Chapter 19
DIVIDENDS AND OTHER PAYOUTS
SLIDES
CHAPTER WEB SITES
Section Web Address
19.2 www.earnings.com
19.10 www.investmenthouse.com
finance.yahoo.com
19.1 Key Concepts and Skills
19.2 Chapter Outline
19.3 Different Types of Payouts
19.4 Standard Method of Cash Dividend
19.5 Procedure for Cash Dividend
19.6 Price Behavior
19.7 The Irrelevance of Dividend Policy
19.8 Homemade Dividends
19.9 Dividend Policy Is Irrelevant
19.10 Dividends and Investment Policy
19.11 Repurchase of Stock
19.12 Stock Repurchase versus Dividend
19.13 Stock Repurchase versus Dividend
19.14 Stock Repurchase versus Dividend
19.15 Share Repurchase
19.16 Personal Taxes, Dividends, and Stock Repurchases
19.17 Firms without Sufficient Cash
19.18 Firms with Sufficient Cash
19.19 Taxes and Dividends
19.20 Real-World Factors Favoring High Dividends
19.21 The Clientele Effect
19.22 What We Know and Do Not Know
19.23 Putting It All Together
19.24 General Dividend Guidelines
19.25 Stock Dividends
19.26 Stock Splits
19.27 Quick Quiz
CHAPTER ORGANIZATION
19.1 Different Types of Payouts
19.2 Standard Method of Cash Dividend Payment
19.3 The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy
Current Policy: Dividends Set Equal to Cash Flow
Alternative Policy: Initial Dividend Is Greater Than Cash Flow
The Indifference Proposition
Homemade Dividends
A Test
Dividends and Investment Policy
19.4 Repurchase of Stock
Dividend versus Repurchase: Conceptual Example
Dividends versus Repurchases: Real-World Considerations
19.5 Personal Taxes, Dividends, and Stock Repurchases
Firms without Sufficient Cash to Pay a Dividend
Firms with Sufficient Cash to Pay a Dividend
Summary of Personal Taxes
19.6 Real-World Factors Favoring a High-Dividend Policy
Desire for Current Income
Behavioral Finance
Agency Costs
Information Content of Dividends and Dividend Signaling
19.7 The Clientele Effect: A Resolution of Real-World Factors?
19.8 What We Know and Do Not Know about Dividend Policy
Corporate Dividends Are Substantial
Fewer Companies Pay Dividends
Corporations Smooth Dividends
Some Survey Evidence about Dividends
19.9 Putting It All Together
19.10 Stock Dividends and Stock Splits
Some Details about Stock Splits and Stock Dividends
Value of Stock Splits and Stock Dividends
Reverse Splits
ANNOTATED CHAPTER OUTLINE
Slide 19.0 Chapter 19 Title Slide
Slide 19.1 Key Concepts and Skills
Slide 19.2 Chapter Outline
Lecture Tip: Can the wrong dividend policy bankrupt a firm? The
following anecdote suggests that dividend policy can play a role in a
company’s downfall.
The automobile industry was quite prosperous in the 1920s, but was hit
hard by the depression. Studebaker Corporation, which was relatively
weak to begin with, suffered more than other automotive manufacturers.
Part of the reason for its financial problems was the belief by the firm’s
president that dividends alone could increase the value of the stock. He
implemented a dividend policy that increased the dividend payout ratio
from 43 percent in the early 1920s to 91 percent in 1929. However, the
dividend was held constant in 1930 and 1931, even as sales and earnings
decreased. This led to a payout ratio of 500 percent (!) in 1930 and 350
percent in 1931. In 1932, the company lost $8.7 million, but still paid $1
million in dividends! The firm’s financial health was damaged
significantly by the generous dividend policy, and it filed for
reorganization in March, 1933. Tragically, the firm’s president took it very
personally and shot himself three months later.
1. Different Types of Payouts
Regular cash dividend – normal dividends, usually paid on a quarterly
basis
Extra cash dividend – paid over and above the regular dividend, may or
may not be repeated
Special dividend – one-time dividend paid over and above the regular
dividend, will not be repeated
Stock dividend – pay owners with additional shares of stock. No cash
actually leaves the firm.
Dividends in kind – pay owners using products or services of the firm
A stock repurchase is an alternative form of cash payout.
Slide 19.3 Different Types of Payouts
Lecture Tip: Students may find it interesting to review the various
dividend policies companies have employed by examining the stock quotes
in The Wall Street Journal. Ask the students to bring a copy of the Journal
to class and examine the Explanatory Notes box provided with the stock
quotations. Then explain the presentation with examples.
