Chapter: 13

1. Chapter: 13 Dividend Policy

2. Regular Cash Dividends VS Specially Designated Dividends • A regular cash dividend is the distribution of earnings to shareholders in the form of cash. If a company pays regular, steady dividends, investors will come to expect them. Regular cash dividends represent unlabeled dividends. • A specially designated dividend (SDD) is one that management labels as “extra”, “special”, or “year-end”. Labeling dividends allows management to differentiate a SDD from a regular cash dividend and communicate this difference to stockholders. This ability to label dividends indicates how seriously management considers this communication through dividend announcements. • Regular dividends should potentially convey more information than SDDs because management labels the latter as temporary dividends. Although firms often declare SDDs after experiencing good earnings over the previous year, investors should not expect the operating performance that precedes a special dividend to continue after the announcement.

3. Four key dates in the dividend payment procedure • The declaration dateis the date on which the board of directors announces the next dividend payment. • The record date, also called the holder-of-record date, is the date on which a stockholder must own a share to receive a declared dividend at some specified future time. • The ex-dividend dateis the date on which the stock begins trading without the right to receive the upcoming dividend. Thus, buyers of a stock selling ex dividend do not receive the current dividend. The ex-dividend date is generally several weeks after the declaration date and several weeks before the payment date. • The payment dateis the actual date on which the firm mails the dividend payment to the holders of record.

4. Importance of Dividend Policy • It bears upon investor attitude. • It impacts the financing program & capital budget of the firm. • It affects the firm’s cash flow position. • It lowers stockholders’ equity, since dividends are paid from retained earnings, & results in a higher debt-to-equity ratio.

5. Irrelevance of Dividends • M&M contend that the effect of dividend payments on shareholder wealth is exactly offset by other means of financing. • The dividend plus the “new” stock price after dilution exactly equals the stock price prior to the dividend distribution. A. Current dividends versus retention of earnings

6. Irrelevance of Dividends • M&M and the total-value principle ensures that the sum of market value plus current dividends of two firms identical in all respects other than dividend-payout ratios will be the same. • Investors can “create” any dividend policy they desire by selling shares when the dividend payout is too low or buying shares when the dividend payout is excessive. B. Conservation of value

7. Relevance of Dividends • Uncertainty surrounding future company profitability leads certain investors to prefer the certainty of current dividends. • Investors prefer “large” dividends. • Investors do not like to manufacture “homemade” dividends, but prefer the company to distribute them directly. A. Preference for dividends

8. Relevance of Dividends • Capital gains taxes are deferred until the actual sale of stock. This creates a timing option. • Capital gains are preferred to dividends, everything else equal. Thus, high dividend-yielding stocks should sell at a discount to generate a higher before-tax rate of return. • Certain institutional investors pay no tax. B. Taxes on the investor

9. Relevance of Dividends • Corporations can typically exclude 70% of dividend income from taxation. Thus, corporations generally prefer to receive dividends rather than capital gains. • The result is clienteles of investors with different dividend preferences. In equilibrium, there will be the proper distribution of firms with differing dividend policies to exactly meet the needs of investors. • Thus, dividend-payout decisions are irrelevant. B. Taxes on the investor (continued)

10. Empirical Testing of Dividend Policy Tax Effect • Dividends are taxed more heavily than capital gains, so before-tax returns should be higher for high-dividend-paying firms. • Empirical results are mixed -- recently the evidence is largely consistent with dividend neutrality. Financial Signaling • Expect that increases (decreases) in dividends lead to positive (negative) excess stock returns. • Empirical results are consistent with these expectations.

11. Factors Influencing Dividend Policy • Capital Impairment Rule-- many states prohibit the payment of dividends if these dividends impair “capital” (usually either par value of common stock or par plus additional paid-in capital). • Incorporation in some states (notably Delaware) allows a firm to use the “fair value,” rather than “book value,” of its assets when judging whether a dividend impairs “capital.” Legal Rules

12. Factors Influencing Dividend Policy • Insolvency Rule-- some states prohibit the payment of cash dividends if the company is insolvent under either a “fair market valuation” or “equitable” sense. • Undue Retention of Earnings Rule-- prohibits the undue retention of earnings in excess of the present and future investment needs of the firm. Legal Rules

13. Factors Influencing Dividend Policy • Funding Needs of the Firm • Liquidity • Ability to Borrow • Restrictions in Debt Contracts • Control Other Issues to Consider

14. Why do Miller and Modigliani contend that dividend policy is irrelevant? • Assuming an idealized world of perfect capital markets and rational investors, Miller and Modigliani (M&M) conclude that the firm’s choice of dividend policy is irrelevant. According to their theory, M&M contend that the distribution of dividends does not affect a firm’s value. Instead, the earning power and risk of its assets solely determine the value of the firm. M&M also argue that shareholders are indifferent to the payment of dividends because they can create any dividend policy they desire by buying or selling shares of the stock. This controversial conclusion means that dividend policy has no affect on shareholders’ wealth. The view of dividend irrelevance is contrary to traditional wisdom. If dividend policy is relevant to investors, some of M&Ms assumptions must be in error.

15. What are the key assumptions of perfect capital markets as per MM? • In a perfect capital markets, there are no taxes and no flotation, transactions, or agency costs. Investors are symmetrically informed, which means that information is costless and available to everyone equally. Investors act rationally and no single investor can exert enough power to influence the price of a security.

16. What are the “three big imperfections” and the “three little frictions” involving capital markets? • The “three big imperfections” involving capital markets are taxes, asymmetric information, and agency costs. The “little three frictions” are transaction costs, flotation costs, and behavioral considerations.

17. Investors’ preference for high dividend pay out ratio? • Are lower-income shareholders who need dividend income, • Believe that current dividend payments reduce uncertainty, • Are low-tax bracket shareholders who do not prefer to deter taxes, and • Have little concern about dilution of ownership.

18. Types of Dividend policy • Residual Dividend Policy. • Stable Dollar Dividend Policy. • Constant Payout Policy. • Regular plus specially designated dividends policy

19. Residual Dividend Policy • A residual dividend policy is one in which a firm pays dividends from the amount remaining after undertaking all desirable projects from internally generated cash flows. A desirable project is usually one having a positive net present value. Under this passive type of dividend policy, shareholders receive any excess cash as dividends. Both the amount of internally generated cash flows and desirable projects are unpredictable over time. Thus, an implication of this theory is that the amount of the residual dividend is likely to be highly variable and often zero. Such instability of dividend payments may result in increased uncertainty by investors.

20. Stock Dividends Small-percentage stock dividends • Typically less than 25% of previously outstanding common stock. • Assume a company with 400,000 shares of $5 par common stock outstanding pays a 5% stock dividend. The pre-dividend market value is $40. How does this impact the shareholders’ equity accounts? Stock Dividend -- A payment of additional shares of stock to shareholders. Often used in place of or in addition to a cash dividend.

21. Stock Dividends and Stock Splits • Similar economic consequences as a 100% stock dividend. • Primarily used to move the stock into a more popular trading range and increase share demand. • Assume a company with 400,000 shares of $5 par common stock splits 2-for-1. How does this impact the shareholders’ equity accounts? Stock Split-- An increase in the number of shares outstanding by reducing the par value of the stock.

22. What is Treasury stock? • Treasury stock is stock reacquired by the issuing company and available for retirement or resale. Such stock is issued but not outstanding. Treasury stock has no voting rights, accrues no dividends, and is not part of the ratios measuring values per common share.