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Topics Covered
The Choice of Payout Policy Types of Dividends How Firms Pay Dividends and Repurchase Stock The Dividend Decision Dividend Policy Irrelevancy of Dividends The Clientele Effect The Si nalin Effect Ta!es and Dividend Policy Dividends and " ent#Principle conflicts Information Content of Dividends $arious Hypotheses of Dividend Policy Share Repurchases

Types of Dividends
Cash Div Re ular Cash Div Special Cash Div Stock Div Stock Repurchase %& methods'
() *uy shares on the market +) Tender ,ffer to Shareholders -) Dutch "uction &) Private .e otiation %/reen 0ail'

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Dividend Payments
Cash Dividend # Payment of cash 2y the firm to its shareholders) Ex-Dividend Date # Date that determines whether a stockholder is entitled to a dividend payment1 anyone holdin stock 2efore this date is entitled to a dividend) Record Date # Person who owns stock on this date received the dividend)

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Dividend Payments
Stock Dividend # Distri2ution of additional shares to a firm3s stockholders) Stock Splits # Issue of additional shares to firm3s stockholders) Stock Repurchase # Firm 2uys 2ack stock from its shareholders)

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The Dividend Decision


Lintners Stylized Facts (How Dividends are Determined)
() Firms have lon er term tar et dividend payout ratios) +) 0ana ers focus more on dividend chan es than on a2solute levels) -) Dividends chan es follow shifts in lon #run4 sustaina2le levels of earnin s rather than short#run chan es in earnin s) &) 0ana ers are reluctant to make dividend chan es that mi ht have to 2e reversed) 5) Firms repurchase stock when they have accumulated a lar e amount of unwanted cash or wish to chan e their capital structure 2y replacin e6uity with de2t)

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Dividend Decisions
Dividend Decision Survey (2004)

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Executives who agree or strongly agree (%)

The Dividend Decision


"ttitudes concernin dividend tar ets vary
DI$ DI$ = tar tar et etdividend dividend (( = = = tar tar et etratio ratio EPS EPS ((

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Dividend Chan e
DI$ DI$ DI$ = tar tar et etchan chan e e ((##DI$ 77 = = = tar tar et etratio ratio EPS EPS DI$ (( ##DI$ 77

The Dividend Decision


Dividend chan es confirm the followin

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DI$ DI$ DI$ =ad8ustment ad8ustmentrate rate tar tar et etchan chan ee ((##DI$ 77 = = =ad8ustment ad8ustmentrate rate ( (tar tar et etratio ratio EPS EPS DI$ ((##DI$ 77) )

Dividend Policy
Impact of Dividend Changes on EPS
Change EPS/Price at t = 0 as %

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Year Source: Healy & Pale u (!"##)

Dividend Policy
*efore Dividend "fter Dividend .ew stockholders Total value of firm
Each share worth this 2efore 9 9 and worth this after

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,ld stockholders

Total num2er of shares

Total num2er of shares

$%am le o& !'(rd o& wort) aid as dividend and raisin* money via new s)ares

Dividend Policy
Dividend financed 2y stock issue .o dividend4 no stock issue

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#e$ stockholders
Shares Cash

#e$ stockholders

ir!
Cash

Cash

Shares

"ld stockholders

"ld stockholders

Dividend Policy is Irrelevant


Since investors do not need dividends to convert shares to cash they will not pay hi her prices for firms with hi her dividend payouts) In other words4 dividend policy will have no impact on the value of the firm)

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Dividend Policy is Irrelevant


Exa!ple # "ssume Rational Demiconductor has no e!tra cash4 2ut declares a :(4777 dividend) They also re6uire :(4777 for current investment needs) ;sin 0<0 Theory4 and iven the followin 2alance sheet information4 show how the value of the firm is not altered when new shares are issued to pay for the dividend)

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Record Date Cash %&000 "sset $alue '&000 Total $alue %0&000 ( .ew Pro8 .P$ )&000 = of Shares %&000 price>share *%)

Dividend Policy is Irrelevant


Exa!ple # "ssume Rational Demiconductor has no e!tra cash4 2ut declares a :(4777 dividend) They also re6uire :(4777 for current investment needs) ;sin 0<0 Theory4 and iven the followin 2alance sheet information4 show how the value of the firm is not altered when new shares are issued to pay for the dividend)

