Figure 14.1 Per Share Earnings and Dividends of the S&P500 Index. III. Figure 14.2 Aggregate Dividends and Repurchases for All U.S.

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1 I. The Basics of Payout Policy: A. The term payout policy refers to the decisions that a firm makes regarding whether to distribute cash to shareholders, how much cash to distribute, and the means by which cash should be distributed. II. Figure 14.1 Per Share Earnings and Dividends of the S&P500 Index III. Figure 14.2 Aggregate Dividends and Repurchases for All U.S.-Listed Companies What seems to be happening to the relationship?

2 IV. Matter of Fact A. Growth firms generally pay lower dividends. B. Share Repurchases Gain Worldwide Popularity C. A recent study of payout policy at firms from 25 different countries found that share repurchases rose at an annual rate of 19% from D. When business conditions are weak, companies are more likely to cut back on repurchases rather than dividends. V. Cash Dividend Payment Procedures A. At quarterly or semiannual meetings, a firm s board of directors decides whether and in what amount to pay cash dividends. B. Boards rarely cut dividends unless they believe that the firm s ability to generate cash is in serious jeopardy. VI. Figure 14.3 U.S. Firms Increasing or Decreasing Dividends

3 VII. Figure 14.4 Dividend Payment Time Line A. The date of record (dividends) is set by the firm s directors, the date on which all persons whose names are recorded as stockholders receive a declared dividend at a specified future time. B. A stock is ex dividend for a period, beginning 2 business days prior to the date of record, during which a stock is sold without the right to receive the current dividend. C. The payment date is set by the firm s directors, the actual date on which the firm mails the dividend payment to the holders of record. VIII. Share Repurchase Procedures A. Common methods for repurchasing shares include: 1. An open-market share repurchase 2. A tender offer repurchase - a firm offers to repurchase a fixed number of shares, usually at a premium, and shareholders decide whether or not they want to sell back their shares at that price.

4 3. A Dutch Auction repurchase is a repurchase method in which the firm specifies how many shares it wants to buy back and a range of prices at which it is willing to repurchase shares. IX. Tax Treatment of Dividends and Repurchases A. For many years, dividends and share repurchases had very different tax consequences. B. The dividends that investors received were generally taxed at ordinary income tax rates. C. On the other hand, when firms repurchased shares, the taxes triggered by that type of payout were generally much lower. D. Now this is different. X. Dividend Reinvestment Plans A. Dividend reinvestment plans (DRIPs) are plans that enable stockholders to use dividends received on the firm s stock to acquire additional shares even fractional shares at little or no transaction cost. XI. Stock Price Reactions to Corporate Payouts A. What happens to the stock price when a firm pays a dividend or repurchases shares? B. In theory, when a stock begins trading ex dividend, the stock price should fall by exactly the amount of the dividend. C. In theory, when a firm buys back shares at the going market price, the market price of the stock should remain the same. D. In practice, taxes and a variety of other market imperfections may cause the actual change in share price in response to a dividend payment or share repurchase to deviate from what we expect in theory.

5 XII. Relevance of Payout Policy A. The financial literature has reported numerous theories and empirical findings concerning payout policy. B. In other words, firms should not sacrifice good investment and financing decisions for a payout policy of questionable importance. C. The most important question about payout policy is this: Does payout policy have a significant effect on the value of a firm? XIII. Relevance of Payout Policy: Residual Theory of Dividends A. The residual theory of dividends is a school of thought that suggests that the dividend paid by a firm should be viewed as a residual the amount left over after all acceptable investment opportunities have been undertaken. B. Using the residual theory of dividends, the firm would treat the dividend decision in three steps, as follows: 1. Determine its optimal level of capital expenditures, which would be the level that exploits all of a firm s positive NPV projects. 2. Using the optimal capital structure proportions, estimate the total amount of equity financing needed to support the expenditures generated in Step Because the cost of retained earnings, r r, is less than the cost of new common stock, r n, use retained earnings to meet the equity requirement determined in Step 2. If retained earnings are inadequate to meet this need, sell new common stock. If the available retained earnings are in excess of this need, distribute the surplus amount the residual as dividends. How would this work Your company has a 30% debt capital structure. Next years RE is estimated to be 8 million. Capital budgeting requires funding at 10 million. How much debt will be used to fund capital budgeting? 30% of 10 million = 3 million How much equity is required 10 3 = 7 million. Where will the company get the equity? 8 million in RE 7 million need = 1 million remaining This is paid out as a dividend. What if RE is estimated to be 6 million? The company must issue equity and no dividends will be paid.

6 XIV. Relevance of Payout Policy: The Dividend Irrelevance Theory A. The dividend irrelevance theory is Miller and Modigliani s theory that in a perfect world, the firm s value is determined solely by the earning power and risk of its assets (investments) and that the manner in which it splits its earnings stream between dividends and internally retained (and reinvested) funds does not affect this value. 1. Dividends reflect the financing of the company. 2. Assets create value B. The clientele effect is the argument that different payout policies attract different types of investors but still do not change the value of the firm. 1. Tax-exempt investors may invest more heavily in firms that pay dividends because they are not affected by the typically higher tax rates on dividends. 2. Investors who would have to pay higher taxes on dividends may prefer to invest in firms that retain more earnings rather than paying dividends. 3. If a firm changes its payout policy, the value of the firm will not change what will change is the type of investor who holds the firm s shares. 4. Investors do not just care about the size of returns but also the form. 5. This probably has little impact now. The tax rates are the same. The only benefit to capital gains is the deferral of taxes.

7 XV. Relevance of Payout Policy: Arguments for Dividend Relevance A. Dividend relevance theory is the theory, advanced by Gordon and Lintner, that there is a direct relationship between a firm s dividend policy and its market value. B. The bird-in-the-hand argument is the belief, in support of dividend relevance theory, that investors see current dividends as less risky than future dividends or capital gains. C. Studies have shown that large changes in dividends do affect share price. 1. Informational content is the information provided by the dividends of a firm with respect to future earnings, which causes owners to bid up or down the price of the firm s stock. XVI. Factors Affecting Dividend Policy A. Dividend policy represents the firm s plan of action to be followed whenever it makes a dividend decision. B. First consider five factors in establishing a dividend policy: 1. legal constraints 2. contractual constraints 3. the firm s growth prospects 4. owner considerations 5. market considerations Constraints legal capital Contracts restrictive covenants Growth need cash Owners tax considerations Market reaction to the proposed changes

8 XVII. Types of Dividend Policies: A. Constant-Payout-Ratio Dividend Policy B. Regular Dividend Policy C. Low-Regular-and-Extra Dividend Policy Same ratio each quarter (uneven payout) Very similar dividend payout with potential growth (inflation) investors prefer this. Pay a very low dividend and then a bonus is announced. XVIII. Other Forms of Dividends A. A stock dividend is the payment, to existing owners, of a dividend in the form of stock. 1. In a stock dividend, investors simply receive additional shares in proportion to the shares they already own. B. A stock split is a method commonly used to lower the market price of a firm s stock by increasing the number of shares belonging to each shareholder. 1. Stock splits are often made prior to issuing additional stock to enhance that stock s marketability and stimulate market activity. No change in equity. Merely rearrange the pieces of pie in the ownership of the company. Each person maintains their ownership.

9 Stock dividends and splits are not taxed. The government says you are getting nothing of value.