- Cash Dividends: Firms pay out cash to stockholders
of the company on a regular basis, usually quarterly.
- Extra Cash Dividend: An additional cash dividend
paid out of cycle.
- Stock dividend: A dividend paid out in shares of
- Stock split: A stock dividend where the number of
shares paid out per original share is much larger. A stock dividend
(or a stock split) increases the number of share outstanding.
date: The board of directors declares a payment
Record date: The declared dividends are distributable to shareholders
of record on this date.
Payment date: The dividend checks are mailed to shareholders of record.
date: A share of stock becomes ex-dividend on the date the seller is
entitled to keep the dividend. At this point, the stock
is said to be trading ex-dividend. The buyer of
an ex-dividend stock is not entitled to the next dividend payment.
For example, a dividend may be declared as payable to stockholders of
record on a given Friday. Since three business days are allowed for
delivery of stock in a regular transaction on the New York Stock Exchange,
the Exchange would declare the stock "ex-dividend" as of the
opening of the market on the preceding Wednesday. That means anyone
who bought it on or after that Wednesday would not be entitled to that
dividend. When stocks go "ex-dividend", the stock tables include
the symbol "x" following the name. (Source: http://www.nyse.com)
- Dividends follow earnings (Lintner's model)
- Dividends are sticky
- A firm's dividend policy tends to follow the life cycle of the firm
||Limited by size and other infrastructure limits
||High relative to firm value
||Moderate relative to firm value
||Low as projects dry up
|Cash flows generated
||Negative as investments are made
||Cash flow low relative to firm value
||Cash flow increases as percentage of firm value
||Cash flow high relative to firm value
New Stock Issues
|No or very low dividends
- Dividend Yield = Dividend/Price: this ratio tends to be large for
firms that are not growing. Hence their stock prices reflect current
dividends to a larger extent, rather than expected future dividends.
Concomitantly, their P/E ratios are also lower.
- Dividend Payout Ratio = Dividend/Earnings: this ratio tends to be
larger for more mature firms.
What does dividend irrelevance mean? Obviously it cannot mean that
shareholders don't value dividends. Rather, what it means is that under
the right assumptions, shareholders' wealth is unaffected by the dividend
decision. It will be easiest to see this by means of an example:
Stellar, Inc. has decided to invest $10 m. in a new
project with a NPV of $20 m., but it has not made an announcement. The
company has $10 m. in cash to finance the new project. Stellar has 10
m. shares of stock outstanding, selling for $24 each, and no debt. Hence,
its aggregate value is $240 m. prior to the announcement ($24 per share).
Consider the following alternatives:
- Pay no dividend and finance the project with cash.
The value of each share rises to $26 following the
announcement. Each shareholder can sell 0.0385 (= 1/26) shares to
obtain a $1 dividend, leaving him with .9615 shares value at $25 (26
Hence the shareholder has one share
worth $26, or one share worth $25 plus $1 in cash.
- Pay a dividend of $1 per share, and sell $10 m. worth
of new shares to finance the project.
After the company announces the new project and pays
the $1 dividend, each share will be worth $25. To raise the $10 m.
needed for the project, the company must sell 400,000 (=10,000,000/25)
shares. Immediately following the share issue, Stellar will have 10,400,000
shares trading for $25 each, giving the company an aggregate value
of 25 x 10,400,000 = $260 m. If a shareholder does not want the $1
dividend, he can buy 0.04 shares (1/25).
Hence, the shareholder has one share worth $25 and
$1 in dividends, or 1.04 shares worth $26 in total.
We see that in both cases, the shareholder obtains the
same value. When will this be true? Here is a sufficient set of conditions.
- The issue of new stock (to replace excess dividends) is costless
and can, therefore, cover the shortfall caused by paying excess
- Firms that face a cash shortfall do not respond by cutting back
on projects and thereby affect future operating cash flows.
- Stockholders are indifferent between receiving dividends and price
- Any cash remaining in the firm is invested in projects that have
zero net present value. (such as financial investments) rather than
used to take on poor projects (i.e. there are no agency costs of
- A firm cannot resurrect its image with stockholders by offering
higher dividends when its true prospects are bad.
- The price of a company's stock will not be affected by its dividend
policy, all other things being the same. (Of course, the price will
fall on the ex-dividend date.)
- Dividend Clienteles based on age, tax bracket
A manager who perceives his firm's stock price to be undervalued,
may choose to increase dividends to signal to the market his belief
that the true market value of the stock is higher. Managers
of overvalued firms (bad firms) will not mimic the undervalued
firm (good firm) manager's actions because the cost of increasing
dividends is much higher for the overvalued firm manager.