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Record Date Cash (4777 "sset $alue ?4777 Total $alue (74777 @ .ew Pro8 .P$ +4777 = of Shares (4777 price>share :(+

P!t Date 0 '&000 '&000 )&000 %&000 *%%

Dividend Policy is Irrelevant


Exa!ple # "ssume Rational Demiconductor has no e!tra cash4 2ut declares a :(4777 dividend) They also re6uire :(4777 for current investment needs) ;sin 0<0 Theory4 and iven the followin 2alance sheet information4 show how the value of the firm is not altered when new shares are issued to pay for the dividend)

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Record Date Cash (4777 "sset $alue ?4777 Total $alue (74777 @ .ew Pro8 .P$ +4777 = of Shares (4777 price>share :(+

Pmt Date 7 ?4777 ?4777 +4777 (4777 :((

Post P!t %&000 +'% sh , *%%'&000 %0&000 )&000 %&0'% *%%

#E. S/0RES 0RE 1SS2ED

Dividend Policy is Irrelevant


Exa!ple # continued # Shareholder $alue Record (+4777 7 (+4777

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Stock Cash Total $alue

Stock A (4777 sh B :(+ A (+4777

Dividend Policy is Irrelevant


Exa!ple # continued # Shareholder $alue Record (+4777 7 (+4777 Pmt ((4777 (4777 (+4777

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Stock Cash Total $alue

Stock = %&000sh , *%% = %%&000

Dividend Policy is Irrelevant


Exa!ple # continued # Shareholder $alue Record (+4777 7 (+4777 Pmt ((4777 (4777 (+4777 Post %)&000 0 %)&000

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Stock Cash Total $alue

Stock = %&0'%sh , *%%3 = %)&000 "ssume stockholders purchase the new issue with the cash dividend proceeds)

Dividends Increase $alue


4arket 1!per5ections and Clientele E55ect There are natural clients for hi h#payout stocks4 2ut it does not follow that any particular firm can 2enefit 2y increasin its dividends) The hi h dividend clientele already have plenty of hi h dividend stock to choose from) These clients increase the price of the stock throu h their demand for a dividend payin stock)

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Dividends Increase $alue


Dividends as Signals Dividend increases send ood news a2out cash flows and earnin s) Dividend cuts send 2ad news) *ecause a hi h dividend payout policy will 2e costly to firms that do not have the cash flow to support it4 dividend increases si nal a company3s ood fortune and its mana er3s confidence in future cash flows)

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Dividends Decrease $alue


6ax Conse7uences Companies can convert dividends into capital ains 2y shiftin their dividend policies) If dividends are ta!ed more heavily than capital ains4 ta!payin investors should welcome such a move and value the firm more favora2ly) In such a ta! environment4 the total cash flow retained 2y the firm and>or held 2y shareholders will 2e hi her than if dividends are paid) Please read the paper %"slam4 "riff < Shamsher4 +7(+' distri2uted in the classC

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Ta!es and Dividend Policy


Since capital ains are ta!ed at a lower rate than dividend income4 companies should pay the lowest dividend possi2le) Dividend policy should ad8ust to chan es in the ta! code)

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Do ta!es and transaction costs affect dividend policyD


If there are ta!es %dividends and capital ains4 and capital ains ta! is lower' and transaction costs4 then firms with profita2le investment opportunities usually refrain from payin dividends) How to e!amine the chan e in stock prices as it oes e!#dividendE # %Price 2efore F Price after' A DPS G%(# ta! dividend' > %(# ta! capital ains'H # Implication F investors with hi h dividend ta! will invest in low dividend yield stocks and investors with lower dividend ta!es will invest in hi her dividend yield stocksC

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Ta!es and Dividend Policy


Firm " %no dividend' ((+)57 7 ((+)57 (77 (+)57
(+)5 (77

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.e!t yearL s price Dividend Total preta! payoff TodayL s stock price Capital ain Preta! rate of return %I' Ta! on div B 57I Ta! on Cap /ain B +7I Total "fter Ta! income %div + cap ain # ta!es' "fter ta! rate of return %I'

Firm * %hi h dividend' (7+)57 (7 ((+)57 ?J)JK &)J+


(&)J+ ?J)JK

(77 = (+)5

(77 = (5)75

7 )+7 (+)57 = +)57 %7 + (+)57' +)57 = (7


(7 (77

)&7 (7 = &)77 )+7 &)J+ = 7)?& %(7 &)J+' %& + 7)?&' = ?)JK
?)JK ?J)JK

(77 = (7)7

(77 = (7)7

Ta!es and Dividend Policy


In ;)S)4 shareholders are ta!ed twice %fi ures in dollars'

