Practical financial managment 7e LASHER chapter 15

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

Chapter 15 Dividends

Dividends as a Basis for Value

– Dividends are important in determining stock value

Individual investors buy stocks expecting dividends and price

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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

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 Pn

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Concept Connection Example 15-3

Tailoring the Income Stream

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

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?

9

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

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 retained earnings

Insolvent firms can’t

pay dividends

Contractual Restrictions

Loan indentures and covenants may limit dividend payments to protect creditors’ interests

Cumulative feature of preferred stock limits dividend payments

– 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

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

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

17

Stock Splits and Dividends

dividend if the number

of new shares is less than or equal to 20%

of previously outstanding shares

Rationale for Stock Splits and

Stock usually split when

prices are increasing

– May give false

impression that price

increase is from split

Stock Dividend

Giving Something that Doesn’t Cost Anything– Stock dividends are an attempt at signaling

– 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

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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Concept Connection Example 15-6

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

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