F T9 Dividend Policy

Key Concepts and Skills in Dividend Policy

• Understand the various types of dividends and the mechanisms of how they are paid to shareholders.

• Analyze the critical issues and decision-making processes surrounding dividend policy.

• Evaluate the differences between cash dividends and stock dividends.

• Identify why share repurchases serve as a viable alternative to cash dividends.

Cash Dividends and Their Forms

• Definition: The term "dividend" typically refers to cash paid out of a firm’s earnings to its shareholders.

• Regular Cash Dividends: These are cash payments made directly to stockholders, occurring on a regular basis, usually each quarter.

• Extra Cash Dividends: These represent a payment over the regular amount. The use of the word "extra" serves as an indication to shareholders that this specific amount may not be repeated in the future.

• Special Dividends: These are similar to extra dividends but are designated as unusual or one-time events that will definitely not be repeated.

• Liquidating Dividends: These occur when some or all of the business has been sold off, and the proceeds are distributed to shareholders.

Cash Dividend Payment Procedures and Expressions

• Decision Authority: The decision to pay a dividend rests solely with the corporation's Board of Directors.

• Legal Liability: Once a dividend has been declared by the board, it becomes a formal liability of the firm and cannot be easily rescinded.

• Methods of Expression:

  • Dividends Per Share (DPS): Expressed as dollars per share (e.g., $0.17$ per share).

  • Dividend Yield: Expressed as a percentage of the market price.

  • Dividend Payout: Expressed as a percentage of net income or earnings per share.

Dividend Payment Chronology

• Declaration Date: The date on which the Board of Directors passes a resolution to pay a dividend. At this point, the dividend becomes a liability.

• Ex-Dividend Date:

  • This occurs two business days before the Date of Record.

  • If an investor purchases stock on or after this date, they will not receive the upcoming dividend.

  • The stock price generally drops by approximately the amount of the dividend on this date.

• Date of Record: The date on which the company determines the "holders of record." You must be a shareholder on this specific date to be eligible for the dividend.

• Date of Payment: The date on which the dividend checks are actually mailed or electronic transfers are made.

Case Study: Best Buy Dividend Chronology (2013)

• Timeline Details:

  • Declaration Date: Wednesday, August 21, 2013. The board announced a quarterly cash dividend of $0.17$ per share.

  • Ex-Dividend Date: Friday, September 6, 2013. This is two business days before the record date.

  • Date of Record: Tuesday, September 10, 2013.

  • Payment Date: Tuesday, October 1, 2013.

• Volume and Total Payout: At the time, Best Buy had $341 \times 10^6$ shares of common stock outstanding. Total payment calculation: $341 \times 10^6 \times 0.17 = 58 \times 10^6$ ($58$ million).

• Accounting Impact (Dollar values in thousands):

  • Pre-Declaration: Cash = $680,000$, Dividends Payable = $0$, Retained Earnings = $3,395,000$.

  • Post-Announcement: Cash = $680,000$, Dividends Payable = $58,000$, Retained Earnings = $3,337,000$ (Retained earnings reduced by the declared amount).

  • Post-Payment (October 26): Cash = $622,000$, Dividends Payable = $0$, Retained Earnings = $3,337,000$.

  • Net Effect: The total assets and stockholders' equity of the firm were reduced by $58$ million.

The Ex-Dividend Day Price Drop

• In a theoretical world, the stock price will fall by exactly the amount of the dividend on the ex-dividend date.

• Example: If the price is $10$ at Time $-1$ (before the ex-date) and the dividend is $1$, the price will be $10 - 1 = 9$ at Time $0$ (the ex-date).

Theories on Dividend Policy Relevance

• Dividends Matter: The value of a stock is essentially the present value of all expected future dividends.

• Dividend Policy May Not Matter: This theory suggests that the decision to pay dividends versus retaining funds is secondary. If a firm reinvests capital now instead of paying it out, it may grow faster and pay even higher dividends in the future, offsetting the current lack of payout.

Factors Influencing Payout Policy

• Factors Favoring Low Payout:

  • Taxes: Individuals in high tax brackets may prefer capital gains (taxed later) over immediate cash dividends.

  • Flotation Costs: Paying low dividends allows the firm to retain more cash, reducing the need to issue new stock and incurring associated flotation costs.

  • Dividend Restrictions: Bond indentures or debt covenants often limit the amount of dividends a firm can pay to protect creditors.

• Factors Favoring High Payout:

  • Tax Brackets: Investors in low tax brackets or tax-exempt investors (like pension funds) may prefer current income.

  • Legal Restrictions: Some trusts and endowments are prohibited from spending the principal and rely solely on dividend income.

  • Uncertainty Resolution: Dividends provide a bird-in-the-hand; there is no guarantee that future dividends from reinvestment will materialize.

  • Corporate Investors: Corporations may receive a tax exclusion on dividends received from other corporations.

Clientele Effects

• Definition: Different groups of investors (clienteles) have different preferences for dividend yield.

• Market Equilibrium: Investors will gravitate toward companies whose dividend policies match their preferences (e.g., high-tax individuals seek low-growth/low-dividend stocks, while retirees might seek high-dividend stocks).

• Policy Changes: If a firm changes its policy, it may cause its current clientele to sell and a new clientele to buy, potentially causing temporary stock price volatility.

