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Chapter 16
Dividend Policy
Chapter 16 Outline
16.1 Distributions to
Shareholders
•Dividends
•Cash dividends
•Stock dividends
•Stock splits
•Share repurchases
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16.2 Why Do
Companies Pay
Cash Dividends?
•Residual Theory
•Agency costs
•“Bird in the hand”
•Signaling
•Taxes
16.3 Dividend Policy
in Practice
•Dividend Ratios
•What do we know
about dividends?
16.1 Distributions to
Shareholders
A corporation has no legal obligation to make
any type of distribution to common
shareholders, whether this is a distribution of
cash or a distribution of shares.


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A company’s board of directors declares a dividend,
and only then does a dividend become a contractual
commitment of the company.
Shareholders cannot force the members of the
board to declare a dividend, and there may be legal
restrictions on whether or not the company can
declare a dividend.
Cash Dividends
The dividend
payout ratio is
dividends as a
percentage of
earnings, as shown
in the graph for
the stocks that
comprise the S&P
500 Index.
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Aggregate Dividends and Profits,
1871 Through 2010
Dividend Payout Ratio
We can draw a few conclusions from the graph:

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The payout rate is normally around 40 to 60%, but
increased to over 100% during economic
downturns, when profits dropped dramatically but
dividends remained relatively stable.
The payout rate has been trending downward over
time.
The median payout for the most recent 10 years is
35.5%.
Dividend Yield
We can also look at
dividends from another
perspective.
Consider the dividend
yield of stocks in the S&P
500 Index, as shown in
the graph.
The dividend yield is the
ratio of the dividend to
the price of the stock;
with the price of the
stock in the denominator.
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Dividend Yields of Stocks in the
S&P 500 Index, 1871 Through
2010
The Mechanics of Cash
Dividends
On the declaration date, the board specifies:



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The amount of the dividend, generally stated as an
amount per share of stock
The record date or date of record, which is the date
used to determine the shareholders who will
receive the dividend
The payment date or payable date, which is the day
the dividend is actually paid by the company.
Declaration
date
Exdividend
date
Record
date
Payment
date
|
|
|
|
Holder of Record
 Because shares of stock are traded in markets on a
continual basis, it can take a day or so to determine
who actually owns the shares at a point in time; in
this case, who the holder of record is on a particular
day.
 The holder of record is resolved by the markets,
which specify the ex-dividend date as two trading
days prior to the record date.
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Holder of Record
How this works is as follows:


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If you buy the stock on the ex-dividend date or later, you do
not get the forthcoming, declared dividend.
If you buy the stock before the ex-dividend date and own it at
least until the day before the ex-dividend date, you will
receive the forthcoming dividend.
This explains why we typically see a drop in the share
price of a dividend-paying stock from the day before to
the ex-dividend date: If you buy the stock on the day
before the ex-dividend date, you receive the dividend; if
you buy the stock on the ex-dividend date, you do not
receive the dividend.
Timeline of IBM’s Cash Dividend
Paid November 8, 2010
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Dividend Reinvestment Plans
 If the investor does not want to receive a dividend,
many corporations offer the option of using the cash
dividend proceeds to buy new shares by way of a
dividend reinvestment plan (DRIP or DRP).
 Why wouldn’t an investor want a cash dividend?
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DRPS, continued
 DRIPs are popular with both investors and
companies. For the company, it means that it can
issue shares on a regular basis continuously at no
cost, whereas investors perceive that it is paying a
regular dividend.
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Stock Dividends
A stock dividend is generally defined as any share
distribution, but typically we use the term “stock
dividend” when the number of shares issued is less
than 25% of the outstanding shares.
 If a company declares a 10% stock dividend,
each investor will get 10% more shares.
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Stock Dividends
In terms of accounting, a company paying a stock
dividend transfers the value of the shares from
retained earnings into the capital stock account.
 As a result, a company cannot issue a stock
dividend if there are no available retained
earnings.
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Stock Dividends
A stock dividend will likely have the effect of
reducing the share price proportionately.
 If a company had 10 million shares outstanding
and a share price of $20, and then pays a 15%
stock dividend, the expected share price after
the dividend is the total market value of the
company, divided by the new number of shares:
($20 × 10,000,000) ÷ (10,000,000 × 1.15) =
$17.9 per share.
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Stock Splits
 A stock split
is similar (but not identical) to a stock
dividend.
 Typically, when a company has a goal of issuing
more than 25% additional shares, it uses a stock
split; however, there is no rule or restriction with
regard to this.
 We refer to a stock split in terms of shares after
compared to shares before. Examples:
 2:1
 3:2
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Reverse Stock Split
 Related to the stock split is the reverse stock
split.
 Like the stock split that we have already
discussed, a company might try to lift its stock
price by undergoing a reverse stock split, in
which the company issues fewer shares for
the existing outstanding shares.
 Why reverse stock split? The typical stock split
reduces the share price, so the logic is that the
reverse stock split will increase the share price
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Summary of Dividends
Effect on…
Cash Dividend
Cash flow
Cash outflow for No cash flow
the total
amount of
dividends
No cash flow
Retained
earnings
Reduce by the
Reduce by the
amount
value of the
of the dividends shares
distributed
No effect
Taxable income Dividend
of investor
income
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Stock Dividend
No taxable
income
Stock Split
No taxable
income
Share Repurchases
A share repurchase (or stock repurchase) is an
outright purchase of the company’s own shares,
either through open market purchases through a
broker or through a tender offer in which
shareholders can elect to sell their shares.
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Share Repurchases
 To see the effect of a repurchase on share
price, consider that the value of a share of
stock is the present value of future cash flows.
 If a company is expected to pay a dividend
next period of D1, has a market value of the
shares at the end of next period P1, and has S0
shares outstanding, the present value of a
share of stock is:
or, using notation:
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Why Repurchase?
 Remove cash without generating expectations
for future distributions
 Information or signaling effects
 Offsetting the exercise of executive stock
options
 Leveraged recapitalizations
 Repurchase dissidents’ shares (a.k.a.
greenmail)
 Take the company private
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Repurchase Methods
 Open
market repurchase
 Tender offer
 Traditional tender offer
 Dutch Auction tender offer
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Repurchase Methods
In a Dutch auction tender offer,
shareholders submit bids for the price they
are willing to sell their shares; the company
will pay the minimum price necessary to
acquire the stated number of shares.
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16.2 Why Do Companies Pay
Cash Dividends?
Explanations of why companies pay
dividends include the following:
 Residual cash flow
 Agency costs
 “Bird in the hand”
 Signaling
 Taxes
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Residual Theory
 Residual
theory of dividends - theory that
the dividends paid out should be the
residual cash flow that remains after the
company has taken care of all of its
investment requirements.
 Faced with significant costs attached to
raising new money, cash-poor growth
companies have little incentive to pay a
dividend because all they are doing is
compounding their financing problems.
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Residual Theory

Similarly, companies that face volatile earnings, so that
their cash fluctuates significantly from year to year, will
attempt to “store” cash from one period to another. As
a result, companies maintain their dividend payments
conservatively and at a level that minimizes the need
to constantly access the capital markets.
BOTTOM LINE: companies will pay dividends if they do not
need additional capital and they have cash flows remaining
after all profitable investment projects. If dividends are paid
based on residual cash flows, we should see profitable,
mature companies paying dividends, but also observe that
high-growth companies do not.
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Agency Costs
 The announcement
of a dividend increase is
generally associated with the increase in the
share price.
 The
fear is that senior management may waste
corporate resources by overinvesting in poor (that
is, negative NPV) projects because it is not “their”
money but the shareowners’.
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The “Bird in the Hand”
Argument
 This idea
of the bird in the hand argument is that
a “bird in the hand” (that is, a cash dividend) is
worth more than “two in the bush” (twice as
much in capital gains).
 Dividends are more stable than capital gains
and, as a result, more highly valued.
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Signaling
 Management usually knows more than external
investors, so the company has to have some way of
signaling to investors that their press releases can be
believed because investors tend to view such
information with a great deal of skepticism.
 One way of doing this is to increase the dividend
only when the company believes that it will not have
to cut it in the future.
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Taxes
 Describing how taxes affect financial policy is
very difficult because different classes of
investors have different tax brackets, so with
taxes the general rule is that “one size does not
fit all.”
 Corporations pay little or no tax on dividend
income if it is from another corporation.


