Sixth Edition

1. 411/02 Lecture 19 Dividend Policy Sixth Edition Principles of Corporate Finance BFIN 351 Sierra Nevada College Lake Tahoe Delivered by Mark R. Davidson, MBA

2. Influencing the Value of the Firm • Investment Decisions • Determine the level of future earnings and future potential dividends • Financing Decisions • Influence the cost of capital, which can determine the number of acceptable investment opportunities • Dividend Decisions • Influences the amount of equity capital in a firm’s capital structure and the cost of capital

3. Lecture Outline • Dividend Policy • Different Types of Dividends • Standard Method of Cash Dividend Payment • Repurchase of Stock • What We Know and Do Not Know About Dividend Policy • Summary and Conclusions

4. Dividend Policy • What is Dividend Policy? The policy that a firm uses to determine whether or not to distribute earnings to shareholders in the form of dividends • Why is it Important? We know capital structure affects firm value. Increasing shareholder equity by retaining earnings impacts capital structure. Therefore, managers can indirectly influence firm value and cost of capital by making dividend payout/retention decisions • What are major determinants of Dividend Policy? Glad you asked – there are several. Lets go on to the next slide

5. Variations in payout Legal constraints Restrictive covenants Tax considerations Liquidity and CF considerations Earnings stability Growth prospects Inflation Shareholder preference Protection against dilution Determinants of Dividend Policy

6. Passive Residual Policy • Suggests that a firm should retain its earnings as long as it has investment opportunities that promise higher rates of return than the required rate (eg NPV > 0 or IRR > WACC). • Dividends can fluctuate significantlyDepends on the firm’s investment opportunities • In practice dividends can be smoothed • Growth firms will have low dividend payout

7. Stable Dollar Dividend Policies • Reluctance to reduce dividends • Increases in dividends tend to lag earnings • Desirability • Information content • Many shareholders depend on dividends • Stability tends to reduce uncertainty • Legally desirable

8. Other Dividend Payment Policies • Constant Payout Ratio • Pays a constant % of earnings as dividends • Fluctuating dividends • Small Regular Dividends Plus Extras • Stockholders can depend on regular payout • Accommodates changing earnings and investment requirements • Small Firms and Dividends • Tend to pay out a smaller % of earnings • Rapid growth and limited access to capital markets

9. Different Types of Dividends • Many companies pay a regular cash dividend. • Public companies often pay quarterly. • Sometimes firms will throw in an extra cash dividend. • The extreme case would be a liquidating dividend. • Often companies will 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 around a box of chewing gum. • Dundee Crematoria offers shareholders discounted cremations.

10. Standard Method of Cash Dividend Payment 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 before this date is entitled to a dividend. Record Date - Person who owns stock on this date received the dividend.

11. Procedure for Cash Dividend Payment 25 Oct. 1 Nov. 2 Nov. 6 Nov. 7 Dec. … Ex-dividend Date Declaration Date Cum-dividend Date Record Date Payment Date Declaration Date: The Board of Directors declares a payment of dividends. Cum-Dividend Date: The last day that the buyer of a stock is entitled to the dividend. Ex-Dividend Date: The first day that the seller of a stock is entitled to the dividend. Record Date: The corporation prepares a list of all individuals believed to be stockholders as of 6 November.

12. Price Behavior around the Ex-Dividend Date • 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 amount of the cash dividend Ex-dividend Date 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.

13. Stock DividendsPayment of additional shares of C/S • Stock splits are similar to stock dividends • Increases the number of shares outstanding • Accounting transaction • Transfer pre dividend market value from retained earnings to other stockholders equity • Market price of C/S should decline in proportion to the # of new shares issued

14. Reasons for Declaring a Stock Dividend • Broaden the ownership of the firm’s shares • May result in an effective increase in cash dividends • Provided the level of cash dividends is not reduced • Reduction in share price may broaden the appeal of the stock to investors • Resulting in a real increase in market value

15. Stock Repurchase • By a tender offer, in the open market, or by negotiation with large holders • Treasury stock • Reduces the number of shares outstanding • Increases EPS • Usually announced • Repurchase as investment • Recent studies has shown that the long-term stock price performance of securities after a buyback is significantly better than the stock price performance of comparable companies that do not repurchase.

16. 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 on of the assumptions underlying the dividend-irrelevance arguments was “The investment policy of the firm is set ahead of time and is not altered by changes in dividend policy.”

17. What We Know and Do Not Know About Dividend Policy • Corporations “Smooth” Dividends. • Dividends Provide Information to the Market. • Firms should follow a sensible dividend policy: • Don’t 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.

18. Summary and Conclusions • The optimal payout ratio cannot be determined quantitatively. • A firm should not reject positive NPV projects to pay a dividend. • Personal taxes and issue costs are real-world considerations that favor low dividend payouts. • Many firms appear to have a long-run target dividend-payout policy. There appears to be some value to dividend stability and smoothing. • There appears to be some information content in dividend payments.