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Chapter 18
Dividend Policy
2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
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Dividend Policy
Passive Versus Active Dividend
Policies
Factors Influencing Dividend Policy
Dividend Stability
Stock Dividends and Stock Splits
Stock Repurchase
Administrative Considerations
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Dividends as a
Passive Residual
The firm uses earnings plus the additional
financing that the increased equity can support to
finance any expected positive-NPV projects.
Any unused earnings are paid out in the form of
dividends. This describes a passive dividend
policy.
Can the payment of cash dividends affect
shareholder wealth?
If so, what dividend-payout ratio will
maximize shareholder wealth?
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Irrelevance of Dividends
M&M contend that the effect of dividend
payments on shareholder wealth is
exactly offset by other means of
financing.
The dividend plus the new stock price
after dilution exactly equals the stock
price prior to the dividend distribution.
A. Current dividends versus retention
of earnings
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Irrelevance of Dividends
M&M and the total-value principle ensures
that the sum of market value plus current
dividends of two firms identical in all
respects other than dividend-payout ratios
will be the same.
Investors can create any dividend policy
they desire by selling shares when the
dividend payout is too low or buying shares
when the dividend payout is excessive.
B. Conservation of value
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Relevance of Dividends
Uncertainty surrounding future company
profitability leads certain investors to
prefer the certainty of current dividends.
Investors prefer large dividends.
Investors do not like to manufacture
homemade dividends, but prefer the
company to distribute them directly.
A. Preference for dividends
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Relevance of Dividends
Capital gains taxes are deferred until the
actual sale of stock. This creates a timing
option.
Capital gains are preferred to dividends,
everything else equal. Thus, high dividend-
yielding stocks should sell at a discount to
generate a higher before-tax rate of return.
Certain institutional investors pay no tax.
B. Taxes on the investor
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Relevance of Dividends
Corporations can typically exclude 70% of dividend
income from taxation. Thus, corporations generally
prefer to receive dividends rather than capital gains.
The result is clienteles of investors with different
dividend preferences. In equilibrium, there will be
the proper distribution of firms with differing
dividend policies to exactly meet the needs of
investors.
Thus, dividend-payout decisions are irrelevant.
B. Taxes on the investor (continued)
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Other Dividend Issues
Flotation costs
Transaction costs and
divisibility of securities
Institutional restrictions
Financial signaling
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Empirical Testing
of Dividend Policy
Tax Effect
Dividends are taxed more heavily than capital gains,
so before-tax returns should be higher for high-
dividend-paying firms.
Empirical results are mixed -- recently the evidence
is largely consistent with dividend neutrality.
Financial Signaling
Expect that increases (decreases) in dividends lead
to positive (negative) excess stock returns.
Empirical results are consistent with these
expectations.
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Implications for
Corporate Policy
Establish a policy that will maximize
shareholder wealth.
Distribute excess funds to shareholders
and stabilize the absolute amount of
dividends if necessary (passive).
Payouts greater than excess funds
should occur only in an environment
that has a net preference for dividends.
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Implications for
Corporate Policy
There is a positive value associated
with a modest dividend. Could be due
to institutional restrictions or
signaling effects.
Dividends in excess of the passive
policy does not appear to lead to
share price improvement because of
taxes and flotation costs.
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Factors Influencing
Dividend Policy
Capital Impairment Rule -- many states prohibit
the payment of dividends if these dividends
impair capital (usually either par value of
common stock or par plus additional paid-in
capital).
Incorporation in some states (notably Delaware)
allows a firm to use the fair value, rather than
book value, of its assets when judging whether
a dividend impairs capital.
Legal Rules
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Factors Influencing
Dividend Policy
Insolvency Rule -- some states prohibit the
payment of cash dividends if the company is
insolvent under either a fair market
valuation or equitable sense.
Undue Retention of Earnings Rule -- prohibits
the undue retention of earnings in excess of
the present and future investment needs of
the firm.
Legal Rules
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Factors Influencing
Dividend Policy
Funding Needs of the Firm
Liquidity
Ability to Borrow
Restrictions in Debt Contracts
Control
Other Issues to Consider
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Dividend Stability
Stability -- maintaining the position of the firms
dividend payments in relation to a trend line.
D
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Earnings per share
Dividends
per share
Time
50% of earnings
paid out as dividends
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Dividend Stability
Dividends begin at 50% of earnings, but are stable and
increase only when supported by growth in earnings.
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3
4
2
1
Earnings per share
Dividends per share
Time
50% dividend-payout
rate with stability
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Valuation of
Dividend Stability
Information content -- management may be able to
affect the expectations of investors through the
informational content of dividends. A stable dividend
suggests that the company expects stable or
growing dividends in the future.
