Study Notes on Chapter 14: Dividends and Dividend Policy

Chapter 14: Dividends and Dividend Policy

Key Concepts and Skills

After studying this chapter, you should be able to:

  • Discuss different types of dividends and their payment mechanisms.
  • Explain the crucial issues concerning dividend policy decisions.
  • Differentiate between cash dividends and stock dividends.
  • Understand why share repurchases serve as an alternative to cash dividends.

Chapter Outline

  • 14-1 Cash Dividends and Dividend Payment
  • 14-2 Dividend Policy
  • 14-3 Stock Repurchase: An Alternative to Cash Dividends
  • 14-4 Stock Dividends, Stock Splits, & Reverse Splits
  • 14-5 Dividend Reinvestment Plans

14-1 Cash Dividends and Dividend Payment

Cash Dividends
  • Regular Cash Dividend
    • Definition: Cash payments made directly to stockholders, typically disbursed quarterly.
  • Extra Cash Dividend
    • Definition: A dividend that exceeds the regular cash dividend; suggests that the additional amount may not recur in future distributions.
  • Special Cash Dividend
    • Definition: A distinctive payment that is guaranteed not to be repeated.
  • Liquidating Dividend
    • Definition: Issued when some or all of the business has been sold.
Dividend Payment Chronology

The key dates in the cash dividend payment process include:

  1. Declaration Date: When the board of directors declares the dividend; it becomes a liability of the firm at this point.
  2. Ex-Dividend Date:
    • Definition: Occurs one business day before the date of record.
    • Implication: If stocks are purchased on or after this date, the buyer does not qualify for the upcoming dividend.
    • Price Behavior: Stock price typically decreases by approximately the amount of the dividend on this date.
  3. Date of Record: Determines the shareholders eligible to receive the dividend.
  4. Date of Payment: The actual date checks are mailed to dividend recipients.
Key Dates in Declaring and Paying Cash Dividends
  1. Declaration Date: Announcement date when the board reveals the dividend amount, the last day for ownership recording, and payment details.
  2. Ex-Dividend Date (informally ex-date): Establishes who is entitled to receive the dividend. The cutoff is one day before the date of record.
  3. Record Date: Date when the issuer tallies its shareholders of record for dividend payment eligibility.
  4. Payment Date: When the dividend payment is made to qualified shareholders.
The Ex-Dividend Day Price Drop
  • Price Behavior Example:
    • For a stock with a $1 cash dividend, the price drops from $10 to $9 on the ex-dividend date.
    • Before ex-date (Time -1): Dividend = $0; Price = $10.
    • On ex-date (Time 0): Dividend = $1; Price = $9.

14-2 Dividend Policy

Elements of Dividend Policy
  • High vs. Low Dividend Payout: Whether the firm will distribute a significant portion of earnings.
  • Stable vs. Irregular Dividends: Consistency in dividend payments over time.
  • Dividend Frequency: How often dividends will be disbursed, i.e., quarterly or annually.
  • Policy Announcement: Whether the firm will publicly declare its dividend policy.
Key Questions Regarding Dividend Policy
  • Should firms distribute a substantial portion of current funds as dividends?
  • Should these funds alternatively be reinvested in the business?
  • Is there an optimal dividend policy?
  • Does dividend policy have an actual impact on a firm's overall value?
Dividend Clienteles
  • Investor categories vary in their dividend preference:
    • Older, Retired Investors: Generally favor regular dividends as a source of income for living expenses.
    • Wealthier Investors: Prefer lower dividends due to the tax implications associated with receiving dividends.
    • Past dividend policies shape current investor clienteles, making changes in policies challenging due to potential negative tax and brokerage costs for investors switching firms.
Dividend Policy Irrelevance
  • Hypothesis: In an ideal world (no taxes, no transaction costs), dividend policy is irrelevant.
    • If a firm declares a dividend, the stock price decreases accordingly, meaning total shareholder value does not change—the dividend merely constitutes a return of capital.
Reasons Favoring a Low- or No-Dividend-Payout Policy
  1. Tax Avoidance: Shareholders can defer taxes on distributions until capital gains are realized.
  2. Potential Higher Future Returns: Firms can reinvest profits into projects with a positive net present value (NPV).
  3. Reduction of External Funding Need: Lower reliance on costly outside funds as profits are retained.
Reasons Favoring a High-Dividend-Payout Policy
  1. No Transaction Costs: Receiving dividends incurs no brokerage fees unlike selling shares.
  2. Certainty: Dividends provide immediate payments, whereas capital gains are uncertain and depend on future performance.
Optimal Dividend Policy
  • No single dividend policy is optimal for all investors due to varying marginal tax rates, income needs, and future stock price expectations. The best policy is the one that aligns with the interests of the majority of shareholders.
    • Example: Some investors favor high dividend payouts (e.g., BRKA versus high-dividend stocks).
Selecting a Dividend Policy
  • Residual Dividend Policy:
    • Retain earnings necessary to fund capital projects and distribute the remaining earnings as dividends.
    • Minimizes flotation costs and signaling issues, thus reducing the overall weighted average cost of capital (WACC).
    • Dividend per share may vary year by year under this policy.
  • Sticky Dividend Policy:
    • Maintains a constant dividend per share over several quarters to avoid misleading market signals.

