Dividend Policy

1. Dividend Policy Prepared by Keldon Bauer

2. Dividend Basics • Once a profit is earned a firm must choose whether to: • Reinvest in the business • This shows up as an increase in retained earnings. • Declare a dividend • Pay the earnings back to owners.

3. Dividend Mechanics Caterpillar Press Release October 12, 2006 PEORIA, IL -- Caterpillar Inc. (NYSE: CAT) today declared a quarterly cash dividend of thirty cents ($0.30) per share on its common stock, payable November 20, 2006, to stockholders of record at the close of business October 23, 2006. The thirty cent dividend maintains the dividend rate for the previous quarter and is 20 percent higher than the dividend paid one year ago and is 46 percent higher than the split-adjusted dividend paid two years ago.

4. Dividend Mechanics • Relevant Dates: • Record Date (October 23 in example) • Date set by board of directors on which all recorded shareholders receive declared dividend at a specified future date. • Ex Dividend (October 21 in example) • The date on which the stock trades without the right to receive the current dividend. Begins 2 business days prior to the date of record.

5. Dividend Mechanics • Relevant Dates (continued): • Declaration Date (October 12 in example) • Date set by board of directors makes the dividend declaration. • Payment Date (November 20 in example) • The date on which the firm mails the dividend payment.

6. Tax Treatment of Dividends • The Jobs and Growth Tax Relief Reconciliation Act of 2003 changed the tax treatment of dividends: • Before the act, dividends were taxed as ordinary income. • Now dividends are taxed at approximately the same rate as capital gains.

7. DRIPs • Many firms offer shareholders a Dividend ReInvestment Plan (DRIP): • The shareholder can opt to receive additional shares rather than a cash dividend. • The transaction saves the shareholder much of the transactions costs. • The transaction saves the firm floatation costs.

8. Dividends or Capital Gains? • The ultimate goal of financial managers should be the maximization of shareholder wealth. • Shareholder wealth can be maximized by maximizing the price of the stock. • As you have learned earlier, the price of the stock is the expected present value of future cash flows.

9. Dividends or Capital Gains? • In the late 1950s, Myron Gordon proposed modeling price on a firm’s dividends and growth potential: • Optimal Dividend Policy: To maximize price, an optimal balance must be found between current dividends (D1) and the need for growth (g).

10. Dividends or Capital Gains? • The Residual Theory of Dividends: • Investors prefer to have the firm retain and reinvest earnings if they can earn a higher risk adjusted return than the investor can. • Residual Dividend Policy suggests that dividends should be that part of earnings which cannot be invested at a rate at least equal to the WACC.

11. Dividend Policy Classes • Residual Dividend Policy Steps: • Determine the optimal capital budget. • Determine the retained earnings that can be used to finance the capital budget. • Use retained earnings to supply as much of the equity investment in the capital budget as necessary. • Pay dividends only if there are left-over earnings.

12. Dividend Policy and Stock Price • Dividend Irrelevance Theory: • Miller/Modigliani argued that dividend policy should be irrelevant to stock price. • If dividends don’t matter, this chapter is irrelevant as well (which is what most of you are thinking anyway).

13. Dividend Irrelevance Theory

14. Dividend Irrelevance Theory Dividends are not in the final equation! Therefore, dividends are irrelevant to value!

15. Dividend Irrelevance Theory Informational content (Signaling Theory) • Managers have superior information to investors about the cash flow prospects of the firm. • Dividends are only increased if they are not likely to be cut in future. • Increased dividends are a positive signal. • Decreased dividends are a negative signal.

16. Dividend Irrelevance Theory Clientele Effect: • Tax-free foundations and retirees at lower marginal tax rates prefer cash now and on a predictable basis. • Investors at higher marginal tax rates prefer capital gains to dividends. • Each firm, therefore, attracts the type of investor that likes its dividend policy.

17. Bird-in-the-Hand Theory • Gordon argued that a dividend-in-the-hand is worth more than the present value of a future dividend. • In essence, he said that the risk premium on the dividend yield is higher than on the growth rate.

18. Factors Affecting Dividend Policy • Legal Constraints – State Statute • Contractual Constraints • Internal Constaints • Growth Prospects • Owner Considerations • Market Considerations • Current research on international dividend policy

19. Dividend Policy Classes • Regular Dividend Policy: Due to the possibility of a negative signal to investors, many CFOs have set the policy of never reducing their dividends. • Dividends are only increased if management is certain future earnings will support such a high dividend.

20. Dividend Policy Classes • Regular Dividend Policy: • A variation of this policy is one in which dividends exhibit a stable, predictable growth rate. • In that instance the company has to set the policy in such a way that the growth rate can be sustained for the foreseeable future.

21. Dividend Policy Classes • Regular Dividend Policy Steps: • Pay a predictable dividend every year. • Base optimal capital budget on residual retained earnings (after dividend).

22. Dividend Policy Classes • Constant Payout Ratio Policy: It is possible that a company could set a policy to payout a certain percentage of earnings as dividends. • The problem is that such a policy would not fit the needs of the firms stockholders, since it would cause a great deal of volatility in dividends paid (see clientele effect spoken of earlier).

23. Dividend Policy Classes • Constant Payout Ratio Policy Steps: • Pay a constant proportion of earnings (if positive). • Base optimal capital budget on residual retained earnings.

24. Dividend Policy Classes • Low Regular Dividend Plus Extras: This policy is a hybrid of the last two policies. It is meant to keep expectations low for dividends, and supplement those dividends with bonuses in good years. • The problem is the potential for negative signaling.

25. Dividend Policy Classes • Low Regular Dividend Plus Extras Steps: • Pay a predictable dividend every year. • In years with good earnings pay a bonus dividend. • Base optimal capital budget on residual of regular dividend and compromising with bonus for capital budgeting projects.

26. General Motors – Dividends

27. Caterpillar – Dividend Policy

28. Stock Dividends and Splits • Stock dividends and stock splits are used by companies to keep their share prices in a marketable range. • Stock Split: Changing the number of shares outstanding. Shareholders exchange old shares for new shares. • e.g. two for three stock split. • No balance sheet effect.

29. Stock Dividends and Splits • Stock Dividends: Dividend paid in stock rather than cash. • On the balance sheet, a transfer of the dividend amount is made from retained earnings to common stock & paid-in-capital accounts at the market price. • There is no price effect on the investor’s holding (although there will be on the value of a share) with either transaction.

30. Stock Repurchases • Definition: • Buying shares back from stockholders. • Purpose: • As an alternative to distributing cash as dividends. • To dispose of one-time cash surplus. • To change the firm’s capital structure.

31. Stock Repurchases • Process • Open Market • Buying them off the market at the market price. • Tender Offer • Offering to buy a specified number of shares at a fixed price. • Negotiated repurchase • Repurchase from one or more major shareholders. • Could be a way to avoid a takeover.