2. Standard Method of Cash Dividend Payment
Slide 19.4 Standard Method of Cash Dividend
Dividend Payment: A Chronology
Declaration date – the dividend is declared by the Board of Directors and
becomes a liability of the firm
Ex-dividend date – occurs 2-3 days prior to the date of record; if you
purchase the stock on or after the ex-dividend date, you will not receive
the dividend
Date of record – firm prepares the list of stockholders who will receive
dividends
Date of payment – checks are mailed
Slide 19.5 Procedure for Cash Dividend
The stock price drops by approximately the amount of the dividend on the
ex-dividend date. This is a good place to make sure students remember
that the value of the stock is the PV of expected future dividends; if one of
those dividends will no longer be received, then the price should drop by
that amount.
Slide 19.6 Price Behavior
Lecture Tip: You may wish to have the class consider if it would be
advantageous to buy a stock on the day before the ex-dividend date. Using
the example in Figure 19.2, assume you bought the stock prior to the ex-
dividend date for $10 per share. This would entitle you to receive the $1
dividend, which will be mailed on the payment date. What is the value of
your investment after the stock goes ex-dividend? You have the $1
dividend plus a share of stock that is now worth $9. In a perfect world,
this would result in a no-arbitrage opportunity. However, you would owe
taxes on the
dividend received. Consequently, if the stock price falls by the full amount
of the dividend, you are worse off because you will have the $1 dividend +
$9 for the stock – taxes paid on the dividend < $10.
Therefore, if the marginal investor is in a positive tax bracket (which is
generally the case), then the stock price should fall by less than the
dividend amount to compensate the investor for the taxes that must be
paid on the dividend. A study by Avner Kalay (Journal of Finance, 1982)
found that the actual average stock price decline on the ex-dividend date
was about 73.4% of the value of the dividend. This implies that the tax
rate for the average investor at that time was about 27%. Of course, there
have been a significant number of tax law changes since then.
Lecture Tip: It was widely reported that in 1988, nearly 13% of the daily
average trading volume on the NYSE was attributable to the actions of
investors using dividend capture strategies. This involves purchasing a
high-dividend stock just before it goes ex-dividend and selling it soon
afterwards. If the price of the stock falls by less than the amount of the
dividend, and if the purchaser’s marginal tax rate is low enough, the
strategy represents a real-world arbitrage opportunity. This opportunity
derives from the differential tax treatment that investors face.
Japanese insurance firms, which were restricted to paying dividends
from current income, have engaged heavily in dividend capture strategies
since they do not face the same tax structure that we face in the U.S.
3. The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy
As with the other decisions we have reviewed, dividend policy will only
matter if it affects the wealth of stockholders.
The idea behind the irrelevance argument is that if the firm has a lower
payout ratio now, it will reinvest the capital into the firm, grow the firm
faster, and pay higher dividends later. On the other hand, if the firm has a
higher payout ratio now, it will reinvest less capital back into the firm and
pay lower dividends later. As long as the required return (exactly) is
earned on investments, it is irrelevant which choice the firm makes.
Slide 19.7 The Irrelevance of Dividend Policy
Lecture Tip: The idea that dividend policy (as opposed to dividends) is
irrelevant is difficult for many students to swallow. After all, we spent a
whole chapter talking about how the value of the stock is the present value
of expected future dividends. And intuitively, they know that higher
dividends will make a firm more valuable, all else equal. The difficult part
is understanding that “all else equal” means that higher dividends today
cannot impact expected dividends in the future, investments, financing, or
anything else. If we could increase dividends without changing anything
else, then the firm would increase in value. However, there is a trade-off
between paying higher dividends and doing other things in the firm. The
irrelevance argument says that this trade-off is essentially a zero-sum
game and that choosing one dividend policy over another will not impact
the stock price.
Lecture Tip: Recall the dividend growth model: P0 = D1 / (RE – g). In the
absence of market imperfections, such as taxes, transaction costs, and
information asymmetry, it can be shown that an increase in the future
dividend, D1, will reduce earnings retention and reinvestment. This will
reduce the growth rate, g. Therefore, both the numerator and the
denominator increase, and the net effect on P0 is zero.
A. Current Policy: Dividends Set Equal to Cash Flow
B. Alternative Policy: Initial Dividend Is Greater Than Cash Flow
C. The Indifference Proposition
D. Homemade Dividends
Homemade dividends – selling shares in the appropriate proportion to
create an equivalent cash flow to receiving the dividend stream you want.
If you receive dividends that you do not want, you can purchase additional
shares.
Lecture Tip: Dividend reinvestment plans (DRIPS) allow investors to
reinvest dividend income back into the issuing company without paying
commissions. Many plans also allow shareholders to buy additional
shares directly from the company, often on a set schedule. This again
avoids commissions, although in some cases you pay a small service fee.
You are still liable for any taxes owed on the dividend payments.
This is one way for an investor to use dollar cost averaging when
investing in individual stocks. Some plans even allow you to buy at below
market prices.
