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INTRODUCTION TOINTRODUCTION TO

CORPORATE FINANCECORPORATE FINANCE

Chapter 22 – Dividend PolicyChapter 22 – Dividend Policy

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CHAPTER 22 – Dividend Policy 22 - 3

Lecture AgendaLecture Agenda

• Learning ObjectivesLearning Objectives

• Important TermsImportant Terms

• Mechanics of Dividend PaymentsMechanics of Dividend Payments

• Cash Dividend PaymentsCash Dividend Payments

• M&M’s Dividend Irrelevance TheoremM&M’s Dividend Irrelevance Theorem

• The !ird in the "and# $rg%ment The !ird in the "and# $rg%ment

• Dividend Policy in PracticeDividend Policy in Practice

• ela'ing the M&M $ss%mptionsela'ing the M&M $ss%mptions

• (toc) Dividends and (toc) (plits(toc) Dividends and (toc) (plits• (hare ep%rchases(hare ep%rchases

• (%mmary and Concl%sions(%mmary and Concl%sions – Concept Review QuestionsConcept Review Questions

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Learning ObjectivesLearning Objectives

*o% sho%ld %nderstand the follo+ing, *o% sho%ld %nderstand the follo+ing,

• The mechanics of dividend payments and +hy they are di-erent The mechanics of dividend payments and +hy they are di-erent

from interest paymentsfrom interest payments

• The di-erence bet+een a stoc) split and a stoc) dividend The di-erence bet+een a stoc) split and a stoc) dividend

• .nder +hat ass%mptions a dividend payment is irrelevant and.nder +hat ass%mptions a dividend payment is irrelevant and+hat a homemade dividend is+hat a homemade dividend is

• /hy dividend payments generally re0ect the b%siness ris) of the/hy dividend payments generally re0ect the b%siness ris) of the

1rm1rm

• "o+ transactions costs2 ta'es and information problems give val%e"o+ transactions costs2 ta'es and information problems give val%e

to corporate dividend policiesto corporate dividend policies

• "o+ stoc) dividends and stoc) splits di-er"o+ stoc) dividends and stoc) splits di-er

• "o+ a share rep%rchase program can s%bstit%te for a dividend"o+ a share rep%rchase program can s%bstit%te for a dividend

payo%t policy3payo%t policy3

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Important Chapter TermsImportant Chapter Terms

• $gency theory$gency theory

• !ird in the hand arg%ment!ird in the hand arg%ment

• Cash co+Cash co+

• Declaration dateDeclaration date• Dividend reinvestmentDividend reinvestment

plansplans

• Dividend yieldDividend yield

• 45%ity mar)et45%ity mar)et

capitali6ationcapitali6ation

• 4'7dividend date4'7dividend date

• 8ree cash 0o+8ree cash 0o+• "older of record"older of record• "omemade dividends"omemade dividends• Income strippingIncome stripping• Odd lotsOdd lots• esid%al theory ofesid%al theory of

dividendsdividends• (pecial dividend(pecial dividend• (plit shares(plit shares

• (toc) dividend(toc) dividend• (toc) split(toc) split• Ta' clienteles Ta' clienteles

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What is Dividend o!ic"#What is Dividend o!ic"#

Dividend PolicyDividend Policy

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Dividend o!ic"Dividend o!ic"What is It#What is It#

• Dividend Policy refers to the e'plicit orDividend Policy refers to the e'plicit or

implicit decision of the !oard of Directorsimplicit decision of the !oard of Directors

regarding the amo%nt of resid%al earningsregarding the amo%nt of resid%al earnings9past or present: that sho%ld be distrib%ted to9past or present: that sho%ld be distrib%ted to

the shareholders of the corporation3the shareholders of the corporation3

– This decision is considered aThis decision is considered a financing decisionfinancing decision

because the pro$its o$ the corporation are anbecause the pro$its o$ the corporation are animportant source o$ $inancing avai!ab!e to the $irm%important source o$ $inancing avai!ab!e to the $irm%

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T"pes o$ DividendsT"pes o$ Dividends


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T"pes o$ DividendsT"pes o$ Dividends

• Dividends are a permanent distrib%tion of resid%alDividends are a permanent distrib%tion of resid%al

earnings;property of the corporation to its o+ners3earnings;property of the corporation to its o+ners3

• Dividends can be in the form of,Dividends can be in the form of, – CashCash

– Additiona! &hares o$ &toc' (stoc' dividend) Additiona! &hares o$ &toc' (stoc' dividend)

– ropert"ropert"

• If a 1rm is dissolved2 at the end of the process2 a 1nalIf a 1rm is dissolved2 at the end of the process2 a 1nal

dividend of any resid%al amo%nt is made to thedividend of any resid%al amo%nt is made to the

shareholders < this is )no+n as ashareholders < this is )no+n as a liquidating dividendliquidating dividend33

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Dividends and Corporate *inancingDividends and Corporate *inancing


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Dividends versus Interest Ob!igationsDividends versus Interest Ob!igations

InterestInterest• Interest is a payment to lenders for the %se of their f%nds for a givenInterest is a payment to lenders for the %se of their f%nds for a given

period of timeperiod of time• Timely payment of the re5%ired amo%nt of interest is a legal obligation Timely payment of the re5%ired amo%nt of interest is a legal obligation• 8ail%re to pay interest 9and f%l1ll other contract%al commitments8ail%re to pay interest 9and f%l1ll other contract%al commitments

%nder the bond indent%re or loan contract: is an act of ban)r%ptcy and%nder the bond indent%re or loan contract: is an act of ban)r%ptcy andthe lender has reco%rse thro%gh the co%rts to see) remediesthe lender has reco%rse thro%gh the co%rts to see) remedies

• (ec%red lenders 9bondholders: have the 1rst claim on the 1rm’s assets(ec%red lenders 9bondholders: have the 1rst claim on the 1rm’s assetsin the case of dissol%tion or in the case of ban)r%ptcyin the case of dissol%tion or in the case of ban)r%ptcy

DividendsDividends• $ dividend is a discretionary payment made to shareholders$ dividend is a discretionary payment made to shareholders

• The decision to distrib%te dividends is solely the responsibility of the The decision to distrib%te dividends is solely the responsibility of theboard of directorsboard of directors

• (hareholders are resid%al claimants of the 1rm 9they have the last2(hareholders are resid%al claimants of the 1rm 9they have the last2and resid%al claim on assets on dissol%tion and on pro1ts after alland resid%al claim on assets on dissol%tion and on pro1ts after allother claims have been f%lly satis1ed:other claims have been f%lly satis1ed:

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The /echanics o$ Dividend a"mentsThe /echanics o$ Dividend a"ments


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Dividend a"mentsDividend a"ments/echanics o$ Cash Dividend a"ments/echanics o$ Cash Dividend a"ments

• Declaration DateDeclaration Date

• "older of ecord Date"older of ecord Date

• 4'7dividend Date4'7dividend Date

• Payment DatePayment Date

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Dividend a"mentsDividend a"ments/echanics o$ Cash Dividend a"ments/echanics o$ Cash Dividend a"ments

