Dividend Policy and Internal Financing

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Dividend Policy andDividend Policy andInternal FinancingInternal Financing

Chapter 17Chapter 17

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3Dividend Policy and Internal Financing

Dividend PolicyDividend Policy

Dividend Payout Ratio = Dividend per ShareEarnings per Share




A firm calculates and reports Earnings per ShareA firm calculates and reports Earnings per Share




A firm calculates and reportsA firm calculates and reports earn Earnings per Shareearn Earnings per ShareManagement will reinvest part of earnings per share in Management will reinvest part of earnings per share in

the company and pay part as dividendthe company and pay part as dividend




A firm calculates and reportsA firm calculates and reports earn Earnings per Share earn Earnings per Share Management will reinvest part of earnings per share in Management will reinvest part of earnings per share in

the company and pay part as dividendthe company and pay part as dividendIncome Statement

1 Million Shares Outstanding

Sales $3,000,000

Net Income $1,000,000Dividends PaidAddition to RE




Income Statement

Sales $3,000,000



EPS = $1.00

Stockholders earn Earnings per ShareStockholders earn Earnings per ShareManagement will reinvest part of earnings per share in Management will reinvest part of earnings per share in





Income Statement

Sales $3,000,000



If have a 50% dividend payout each share of stock will receive a 50¢ dividend






Income Statement

Sales $3,000,000

Net Income $1,000,000Dividends Paid 500,000Addition to RE $500,000


If have a 50% dividend payout each share of stock will receive a 50¢ dividend

$500,000 paid to stockholders and $500,000 is reinvested in the firm






Income Statement


If it has a 0% dividend payout, all earnings are reinvested in the firmSales $3,000,000







Income Statement


If have a 0% dividend payout, all earnings are reinvested in the firm

$0 paid to stockholders and $1,000,000 is reinvested in the firm

Sales $3,000,000

Net Income $1,000,000Dividends Paid 0Addition to RE $1,000,000



12Can Dividend Policy Affect Share PriceThree Theories of DividendsThree Theories of Dividends

IrrelevanceDividends Increase Stock PriceDividends Decrease Stock Price

13Can Dividend Policy Affect Share Price

If the world was perfect (in perfect markets)If the world was perfect (in perfect markets)No brokerage feesNo floatation costs of issuing sharesNo taxesEqual access to informationManager's act in shareholders' best interests

View 1: Irrelevance View 1: Irrelevance Dividend Policy does not affect stock price




52 Weeks Yld Vol NetHi Lo Stock Sym Div % PE 100s Hi Lo Close Chg

s 42½ 29 MKPS MK 1.75 5.1 24 5067 35 33 34¼ -1

When dividend of $1.75 is paid. the stock price falls by exactly the same amount.


Assumes Perfect MarketsAssumes Perfect MarketsNo brokerage feesNo floatation costs of issuing sharesNo taxesEqual access to informationManager's act in shareholders' best interests


52 Weeks Yld Vol NetHi Lo Stock Sym Div % PE 100s Hi Lo Close Chg

s 42½ 29 MKPS MK 1.75 5.1 24 5067 35 33 34¼ -1

When dividend of $1.75 is paid. the stock price falls by exactly the same amount.

$34.25 – $1.75 = $32.50




Dividends are Irrelevant Since:Dividends are Irrelevant Since:No net gain to investor




Dividends are Irrelevant Since:Dividends are Irrelevant Since:No net gain to investorWithout receiving dividend, an investor can sell shares

of stock costlessly and create their own "dividend"




Dividends are Irrelevant Since:Dividends are Irrelevant Since:No net gain to investorWithout receiving dividend, an investor can sell shares

of stock costlessly and create their own "dividend"If the firm pays a large dividend, but needs cash to

invest can sell additional shares of stock costlessly.