You can get additional information on DRIPS and direct investment at
www.moneypaper.com and www.dripinvestor.com.
Slide 19.8 Homemade Dividends
E. A Test
True or False: Dividends are irrelevant (False)
True or False: Dividend policy is irrelevant (True – absent market
imperfections, and maybe even with market imperfections)
It is important to understand that the only thing that can make dividend
policy relevant is if there is some market imperfection that affects
investors’ desire for dividends now versus later.
Slide 19.9 Dividend Policy Is Irrelevant
F. Dividends and Investment Policy
Since policy is irrelevant, the firm should not forego positive NPV
projects, which would increase firm value, to sustain a high dividend
policy that has no effect on firm value. This assumes that the overall level
of cash flow is fixed and that we are not changing the available positive
net present value projects.
Slide 19.10 Dividends and Investment Policy
4. Repurchase of Stock
A firm may choose to buy back outstanding shares instead of paying a
cash dividend (or instead of increasing a regular dividend). If we assume
no market imperfections, then stockholder wealth is unaffected by the
choice between share repurchases and cash dividends.
Slide 19.11 Repurchase of Stock
A. Dividend versus Repurchase: Conceptual Example
Slide 19.12 –
Slide 19.14 Stock Repurchase versus Dividend
B. Dividends versus Repurchases: Real-World Considerations
One of the most important market imperfections related to cash dividends
versus share repurchases is the (historic) differential tax treatment of
dividends versus capital gains. When a company does a share repurchase,
the investor can choose whether to sell their shares, take the capital gain
(loss) and the associated tax consequences. When a company pays
dividends, the investor does not have a choice, and taxes must be paid
immediately.
The IRS understands the tax differences between the two methods for
returning cash to stockholders and prohibits stock repurchase plans solely
for the purpose of allowing investors to avoid taxes.
Distributing cash via share repurchases may be desirable from the
viewpoint of the investor even in the absence of a capital gains tax
differential. Essentially, a repurchase allows the investor to choose
whether to take cash now (and incur taxes) or hold on to the stock and
benefit from the (unrealized) capital gain. Additionally, empirical evidence
indicates that repurchase announcements are often viewed by market
participants as favorable signals of future firm prospects and/or as
evidence that management believes that shares are undervalued.
Slide 19.15 Share Repurchase
Lecture Tip: Although share repurchases have traditionally been viewed
as positive signals from management, not everyone agrees. An article in
the November 17, 1997, issue of Forbes magazine suggests that some
buybacks are ill-advised.
“In the early 1980s, IBM began a big buyback program.
Between 1985 and 1990 it bought back nearly 50 million
shares, shrinking its common capitalization by 8%. The
buybacks ended with the collapse of IBM’s stock in 1991.
Before the decline was over, IBM was down 75% from its high.
Why, at a time of huge expansion in the computer industry,
didn’t IBM have better uses for its cash?”
The authors of the article go so far as to state that “the [buyback]
fad has gotten out of hand” and that, at least in some cases,
buybacks are used to make management “look good for a while.”
Lecture Tip: A quick search of stock repurchase announcements
following the terrorist attacks on September 11 found at least nine
companies that specifically cited a desire to support American
financial
markets and confidence in the long-term prospects of the economy
and the company as reasons for the repurchase. Some of these
companies were Cisco, E-Trade, and Pfizer.
At least fourteen other major companies made repurchase
announcements in the week that followed the attacks. These
announcements were for new or continuing repurchases without
specifically mentioning the attacks or support for the markets.
These companies included Intel, Federal Express, and PeopleSoft.
Lecture Tip: “Monsanto Proposals Excite Investors.” So read
banner headlines in the March 15, 1996, issue of the St. Louis
Post-Dispatch. St. Louis-based Monsanto Corp. had just
announced a plan to “tie executives’ pay more closely to the
company’s stock price … spread stock options to rank-and-file
employees [and] buy back 8 million shares” of its stock. The news
was viewed favorably by investors – trading volume was 2.5 times
normal and the price per share jumped 3.2% in one day. How
much of the increase in value was due to the repurchase
announcement and how much was due to the revised compensation
plan? Unfortunately, the commingling of events makes it difficult
to say. Share repurchase announcements are frequently made in
conjunction with other announcements, making it difficult to
isolate their true impact on stock prices.
While EPS rises with a repurchase (there are fewer shares and presumably
net income does not decrease), the market value of those earnings is the
same as with a cash dividend.
5. Personal Taxes, Dividends, and Stock Repurchases
Taxes on dividends are paid immediately, but capital gains taxes are
deferred until recognized (i.e., sale of the security). Thus, taxes on
dividends are effectively higher, even though the current rate on both is
15%. (But, the rates on both are subject to change by Congress.)