Declaration DateDeclaration Date – this is the date on which the 0oard o$ Directors meet and dec!are the dividend% In theirthis is the date on which the 0oard o$ Directors meet and dec!are the dividend% In their

reso!ution the 0oard wi!! set thereso!ution the 0oard wi!! set the date o$ recorddate o$ record+ the+ the date o$ pa"mentdate o$ pa"ment and theand the amount o$ theamount o$ thedividenddividend $or each share c!ass%$or each share c!ass%

– when CARRI.D+ this reso!ution ma'es the dividend a current !iabi!it" $or the $irm%when CARRI.D+ this reso!ution ma'es the dividend a current !iabi!it" $or the $irm%

Date of ecordDate of ecord

– is the date on which the shareho!ders register is c!osed a$ter the trading da" and a!! thoseis the date on which the shareho!ders register is c!osed a$ter the trading da" and a!! thosewho are !isted wi!! receive the dividend%who are !isted wi!! receive the dividend%

4' dividend Date4' dividend Date – is the date that the va!ue o$ the $irm1s common shares wi!! re$!ect the dividend pa"ment (ie%is the date that the va!ue o$ the $irm1s common shares wi!! re$!ect the dividend pa"ment (ie%

$a!! in va!ue)$a!! in va!ue) – 22e-1 means without%e-1 means without% –

At the start o$ trading on the e-3dividend date+ the share price wi!! norma!!" open $or trading At the start o$ trading on the e-3dividend date+ the share price wi!! norma!!" open $or tradingat the previous da"s c!ose+ !ess the va!ue o$ the dividend per share% This re$!ects the $actat the previous da"s c!ose+ !ess the va!ue o$ the dividend per share% This re$!ects the $actthat purchasers o$ the stoc' on the e-3dividend date and be"ond WILL 4OT receive thethat purchasers o$ the stoc' on the e-3dividend date and be"ond WILL 4OT receive thedec!ared dividend%dec!ared dividend%

Date of PaymentDate of Payment – is the date the che,ues $or the dividend are mai!ed out to the shareho!ders%is the date the che,ues $or the dividend are mai!ed out to the shareho!ders%

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Dec!aration Date

Date o$

Record

Date o$

a"ment

Ex Dividend Date is determined

b" the Date o$ Record%The mar'et va!ue o$ the sharesdrops b" the va!ue o$ the dividendper share on mar'et opening5comparedto the previous da"1s c!ose%

The 0oard /eetsand passes themotion to createthe dividend

2 business days prior to the Date of Record

Dividend Dec!aration Time LineDividend Dec!aration Time Line

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Changes in the (ettlement CycleChanges in the (ettlement Cycle• In =%ne >??@ the settlement cycle for all non7money7mar)et Canadian andIn =%ne >??@ the settlement cycle for all non7money7mar)et Canadian and

.3(3 sec%rities +as red%ced from 1ve b%siness days 9T A @: to.3(3 sec%rities +as red%ced from 1ve b%siness days 9T A @: to threethreeb%siness daysb%siness days 9T A B:39T A B:3

• The rationale for the change stems from the >? stoc) mar)et crash The rationale for the change stems from the >? stoc) mar)et crash+hen it +as reali6ed that a sec%rities mar)et fail%re co%ld res%lt in a credit+hen it +as reali6ed that a sec%rities mar)et fail%re co%ld res%lt in a creditmar)et fail%re3 The gridloc) created in >??E by the ban)r%ptcy of Dre'elmar)et fail%re3 The gridloc) created in >??E by the ban)r%ptcy of Dre'el!%rnham Lambert2 a large .3(3 bro)er2 increased the need to minimi6e the!%rnham Lambert2 a large .3(3 bro)er2 increased the need to minimi6e theris)s involved in the clearing and settlement of sec%rities3ris)s involved in the clearing and settlement of sec%rities3

• The shortened settlement cycle re5%ires that the payment of f%nds and The shortened settlement cycle re5%ires that the payment of f%nds andthe delivery of sec%rities ta)e place on thethe delivery of sec%rities ta)e place on the third b%siness daythird b%siness day after theafter thetrade date3 This +ill red%ce credit2 mar)et and li5%idity ris)s bytrade date3 This +ill red%ce credit2 mar)et and li5%idity ris)s bydecreasing post7trade settlement e'pos%re3decreasing post7trade settlement e'pos%re3

4' Dividend Date4' Dividend Date• The date is not chosen by the board of directors2 rather it is determined as The date is not chosen by the board of directors2 rather it is determined as

a res%lt of the e'changes settlement practices and is a f%nction of thea res%lt of the e'changes settlement practices and is a f%nction of thedate of record3date of record3

Trade &ett!ement and the .- DividendTrade &ett!ement and the .- Dividend

DateDate

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Dividend Decision and the 0oard o$Dividend Decision and the 0oard o$

DirectorsDirectors


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Dividend o!ic"Dividend o!ic"Dividends+ &hareho!ders and the 0oard o$ DirectorsDividends+ &hareho!ders and the 0oard o$ Directors

• There is no legal obligation for 1rms to pay dividends to There is no legal obligation for 1rms to pay dividends tocommon shareholderscommon shareholders

• (hareholders cannot force a !oard of Directors to(hareholders cannot force a !oard of Directors todeclare a dividend2 and co%rts +ill not interfere +ithdeclare a dividend2 and co%rts +ill not interfere +iththe !OD’s right to ma)e the dividend decision beca%se,the !OD’s right to ma)e the dividend decision beca%se, – 0oard members are joint!" and severa!!" !iab!e $or an" damages0oard members are joint!" and severa!!" !iab!e $or an" damages

the" ma" causethe" ma" cause – 0oard members are constrained b" !ega! ru!es a$$ecting dividends0oard members are constrained b" !ega! ru!es a$$ecting dividends

inc!uding6inc!uding67 4ot pa"ing dividends out o$ capita!4ot pa"ing dividends out o$ capita!7 4ot pa"ing dividends when that decision cou!d cause the $irm to4ot pa"ing dividends when that decision cou!d cause the $irm to

become inso!ventbecome inso!vent7 4ot pa"ing dividends in contravention o$ contractua! commitments4ot pa"ing dividends in contravention o$ contractua! commitments

(such as debt covenant agreements)(such as debt covenant agreements)

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Dividend a"mentsDividend a"ments


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Dividend a"mentsDividend a"mentsDividend Reinvestment !ans (DRIs)Dividend Reinvestment !ans (DRIs)

• Involve shareholders deciding to %se the cashInvolve shareholders deciding to %se the cash

dividend proceeds to b%y more shares of the 1rmdividend proceeds to b%y more shares of the 1rm – DRIs wi!! bu" as man" shares as the cash dividend a!!ows withDRIs wi!! bu" as man" shares as the cash dividend a!!ows with

the residua! deposited as cashthe residua! deposited as cash – Leads to shareho!ders owning odd !ots (!ess than 899 shares)Leads to shareho!ders owning odd !ots (!ess than 899 shares)