Theory states:Theory states:Dividends are more predicable that capital gains,

so investors prefer dividends--"Bird in the Hand theory”

View 2: High Dividends Increase Stock ValueView 2: High Dividends Increase Stock Value



so investors prefer dividends--"Bird in the Hand theory"

To be indifferent, investors will require a higher rate on capital gains than dividends




so investors prefer dividends-- "Bird in the Hand theory”

To be indifferent, investors will require a higher rate on capital gains than dividends

Critics of this theoryPoint out cash flows of overall firm are not

affected by dividendsIf investors want cash, they should leave money

in a bank account



Based on Tax Effects:Based on Tax Effects:Individual investors must pay taxes on dividends as

the dividends are received

View 3: Low Dividends Increase Stock ValueView 3: Low Dividends Increase Stock Value



the dividends are receivedIndividual investors can deferdefer taxes on capital gains

until they sell the stock


Before 1987, Capital Gains were taxed at a lower rate than dividends. Once again, capital gain taxes are lower than current income taxes today.




until they sell the stock.


However, corporations may exclude 70% of dividends from corporate income taxes, so they may actually prefer a higher level of dividends




until they sell the stock


However, corporations may exclude 70% of dividends from corporate income taxes, so they may actually prefer a higher level of dividends

Investors prefer the dividend policy that gives the highest after-tax return

27Residual Dividend Theory

Recognizes that floatation costs are involved in issuing new stock are very high


Companies with investment opportunities which require capital would prefer to use internal funds rather than issue new stock



Residual Dividend MethodResidual Dividend MethodAccept all investments with positive net present values




Residual Dividend MethodResidual Dividend MethodAccept all investments with positive net present valuesUse retained earnings to finance investments to the

extent possible




Residual Dividend MethodResidual Dividend MethodAccept all investments with positive net present valuesUse retained earnings to finance investments to the

extent possibleIf earnings left over after making investments, pay a

dividend with the residual




Residual Dividend MethodResidual Dividend MethodAccept all investments with positive net present valuesUse retained earnings to finance investments when possibleIf retained earnings left over after making investments, pay

a dividend with the residualIf there are no residual funds, pay no dividend




Residual Dividend MethodResidual Dividend MethodAccept all investments with positive net present valuesUse retained earnings to finance investments when

possibleIf retained earnings left over after making investments,

pay a dividend with the residualIf there are no residual funds, pay no dividend


Recognizes that floatation costs when issuing new stock are very high

Residual Theory minimizes floatation costs

34The Clientele Effect

There are all kinds of investors, some like dividends, others do not.

According to clientele effect, investors who prefer dividends over capital gains will gravitate to high dividend paying firms. Others will choose to invest in no or low dividend paying firms.

As an investor’s circumstances and or outlook for dividends changes, he will sell one kind of shares to invest in another kind.

Recognizes that investors are not all alike

35The Information Effect

Changes in dividends may provide a signal of firm's financial condition

Dividend Increase - May signal managers expect higher earnings in the future

Earnings UP 10%

50¢ Dividend Increase



Earnings OFF 10%

25¢ Dividend CutDividend Decrease - May signal managers expect earnings downturn



Earnings OFF 10%

25¢ Dividend CutDividend Decrease - May signal managers expect earnings downturn

In practice, stock price usually rises with a In practice, stock price usually rises with a unexpected dividend increase and falls with a unexpected dividend increase and falls with a dividend decreasedividend decrease

38Drop Agency Costs

40Expectations Theory

Investors have expectations of managers' actions

If managers announce a dividend at the level that investors expect, stock price will not be affected




$2.25/share$2.25/share$2.25 share?$2.25 share?

InvestorInvestor ManagerManager



If managers announce unexpectedly high or low dividend, stock price will be affected






If dividend is lower than expected, investors may believe earnings will be lower than expected and stock price will go down






If dividend is higher than expected, investors may believe earnings will be higher than expected and stock price will go up

50Summary of Dividend Theories

Tests of dividend policy have not found Tests of dividend policy have not found conclusively that dividends affect stock priceconclusively that dividends affect stock price

The majority of managers believe that dividend The majority of managers believe that dividend policy is importantpolicy is important

There are tax disadvantages to paying dividendsThere are tax disadvantages to paying dividends Almost all companies pay regular dividendsAlmost all companies pay regular dividends Dividend Policy is a "puzzle" to academic Dividend Policy is a "puzzle" to academic

researchersresearchers

51Dividends in PracticeWhat determines dividends?What determines dividends?