Current income desires -- some investors who desire
a specific periodic income will prefer a company with
stable dividends to one with unstable dividends.
Institutional considerations -- a stable dividend may
permit certain institutional investors to buy the
common stock as they meet the requirements to be
placed on the organizations approved list.
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Types of Dividends
Extra dividend
A nonrecurring dividend paid to
shareholders in addition to the regular
dividend. It is brought about by special
circumstances.
Regular Dividend
The dividend that is normally expected to
be paid by the firm.
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Stock Dividends
and Stock Splits
Small-percentage stock dividends
Typically less than 25% of previously
outstanding common stock.
Assume a company with 400,000 shares of $5 par
common stock outstanding pays a 5% stock
dividend. The pre-dividend market value is $40.
How does this impact the shareholders equity
accounts?
Stock Dividend -- A payment of additional
shares of stock to shareholders. Often used
in place of or in addition to a cash dividend.
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B/S Changes for the Small-
Percentage Stock Dividend
$800,000 ($5 x 20,000 new shares)
transferred (on paper) out of retained
earnings.
$100,000 transferred into common stock
account.
$700,000 ($800,000 - $100,000) transferred
into additional paid-in-capital.
Total shareholders equity remains
unchanged at $10 million.
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Small-Percentage
Stock Dividends
Before 5% Stock Dividend
Common stock
($5 par; 400,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders equity $10,000,000
After 5% Stock Dividend
Common stock
($5 par; 420,000 shares) $ 2,100,000
Additional paid-in capital 1,700,000
Retained earnings 6,200,000
Total shareholders equity $10,000,000
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Stock Dividends,
EPS, and Total Earnings
Assume that investor SP owns 10,000 shares and the
firm earned $2.50 per share.
Total earnings = $2.50 x 10,000 = $25,000.
After the 5% dividend, investor SP owns 10,500 shares
and the same proportionate earnings of $25,000.
EPS is then reduced to $2.38 per share because of the
stock dividend ($25,000 / 10,500 shares = $2.38 EPS).
After a small-percentage stock dividend, what
happens to EPS and total earnings of
individual investors?
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Stock Dividends
and Stock Splits
Typically 20% or greater of previously outstanding
common stock.
The material effect on the market price per share
causes the transaction to be accounted for differently.
Reclassification is limited to the par value of additional
shares rather than pre-stock-dividend value of
additional shares.
Assume a company with 400,000 shares of $5 par
common stock outstanding pays a 100% stock
dividend. The pre-stock-dividend market value per
share is $40. How does this impact the shareholders
equity accounts?
Large-percentage stock dividends
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B/S Changes for the Large-
Percentage Stock Dividend
$2 million ($5 x 400,000 new
shares) transferred (on paper)
out of retained earnings.
$2 million transferred into
common stock account.
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Large-Percentage
Stock Dividends
Before 100% Stock Dividend
Common stock
($5 par; 400,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders equity $10,000,000
After 100% Stock Dividend
Common stock
($5 par; 800,000 shares) $ 4,000,000
Additional paid-in capital 1,000,000
Retained earnings 5,000,000
Total shareholders equity $10,000,000
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Stock Dividends
and Stock Splits
Similar economic consequences as a 100% stock
dividend.
Primarily used to move the stock into a more
popular trading range and increase share demand.
Assume a company with 400,000 shares of $5 par
common stock splits 2-for-1. How does this impact
the shareholders equity accounts?
Stock Split -- An increase in the number of
shares outstanding by reducing the par value
of the stock.
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Stock Splits
Before 2-for-1 Stock Split
Common stock
($5 par; 400,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders equity $10,000,000
After 2-for-1 Stock Split
Common stock
($2.50 par; 800,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders equity $10,000,000
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Value to Investors of Stock
Dividends or Stock Splits
Effect on investor total wealth
Effect on investor psyche
Effect on cash dividends
More popular trading range
Informational content
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Stock Dividends
and Stock Splits
Used to move the stock into a more popular trading
range and increase share demand.
Usually signals negative information to the market
upon its announcement (consistent with empirical
evidence).
Assume a company with 400,000 shares of $5 par
common stock splits 1-for-4. How does this impact
the shareholders equity accounts?
Reverse Stock Split -- A stock split in which the
number of shares outstanding is decreased.