• 8irms are able to raise additional common stoc)8irms are able to raise additional common stoc)

capital contin%o%sly at no cost and fosters an on7capital contin%o%sly at no cost and fosters an on7going relationship +ith shareholders3going relationship +ith shareholders3

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Dividend a"mentsDividend a"ments&toc' Dividends&toc' Dividends

• (toc) dividends simply amo%nt to distrib%tion of(toc) dividends simply amo%nt to distrib%tion of

additional shares to e'isting shareholdersadditional shares to e'isting shareholders

• They represent nothing more than recapitali6ation They represent nothing more than recapitali6ationof earnings of the company3 9that is2 the amo%ntof earnings of the company3 9that is2 the amo%nt

of the stoc) dividend is transferred from the ;4of the stoc) dividend is transferred from the ;4

acco%nt to the common share acco%nt3acco%nt to the common share acco%nt3

• !eca%se of the!eca%se of the capital impairment rulecapital impairment rule stoc)stoc)

dividends red%ce the 1rm’s ability to paydividends red%ce the 1rm’s ability to pay

dividends in the f%t%re3dividends in the f%t%re3

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Dividend a"mentsDividend a"ments&toc' Dividend .-amp!e&toc' Dividend .-amp!e

ABC CompanyABC Company

Equity AccountsEquity Accounts

as at February xx, 20x9as at February xx, 20x9

Common stoc) 9F>@2EEE:Common stoc) 9F>@2EEE: G@2EEE2EEEG@2EEE2EEE

etained earningsetained earnings FE2EEE2EEE FE2EEE2EEE

Het /orthHet /orth GF@2EEE2EEEGF@2EEE2EEE

The company, on March 1, 20x9 declares a 10 percent stock dividend when theThe company, on March 1, 20x9 declares a 10 percent stock dividend when thecurrent market price for the stock is !0"00 per share"current market price for the stock is !0"00 per share"

This stock dividend will increase the num#er of shares outstanding #y 10 percent"This stock dividend will increase the num#er of shares outstanding #y 10 percent"This will mean issuing 21,$00 shares" The value of the shares is%This will mean issuing 21,$00 shares" The value of the shares is%

GE3EE 9F>2@EE: J GKE2EEEGE3EE 9F>2@EE: J GKE2EEE

This stock dividend will result in &'0,000 #eing transferred from the retainedThis stock dividend will result in &'0,000 #eing transferred from the retainedearnings account to the common stock account%earnings account to the common stock account%

next page"""next page"""

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Dividend a"mentsDividend a"ments&toc' Dividend .-amp!e&toc' Dividend .-amp!e

(fter the stock dividend% (fter the stock dividend%

$!C Company$!C Company

45%ity $cco%nts45%ity $cco%nts

as at March >2 FE'?as at March >2 FE'?

Common stoc) 9FBK2@EE:Common stoc) 9FBK2@EE: G@2KE2EEEG@2KE2EEEetained earningsetained earnings >?2>E2EEE>?2>E2EEE

Het +orthHet +orth GF@2EEE2EEEGF@2EEE2EEE

The market price of the stock will #e a)ected #y the stock dividend%The market price of the stock will #e a)ected #y the stock dividend%

He+ (hare Price J Old Price; 9>3>: J GE3EE;>3> J GBK3BKHe+ (hare Price J Old Price; 9>3>: J GE3EE;>3> J GBK3BK

The individual shareholder*s wealth will remain unchanged"The individual shareholder*s wealth will remain unchanged"

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Dividend a"mentsDividend a"ments&toc' &p!its&toc' &p!its

• $ltho%gh there is no theoretical proof2 there is some$ltho%gh there is no theoretical proof2 there is some+ho believe that an optimal price range e'ists for a+ho believe that an optimal price range e'ists for acompany’s common shares3company’s common shares3

• It is generally felt that there is greater demand forIt is generally felt that there is greater demand for

shares of companies that are traded in the GE 7 GEshares of companies that are traded in the GE 7 GEdollar range3dollar range3

• The p%rpose of a stoc) split is to decrease share price3 The p%rpose of a stoc) split is to decrease share price3

• The res%lt is, The res%lt is, – increase in the number o$ share outstandingincrease in the number o$ share outstanding

– theoretica!!"+ no change in shareho!der wea!ththeoretica!!"+ no change in shareho!der wea!th• easons for %se,easons for %se,

– better share price trading rangebetter share price trading range

– ps"cho!ogica! appea! (signa!!ing a$$ect)ps"cho!ogica! appea! (signa!!ing a$$ect)

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Dividend a"mentsDividend a"ments&toc' &p!it .-amp!e&toc' &p!it .-amp!e

The !oard of Directors of * Company is considering %sing a stoc) split The !oard of Directors of * Company is considering %sing a stoc) splitto p%t its shares into a better trading range3 They are con1dent that theto p%t its shares into a better trading range3 They are con1dent that the1rm’s stoc) price +ill contin%e to rise given the 1rm’s o%tstanding1rm’s stoc) price +ill contin%e to rise given the 1rm’s o%tstanding1nancial performance3 C%rrently2 the company’s shares are trading for1nancial performance3 C%rrently2 the company’s shares are trading forG>@E and the company’s shareholders e5%ity acco%nts are as follo+s,G>@E and the company’s shareholders e5%ity acco%nts are as follo+s,

Commons shares 9>EE2EEE o%tstanding:Commons shares 9>EE2EEE o%tstanding: G>2@EE2EEEG>2@EE2EEE

etained earningsetained earnings >@2EEE2EEE>@2EEE2EEEHet /orthHet /orth G>K2@EE2EEEG>K2@EE2EEE

$ F for > (toc) (plit,$ F for > (toc) (plit,

He+ (hare Price J PHe+ (hare Price J PEEN>;9F;>: J G>@EN>;9F;>: J G>@EN3@ J G@3EEN>;9F;>: J G>@EN>;9F;>: J G>@EN3@ J G@3EE The 1rm’s e5%ity acco%nts, The 1rm’s e5%ity acco%nts,Commons shares 9FEE2EEE o%tstanding:Commons shares 9FEE2EEE o%tstanding: G>2@EE2EEEG>2@EE2EEE

etained earningsetained earnings >@2EEE2EEE>@2EEE2EEE

Het /orthHet /orth G>K2@EE2EEEG>K2@EE2EEE

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Dividend a"mentsDividend a"ments*urther &toc' &p!it .-amp!es*urther &toc' &p!it .-amp!es

$ for B (toc) (plit,$ for B (toc) (plit,He+ (hare Price J PHe+ (hare Price J PEEN>;9;B: J G>@EN>;9;B: J G>@EN3@ J G>>F3@EN>;9;B: J G>@EN>;9;B: J G>@EN3@ J G>>F3@E