For example, bad firms will be more likely to run into liquidity
problems with a higher dividend, and are more likely to have to
resort to expensive outside financing to pay the higher dividend.
- Psychological Theories of Dividend Preference
Dividends and Capital Gains may not be perfect substitutes for
each other. A lack of self-control may lead an investor to prefer
regular cash fdividends. If the investor must sell stock to get
income he might have a tendency to sell too much stock too soon.
Hence an investor might choose to invest in a firm that follows
a particular type of dividend policy to minimize the total agency
costs of shareholding, including the investor's human frailties.
- Tax and Transaction Clienteles
Disciplinary Effects on Managers
Contracts between the firm and its managers cannot always be
designed to take into account all possible contingencies. Hence,
managers may sometimes take actions that reduce firm value.
For example, it may be in the interest of managers to increase
firm size or to unduly reduce the riskiness of the firm in order
to reduce the probability of bankruptcy, and increase the present
value of their firm specific skills. This may lead them to accept
negative NPV projects or to engage in undesirable mergers.
This may lead some managers to reduce dividends to a suboptimal
level. In contrast, managers, who want to assure the market
of their desire to maximize firm value by reducing the amount
of disposable resources (free cash flow beyond current investment
needs) available to them, may choose to increase dividends.
By doing so, they force themselves to submit to the discipline
of the markets any time that they wish to raise funds to invest
in a project. Such credible proof of a manager's unwillingness
to take NPV < 0 projects will be rewarded by the market with
an increase in the price of the stock.
- Bird-in-the-hand Fallacy
This argument, which is often made by naive investors, is that
dividends represent cash in hand, whereas reinvesting
that cash in the hope of greater dividends in the future is a
risky prospect. Hence, shareholders are better off with the dividend.
The proper rebuttal to this assertion is that if cash flows are
priced correctly in the market, then the present value of the
larger riskier future dividends is equal to the present certain
dividend. Any shareholder that decides otherwise can undo the
firm's dividend decision.
- Temporary Excess Cash
This argument is also faulty. If the excess is a temporary
situation, then paying it out now as dividends will necessitate
higher costs of raising funds in the future when it becomes necessary.
It would be preferable to invest it in some short-term liquid
A simple shareholder preference for dividends will not
change the irrelevance of dividend policy because individual shareholders
can always create home-made dividends. But there are two conditions
under which this conclusion must be modified.
I. If dividends and capital gains are treated differently:
For individual investors, dividends are more
heavily taxed than capital gains because of the tax-timing option--the
ability for individual investors to postpone the tax liability on capital
gains income. Hence individuals may prefer capital gains.
Corporate shareholders pay income tax at a 34%
peak marginal rate, but are permitted to claim a 70% dividends-received
deduction. Hence the top marginal tax rate on dividend income for a
corporation is only (1-.7) x 34 = 10.2%. They have a greater preference
Tax-exempt institutions, such as pension funds,
do not have a bias in favor of capital gains or dividends.
II. Trading in shares is costly:
A shareholder who desires a high income stream would
prefer real cash dividend payments over homemade dividends if the firm
can sell new shares more cheaply than the shareholder can sell his/her
own shares. Hence such shareholders might prefer firms with a high payout
ratio, while other shareholders may prefer firms with a low payout policy.
Consequently, some investors prefer equity income in
the form of dividends, while others prefer capital gains.
Taxes and transaction costs reduce the return to shareholders.
Therefore, investors should invest in a company that follows the dividend
policy that is optimal for themselves. Thus, a clientele group will
be better off if they pay up to some maximum premium for shares of firms
that follow their optimal policy. The maximum premium is the additional
cost if they invest in the next best company that is otherwise identical
but does not follow their optimal policy.
As long as a premium is offered, companies have the
incentive to change their policy and sell shares to the clientele group
offering the premium. Over time, competition among companies drives
the premium to zero. In the aggregate, companies will supply enough
of each type of stock so that all the positive-NPVs resulting from dividend
policy choices have been extracted and the premiums have been driven
to zero. In equilibrium, the marginal gain from changing dividend policy
But, whenever there are changes in tax laws, or in transaction
costs, there may opportunities for firms that are willing to change
dividend policies. It may be possible to earn a premium for supplying
a dividend policy that is in short supply.
Historically, dividends have been taxed at a higher rate than capital
gains (except for a short period in 1986). This implies that there are
disadvantages to paying dividends compared to capital gains. However,
not all shareholders find capital gains more attractive than dividends.
