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Contemporary Financial Management
Chapter 14:Dividend Policy
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Introduction
This chapter examines the factors that influence a company’s choice of dividend policy
The pros and cons of dividend policies
The mechanics of dividend payments
Stock dividends
Share repurchase plans
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Dividends
When a company earns a profit, there are only two things it can do with the earnings: Pay a dividend to the shareholders Retain the earnings in the form of Retained
Earnings
The choice as to how to divide firm earnings between Retained Earnings and Dividends and the implications of the choice made is the subject of this chapter.
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Influencing the Value of the Firm
Investment Decisions Determine the level of future earnings and future
potential dividends
Financing Decisions Influence the cost of capital, which can determine
the number of acceptable investment opportunities
Dividend Decisions Influence the amount of equity in a firm’s capital
structure and the cost of capital
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Determinants of Dividend Policy
Legal Constraints A firm’s capital cannot be used to pay dividends
(capital impairment restriction) Dividends can only be paid out of past & present
net earnings (net earnings restriction) Dividends cannot be paid when a firm is insolvent
(insolvency restriction)
Restrictive Covenants & Sinking Funds Usually imposed by creditors to prevent excessive
withdrawals by owners
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Determinants of Dividend Policy
Tax considerations Investment income can be received as a capital
gain or as a dividend The marginal tax rate will determine which form of
income is preferred by investors
Liquidity and Cash Flow Considerations Dividends represent an outflow of cash
Access to New Equity and Debt Capital A firm may decide to pay dividends and
simultaneously issue new equity or borrow
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Determinants of Dividend Policy
Variability of Earnings (stable vs. growth) The more stable the earnings pattern, the
greater the percentage of earnings the firm can safely pay out as a dividend
Inflation During periods of high inflation, the firm may
need to retain more earnings to fund the replacement of fixed assets
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Determinants of Dividend Policy
Shareholder Preference Firms often develop “clienteles” that are
attracted to the firm’s stated dividend policy
Protection Against Dilution If the firm pays dividends and issues new
equity, existing shareholders will be diluted if they do not purchase a portion of the new equity sold
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Dividend Irrelevance
Miller & Modigliani (MM) argue that dividends are irrelevant (under certain assumptions)
MM argue that firm value is determined by the firm’s investment policy, not dividend policy
MM’s assumptions for dividend irrelevance No taxes No transaction costs No issuance costs (for selling new equity) Existence of a fixed investment policy
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Dividend Irrelevance
MM recognize that changes in dividend policy affect share prices They argue this is due to the informational content
conveyed by the change, not the change itself
Changes in dividend policy have a signaling effect – it signals management beliefs about future firm prospects
The existence of clienteles should not affect share price, since one clientele is as good as another clientele
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Are Dividends Relevant?
?What happens when the assumptions are relaxed?
MM probably correct, given their restrictive
assumptions.
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Are Dividends Relevant?
Risk aversion (Bird in the Hand Theory) Dividends represent a regular, certain return,
thereby lowering risk and increasing firm value
Transaction costs With no transaction costs, investors can sell a portion
of their shares to “create” a dividend In reality, transactions costs are real and significant
Taxes Investors care only about their after-tax return Thus taxes affect the preferred form of income
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Relevance of Dividends
Issuance (Flotation) costs The existence of issuance costs reduces the
attractiveness of paying dividends and issuing equity
Agency costs are reduced when management is subjected to market scrutiny
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Conclusions Regarding Dividend Policy
Empirical evidence is mixed Some studies found that, due to tax effects,
investors require a higher pretax return on high-dividend shares
Other studies found no difference
Many practitioners believe that dividends are important due to: Their informational content External equity is expensive
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Passive Residual Policy
Suggests that a firm should retain its earnings as long as it has investment opportunities that promise higher rates of return than the shareholder’s required return
Would imply that dividends fluctuate significantly, based on earnings & investment opportunities
In practice, firms can smooth their dividends payments by using debt and varying their earnings retention policy
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Stable Dollar Dividend Policies
Firms are reluctant to reduce dividends; shareholders like a stable dividend stream
Increases in dividends tend to lag earnings
Investors prefer stable dividends because: Dividend changes convey information Many shareholders depend on dividend income Stability tends to reduce uncertainty, thereby
lowering the firm’s cost of capital Certain institutions can only hold the shares of firms
with a record of continuous and stable dividends
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Other Dividend Payment Policies
Constant Payout Ratio Pays a constant percent of earnings as
dividends Causes the dividend to fluctuate
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Other Dividend Payment Policies
Small Regular Dividends Plus Extras Shareholders can depend on regular payout Accommodates changing earnings and
investment requirements
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Other Dividend Payment Policies
Small Firms and Dividends Tend to pay out a smaller percent of earnings Rapid growth requires capital; small firms retain
more of their income to fund growth Small firms have limited access to capital
markets
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Multinational Firms & Dividends
Primary means of transferring funds to parent company
Important issues to consider include:
Tax Foreign Exchange Political risk Funds availability Financing needs
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Paying Dividends
DeclarationDate
Ex-DividendDate
Record Date
PaymentDate
TwoDays
Usually Four Weeks
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Dividend Reinvestment Plan
Cash dividends reinvested automatically into additional shares
Purchase new or existing shares Purchasing new shares raises new equity capital
for the firm
No brokerage commissions
Income tax liability
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Stock Dividends
Stock dividends are similar to stock splits
Both increase the number of shares outstanding
Accounting transaction Transfer pre-dividend market value from
retained earnings to other stockholder’s equity
Market price of common shares should decline in proportion to the number of new shares issued
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Reasons for Stock Dividends
Broaden the ownership of the firm’s shares
May result in an effective increase in cash dividends, provided the level of cash dividends per share is not reduced
Reduction in share price may broaden the appeal of the stock to investors Thus may result in a real increase in market
value
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Share Repurchase
By Tender Offer in the open market or by negotiation with large holders
Acquired shares may be cancelled or held as Treasury stock
Reduces the number of shares outstanding Increases EPS for the remaining shareholders
Stock repurchase programs are usually publicly announced
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Share Repurchase
Advantages Converts dividend income into capital gains Greater financial flexibility Greater control over timing Signaling effect
Disadvantages Company may overpay for the stock Tax avoidance Some current shareholders may be unaware
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Major Points
Firm profits are split into Retained Earnings and Dividends. Dividend policy explicitly states how the firm intends to make this split.
In a perfect world, it would not matter whether the firm paid dividends or not.
In the real world, where taxes and transaction costs exist, dividends probably do matter.
Dividends can be paid in cash or stock. In both cases, stock price declines on ex-dividend date
Share repurchases reduce shares outstanding, thereby pushing up the future price of the stock.