Chapter 17 – Dividends and Dividend Policy
Chapter 17
DIVIDENDS AND DIVIDEND POLICY
CHAPTER WEB SITES
Section Web Address
17.1 www.reuters.com/finance/EarningsUS
17.2 www.fool.com
17.8 www.stocksplits.net
CHAPTER ORGANIZATION
17.1 Cash Dividends and Dividend Payment
Cash Dividends
Standard Method of Cash Dividend Payment
Dividend Payment: A Chronology
More about the Ex-Dividend Date
17.2 Does Dividend Policy Matter?
An Illustration of the Irrelevance of Dividend Policy
Homemade Dividends
A Test
17.3 Real-World Factors Favoring a Low Dividend Payout
Taxes
Flotation Costs
Dividend Restrictions
17.4 Some Real-World Factors Favoring a High Payout
Desire for Current Income
Tax and Other Benefits from High Dividends
Conclusion
17.5 A Resolution of Real-World Factors?
Information Content of Dividends
The Clientele Effect
17.6 Stock Repurchase: An Alternative to Cash Dividends
Cash Dividends versus Repurchase
Real-World Considerations in a Repurchase
Share Repurchase and EPS
17.7 What We Know and Do Not Know about Dividends and Payout Policies
Dividends and Dividend Payers
Corporations Smooth Dividends
Putting It All Together
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Chapter 17 – Dividends and Dividend Policy
Some Survey Evidence on Dividends
17.8 Stock Dividends and Stock Splits
Some Details about Stock Splits and Stock Dividends
Value of Stock Splits and Stock Dividends
Reverse Splits
17.9 Summary and Conclusions
ANNOTATED CHAPTER OUTLINE
Real-World 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 filed
for reorganization in March, 1933. Tragically, the firm’s president
took it very personally and shot himself three months later.
1. Cash Dividends and Dividend Payment
A. Cash Dividends
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, won’t be repeated
B. Standard Method of Cash Dividend Payment
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Chapter 17 – Dividends and Dividend Policy
The Board of Directors declares dividends, after which the
dividends become a liability of the firm.
C. 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 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
Lecture Tip: The ex-dividend date went from four business days
prior to the record date to two in June 1995 as a result of a change
in settlement requirements.
Date of record – firm prepares the list of stockholders who will
receive dividends
Date of payment – checks are mailed
D. More on the Ex-Dividend Date
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.
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 17.2, if you bought the stock
prior to the ex-dividend date, you would pay $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.
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Chapter 17 – Dividends and Dividend Policy
Therefore, if the marginal investor is in a positive tax bracket
(which is always 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, most notably the
change to taxing qualified dividends at the lower capital gains rate
in 2003. This should lead to a drop in price that is much closer to
the actual dividend amount.
International Note: 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.
2. Does Dividend Policy Matter
A. 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 is earned on investments, it is irrelevant which
choice the firm makes.
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Chapter 17 – Dividends and 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.
B. 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 don’t want, you can
purchase additional shares.
Real-World 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.
C. A Test
True or False: Dividends are irrelevant (False)
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Chapter 17 – Dividends and Dividend Policy
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.
3. Some Real-World Factors Favoring a Low Dividend Payout
A. Taxes
Investors that are in high marginal tax brackets might prefer lower
dividend payouts. If the firm reinvests the capital back into
positive NPV investments, then this should lead to an increase in
the stock price. The investor can then sell the stock when she
chooses and pay capital gains taxes at that time. Taxes must be
paid on dividends immediately, and even though qualified
dividends are currently taxed at the same rate as capital gains, the
effective tax rate is higher because of the timing issue.
B. Flotation Costs
If a firm has a high dividend payout, then it will be using its cash
to pay dividends instead of investing in positive NPV projects. If
the firm has positive NPV projects available, it will need to go to
the capital market to raise money for the projects. There are fees
and other costs (flotation costs) associated with issuing new
securities. If the company had paid a lower dividend and used the
cash on hand for projects, it could have avoided at least some of
the flotation costs.
