November 26, 2014

Chapter 14. Dividend Policy

Chapter 14 -- Dividend Policy

. Dividend vs. retained earnings
. Dividend policy: three basic views
. The clientele effect
. The information content or signaling hypothesis
. Dividend policy in practice
. Dividend payment procedures
. Factors influencing dividend policy
. Stock repurchase, stock dividends and stock splits

. Dividend vs. retained earnings

 Dividend payout ratio vs. profit retention ratio: a review

 Higher dividends mean lower retained earnings, which means lower growth rate
and less capital gains

. Dividend policy: three basic views

 Dividend policy: to determine the optimal payout ratio to maximize the stock price

 View 1: dividend policy is irrelevant (Irrelevance Theory by MM 1961)

Assumptions: perfect capital markets with no taxes, no transaction costs, no
flotation costs, etc.

 Result: dividend policy doesn't matter; dividend policy does not affect a firm ‘s
value or its overall cost of capital

 View 2: high dividends increase stock price (Bird-in-the-hand theory 1979)

 Result: investors feel more secure to receive cash dividends than the income from
capital gains. Therefore, the higher the cash dividend, the better the stock

 View 3: low dividends increase stock price (Tax differential theory 1979)

 The tax rates on cash dividends were higher than the tax rates on long-term
capital gains before 2003. In addition, capital gains tax can be delayed until the
stocks are sold (time value of money) or can be avoid if stocks are passed to
beneficiaries provided the original owner passes away.

 Result: the lower the cash dividend, the better the stock

. The clientele effect

 Different dividend policies will attract different investors

. The information content or signaling hypothesis

 Information asymmetry: insiders and outsiders have different information

 Dividends reveal some inside information about firm's future profitability. By
increasing dividends, managers signal to the market that the firm will have enough
earnings to support future projects.

 Result: an increase in dividend is regarded as a good signal, which causes the stock

 price to go up.

. Dividend policy in practice

 Residual dividend model

 A model that states that the dividends to be paid should equal to the capital left over
after financing of profitable investments.


 Constant dividend payout ratio

 Stable dividend per share

 Low regular dividend plus extras when time is good

. Dividend payment procedure

 Declaration date

 Holder-of record date

 Ex-dividend date: two business days prior to the holder-of record date

 Payment date

 2 business   days

 Declaration Ex-div Record Payment

 Tax implications: if you buy the stock before Ex-dividend date, you will receive
dividend (but you pay a higher price); if you buy the stock after Ex-dividend date,
you will not receive dividend (but you pay a lower price).

. Factors influencing dividend policy


 Bond indenture

 Preferred stock restrictions

 Impairment of capital structure: dividends cannot exceed the balance sheet item R/E

 Availability of cash

 Penalty tax on improperly accumulated earnings

 Investment opportunities:

 Profitable investment opportunities

 Possibility of accelerating or delaying projects

 Alternative sources of capital:

 Cost of selling new stock

 Ability to substitute debt for equity

 Control of the company

 Effects of dividend policy on cost of equity

(1) Stockholders’ desire for current vs. future income
(2) The perceived riskiness of dividends vs. capital gains
(3) The tax advantage of capital gains
(4) The information (signaling) content

. Stock repurchase, stock dividend and stock splits

 Stock repurchase: transactions in which a firm buys back shares of its own stock


 Internal investment opportunity

 Decreasing the number of shares outstanding

 Changing capital structure

 Increase in EPS

 Changing the ownership

 Taking tax advantage

Stock dividend: a distribution of new shares to current stock holders based on a
pro rata basis. For example, a 20% stock dividend will give a shareholder with
100 shares additional 20 shares (usually in small percentages)

Stock splits: an action taken by a firm to increase the number of shares
outstanding. For example, a 2-for-1 stock split will give a shareholder with 100
shares additional 100 shares (usually for large percentages)

 After stock dividend or stock split, the number of shares outstanding increases,

 earnings per share, dividend per share, and stock price all decline

 Why stock dividends and/or stock splits?

 Conserve cash

 Optimal stock price range

 Positive signals

Higher total value

 Examples: APPLE is using stock buyback program to increase its stock price

MBA Core Management Knowledge - One Year Revision Schedule


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