The 1rm’s e5%ity acco%nts, The 1rm’s e5%ity acco%nts,Commons shares 9>BB2BBB o%tstanding:Commons shares 9>BB2BBB o%tstanding: G>2@EE2EEEG>2@EE2EEE

etained earningsetained earnings >@2EEE2EEE>@2EEE2EEE


$ B for everse (toc) (plit,$ B for everse (toc) (plit,He+ (hare Price J PHe+ (hare Price J PEEN>;9B;: J G>@EN>;9B;: J G>@EN>3BB J GFEE3EEN>;9B;: J G>@EN>;9B;: J G>@EN>3BB J GFEE3EE

The 1rm’s e5%ity acco%nts, The 1rm’s e5%ity acco%nts,

Commons shares 9@2EEE o%tstanding:Commons shares 9@2EEE o%tstanding: G>2@EE2EEEG>2@EE2EEEetained earningsetained earnings >@2EEE2EEE>@2EEE2EEE


+learly the oard can use stock splits and reverse stock splits to place the -rm*s+learly the oard can use stock splits and reverse stock splits to place the -rm*sstock in a particular trading range"stock in a particular trading range"

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Dividend a"mentsDividend a"ments&toc' &p!it .$$ects&toc' &p!it .$$ects

• shareholders +ealth sho%ld remain %na-ected,shareholders +ealth sho%ld remain %na-ected,

Original "oldings, 9>EE shares G>@E;share: J G>@2EEEOriginal "oldings, 9>EE shares G>@E;share: J G>@2EEE

$fter a for > split, 9EE shares GB3@E;share: J G>@2EEE$fter a for > split, 9EE shares GB3@E;share: J G>@2EEE

• the above +ill hold tr%e if there is no psychologicalthe above +ill hold tr%e if there is no psychological

appeal to the stoc) split3appeal to the stoc) split3

• There is some evidence that the share price of There is some evidence that the share price of

companies +hich split stoc) is more bo%yantcompanies +hich split stoc) is more bo%yantbeca%se of a positive signal being transferred tobeca%se of a positive signal being transferred to

the mar)et by this action3the mar)et by this action3

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77 lo+ers stoc) price slightlylo+ers stoc) price slightly 77 large drop in stoc) pricelarge drop in stoc) price

77 little psychological appeallittle psychological appeal 77 m%ch stronger potentialm%ch stronger potentialsignalling e-ectsignalling e-ect

77 recapitali6ation of earningsrecapitali6ation of earnings 77 no recapitali6ationno recapitali6ation

77 no change in proportionalno change in proportional 77 samesame

o+nershipo+nership

77 odd lots createdodd lots created 77 odd lots rareodd lots rare77 theoretically2 no val%e totheoretically2 no val%e to 77 samesame

the investorthe investor

&toc' Dividends versus &toc' &p!its&toc' Dividends versus &toc' &p!its

Soc! Dividend" Soc! S#li"

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Cash Dividend a"mentsCash Dividend a"mentsThe /acro erspectiveThe /acro erspective

• 8ig%re FF 7> ill%strates,8ig%re FF 7> ill%strates,

– Aggregate a$ter3ta- pro$its run at appro-imate!" ;< o$ =D but Aggregate a$ter3ta- pro$its run at appro-imate!" ;< o$ =D but

are high!" variab!eare high!" variab!e

– Aggregate dividends are re!ative!" stab!e when compared to Aggregate dividends are re!ative!" stab!e when compared toa$ter3ta- pro$its%a$ter3ta- pro$its%

7 The" are sustained in the $ace o$ drops in pro$it during recessionsThe" are sustained in the $ace o$ drops in pro$it during recessions

7 The" are he!d reasonab!" constant in the $ace o$ pea's in aggregateThe" are he!d reasonab!" constant in the $ace o$ pea's in aggregate

pro$its%pro$its%

(See Figure 22 - 1 on the following slide)(See Figure 22 - 1 on the following slide)

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Cash Dividend a"mentsCash Dividend a"ments Aggregate Dividends and ro$its Aggregate Dividends and ro$its

$%&'RE 22-2

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Cash Dividend a"mentsCash Dividend a"mentsThe /acro erspectiveThe /acro erspective

• 8ig%re FF 7F ill%strates,8ig%re FF 7F ill%strates, – Aggregate Dividend pa"outs $urther i!!ustrates the Aggregate Dividend pa"outs $urther i!!ustrates the

e$$ects o$ re!ative!" stab!e dividend pa"outs in the $acee$$ects o$ re!ative!" stab!e dividend pa"outs in the $ace

o$ pro$it vo!ati!it"6o$ pro$it vo!ati!it"67 The norma! aggregate dividend pa"out rate is about >9< o$The norma! aggregate dividend pa"out rate is about >9< o$

a$ter3ta- pro$ita$ter3ta- pro$it

7 When pro$its drop and dividends are he!d constant+ pa"outWhen pro$its drop and dividends are he!d constant+ pa"outrates rise to 899<rates rise to 899<

(See Figure 22 - 2 on the following slide)(See Figure 22 - 2 on the following slide)

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Cash Dividend a"mentsCash Dividend a"ments Aggregate Dividend a"outs Aggregate Dividend a"outs

$%&'RE 22-3

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Cash Dividend a"mentsCash Dividend a"mentsThe /acro erspective 3 QuestionThe /acro erspective 3 Question

• /hy are dividends smoothed and not/hy are dividends smoothed and not

matched to pro1tsQmatched to pro1tsQ

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Cash Dividend a"mentsCash Dividend a"mentsDividend ?ie!dsDividend ?ie!ds

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/odig!iani and /i!!er1s Dividend/odig!iani and /i!!er1s Dividend

Irre!evance TheoremIrre!evance Theorem

M&M2 Dividends and 8irm Ral%eM&M2 Dividends and 8irm Ral%e

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/odig!iani and /i!!er1s Dividend Irre!evance/odig!iani and /i!!er1s Dividend Irre!evance

TheoremTheorem

The val%e of M&M’s Dividend Irrelevance The val%e of M&M’s Dividend Irrelevance

arg%ment is that in the end2 it sho+s +herearg%ment is that in the end2 it sho+s +here

val%e can be created +ith dividend policy andval%e can be created +ith dividend policy and

+hy3+hy3

8/9/2019 div 44



/@/1s Dividend Irre!evance Theorem/@/1s Dividend Irre!evance Theorem/@/+ Dividends+ and *irm a!ue/@/+ Dividends+ and *irm a!ue

(tart +ith the single7period DDM,(tart +ith the single7period DDM,

1

110

) K (

P D P

e+

+=( 22-1)

8/9/2019 div 44




• M%ltiply by the n%mber of shares o%tstandingM%ltiply by the n%mber of shares o%tstanding

99mm: to convert the single stoc) price model to: to convert the single stoc) price model to

a model to val%e the +hole 1rm,a model to val%e the +hole 1rm,

1

)( 1100

) K (

P DmV mP

e+

+==( 22-2)