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This is because of the dividends received deduction,
which provides a deduction for 70, 80, or 100% of
dividends received.
As a result, there is a preference by corporate owners
of equity for dividend income.
Taxes
 For individuals, the preference
for dividend versus
capital gains income depends on whether the
dividends are considered qualifying dividends and
whether the price appreciation is short or long
term.
 The current tax system, with individual investors,
corporations, and institutional investors facing
different tax rates on dividends, gives rise to tax
clienteles.
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16.3 Dividend Policy in
Practice
 The dividends of most companies follow
some
pattern, though these patterns may be in
terms of a steady payout ratio, a constant
dividend per share, or a constantly growing
dividend per share.
 There is no requirement that a company
follow a consistent pattern in its dividend, but
many shareholders acquire stock with the
expectation of dividends following a pattern.
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Dividend Policy in Practice
 We can
classify many companies’
dividends as falling into one of these
patterns:
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Dividend Ratios
Dividend per share
Dividend pershare
Number of shares outstanding
Dollar amount of dividend per share of
stock
Dividend yield
Dividend per share
Price per share
Return on stock in the form of a cash
dividend
Dividend payout
Dividend per share
Earnings per share
Proportion of earnings paid out in the
form of cash dividends
Dividend coverage
Earnings per share
Dividends per share
Number of times a dividend could be
paid based on earnings
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Percentage of earnings
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2010
2006
2002
0%
1998
0%
1994
1%
1990
20%
1986
3%
1982
60%
1978
Dividend payout
1974
4%
1970
80%
1966
Yield
40%
1962
2010
2006
2002
1998
1994
1990
1986
1982
1978
1974
1970
1966
1962
2010
2006
2002
1998
1994
1990
1986
1982
1978
1974
1970
1966
1962
Per share
Johnson & Johnson’s Dividend
DPS
$3.0
$2.5
$2.0
$1.5
$1.0
$0.5
$0.0
Dividend yield
2%
Source of data: Standard & Poor’s Compustat
What Do We Know about
Dividends?
 Observation 1: Dividends follow earnings.

We observe that many companies do not vary their
dividend each period based on their performance,
but rather smooth the dividends over time so that
they grow from year to year at a constant rate.
 Observation 2: Dividends are

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sticky.
We observe that companies are reluctant to cut
dividends when earnings decline, perhaps because
of the anticipated market reaction to a dividend cut.
1962
1965
1968
1971
1974
1977
1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
2010
Amount per share
Johnson & Johnson: EPS & DPS
EPS
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DPS
$6
$5
$4
$3
$2
$1
$0
Summary
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Corporations may distribute funds to owners by paying
dividends or buying back shares in a share repurchase.
Corporations may also provide shareholders with
additional shares either through a stock dividend or a
stock split, but both of these transactions are merely
slicing the equity “pie” into more pieces.
Investors tend to react favorably to dividend initiations
and increases and react unfavorably to dividend cuts or
omissions. We gauge investors’ reaction to these
dividend decisions by looking at the stock price
movements associated with dividend policy changes.
Summary

There are various theories and explanations for why
companies pay dividends:

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Residual theory - companies pay dividends when they have no
profitable investment opportunities)
Agency theory - by paying dividends, companies have to go to the
capital market more often, and are therefore monitored more
often
The “bird in the hand” explanation - investors prefer the certain
cash flow of dividends to the uncertain price appreciation s
Signaling - by committing to paying more dividends, the
company’s management is signaling that the company will be
able to sustain this dividend into the future
The dividend tax clientele explanation - some investors prefer
dividends because of their tax situation, whereas others do not
Summary
 We observe
that companies that do pay
dividends do so on a regular basis, either
with dividends increasing at a relatively
constant rate or a dividend payout rate
that is consistent over time.
 However, in tough economic periods, some
companies do cut their dividend and wait to
restore their dividend until the economy—and
company—has recovered.
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