14-3 Stock Repurchase

Overview of Stock Repurchase
  • Definition: A firm buying back its own shares.
    • Open Market: Shares bought in the open market.
    • Tender Offer: Offers to buy shares at a specified price and quantity.
    • Targeted Repurchase: Buys shares directly from selected individual shareholders.
Comparison of Repurchase and Cash Dividend
  • A stock repurchase is conceptually similar to a cash dividend regarding returning funds to shareholders, assuming no taxes and transaction costs are applied.
Popularity of Stock Repurchases
  • Recent trends indicate a significant increase in stock repurchases among publicly held U.S. firms from 1971 to 2020.
  • The dynamics of dividends and stock repurchases have shifted, showing varying levels of attractiveness to firms over the years.

14-4 Stock Dividends, Stock Splits, & Reverse Splits

Stock Dividends
  • Definition: Payments made in the form of shares to existing shareholders, up to a maximum value equal to 25% of the stock value.
    • Example: A maximum stock dividend equates to 1 additional share for every 4 shares owned.
    • Impact: No significant change in overall wealth; purely a paper transaction.
Stock Splits
  • Definition: Increase in the number of shares outstanding while proportionately decreasing the stock price by the split ratio.
    • Example: A 2:1 split doubles the number of shares (100 to 200) and reduces the price (from $40 to $20).
    • Impact: Does not materially change an investor's wealth; serves as an accounting method.
Reasons for Stock Splits
  1. Preferred Trading Range: Many splits occur to keep stock prices within a desirable trading range ($25-$40).
  2. Positive Signal: Signals strong performance and confident future outlook to investors.
  3. Increased Liquidity: More shares traded can increase liquidity and facilitate needy trading.
Reverse Splits
  • Definition: Reduction of the number of shares with a corresponding increase in stock price.
    • Example: A 1:3 reverse split converts 3 shares into 1 share worth $12.
    • Purpose: To increase share price to comply with listing requirements or to avoid delisting.

14-5 Dividend Reinvestment Plans (DRIPs)

Overview of DRIPs
  • Definition: Programs that allow investors to reinvest dividends in additional shares of stock.
  • Types of DRIPs:
    1. Company-Run Programs: Managed by the company's investor relations department.
    2. Transfer-Agent Programs: Run by financial institutions on behalf of companies.
    3. Brokerage Programs: Options provided by brokerage firms for clients to reinvest dividends.
Example of a DRIP Calculation
  • Scenario: Joan Watson owns 1,000 shares with a quarterly dividend of $0.25 per share:
    • Total dividend: $1,000 × $0.25 = $250.
    • If she chooses to reinvest, this amount buys additional shares based on the current stock price (ex-dividend) of $25.00.