Stock Repurchases

• Methodology: A company uses its cash to buy back its own shares.

  • Open Market: The firm buys shares on the open market like any other investor.

  • Tender Offer: The firm announces a specific price and number of shares it wishes to buy; shareholders opt-in.

  • Targeted Repurchase: The firm buys back shares from specific, large shareholders.

• Comparison to Dividends: In the absence of taxes and transaction costs, a repurchase is equivalent to a cash dividend for the shareholder.

• Trends: Repurchases have gained massive popularity since the 1980s, often exceeding aggregate dividends in some years.

• Tax Advantages of Repurchases:

  • Timing: Investors decide when to sell and realize the tax consequence.

  • Tax Characterization: Returns are taxed as capital gains rather than ordinary income (which is often higher).

  • 2003 Tax Cut: Figure 14.5 shows a spike in dividend initiations following the 2003 tax cut which reduced the tax rate on dividends.

Managerial Perspectives and Signaling

• Dividend Smoothing: Managers are very reluctant to cut dividends. They prefer to raise them slowly as earnings grow to ensure the increase is sustainable.

• Information Content (Signaling):

  • Dividend Increase: Signals management's confidence in future earnings prospects.

  • Repurchase Announcement: Signals that management believes the stock is currently undervalued.

  • Tender Offer: A stronger positive signal than open market repurchases because the price is specified.

• Survey Results (Table 14.1):

  • $93.8\%$ of managers try to avoid reducing dividends per share.

  • $89.6\%$ try to maintain a smooth dividend from year to year.

  • $42.8\%$ consider the cost of raising external capital to be smaller than the cost of cutting dividends.

Pros and Cons of Paying Dividends

• Pros:

  • Underscores good results and supports the stock price.

  • Attracts institutional investors with "prudent man" restrictions.

  • Reduces agency costs by absorbing excess cash that might otherwise be wasted.

• Cons:

  • Dividends are taxed as ordinary income to recipients.

  • Reduces internal funding, potentially forcing the firm to forgo positive NPV projects or seek expensive external financing.

  • Dividend cuts are extremely difficult to make without damaging the stock price.

Stock Dividends

• Definition: Payment of a dividend in the form of additional shares of stock rather than cash.

• Accounting Classification:

  • Small Stock Dividend: Less than $20\%$ to $25\%$.

  • Large Stock Dividend: Greater than $20\%$ to $25\%$.

• Effect: No cash is distributed, and no real value is transferred. Ownership percentages remain identical.

• Garrison Corporation Example:

  • Original Equity: Common Stock ($4$ par, $100,000$ shares) = $400,000$; Paid-in capital = $600,000$; Retained earnings = $700,000$. Total = $2,000,000$.

  • $10\%$ Stock Dividend at $15$ market price:

  • New Shares = $10,000$.

  • New Common Stock = $400,000 + (10,000 \times 4) = 440,000$.

  • New Paid-in Capital = $600,000 + (10,000 \times (15-4)) = 710,000$.

  • New Retained Earnings = $700,000 - 150,000 = 550,000$.

  • Total Equity remains $2,000,000$.

• Individual Shareholder Impact (Ms. X):

  • Owned $10,000$ shares ($10\%$ of $100,000$) at $15$.

  • After $10\%$ dividend: owns $11,000$ shares ($10\%$ of $110,000$).

  • New Price per share = $15 \times (1.00 / 1.10) = 13.64$.

  • Total Market Value = $11,000 \times 13.6364 = 150,000$ (No change from original value).

Stock Splits and Reverse Splits

• Stock Split: Expressed as a ratio (e.g., $2$-for-$1$). It increases the number of shares and reduces the par value and market price per share.

  • Advanced Technology Inc. Example (3-for-1 split): Investor has $260$ shares at $60$ (Value = $15,600$). After split: Investor has $780$ shares at $20$ (Value = $15,600$). No tax liability is triggered by the split.

• Reverse Stock Split: Exchanging multiple old shares for one new share (e.g., $1$-for-$5$).

  • Reasons: To lower transaction costs, improve liquidity, meet exchange minimum price requirements, or appear more "respectable."

  • Example: $10$ million shares at $5$ each. After $1$-for-$5$ reverse split: $2$ million shares at $25$ each.

Questions & Discussion

• Quiz 1 (Trans World International):

  • Common stock ($1$ par) = $45,000$; Paid-in capital = $125,000$; Retained earnings = $580,000$. Market price = $42$.

  • Goal: Calculate effect of $10\%$ stock dividend.

  • Solution: $4,500$ new shares distributed. Common stock increases by $4,500 \times 1 = 4,500$. Paid-in capital increases by $4,500 \times 41 = 184,500$. Retained earnings decreases by $4,500 \times 42 = 189,000$.

• Quiz 2 (Bob/DEF Stock):

  • Bob owns $1,200$ shares at $90$ (Value = $108,000$).

  • $3$-for-$1$ split results in Bob owning $3,600$ shares at $30$. Total value remains $108,000$.

• Quiz 3 (Betty/GHI Stock):

  • Betty owns $3,600$ shares at $2$ (Value = $7,200$).

  • $1$-for-$5$ reverse split results in Betty owning $720$ shares at $10$. Total value remains $7,200$.