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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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Chapter 17 - Dividends and Dividend Policy
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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