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Reverse Stock Splits
Before 1-for-4 Stock Split
Common stock
($5 par; 400,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders equity $10,000,000
After 1-for-4 Stock Split
Common stock
($20 par; 100,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders equity $10,000,000
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Stock Repurchase
Reasons for stock repurchase:
Available for management stock-option plans
Available for the acquisition of other companies
Go private by repurchasing all shares from
outside stockholders
To permanently retire the shares
Stock Repurchase -- The repurchase (buyback)
of stock by the issuing firm, either in the open
(secondary) market or by self-tender offer.
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Methods of Repurchase
Fixed-price self-tender offer -- An offer by a firm to
repurchase some of its own shares, typically at a set
price.
Dutch auction self-tender offer -- A buyer (seller)
seeks bids within a specified price range, usually for
a large block of stock or bonds. After evaluating the
range of bid prices received, the buyer (seller)
accepts the lowest price that will allow it to acquire
(dispose of) the entire block.
Open-market purchase -- A company repurchases its
stock through a brokerage house on the secondary
market.
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Repurchasing as
Part of Dividend Policy
Assume:
Earnings after taxes $ 800,000
Number of common
shares outstanding 400,000
Earnings per share $ 2
Current market price
per share $ 31
Expected dividend per share $ 1
Expected total dividends
to be paid out $ 400,000
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Repurchasing as
Part of Dividend Policy
If dividend is paid, shareholders receive:
Expected dividend per share $ 1
Market price per share $ 30
Total value $ 31
If shares repurchased, shareholders receive:
Dividend per share $ 0
Market price per share* $ 31
Total value $ 31
* Shares repurchased = $400,000 / $31 = 12,903
Original P/E ratio = $30/$2 = 15
New EPS = $800,000 / 387,097 = $2.07
New market price = $2.07 x 15 = $31
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Summary of Repurchasing
as Part of Dividend Policy
The capital gain arising from the repurchase
(stock rising from $30 to $31) exactly equals
the dividend ($1) that would have otherwise
been paid.
This result holds in the absence of taxes and
transaction costs.
To the taxable investor, capital gains
(repurchases) are favored to dividend income
as the tax on the capital gain is postponed
until the actual sale of the common shares.
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Summary of Repurchasing
as Part of Dividend Policy
Stock repurchases are most relevant for
firms with large amounts of excess cash
that might otherwise generate a significant
taxable transaction to investors.
Firms must be careful not to make regularly
occurring repurchases or the IRS may
consider the capital gains as dividends for
tax purposes.
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Investment or
Financing Decision?
Financing Decision
It possesses capital structure or dividend policy
motivations.
For example, a repurchase immediately changes
the debt-to-equity ratio (higher financial leverage).
Investing Decision
Not really, as stock that is repurchased is held as
treasury stock and does not provide an expected
return like other investments.
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Possible Signaling Effect
Repurchases have a positive signaling effect.
For example, if the stock is undervalued
management may tender for shares at a premium.
This signals that the share prices are undervalued.
Dutch-auction self-tenders have less signaling
power likely due to a smaller tender premium.
Open-market purchases have only a modest
positive signaling effect likely due to many
programs being instituted after significant share
price declines.
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Administrative Considerations:
Procedural Aspects
Record Date -- The date, set by the board of
directors when a dividend is declared, on which
an investor must be a shareholder of record to
be entitled to the upcoming dividend.
The board of directors met on May 8
th
to declare
a dividend payable to shareholders on June 15
th

to the shareholders of record on May 31
st
.
May 8 May 29 May 31 June 15
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Administrative Considerations:
Procedural Aspects
Ex-dividend Date -- The first date on which a
stock purchaser is no longer entitled to the
recently declared dividend.
The buyer and seller of the shares have several days to
settle (pay for the shares or deliver the shares). The
brokerage industry has a rule that new shareholders are
entitled to dividends only if they purchase the stock at
least two business days prior to the record date.
May 8 May 29 May 31 June 15
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Administrative Considerations:
Procedural Aspects
Declaration Date -- The date that the board of
directors announces the amount and date of the
next dividend.

Payment Date -- The date when the corporation
actually pays the declared dividend.
May 8 May 29 May 31 June 15
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Dividend
Reinvestment Plans
The firm can use existing stock. A trustee (e.g., a
bank) purchases the stock on the open market and
credits current shareholders with the new shares.
The firm can issue new stock. This method raises
new funds for the firm. The plan essentially
reduces the effective dividend-payout ratio.
Some plans offer discounts and eliminate
brokerage costs for current shareholders.
Dividend Reinvestment Plan (DRIP) -- An optional plan
allowing shareholders to automatically reinvest
dividend payments in additional shares of the
companys stock.

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