Pension funds and other tax-exempt entities do not have any preference
for capital gains over dividends, since they are not taxed at all. Stock
brokers and dealers who trade for their own account are taxed on both
dividends and capital gains at the same rate. Corporations are only
taxed on 70% of their dividends, while they pay taxes on all of their
capital gains. Furthermore, some investors may prefer dividends over
capital gains for reasons of transactions costs. Finally, firms that
do not have profitable projects to invest in, will be better off paying
out earnings as dividends. Consequently, in equilibrium, different firms
might have different payout ratios. One implication of the tax disadvantages
of dividends relative to capital gains is that stock prices might not
fall by the same amount as the dividend payment:
Suppose to represents the tax rate on ordinary dividends
and tcg represents the tax rate on capital gains. Let PB
denote the cum-dividend stock price, and PA the ex-dividend
stock price, and P the price at which the stock was acquired. Then,
for the marginal investor,
PB-(PB-P)tcg = PA-(PA-P)tcg
+ D(1-to), where the LHS is the after-tax gain from selling
the stock cum-dividend and the RHS is the after-tax gain from selling
the stock ex-dividend. This yields the relationship .
By examining the empirical price drop, one may then infer the marginal
tax bracket for holders of the firm's stock. Studies in 1970 found that
the difference between the cum-dividend and ex-dividend prices was about
78% on average, and they concluded that there must be a tax clientele
effect. They also found that the drop was largest for firms with the
highest dividend yields. They argued that this was due to the fact that
the investors in these firms were in the lowest tax brackets, as would
be predicted by the relationship above. However, consider the possibility
of dividend capture, where a low tax bracket investor can buy the cum-dividend
stock, obtain the dividends sell it at the ex-dividend price, thus capturing
the difference between the theoretical no-clientele effect price drop
and the actual price drop.
Here is an example
of dividend capture (no recommendation intended)
- Investment Opportunities: A firm with more investment opportunities
should pay a lower fraction of its earnings.
- Stability of earnings: A firm with more volatile earnings should
pay, on average, a lower proportion of its earnings, so that it will
not have to cut dividends.
- Alternative sources of capital: To the extent that a firm can raise
alternative capital at low cost, it can afford to pay higher dividends
- Degree of financial leverage: If a firm has high leverage, it will
probably also have covenants restricting the payment of dividends.
Furthermore, to a certain extent, dividends and debt can be considered
substitutes for the purpose of manager discipline.
- Signalling incentives: To the extent that a firm can signal using
other less costly means, for example debt, it should pay lower dividends.
- Stockholder Characteristics: If a firm's stockholders want higher
dividends, it should provide them.
In analyzing dividend policy, two questions need to be answered:
- How much cash is available to be paid out as dividends?
- How good are the projects available to the firm?
The funds available to be paid out as dividends are essentially equal
to free cash flow to equity (FCFE), where FCFE = Net Income - (Capital
Expenditures - Depreciation)(1- Debt Ratio) - change in Non-cash Working
Capital (1-Debt Ratio).
If FCFE greatly exceed Dividends, the CFO must check to see how funds
are being invested. If the actual rate of return (accounting rate of
return) is greater than the required rate of return, then the NPV or
projects is positive. Then, if other such NPV>0 projects are available,
the excess FCFE should be employed in those projects; if not, it should
be redistributed to stockholders, unless the excess slack is necessary
to hedge against uncertainty or to smooth dividends.
If the actual rate of return is low relative to the required rate of
return, then investment is unprofitable; it would make sense, then,
that investment should be reduced and dividends increased.
On the other hand, if FCFE is much lower than the amount of dividends
paid, dividends should be cut. If the rate of return on equity is greater
than the cost of equity, the released funds should be invested in new
projects and if funds are inadequate, funding should be sought from
elsewhere. If projects are unprofitable, investment should be reduced.
|ROE>Cost of Equity
Invest in Projects
|ROE<Cost of Equity
However, the analyst should be careful to ensure that the accounting
numbers are not incorrect or misleading.
The following are some important steps in the determination of a dividend
1. Estimate Future Residual Funds (FCFE): Project the firm's operating
cash flows and capital expenditure needs over a reasonable time horizon,
say 5 years.
2. Determine Feasible Payout Ratios: Taking into account available
future free cash flow, flotation costs of new security issues, and cash
flow uncertainties, determine a range of feasible target payout ratios.