There may be legal restrictions on dividendsThere may be legal restrictions on dividendsState laws have restrictions on dividends if company is not financially soundBond and Preferred Stock contracts may restrict dividends

Liquidity PositionLiquidity PositionThe firm must have sufficient cashcash to pay the dividend

Sources of FinancingSources of FinancingSmall firms may be able to easily raise money in the capital markets so they

will have low dividendsEarnings PredictabilityEarnings Predictability

Firms with stable earnings typically pays higher dividends as it expects to have future profits needed to pay dividend

52Alternative Dividend Policies

Constant Dividend Payout Ratioevery year firm pays the same percentage of earnings as a dividend to shareholders



Example:Firm pays a constant 40% dividend annually




1994 1995 1996EPS $2.00 $5.00 $3.00Dividend




1994 1995 1996EPS $2.00 $5.00 $3.00Dividend $0.80

2.00 x .40




1994 1995 1996EPS $2.00 $5.00 $3.00Dividend $0.80 $2.00

5.00 x .40




1994 1995 1996EPS $2.00 $5.00 $3.00Dividend $0.80 $2.00 $1.20

3.00 x .40




1994 1995 1996EPS $2.00 $5.00 $3.00Dividend $0.80 $2.00 $1.20

Dollar dividend fluctuates every year


Stable Dollar DividendDividend does not change quickly: small increases in dollar dividend when management is certain higher dividend can be maintained.



Example:1991 1992 1993 1994 1995 1996

EPS $2.00 $2.20 $2.10 $3.00 $2.90 $3.10Dividend



Example:1991 1992 1993 1994 1995 1996

EPS $2.00 $2.20 $2.10 $3.00 $2.90 $3.10Dividend $0.80 $0.80 $0.80 $0.80 $0.80 $1.20



Example:1991 1992 1993 1994 1995 1996

EPS $2.00 $2.20 $2.10 $3.00 $2.90 $3.10Dividend $0.80 $0.80 $0.80 $0.80 $0.80 $1.20

Increase dividend in 1996 when EPS levels out around $3.00


Constant Dividend PayoutConstant Dividend PayoutStable Dollar DividendStable Dollar DividendSmall regular dividend plus year-end extra paymentSmall regular dividend plus year-end extra payment

Regular dividend is small, if earnings permit pay an extra dividend at end of year

SummarySummary


Constant Dividend PayoutConstant Dividend PayoutStable Dollar DividendStable Dollar DividendSmall regular dividend plus year-end extra paymentSmall regular dividend plus year-end extra payment

Regular dividend is small, if earnings permit pay an extra dividend at end of year

Most popular method is the Stable Dollar DividendMost popular method is the Stable Dollar Dividend

SummarySummary

65Dividend Payment Procedures

Dividends are usually paid quarterlyDividends are usually paid quarterly


ExampleExampleOn August 25, 2004 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to share holders on record September 9, 2004, payable September 15, 1995





Declaration Date

25 31 1 7 9 15

August September

Date that dividend is announced




Date of Record

Declaration Date

25 31 1 7 9 15

August September

All owners of record will receive the dividend.


ExampleExampleOn August 25, 2004 Southside Bankshares announced a quarterly dividend of $1 per share to be paid to share holders on record September 9, 2004, payable September 15, 2004.


Declaration Date

25 31 1 7 9 15

August September

Date of Record

- 2 days- 2 days




Date of Record

Declaration Date Ex-Dividend Date

25 31 1 7 9 15

August September

To allow time for the official list of stockholders to be updated, stockholders must buy stock before the ex-dividend ex-dividend datedate (2 days prior to date of record)




Payable Date

Date of Record

Declaration Date Ex-Dividend Date

25 31 1 7 9 15

August September

Date that the dividend is paid out to the stockholders.