C. Dividend Restrictions
Bond indentures often contain a provision that limits the level of
dividend payments
Lecture Tip: There is a conflict of interest between stockholders
and bondholders. As a result, bond indentures contain restrictive
covenants to prevent the transfer of wealth from bondholders to
stockholders. Dividend restrictions are one of the most common
restrictive covenants. They normally require that dividends be
forgone when net working capital falls below a certain level or
that dividends only be paid out of net income, not retained
earnings that existed before the bond agreement was signed.
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Chapter 17 – Dividends and Dividend Policy
4. Real-World Factors Favoring a High Payout
A. Desire for current income
-Individuals that want current income can either invest in
companies that have high dividend payouts or they can sell
shares of stock. An advantage to dividends is that you don’t
have to pay commission.
-Trust funds and endowments may prefer current income
because they may be restricted from selling stock to meet
expenses if it will reduce the fund below the initial principal
amount.
Lecture Tip: A fascinating real-world example of the desire for
increased dividend payout can be found in Kirk Kerkorian’s battle
with the management at Chrysler. In late 1994, Mr. Kerkorian
demanded that Chrysler use its cash hoard (about $6.6 billion at
the time) to increase the cash dividend on common stock and to
institute a stock repurchase program. The management of Chrysler
contended that, in the interest of prudent management, they were
amassing cash with which to ride out the next cyclical downturn.
Unhappy with Chrysler’s response, Mr. Kerkorian offered $55 per
share (nearly $23 billion total) to take over Chrysler. This bid
ultimately failed, but Chrysler’s management did raise the
dividend. Incidentally, Ford and GM subsequently found it
necessary to publicly defend their large cash positions in the
period after the Chrysler takeover bid.
B. Tax and Other Benefits from High Dividends
-Corporate investors –at least 70% of dividends received from
other corporations does not have to be included in taxable
income
-Tax-exempt investors – tax-exempt investors do not care about
the differential tax treatment between dividends and capital
gains. And, in many cases, tax-exempt institutions have a
fiduciary responsibility to invest money prudently. The courts
have found that it is not prudent to invest in firms without an
established dividend policy
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Chapter 17 – Dividends and Dividend Policy
C. Conclusion
Differences in tax laws and regulations cause some groups to
prefer dividends.
5. A Resolution of Real-World Factors?
A. Information Content of Dividends
Changes in dividends may be important signals if the market
anticipates that the change will be maintained through time. If the
market believes that the change is just a rearrangement of
dividends through time, then the impact will be small. The reaction
to the information contained in dividend changes is called the
information content effect.
Lecture Tip: Selling stock to raise funds for dividends also creates
a “bird-in-the-hand” situation for the shareholder. Again, we are
back to “all else equal.” Can a higher dividend make a stock more
valuable? If a firm must sell more stock or borrow more money to
pay a higher dividend now, it must return less to the stockholder in
the future. The uncertainty over future income (the firm’s business
risk) is not affected by dividend policy.
B. The Clientele Effect
The clientele effect says that dividend policy is irrelevant because
investors that prefer high payouts will invest in firms that have
high payouts, and investors that prefer low payouts will invest in
firms with low payouts. If a firm changes its payout policy, it will
not affect the stock value; it will just end up with a different set of
investors. This is true as long as the “market” for dividend policy
is in equilibrium. In other words, if there is excess demand for
companies with high dividend payouts, then a low payout company
may be able to increase its stock value by switching to a high
payout policy. This is only possible until the excess demand is met.
Lecture Tip: To put the clientele argument into a different light,
consider the case of opening a new restaurant. Even though a lot
of people like to eat hamburgers and French fries, if McDonald’s
already satisfies that clientele you won’t make a fortune by
opening a Burger King next door. In the context of business
finance, the moral is that for dividend policy to be relevant, it must
meet a currently unmet demand if it is to create value.
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Chapter 17 – Dividends and Dividend Policy
Lecture Tip: The dividend clientele argument suggests that
investors that do not need current income will seek low dividend
firms (and vice versa). In a similar fashion, many theorists have
argued that there is also a clientele for various capital structure
policies. Investors in a low tax bracket will prefer highly leveraged
firms because the firms are better able to utilize the interest tax
shield. While investors in higher tax brackets will borrow on their
own and buy firms with less debt. Empirical evidence is mixed,
partially due to the changing nature of the deductibility of interest
for individuals.
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