8/9/2019 div 44



/@/1s Dividend Irre!evance Theorem/@/1s Dividend Irre!evance Theorem Assumptions Assumptions

• Ho Ta'esHo Ta'es

• Perfect capital mar)etsPerfect capital mar)ets

– !arge number o$ individua! bu"ers and se!!ers!arge number o$ individua! bu"ers and se!!ers – cost!ess in$ormationcost!ess in$ormation

– no transaction costsno transaction costs

• $ll 1rms ma'imi6e val%e$ll 1rms ma'imi6e val%e

• There is no debt There is no debt

8/9/2019 div 44




• /itho%t debt2 so%rces and %ses of f%nds identity/itho%t debt2 so%rces and %ses of f%nds identity

9so%rces J %ses: can be e'pressed as,9so%rces J %ses: can be e'pressed as,

• /here,/here,

X X represents cash $!ow $rom operationsrepresents cash $!ow $rom operations

I I represents investmentrepresents investment X – I X – I is free cash flow is free cash flow

DD11 is dividend to current shareho!ders at time 8is dividend to current shareho!ders at time 8

1111 mD I nP X +=+( 22-3)

8/9/2019 div 44




• (olving for dividends paid o%t 9(olving for dividends paid o%t 9m.m.11 :,:,

1111 I nP X mD −+=

8/9/2019 div 44




• If a 1rm pays o%t dividends that e'ceeds its free cashIf a 1rm pays o%t dividends that e'ceeds its free cash0o+ 9 <I:2 then it m%st iss%e ne+ common shares to0o+ 9 <I:2 then it m%st iss%e ne+ common shares topay for these dividends3pay for these dividends3

• (%bstit%ting into 45%ation FF < F +e get,(%bstit%ting into 45%ation FF < F +e get,

• The val%e of the 1rm is the val%e of the ne't period’s The val%e of the 1rm is the val%e of the ne't period’sfree cash 0o+ 9free cash 0o+ 9 / / 11 11: pl%s the ne't period’s e5%ity: pl%s the ne't period’s e5%itymar)et val%eSmar)et val%eS

)1(

])[( 11110

K

V P nm I V

+

=++−=( 22-4)

8/9/2019 div 44




• The 1rm val%e is determined as the present val%e of The 1rm val%e is determined as the present val%e ofthe free cash 0o+s to the e5%ity holders,the free cash 0o+s to the e5%ity holders,

• The dividend is e5%al to the free cash 0o+ each period2 The dividend is e5%al to the free cash 0o+ each period2and dividends are therefore a resid%al after the 1rmand dividends are therefore a resid%al after the 1rmhas ta)en care of all of its investment re5%irements <has ta)en care of all of its investment re5%irements <this is thethis is the esidual Theory of .ividendsesidual Theory of .ividends

)1(1

0 ∑= +

−=

α

t t t t

K

I X

V ( 22-5)

*+l,e +"noin.

o do /idividend"

8/9/2019 div 44



/@/1s Dividend Irre!evance Theorem/@/1s Dividend Irre!evance TheoremResidua! Theor" o$ DividendsResidua! Theor" o$ Dividends

The The esidual Theory of .ividendsesidual Theory of .ividends s%ggests thats%ggests that

logically2 each year2 management sho%ld,logically2 each year2 management sho%ld,

–Identi$" $ree cash $!ow generated in the previous periodIdenti$" $ree cash $!ow generated in the previous period

– Identi$" investment projects that have positive 4sIdenti$" investment projects that have positive 4s

– Invest in a!! positive 4 projectsInvest in a!! positive 4 projects7 I$ $ree cash $!ow is insu$$icient+ then raise e-terna! capita! – inI$ $ree cash $!ow is insu$$icient+ then raise e-terna! capita! – in

this case no dividend is paidthis case no dividend is paid

7 I$ $ree cash $!ow e-ceeds investment re,uirements+ the residua!I$ $ree cash $!ow e-ceeds investment re,uirements+ the residua!

amount is distributed in the $orm o$ cash dividends%amount is distributed in the $orm o$ cash dividends%

8/9/2019 div 44


8/9/2019 div 44



/@/1s Dividend Irre!evance Theorem/@/1s Dividend Irre!evance TheoremInterna! *unds+ Investment+ and DividendsInterna! *unds+ Investment+ and Dividends

22 - 4 $%&'RE

E88+FG;/i!!ion

Rate o$Return

WACC

Interna! *unds Avai!ab!e

PT%A %*ESTET

IO&

E8GG+;9G/i!!ion

/CH/R

8/9/2019 div 44



/@/1s Dividend Irre!evance Theorem/@/1s Dividend Irre!evance Theoremomemade Dividendsomemade Dividends

• (hareholders can b%y or sell shares in an(hareholders can b%y or sell shares in an

%nderlying company to create their o+n cash%nderlying company to create their o+n cash

0o+ pattern30o+ pattern3

– The" don1t need management dec!are a cashThe" don1t need management dec!are a cash

dividend+ the" can create their own%dividend+ the" can create their own%

Conc!usion6 under the assumptions o$ /@/1s mode!+Conc!usion6 under the assumptions o$ /@/1s mode!+the investor is indi$$erent to the $irm1s dividend po!ic"%the investor is indi$$erent to the $irm1s dividend po!ic"%

8/9/2019 div 44


The J0ird3in3the3andK ArgumentThe J0ird3in3the3andK Argument


8/9/2019 div 44



The J0ird3in3the3andK ArgumentThe J0ird3in3the3andK Argument/@/1s Assumptions Re!a-ed/@/1s Assumptions Re!a-ed

• is) is a real +orld factor3is) is a real +orld factor3

• 8irm’s that reinvest free cash 0o+2 p%t that8irm’s that reinvest free cash 0o+2 p%t that

money at ris) < there is no certainty ofmoney at ris) < there is no certainty of

investment o%tcome < those forfeit dividendsinvestment o%tcome < those forfeit dividends

that are reinvestedSco%ld be lostthat are reinvestedSco%ld be lost

• emember the t+o7stage DDMQemember the t+o7stage DDMQ

8/9/2019 div 44




• emember the t+o7stage DDMQemember the t+o7stage DDMQ

– The $irst term is the present va!ue o$ e-isting opportunitiesThe $irst term is the present va!ue o$ e-isting opportunities(.O)(.O)

– The second term is the present va!ue o$ growth opportunitiesThe second term is the present va!ue o$ growth opportunities(=O)(=O)

– These $orecast returns $ace ris's o$ new mar'et entrants toThese $orecast returns $ace ris's o$ new mar'et entrants tocompete $or the e-cess pro$its $orecast in emerging opportunitiescompete $or the e-cess pro$its $orecast in emerging opportunitiesma'ing =O e-treme!" vu!nerab!e%ma'ing =O e-treme!" vu!nerab!e%

)R!"

