction of U.S. companies paying dividends Companies had a lower propensity to pay

dividends in 1999 than before. Recent research documents a clear rebound

in the number of companies paying dividends Provides somewhat less clear-cut evidence of an

increase in average dividend payout ratios Increasing concentration of corporate profits

and dividends among a few large companies

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Cash Dividend Payment Procedures

In the U.S., as in most countries, shareholders have no legal right to receive dividends.

Instead, a firm’s board of directors decides what dividends the firm will pay.

Most U.S. firms that pay dividends do so once every quarter.

Corporations in other industrialized countries generally pay dividends annually or semiannually.

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Relevant Dividend Dates

Shareholders of record are entitled to the dividend.

Because it takes time to make bookkeeping entries after stocks trade, investors who buy stock on the record date will miss the dividend payment.

To receive the dividend, an investor must own the stock before the ex-dividend date, usually two business days prior to the date of record.

Firms distribute dividends on the payment date, which usually comes a few weeks after the record date.

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Relevant Dividend Dates

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External Factors Affecting Dividend Policy

Most U.S. states prohibit corporations from paying out as dividends any portion of their “legal capital,” which the law defines as the par value of common stock.

Some states define legal capital to include the common stock’s par value and any additional paid-in capital.

States establish these capital-impairment restrictions to provide a sufficient equity base to protect creditors’ claims.

Laws do not prohibit a firm from paying more in dividends than its current earnings.

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Calculating the Maximum Amount a Firm Can Pay in Cash Dividends - Example

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Types of Dividend Policies

Constant payout ratio policy pays a set fraction of its earnings to

shareholders each period Constant nominal payment policy

firm pays the same dividend each period Low-regular-and-extra policy

pays a low regular dividend, supplemented by an additional cash payment at irregular intervals

extra dividend or special dividend

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Other Forms of Dividends

Stock dividends additional shares of stock rather than cash

Stock splits its share price declines because the number

of outstanding shares increases. reverse stock splits replacing a certain

number of outstanding shares with just one new share

Share repurchases variety of motivations influence firms’ share

repurchases.

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Market Value of Share Repurchases by U.S. Corporations, 1972–2001

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Methods to Repurchase Shares

Open-market share repurchase: firms buy back their shares in the open market.

Tender offer, or self-tender: firms offer to buy back a certain number of shares at a premium above the current market price.

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Payout Policies Worldwide

Payout policies show distinct national patterns.

Payout policies show pronounced industry patterns, and these are the same worldwide.

Asset-rich, regulated, and slow-growing companies tend to have high dividend payout ratios.

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Payout Policies Worldwide

Firms maintain constant nominal dividend payments per share for significant periods of time.

Whereas the number (and fraction) of publicly traded companies that pay dividends has been declining since roughly the 1970s, the aggregate payout ratio of the U.S corporate sector has been increasing.

Investors react positively to dividend (and share repurchase) initiations and increases but react negatively to dividend decreases or eliminations.

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Aggregate Payout Ratio (Dividends and Share Repurchases) for the U.S. Corporate Sector, 1972–2001

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Payout Policies Worldwide

Taxes influence payout policies, but taxes neither cause nor prevent companies from initiating dividend payments or share repurchases.

In spite of intensive research, it is unclear exactly how dividend payments affect the required return on a firm’s common stock.

Changes in transactions costs or in the technical efficiency of capital markets seem to have little effect on dividend payments.

Ownership matters.

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Agency Cost Model Of Dividends

Agency cost /contracting model of dividends (or simply, the agency cost model)Assumes that firms begin paying to

overcome the agency problems resulting from a separation of corporate ownership and control

Privately-held firmsPublic firms

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Signaling Model

The signaling model of dividends assumes that managers use dividends to convey positive information to poorly informed shareholders

Like the agency cost model, the signaling model predicts that stock prices should rise (fall) in response to dividend increases (cuts)

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Catering Theory

Catering theory of dividends predicts that corporate managers cater to investor preferences by paying dividends when investors

assign a premium to dividend-paying stocks

not paying when investors assign a discount to dividend payers.

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Dividend Irrelevance In A World With Perfect Capital Markets

As long as the firm accepts all positive-NPV investment projects and has costless access to capital markets, it can pay any level of dividends it desires.

If a firm pays out its earnings as a dividend, it must issue new shares to raise the cash required to finance its ongoing investments.

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Real-world Influences on Dividend Policy

Dividends do not exist to overcome changing technical problems with markets and tax regimes;

Dividends exist to overcome unchanging human problems with trust, communication, and commitment.

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Real-world Influences on Dividend Policy

When the personal tax rate on dividends exceeds the tax rate on capital gains, we have a clear-cut prediction: Firms should not pay dividends.

Wealth tax: tax on stock appreciation is levied every period, regardless of whether investors sell their shares

Most countries dictate that investors pay capital gains taxes only when they realize their gains by selling shares.

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Imputation Tax System

Gives individual investors an “imputed” tax credit along with the dividends they receive from companies.

Investors can then claim the corporate income tax paid by the firm as a credit against their personal tax liability.

Ex-dividend-day study: examines whether (and how) differing capital gains and dividend income tax rates impact the average change in a firm’s stock price on its ex-dividend day.