978-0077861704 Chapter 17 Lecture Note Part 2

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Chapter 17 – Dividends and Dividend Policy

1. Stock Repurchase: An Alternative to Cash Dividends

A. Cash Dividends versus Repurchase

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.

Real-World Tip: The dividend yield of DJIA firms fell for many

years, although it is up slightly since 2001. Some have suggested

that the declining dividend yield was not solely attributable to the

market’s rise; it might also have been due to declining dividend

payouts. For example, in a 1987 article in the Journal of

Economic Perspectives, Laurie Bagwell and John Shoven suggest

that for the 10-year period ending in 1987, dividend payments

were being replaced by non-dividend cash payments. These non-

dividend cash payments were primarily in the form of cash paid

out in acquisitions and in share repurchases. What could be the

reasons for this shift in the policy for returning cash to

stockholders? Consider taxes and agency issues. The slight

increase in dividend yield during the last couple of years could be

due to the change in the taxation of dividends.

B. Real-World Considerations in a Repurchase

One of the most important market imperfections related to cash

dividends versus share repurchases is the 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.

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.

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Chapter 17 – Dividends and Dividend Policy

“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 go so far as to state that “the [buyback] fad

has gotten out of hand” and that, in some cases, buybacks

are used to make management “look good for a while.”

Real-World 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 include Intel, Federal

Express, and PeopleSoft.

Lecture Tip: It should be pointed out that distributing cash

via share repurchases is 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.

C. Share Repurchase and EPS

While EPS rises with a repurchase (there are fewer shares and

presumably net income doesn’t decrease), the market value of

those earnings is the same as with a cash dividend.

2. What We Know and Do Not Know about Dividend Policy

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Chapter 17 – Dividends and Dividend Policy

A. Dividends and Dividend Payers

Dividends are large in the aggregate; however, the number of firms

that pay a dividend has declined over time. This suggests that

dividend payments are concentrated in a relatively small set of

(larger, older) firms. This issue remains even after controlling for

the increased use of repurchases, although not to the same extent

following the tax cut on dividends in 2003.

B. Corporations Smooth Dividends

Because of the information content of dividend changes, managers

may prefer to maintain a more stable dividend policy. This reduces

the uncertainty surrounding expected future dividends and should

decrease the risk attributed to the cash flows from the stock.

Lecture Tip: In July, 1995, Venture Corporation, a high-volume

discount retailer, announced the suspension of its quarterly

dividend following a period of poor earnings performance. The

price of the stock (which had already fallen over the preceding

months) fell by approximately one-third on the day of the

announcement. Subsequent quarterly earnings were

“disappointing,” and the firm filed for bankruptcy and was

liquidated a few years later.

At about the same time, Edison Brothers, also a retailer,

announced that its dividend would be reduced in order to

“conserve cash for investment opportunities.” The price of the

stock fell dramatically, and the dividend was subsequently reduced

again about a year later. Eventually the dividend was eliminated,

and the firm filed for bankruptcy. In both cases, dividend

reductions followed periods of poor earnings performance and

were followed by more poor performance. One might say that the

“signal” being sent by the dividend cut was completely accurate!

C. Putting It All Together

This section can be summarized by five primary observations:

1. Aggregate payouts (dividends and repurchases) are massive

and have increased in absolute terms over the years.

2. Dividends are concentrated among a small number of large,

mature firms.

3. Managers are reluctant to cut dividends, normally doing so

only due to firm-specific problems.

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Chapter 17 – Dividends and Dividend Policy

4. Managers smooth dividends, raising them slowly and

incrementally as earnings grow.

5. Stock prices react to unanticipated changes in dividends.

D. Some Survey Evidence on Dividends

-Almost 94% of the managers that responded to the survey

indicated that they try to avoid reducing the dividends per share.

-About 84% of the managers indicate that they try to maintain

consistency with historic dividends.

-Less than 10% of managers worry about flotation costs.

3. Stock Dividends and Stock Splits

Stock dividend – dividend paid in shares of stock rather than in cash.

Commonly expressed as a percentage, e.g., a 25% stock dividend means you

will receive 1 share for every 4 that you own. As with a cash dividend, the

stock price declines proportionally.

Stock split – new outstanding shares issued to existing stockholders,

expressed as a ratio, e.g., a 2-for-1 split means you will receive 2 shares for

every one that you own. Again, the price drops proportionally. Splits are

usually, but not always, larger than dividends and are treated differently for

accounting purposes.

Lecture Tip: Some investors believe that it is desirable to purchase

a company’s stock prior to the announcement of the stock split.

Discuss the accounting treatment of stock splits and show that

there is no difference between the stock before and after the split.

The cash flows to stockholders do not change and the risk of the

stock is unaffected by a stock split, so a stock split should not add

value to the firm. However, empirical evidence has indicated that

there is unusual stock price behavior around the ex-dividend date

for non-taxable stock dividends and stock splits. Grinblatt, Masulis

and Titman (Journal of Financial Economics, 1984) documented a

5-day average abnormal return of about two percent surrounding

the ex-date. The rationale for this is not fully understood, but it is

too large to be due solely to the tax impact.

A. Some Details about Stock Splits and Stock Dividends

Stock dividend – retained earnings transferred to par value and

capital accounts

Stock split – par value adjusted to reflect the split with no effect on

retained earnings

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B. Value of Stock Splits and Stock Dividends

Benchmark case – no change in shareholder wealth

Lecture Tip: In theory, stock dividends and stock splits are

accounting issues and should not impact the value of the firm. Yet,

empirical research has documented large stock price gains at the

announcement of a company’s decision to issue a stock dividend.

Why the apparent discrepancy? A plausible argument is that there

exists a signaling effect. Students should recognize that the value

of the stock dividend is transferred from retained earnings into the

common stock and capital in excess of par accounts. Remind

students that many bond covenants restrict cash dividend payments

when retained earnings fall below a minimum level. Only those

companies confident of future earnings will be willing to reduce

retained earnings through a stock dividend.

Popular trading range – more investors can afford cheaper stocks,

so it will increase the value – or so the argument goes

C. Reverse Splits

Three popular reasons:

-reduced transaction costs (higher priced stocks have lower

commissions on a percentage basis)

-popular trading range – the price has gotten too low and it affects

the stock’s liquidity and marketability

-respectability – many people are leery about investing in “penny

stocks”

Two technical reasons:

-stock exchanges have minimum listing requirements

-may combine a reverse split and a stock repurchase where the

company offers to buy out shareholders that end up owning shares

below some minimum number

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Chapter 17 – Dividends and Dividend Policy

Real-World Tip: Anecdotal evidence indicates that the number of

reverse splits generally increases in market downturns. The

reasoning is that managers of firms whose share price has suffered

are more likely to attempt to inflate the price via a reverse split. It

is important to note that this is not consistent with an

informationally efficient market – by itself, a reverse split is purely

cosmetic. It remains to be demonstrated whether the existence of

market imperfections and institutional requirements provide an

economic rationale for reverse splits.

4. Summary and Conclusions

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