()# (1

$nv 2

e

1

e

e

e K

K

K

BVPS ROE P

−

++

×=( 22-6)

8/9/2019 div 44




• Myron Uordon s%ggests that dividends are more stableMyron Uordon s%ggests that dividends are more stable

than capital gains and are therefore more highly val%edthan capital gains and are therefore more highly val%ed

by investors3by investors3

• This implies that investors perceive non7dividend paying This implies that investors perceive non7dividend paying1rms to be ris)ier and apply a higher disco%nt rate to1rms to be ris)ier and apply a higher disco%nt rate to

val%e them ca%sing the share price to fall3val%e them ca%sing the share price to fall3

• The di-erence bet+een the M&M and Uordon arg%ments The di-erence bet+een the M&M and Uordon arg%ments

are ill%strated in 8ig%re FF 7 @ on the follo+ing slide,are ill%strated in 8ig%re FF 7 @ on the follo+ing slide, – /@/ argue that dividends and capita! gains are per$ect substitutes/@/ argue that dividends and capita! gains are per$ect substitutes

8/9/2019 div 44



The J0ird3in3the3andK ArgumentThe J0ird3in3the3andK Argument/@/ versus =ordon1s 0ird in the and Theor"/@/ versus =ordon1s 0ird in the and Theor"

0

1

P

D

22 - 5 $%&'RE

=ordon

PT%A %*ESTET

/@/

0

01

P P P −

8/9/2019 div 44



The J0ird3in3the3andK ArgumentThe J0ird3in3the3andK Argument/@/ versus =ordon1s 0ird in the and Theor"/@/ versus =ordon1s 0ird in the and Theor"

Concl%sions,Concl%sions,

– *irms cannot change under!"ing operationa!*irms cannot change under!"ing operationa!

characteristics b" changing the dividendcharacteristics b" changing the dividend

– The dividend shou!d re$!ect the $irm1s operationsThe dividend shou!d re$!ect the $irm1s operations

through the residua! va!ue o$ dividendsthrough the residua! va!ue o$ dividends

8/9/2019 div 44


8/9/2019 div 44



Dividend o!ic" in racticeDividend o!ic" in ractice

• 8irms smooth their dividends8irms smooth their dividends

– *irms tend to ho!d dividends constant+ even in the*irms tend to ho!d dividends constant+ even in the

$ace o$ increasing a$ter3ta- pro$it$ace o$ increasing a$ter3ta- pro$it

– *irms are ver" re!uctant to cut dividends*irms are ver" re!uctant to cut dividends

8/9/2019 div 44



Dividend o!ic" in racticeDividend o!ic" in racticeLintner1s Wor' on Dividend AdjustmentLintner1s Wor' on Dividend Adjustment

• =ohn Lintner s%ggested a partial adj%stment =ohn Lintner s%ggested a partial adj%stment

model to e'plain the smoothing of dividendmodel to e'plain the smoothing of dividend

behavio%r ill%strating that 1rms slo+ly changebehavio%r ill%strating that 1rms slo+ly change

dividends as they move to+ard a ne+ targetdividends as they move to+ard a ne+ target

level,level,

1 )-D β(D ΔD t-

*

t t =( 22-7)

8/9/2019 div 44



Dividend o!ic" in racticeDividend o!ic" in ractice Lintner1s Wor' on Dividend AdjustmentLintner1s Wor' on Dividend Adjustment

• The target dividend The target dividend ..t t 33 Lintner s%ggested is a f%nctionLintner s%ggested is a f%nction

of the 1rm’s optimal payo%t rate of the 1rm’s %nderlyingof the 1rm’s optimal payo%t rate of the 1rm’s %nderlying

earnings 9earnings 944t t : leading to the follo+ing e5%ation,: leading to the follo+ing e5%ation,

• The coeVcient on lagged dividends +as estimated at The coeVcient on lagged dividends +as estimated at

E3E indicating an adj%stment speed 9E3E indicating an adj%stment speed 9##: coeVcent of: coeVcent ofE3BE3E3BE3

• The coeVcient on c%rrent earnings 9 The coeVcient on c%rrent earnings 9cc: +as estimated at: +as estimated at

E3>@E3>@

)1( 11 cE Dba D t-t +−+=( 22-8)

8/9/2019 div 44



Dividend o!ic" in racticeDividend o!ic" in ractice Lintner1s Wor' on Dividend AdjustmentLintner1s Wor' on Dividend Adjustment

ImplicationsImplications

– The speed o$ dividend adjustment is on!" about 9The speed o$ dividend adjustment is on!" about 9

percentpercent

– *irms are ver" re!uctant to $u!!" adjust*irms are ver" re!uctant to $u!!" adjust

– *irms do not $o!!ow a po!ic" o$ pa"ing a constant*irms do not $o!!ow a po!ic" o$ pa"ing a constant

proportion o$ earnings out as dividendsproportion o$ earnings out as dividends

Dividend po!ic" in practice does not $o!!ow /@/1sDividend po!ic" in practice does not $o!!ow /@/1sirre!evance arguments because the rea! wor!d doesirre!evance arguments because the rea! wor!d does

not match the assumptions used%not match the assumptions used%

8/9/2019 div 44



Re!a-ing the /@/ AssumptionsRe!a-ing the /@/ AssumptionsWe!come to the Rea! Wor!dMWe!come to the Rea! Wor!dM

Transactions Costs Transactions Costs

– Nnderwriting costs are ver" high+ providing a strongNnderwriting costs are ver" high+ providing a strong

incentive $or $irms to $inance growth out o$ $ree cashincentive $or $irms to $inance growth out o$ $ree cash

$!ow$!ow

– *acing these high underwriting costs $irms6*acing these high underwriting costs $irms67 With high growth rates have !itt!e incentive to pa" dividendsWith high growth rates have !itt!e incentive to pa" dividends

7 With vo!ati!e earnings conserve cash $rom "ear to "ear toWith vo!ati!e earnings conserve cash $rom "ear to "ear to

$inance projects and there$ore pa" ver" conservative$inance projects and there$ore pa" ver" conservative

dividendsdividends

8/9/2019 div 44




Dividends and (ignallingDividends and (ignalling

– Nnder conditions o$ in$ormation as"mmetr"+ shareho!ders andNnder conditions o$ in$ormation as"mmetr"+ shareho!ders and

the investing pub!ic watch $or management signa!s (actions)the investing pub!ic watch $or management signa!s (actions)

about what management 'nows%about what management 'nows%

–/anagement is there$ore ver" cautious about dividend/anagement is there$ore ver" cautious about dividendchanges5the" don1t want to create high e-pectations (this is thechanges5the" don1t want to create high e-pectations (this is the

reason $or e-tra or specia! dividends) that wi!! !ead toreason $or e-tra or specia! dividends) that wi!! !ead to

disappointment+ and the" don1t want to have investors over reactdisappointment+ and the" don1t want to have investors over react

to negative earnings surprises (the stic'" dividend phenomenon)to negative earnings surprises (the stic'" dividend phenomenon)

(!he Signalling "odel is ex#lained in Figure 22 – $ found on the next slide%)(!he Signalling "odel is ex#lained in Figure 22 – $ found on the next slide%)

8/9/2019 div 44



Re!a-ing the /@/ AssumptionsRe!a-ing the /@/ AssumptionsThe &igna!!ing /ode!The &igna!!ing /ode!

