Foundations of Finance

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Chapter 13
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Dilemma Should the firm use retained earnings
for

• a) Financing profitable capital investments?
• b) Paying dividends to stockholders?

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So, dividend policy really involves 2 decisions

• How much of the firms earnings should be
  distributed to shareholders as dividends, and
• How much should be retained for capital
  investment?

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Is Dividend Policy Important?

• Three viewpoints
• 1) Dividends are Irrelevant. If we assume
  perfect markets (no taxes, no transaction costs,
  etc.) dividends do not matter. If we pay a
  dividend, shareholders dividend yield rises, but
  capital gains decrease.

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2) High Dividends are Best

• Some investors may prefer a certain dividend now
  over a risky expected capital gain in the future.

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3) Low Dividends are Best

• Dividends are taxed immediately. Capital gains
  are not taxed until the stock is sold.
• Therefore, taxes on capital gains can be deferred
  indefinitely.

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Do Dividends Matter?

• Other Considerations
• 1) Residual Dividend Theory
• The firm pays a dividend only if it has retained
  earnings left after financing all profitable
  investment opportunities.
• This would maximize capital gains for
  stockholders and minimize flotation costs of
  issuing new common stock.

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Do Dividends Matter?

• 2) Clientele Effects
• Different investor clienteles prefer different
  dividend payout levels.
• Some firms, such as utilities, pay out over 70
  of their earnings as dividends. These attract a
  clientele that prefers high dividends.
• Growth-oriented firms which pay low (or no)
  dividends attract a clientele that prefers price
  appreciation to dividends.

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Do Dividends Matter?

• 3) Information Effects
• Unexpected dividend increases usually cause stock
  prices to rise, and unexpected dividend decreases
  cause stock prices to fall.
• Dividend changes convey information to the market
  concerning the firms future prospects.

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Dividend Policies

• 1) Constant Dividend Payout Ratio if directors
  declare a constant payout ratio of, for example,
  30, then for every dollar of earnings available
  to stockholders, 30 cents would be paid out as
  dividends.
• The ratio remains constant over time, but the
  dollar value of dividends changes as earnings
  change.

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Dividend Policies

• 2) Stable Dollar Dividend Policy the firm
  tries to pay a fixed dollar dividend each
  quarter.
• Firms and stockholders prefer stable dividends.
  Decreasing the dividend sends a negative signal!

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Dividend Policies

• 3) Small Regular Dividend plus Year-End Extras
• The firm pays a stable quarterly dividend and
  includes an extra year-end dividend in prosperous
  years.
• By identifying the year-end dividend as extra,
  directors hope to avoid signaling that this is a
  permanent dividend.

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Stock Dividends and Stock Splits

• Stock dividend payment of additional shares of
  stock to common stockholders.
• Example Citizens Bancorporation of Maryland
  announces a 5 stock dividend to all shareholders
  of record. For each 100 shares held,
  shareholders receive another 5 shares.
• Does the shareholders wealth increase?

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Stock Dividends and Stock Splits

• Stock Split the firm increases the number of
  shares outstanding and reduces the price of each
  share.
• Example Joule, Inc. announces a 3-for-2 stock
  split. For each 100 shares held, shareholders
  receive another 50 shares.
• Does this increase shareholder wealth?
• Are a stock dividend and a stock split the same?

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Stock Dividends and Stock Splits

• Stock Splits and Stock Dividends are economically
  the same the number of shares outstanding
  increases and the price of each share drops. The
  value of the firm does not change.
• Example A 3-for-2 stock split is the same as a
  50 stock dividend. For each 100 shares held,
  shareholders receive another 50 shares.

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Stock Dividends and Stock Splits

• Effects on Shareholder Wealth these will cut
  the company pie into more pieces but will not
  create wealth. A 100 stock dividend (or a
  2-for-1 stock split) gives shareholders 2
  half-sized pieces for each full-sized piece they
  previously owned.
• For example, this would double the number of
  shares, but would cause a 60 stock price to fall
  to 30.

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Stock Dividends and Stock Splits

• Why bother?
• Proponents argue that these are used to reduce
  high stock prices to a more popular trading
  range (generally 15 to 70 per share).
• Opponents argue that most stocks are purchased by
  institutional investors who have millions of
  dollars to invest and are indifferent to price
  levels. Plus, stock splits and stock dividends
  are expensive!

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Stock Repurchases

• Stock Repurchases may be a good substitute for
  cash dividends.
• If the firm has excess cash, why not buy back
  common stock?

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Stock Repurchases

• Methods
• Buy shares in the open market through a broker.
• Buy a large block by negotiating the purchase
  with a large block holder, usually an institution
  (targeted stock repurchase).
• Tender offer offer to pay a specific price to
  all current stockholders.