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 firms 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).

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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.

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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.

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Dividend Policy and Stock Price

• Dividend Irrelevance Theory
• Miller/Modigliani argued that dividend policy
  should be irrelevant to stock price.
• If dividends dont matter, this chapter is
  irrelevant as well (which is what most of you are
  thinking anyway).

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Dividend Irrelevance Theory
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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.

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Theory Summary

• Dividend Discount
• Dividend Irrelevance
• Bird-in-the-Hand

19
Factors Affecting Dividend Policy

• Legal Constraints State Statute
• Contractual Constraints
• Internal Constaints
• Growth Prospects
• Owner Considerations
• Market Considerations
• Current research on international dividend policy

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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.

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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.

22
Dividend Policy Classes

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

23
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).

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Dividend Policy Classes

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

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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.

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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.

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Dividend Policy Summary

• Residual Dividend
• Regular Dividend
• Constant Payout Ratio
• Regular Dividend Plus Extras

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General Motors Dividends
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General Motors - Dividend

• What should General Motors do?
• February 7, 2006 - General Motors Corp., under
  shareholder pressure to return to profitability,
  announced Tuesday that it is cutting in half its
  yearly dividend to 1 a share and reducing the
  salaries of its chairman and senior leadership
  team. (Associated Press David Runk )
• Why still pay a dividend at all?

30
Caterpillar Dividend Policy
31
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.

32
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 investors
  holding (although there will be on the value of a
  share) with either transaction.

33
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 firms capital structure.

34
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.