22 - 6 $%&'RE

et

8 Time

et

dt

dt

8/9/2019 div 44


8/9/2019 div 44




Ta'es and the Clientele 4-ect Ta'es and the Clientele 4-ect – Tab!e 3 (on the $o!!owing s!ide) i!!ustrates that di$$erentTab!e 3 (on the $o!!owing s!ide) i!!ustrates that di$$erent

c!asses o$ investors $ace di$$erent ta- brac'etsc!asses o$ investors $ace di$$erent ta- brac'ets

– re$erence $or dividends versus capita! gains income dependsre$erence $or dividends versus capita! gains income dependson the province o$ residence and ta-ab!e income !eve! !eading toon the province o$ residence and ta-ab!e income !eve! !eading to

ta- c!iente!es%ta- c!iente!es%7 igh income earners tend to pre$er capita! gains (there is anigh income earners tend to pre$er capita! gains (there is an

additiona! ta- incentive $or such individua!s in that the" can chooseadditiona! ta- incentive $or such individua!s in that the" can choosethe timing o$ the sa!e o$ their investment5remember on!" 2rea!iBed1the timing o$ the sa!e o$ their investment5remember on!" 2rea!iBed1capita! gains are subject to ta-capita! gains are subject to ta-

7 Low income earners tend to pre$er dividendsLow income earners tend to pre$er dividends

Conc!usion – $irm1s shou!d not change dividend po!ic" drastica!!"Conc!usion – $irm1s shou!d not change dividend po!ic" drastica!!"since it upsets the e-isting ownership base%since it upsets the e-isting ownership base%

R ! i h /@/ A i

8/9/2019 div 44



Re!a-ing the /@/ AssumptionsRe!a-ing the /@/ AssumptionsTa-esTa-es

R ! i th /@/ A ti

8/9/2019 div 44



Re!a-ing the /@/ AssumptionsRe!a-ing the /@/ AssumptionsRepac'aging Dividend3a"ing &ecuritiesRepac'aging Dividend3a"ing &ecurities

• Ta' clienteles help to e'plain the 1nancial Ta' clienteles help to e'plain the 1nancial

engineering +hereby di-erent parts of theengineering +hereby di-erent parts of the

ret%rn by the 1rm are stripped2 repac)agedret%rn by the 1rm are stripped2 repac)aged

and sold to di-erent investors as ill%strated inand sold to di-erent investors as ill%strated in

8ig%re FF < 3 9(ee the follo+ing slide:8ig%re FF < 3 9(ee the follo+ing slide:

• (plit shares are shares sold as the dividends(plit shares are shares sold as the dividends

and capital gains parts3and capital gains parts3

@R ! i th /@/ A ti

8/9/2019 div 44



Re!a-ing the /@/ AssumptionsRe!a-ing the /@/ Assumptions/?W1s 0 Corporation &hares/?W1s 0 Corporation &hares

)1()1(

%

1%

00 ∑

= ++

+=

t t

t

k

P

k

d P

&'

)1(

)1*0+in(,

)1(Pref

%

1%

%∑= +

−+

+=

t t

t

k

P

k

d

22 - 7 $%&'RE

E8> mi!!ionE9 mi!!ion

E>P> mi!!ion

)1(

)1*0+in(,$R %

%%

k

P P

+

−−=

8/9/2019 div 44



&hare Repurchases&hare Repurchases

• (imply another form of payo%t policy3(imply another form of payo%t policy3

• $n alternative to cash dividend +here the$n alternative to cash dividend +here the

objective is to increase the price per shareobjective is to increase the price per share

rather than paying a dividend3rather than paying a dividend3• (ince there are r%les against improper(ince there are r%les against improper

acc%m%lation of f%nds2 1rms adopt a policy ofacc%m%lation of f%nds2 1rms adopt a policy of

large infre5%ent share rep%rchase programs3large infre5%ent share rep%rchase programs3

8/9/2019 div 44




8/9/2019 div 44



• allo+ed %nder the O!C$ and C!C$allo+ed %nder the O!C$ and C!C$

• reasons for %se,reasons for %se, – O$$setting the e-ercise o$ e-ecutive stoc' optionsO$$setting the e-ercise o$ e-ecutive stoc' options

– Leveraged recapita!iBationsLeveraged recapita!iBations

– In$ormation or signa!!ing e$$ectsIn$ormation or signa!!ing e$$ects

– Repurchase dissident sharesRepurchase dissident shares

– Removing cash without generating e-pectations $or $utureRemoving cash without generating e-pectations $or $uture

distributionsdistributions – Ta'e the $irm private%Ta'e the $irm private%


8/9/2019 div 44


8/9/2019 div 44



• tender o-er,tender o-er,

– this is a $orma! o$$er to purchase a given number o$ shares at athis is a $orma! o$$er to purchase a given number o$ shares at a

given price over current mar'et price%given price over current mar'et price%

• open mar)et p%rchase,open mar)et p%rchase,

– the purchase o$ shares through an investment dea!er !i'e an"the purchase o$ shares through an investment dea!er !i'e an"other investor other investor

– this is not designed $or !arge b!oc' purchases%this is not designed $or !arge b!oc' purchases%

• private negotiation +ith major shareholdersprivate negotiation +ith major shareholders

n any repurchase program, the securities commissionn any repurchase program, the securities commissionrequires disclosure of the event as well as all otherrequires disclosure of the event as well as all other

material information through a prospectus"material information through a prospectus"

/ethods o$ &hare Repurchases/ethods o$ &hare Repurchases

8/9/2019 div 44



• called treas%ry stoc) 9.3(3:called treas%ry stoc) 9.3(3:

• non7voting 9.3(3:non7voting 9.3(3:

• may not receive dividends 9.3(3:may not receive dividends 9.3(3:

• if not retired2 can be resold 9.3(3:if not retired2 can be resold 9.3(3:

• %nli)e the .3(32 rep%rchases in Canada do not%nli)e the .3(32 rep%rchases in Canada do not

involve shares that can be placed intoinvolve shares that can be placed into

treas%ry stoc) 7 they are canceledtreas%ry stoc) 7 they are canceled

Repurchased &haresRepurchased &hares

8/9/2019 div 44


8/9/2019 div 44



• 4P( sho%ld increase follo+ing the rep%rchase4P( sho%ld increase follo+ing the rep%rchase

if earnings after7ta' remains the sameif earnings after7ta' remains the same

• a higher mar)et price per o%tstanding sharea higher mar)et price per o%tstanding shareof common stoc) sho%ld res%ltof common stoc) sho%ld res%lt