3. Set Target Payout Ratio: Analyze payout ratios of comparable firms
(those in the same industry and of similar size and with similar product
mix and other operating characteristics) and special shareholder mix
considerations and set long-term target payout ratio.
4. Set Quarterly Dividend Rate: Because of the informational content
of dividends, a fluctuating regular dividend is undesirable; such a
policy may also lead to shifts in the shareholder clientele and reduce
firm value. Given target payout ratio and cash flow projections, set
quartely dividend rate at highest sustainable level.
Many of the same factors that affect capital structure also affect
dividend policy. (See exercises.)
However, in addition to this, there maybe some interactions between
dividend policy and capital structure. For example, it is possible
to pay out more in dividends than the amount of FCFE for a while, by
borrowing. This would be desirable if the firm is underlevered. On the
other hand, if the firm is overleveraged, then it may be desirable to
use FCFE to repay debt, and bring leverage back into line.
The value of the shareholders' wealth is not affected by share repurchases,
if capital markets are perfect. This can be seen in the following example:
Buttle Wilson and Co. has $50 m. available for distribution. Buttle
has 10 m. shares outstanding. It expects to earn $2.50 a share, and
the current market value per share is $25. The firm has unused cash
that could be used to pay a cash dividend of $5 per share, implying
an ex-dividend value of $20 per share.
Alternatively, the firm could use the $50 m. to repurchase 2 m. shares
($50,000,000/$25). Following the share repurchase, each share would
Thus, as long as the firm repurchases the shares at the market price
of $25, a shareholder who does not sell will have the same wealth as
a shareholder who does sell--$25. The difference is that the former
has it in stock, the latter in cash.
If Buttle paid the $5 dividend, every shareholder would have their
wealth in the same form--$5 in cash plus $20 in stock.
Following the distribution of the $50 m. whether through a stock repurchase
or through a dividend payment, the firm's shares will trade at a P/E
ratio of 8 (= $20/$2.50).
Neither the firm's capital structure nor its capital investment policies
are affected by the method of cash distribution; hence the risk-return
tradeoff is the same.
Under the dividend alternative, the EPS is unchanged at $2.50, because
the $50 m. paid out were unused, and the number of shares is unchanged.
Each shareholder gets (EPS x P/E = $2.50 x 8 =) $20 + $5 = $25 in total
Under the share repurchase alternative, the projected EPS is higher
However, shareholder value is (EPS x P/E =) $3.125 x 8 = $25, once
again. The higher EPS is exactly offset by the drop in the P/E ratio
from ($25/2.5 =) 10 before the stock repurchase to 8 afterwards.
The confusion over the impact of share repurchases results from the
mistaken view that share repurchase will not alter the P/E ratio. But
paying out cash results in a riskier firm and hence the P/E ratio must
drop (the required rate of return must rise).
VALUE ENHANCING REASONS
Gains to individual shareholders from share repurchases are taxed at
the capital gains rate, which is usually smaller than the tax rate on
cash dividends. However, a regular policy of repurchasing shares could
be disallowed by the IRS for favorable capital gains treatment.
Eliminate Small Shareholdings:
The cost of servicing a small shareholder account is roughly the same
as that of servicing a large shareholder account. Hence repurchasing
shares of small stockholders could reduce overall stockholder service
If the firm wishes to increase debt in its capital structure, it could
borrow funds and use the proceeds to repurchases shares or offer it
sshareholders the opportunity to exchange their shares for a new debt
Exploit Perceived Undervaluation:
If a firm's stock is perceived by the management to be undervalued,
repurchasing shares at a favorable price could increase the wealth of
the firm's remaining shareholders. However, if investors believe that
the share repurchase is being undertaken for this purpose, share prices
will jump to reflect market belief in a higher share value. If so, the
true wealth of the firm's remaining shareholders would not increase;
however, the market value of their shareholdings will increase, which
can be valuable for shareholders who desire liquidity.
VALUE DECREASING REASONS
Consolidation of Insider Control:
Firms sometimes purchase stock from contentious minority stockholders,
sometimes at a premium (greenmail). At other times, they may do
so to reduce public float--to reduce the percentage of stock held by
persons not affiliated with the insider group.
Protection against Takeovers
Stock repurchases may also be designed to reduce the attractiveness
of the company as an acquisition candidate, thus enhancing management's
These objectives may not be consistent with firm value maximization.
- Go to Hoover's Online and
select firms that have zero dividend yield. Set the required
beta between -0.5 and 100 and the debt/equity ratio between 0 and
100 as well. Can you find a connection between the two?
Explain. Follow-up the exceptions and explain them.
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