72Stock Dividends and Splits

Stock DividendsStock Dividends Company issues new shares and sends them on Company issues new shares and sends them on

a pro rata basis to current shareholders instead a pro rata basis to current shareholders instead of using cash to pay a dividendof using cash to pay a dividend


Company issues new shares and sends them on Company issues new shares and sends them on a pro rata basis to current shareholders instead a pro rata basis to current shareholders instead of using cash to pay a dividendof using cash to pay a dividend

Number of shares increase, no money is Number of shares increase, no money is collected or paid by the companycollected or paid by the company




With a 10% stock dividend, an investor will With a 10% stock dividend, an investor will receive one tenth of a share for every share receive one tenth of a share for every share owned.owned.




With a 10% stock dividend, an investor will With a 10% stock dividend, an investor will receive one tenth of a share for every share receive one tenth of a share for every share owned.owned.

If company issues more than a 25% stock If company issues more than a 25% stock dividend it is considered a stock splitdividend it is considered a stock split Only difference between a stock dividend and stock

split is accounting treatment on the balance sheet. Neither stock dividends nor stock splits are taxable.

78Rationale for Stock Split or DividendAre Investors Better Off? Are Investors Better Off?

ExampleExampleKatie Corporation announces a 50% stock split. Before the split Katie has 100,000 shares of stock outstanding at a price of $50 per share.



Investors will receive one-half a share for every share outstanding




No new money going into the firm so overall the stock will still be worth $50 x 100,000 = $5 million





Each share will be worth $5 million 150,000 shares

= $33.33


ExampleExampleKatie Corporation announces a 50% stock dividend. Before the dividend Katie has 100,000 shares of stock outstanding at a price of $50 per share.




= $33.33

Alternative way to solve: Price before div 1 + % dividend

$50 1 + .50 = $33.33=





Investors are no better off, have 50% more shares of stock, each share is worth less.

Alternative way to solve: Price before div 1 + % dividend

$50 1 + .50 = $33.33=


= $33.33

84Rationale for Stock Split or DividendIf Investors wealth is not increased, why issue stock If Investors wealth is not increased, why issue stock

dividends? dividends? Optimal Price RangeOptimal Price Range

Some managers believe stock price should not be too high an will split the stock or reduce the dividend to reduce the price

InformationInformationStock splits and dividends are seen as a signal that the

company is growingCash Dividend SubstituteCash Dividend Substitute

Companies who do not have cash available to pay a regular dividend may issue a stock dividend instead

85Stock Repurchases

Repurchase as an alternative to dividendRepurchase as an alternative to dividendInvestors who sell shares receive cash -- must pay taxes on any capital

gain. Investors who do not want cash simple do not sell sharesCompany pays excess cash to stockholders.

Repurchase as a financing methodRepurchase as a financing methodFirm may issue debt and then repurchase stockThis would result in a higher debt ratio

Repurchase as an investment decisionRepurchase as an investment decisionIf management thinks that their stock price is too low, may buy back its

own stock

Company buys back its own stock from investors

86Stock Repurchase Procedure

Market PurchaseMarket PurchaseFirm buys its own shares through a broker at the

market price.


Market PurchaseMarket PurchaseFirm buys its own shares through a broker at the

market price.Tender OfferTender Offer

Company announces it will repurchase shares at a fixed price.

Must announce a price above the current market price to induce shareholders to sell


Market PurchaseMarket PurchaseFirm buys its own shares through a broker at the market price.

Tender OfferTender OfferCompany announces it will repurchase shares at a fixed price.

Negotiated OfferNegotiated OfferCompany negotiates buying stock from specific group of

stockholders.Often done to buy out dissident shareholders.


Market PurchaseMarket PurchaseFirm buys its own shares through a broker at the market price.

Tender OfferTender OfferCompany announces it will repurchase shares at a fixed price.

Negotiated OfferNegotiated OfferCompany negotiates buying stock from specific group of

stockholders.Often done to buy out dissident shareholders.

Greenmail Greenmail - Dissident shareholders ask management to buy their shares at an inflated price or dissidents will take over the firm

Dividend Policy and Internal Financing

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