• stoc)holders not selling their shares bac) tostoc)holders not selling their shares bac) to

the 1rm +ill enjoy a capital gain if thethe 1rm +ill enjoy a capital gain if the

rep%rchase increases the stoc) price3rep%rchase increases the stoc) price3

.$$ects o$ A &hare Repurchase.$$ects o$ A &hare Repurchase

8/9/2019 div 44



• signal positive information abo%t the 1rm’s f%t%re cashsignal positive information abo%t the 1rm’s f%t%re cash

0o+s0o+s

• %sed to e-ect a large7scale change in the 1rm’s capital%sed to e-ect a large7scale change in the 1rm’s capital

str%ct%restr%ct%re

• increase investor’s ret%rn +itho%t creating anincrease investor’s ret%rn +itho%t creating an

e'pectation of higher f%t%re cash dividendse'pectation of higher f%t%re cash dividends

• red%ce f%t%re cash dividend re5%irements or increasered%ce f%t%re cash dividend re5%irements or increase

cash dividends per share on the remaining shares2cash dividends per share on the remaining shares2

+itho%t creating a contin%ing incremental cash drain+itho%t creating a contin%ing incremental cash drain

• capital gains treated more favo%rably than cashcapital gains treated more favo%rably than cash

dividends for ta' p%rposes3dividends for ta' p%rposes3

Advantages o$ &hare Repurchases Advantages o$ &hare Repurchases

8/9/2019 div 44



• signal negative information abo%t the 1rm’ssignal negative information abo%t the 1rm’s

f%t%re gro+th and investment opport%nitiesf%t%re gro+th and investment opport%nities

•the provincial sec%rities commission maythe provincial sec%rities commission mayraise 5%estions abo%t the intentionraise 5%estions abo%t the intention

• share rep%rchase may not 5%alify the investorshare rep%rchase may not 5%alify the investor

for a capital gainfor a capital gain

Disadvantages o$ &hare RepurchasesDisadvantages o$ &hare Repurchases

8/9/2019 div 44


0orrowing to a" Dividends0orrowing to a" Dividends

(ignalling(ignalling

8/9/2019 div 44



• Is this legalQ is it possible to doQIs this legalQ is it possible to doQ

• *es *es – the $irm must have the abi!it" and capacit" to borrowthe $irm must have the abi!it" and capacit" to borrow

– the $irm must have su$$icient retained earnings to a!!ow itthe $irm must have su$$icient retained earnings to a!!ow it

to pa" the dividendto pa" the dividend – the $irm must have su$$icient cash on hand to pa" thethe $irm must have su$$icient cash on hand to pa" the

cash dividendcash dividend

– the $irm must 4OT have agreed to an" !imitations on thethe $irm must 4OT have agreed to an" !imitations on thepa"ment o$ dividends under the bond indenture%pa"ment o$ dividends under the bond indenture%

• /hyQ/hyQ – A possib!e answer is to signa! to the mar'et that the A possib!e answer is to signa! to the mar'et that the

board is con$ident about the $irm1s abi!it" to sustain cashboard is con$ident about the $irm1s abi!it" to sustain cashdividends into the $uture%dividends into the $uture%



8/9/2019 div 44



Assets6 Liabi!ities6

Cash 89 Long3term Debt 9*i-ed Assets 8>9 Common &toc' P9

Retained .arnings 899Tota! Assets E8P9 Tota! C!aims E8P9

After Borrowing…before cash dividend &


Cash ;9 Long3term Debt P9*i-ed Assets 8>9 Common &toc' P9

Retained .arnings 899

Tota! Assets E99 Tota! C!aims E99

Before Borrowing:

9< Debt

P< Debt

0orrowing to a" Dividends0orrowing to a" Dividends An .-amp!e An .-amp!e


8/9/2019 div 44




Cash ;9 Current !iabi!ities P9*i-ed Assets 8>9 Long3term Debt P9

Common &hares P9Retained earnings P9

Tota! Assets E99 Tota! C!aims E99

After Cash Dividend payment of $50


Cash 89 Long3term Debt P9*i-ed Assets 8>9 Common &toc' P9

Retained earnings P9

Tota! Assets E8P9 Tota! C!aims E8P9

After Dividend Declaration…before date of payment.

P9< Debt

< Debt

0orrowing to a" Dividends0orrowing to a" Dividends An .-amp!e 5 An .-amp!e 5


8/9/2019 div 44



• The foregoing e'ample ill%strates, The foregoing e'ample ill%strates,

– it is possib!e $or a $irm with 2borrowing capacit"1 to borrow $unds toit is possib!e $or a $irm with 2borrowing capacit"1 to borrow $unds to

pa" cash dividends%pa" cash dividends%

– this is not possib!e i$ the !enders insist on restrictive covenants thatthis is not possib!e i$ the !enders insist on restrictive covenants that

!imit or prevent this $rom occurring%!imit or prevent this $rom occurring%

– the cash $or the dividend must be present in the cash account%the cash $or the dividend must be present in the cash account%

– pa"ment o$ dividends reduces both the cash account on the assetpa"ment o$ dividends reduces both the cash account on the asset

side o$ the ba!ance sheet as we!! as the retained earnings accountside o$ the ba!ance sheet as we!! as the retained earnings account

on the 2c!aims1 side o$ the ba!ance sheet%on the 2c!aims1 side o$ the ba!ance sheet%

– in the absence o$ restrictions+ it is possib!e to trans$er wea!th $romin the absence o$ restrictions+ it is possib!e to trans$er wea!th $rom

the bondho!ders to the stoc'ho!ders%the bondho!ders to the stoc'ho!ders% (0ondho!ders in this e-amp!e(0ondho!ders in this e-amp!ema" have thought their $irm wou!d have on!" a P< debt ratio5%a$ter thema" have thought their $irm wou!d have on!" a P< debt ratio5%a$ter the

dividend the debt ratio rose to < and the e,uit" cusion dropped $romdividend the debt ratio rose to < and the e,uit" cusion dropped $rom

GP< to ;;<%)GP< to ;;<%)

0orrowing to a" Dividends0orrowing to a" Dividends An .-amp!e An .-amp!e

& d C ! i

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&ummar" and Conc!usions&ummar" and Conc!usions

In this chapter yo% have learned,In this chapter yo% have learned,

– About the di$$erent t"pes o$ dividends inc!uding+ regu!ar and About the di$$erent t"pes o$ dividends inc!uding+ regu!ar and

specia! cash dividends+ stoc' dividends+ stoc' sp!its as we!! asspecia! cash dividends+ stoc' dividends+ stoc' sp!its as we!! asshare repurchases%share repurchases%

– /@/1s dividend irre!evance argument and the rea! wor!d $actors/@/1s dividend irre!evance argument and the rea! wor!d $actors

such as transactions costs+ ta-es+ c!iente!e e$$ects andsuch as transactions costs+ ta-es+ c!iente!e e$$ects and

signa!!ing tend to $avour rea!3wor!d dividend re!evancesigna!!ing tend to $avour rea!3wor!d dividend re!evance

– Ta- motives and other reasons e-p!ain wh" $irms might want toTa- motives and other reasons e-p!ain wh" $irms might want torepurchase their shares%repurchase their shares%

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