Practical financial management lasher 7th ed chapter 015

Understanding the Dividend DecisionThe Discretionary Nature of Dividends – Board of Directors determines the dividend Can be more than earnings or nothing The Dividend Decision – Whether

Chapter 15 Dividends

Dividends as a Basis for Value

– Dividends are important in determining stock value

Individual investors buy stocks expecting dividends and price appreciation

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Understanding the Dividend Decision

The Discretionary Nature of Dividends

– Board of Directors determines the dividend

Can be more than earnings or nothing

The Dividend Decision

– Whether to pay cash dividends or retain earnings for growth

Current income

Deferred income

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The Dividend Controversy

Does paying or not paying dividends affect stock price?

Do stockholders prefer current or deferred income?

Three arguments regarding investors’ preferences for or against dividends

1 Dividend Irrelevance

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Dividend Irrelevance

Most theorists say dividends matter very little to stock price

– Value of eliminated early dividends is offset by growth-created value in the future

– In valuation equation loss of D1, D2 … is made up by gains in later Di (i = 1, 2,…n) and

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Concept Connection Example 15-3 Tailoring the Income Stream

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The Winters are retirees with most of their savings invested in 10,000 shares of Ajax Corporation (AJAX) AJAX sells for $10 per share and pays an annual dividend of $0.50 per share

This year AJAX eliminated the dividend, but began to grow at 5% a year due to the

reinvested earnings

How can the Winters maintain their income and their position in AJAX?

Concept Connection Example 15-3 Tailoring the Income Stream

Original value of the Winters’ AJAX shares

– Dividends are taxed as ordinary income

– Appreciation is taxed as a capital gain

The View from Within the Company

– Dividends represent a cash outflow

– Firms prefer not paying dividends if it avoids selling new stock

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Dividend Preference

Investors prefer immediate cash to uncertain future benefits

– Poor management may waste the funds rather than using effectively for growth

Inconsistency in theory:

– If investors are worried about management not using resources effectively, why did they invest in the firm in the first place?

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Dividend Aversion

Investors prefer future capital gains to current dividends because of tax rates

– Price appreciation taxed as capital gain

– Dividends taxed as ordinary income

Argument hinges on current tax rates on dividend income vs capital gains income

– Capital gains taxes are not paid until stock is sold so taxes are deferred

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Other Theories and Ideas

The Clientele Effect

– Investors choose stocks for dividend policy so any change in payments policy is disruptive

The Residual Dividend Theory

– Dividends are paid from earnings only after viable projects are funded

The Signaling Effect of Dividends

– Cash dividends signal management’s confidence

The Expectations Theory

– A refinement of the signaling effect

– Dividends that fail to fulfill stockholders’ expectations send a negative message even if the payment is good

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Legal and Contractual Restrictions

on Dividends

Legal Restrictions

Dividends can’t be paid out of

contributed capital – must come from

Cumulative feature of preferred stock limits dividend payments

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– The constancy of dividends over time

– A stable dividend is non-decreasing

– A dividend with a stable growth rate increases at a fairly constant growth rate

EPS

share per

dividend earnings

dividend ratio

Alternate Policies

Target Payout Ratio

– Firm selects a long-run target payout ratio

Stable Dividends Per Share

– A constant dividend is paid regardless of earnings

Small Regular Dividend with a Year-End Extra if Earnings Permit

– An effort to avoid the signaling effect

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The Mechanics of Dividend Payments

Each quarterly dividend has key dates:

– Declaration Date: Date the board authorizes the dividend

– Date of Record: Date by which you must be an owner to receive the dividend

– Payment Date: Date on which the dividend will actually be paid – check in the mail

– Ex-Dividend Date: Date from which new stock buyers no longer receive the dividend

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Figure 15.1 The Dividend Declaration and Payment Process

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Dividend Reinvestment Plans

Large companies offer automatic dividend reinvestment plans (DRIPs) to stockholders

– Instead of receiving cash dividends, the stockholder receives additional shares

– The payment is taxable

– Don’t confuse with stock dividend

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Stock Splits and Dividends

Stock Split

– Stockholders issued new shares in

proportion to current holdings

– No change in proportionate

ownership of company

– Reverse splits also possible

Stock Dividend

– Similar to stock split

– Called a stock dividend if the number of new shares is less than or equal to 20% of previously outstanding shares

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Rationale for Stock Splits and

Stock Dividends

Stock Split

Trading Range Argument for splits

– Splits keep stock prices in a trading

range: accessible to small investors

Stock usually split when prices are

increasing

– May give false impression that

price increase is from split

– Employed to send a positive message

– Doesn’t really give shareholders anything

Effect On Price And Value

Splits and stock dividends increase shares outstanding without changing economic value of the underlying company

– Have no real economic effect

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Accounting for a Stock Split

Accounting for a Stock Dividend

Stock Repurchases

Alternative to Dividend

– Firms with cash on hand can pay dividends or repurchase their own stock

Repurchase reduces the number of shares outstanding and increases EPS

Remaining shares will increase in value if the market maintains the P/E ratio after the repurchase

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Johnson has $1 million in cash to distribute to stockholders

Per share dividend

$1,000,000 / 2,500,000 = $0.40 per share

If Johnson repurchases shares instead it will retire

$1,000,000 / $20 = 50,000 shares leaving 2,450,000 shares outstanding

Stock Repurchases

Methods of Repurchasing Shares

– Buy on open market – easiest method

– Tender offer – buy shares at a set price offered to interested stockholders

– Negotiated deal – buy from a large investor who owns a block of stock

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Other Repurchase Issues

Opportunistic Repurchase

– Stock is temporarily undervalued

Repurchase to Dispose of Excess Cash

– Distributes cash without a signaling effect

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Other Repurchase Issues

Taxes

– Occasional stock repurchases can benefit stockholders because capital gains tax rates may be lower than ordinary rates

Repurchases to Restructure Capital

– Borrowing money to repurchase stock raises leverage level and debt ratio

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