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Ta!es and Dividend Policy


;nder imputed ta! systems4 such as that in "ustralia4 Shareholders receive a ta! credit for the corporate ta! the firm pays %fi ures in "ustralian dollars'
+ate o& ,ncome ta%
%3% ,peratin Income Corporate ta! %TcA)-7' "fter Ta! income /rossed up Dividend Income ta! Ta! credit for Corp Pmt Ta! due from shareholder Cash to Shareholder (77 -7 J7 (77 (5 #-7 #(5 K5 80% (77 -7 J7 (77 -7 #-7 7 J7 9:% (77 -7 J7 (77 &J #-7 (J 5-

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Dividends and Principal#" ent Conflicts

Two ma8or principal#a ent pro2lems attend to the dividend policyE # Free cash flow pro2lem
F 0ana ement incentive to increase siMe of the firm and earn hi her perks and salaries %therefore reduce dividends' F "lso makes the firm comple! and therefore difficult to fire current mana ement%entrenchment incentive' F *ut for firms with no Nfree cash flows3 %2ecause profita2le opportunities4 or the e!penditures e!ceed availa2le cash' pay less or no dividends

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Dividends and Principal#" ent Conflicts

# E!propriate wealth from its creditors


F # *y increasin dividends4 mana ement can reduce assets a ainst which the creditors of the firm have priority claims) F ;nderinvestment pro2lem F if firm has risky de2ts and profita2le investment opportunities4 mana ement %actin in the interest of shareholders' will pay dividends %and sacrifice investments' if investments do not 2enefit the shareholders 2ut %and also' the creditors

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Information content of dividend chan es ,n avera e4 market reacts positively to dividend increase announcements and ne atively to dividends cut9whyD This is perceived as the mana ement3s assessment of the lon #term earnin s prospects of the firm 0ana ement are conservative4 increase dividends only when they can maintain it) Ohen can dividend increase is 2ad news and dividend decrease is ood newsD

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Information "symmetry and Si nalin Dividends

Si nalin is 2ased on the premise thatE


F Firms of hi h value cannot convey the value to the market 2ecause the info is strate ic in nature and if divul e will ive undue advanta e to competitors F Firms need to devise an afforda2le and credi2le si nal of its hi h valuation4 one that lower#value firms will find e!pensive to mimic F Dividends are an effective si nal of a firm3s true value in a market 2eset 2y info asymmetry

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Hypotheses
Cash flow si nalin hypothesis# posits positive relationship 2etween dividend chan es and capital e!penditure chan es) Free Cash Flow Hypothesis F posits that dividends increase is ood news 2ecause the firm3s mana ement is 2ein disciplined to pay hi her dividends and reduce wasteful capital e!penditures4 whereas a dividend decrease is 2ad news as mana ement has more free cash flows to waste on unprofita2le investments) Therefore there is ne ative relationship 2etween dividend chan es and capital e!penditures) Information Content Hypothesis F posits that the announcement conveys info a2out the value of the firm# hi her than market e!pected in case of dividend increase and lower than market e!pected in case of dividend decrease) Oealth Redistri2ution Hypothesis F posits that a dividend increase is an e!propriation of wealth from creditors to shareholders and dividend decrease is e!propriation of wealth from shareholders to creditors)

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Share Repurchases 0ethodsE


F ,pen#0arket Repurchase %,0R'F on radual 2asis F Dutch "uction Self#Tender F Fi!ed Price Self Tender Potential effects of share repurchasesE # Firm3s cash assets are reduced
# Firm3s e6uity 2ase is reduced # For levered firm4 the levera e increases # Increase in the stock price due to increase in demand for shares # Increase li6uidity # Reduce li6uidity as num2er of free#float shares are reduced or in case of ,0R as they face the firm as on# oin informed trader

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Case < "rticles


CaseE
E0I /roup Plc %Refer to Pa es -P-# -K7' of the *ook4 Case Studies in FinanceE 0ana in for Corporate $alue Creation4 2y Ro2ert F) *runer4 Qenneth 0) Eades and 0ichael R) Schill4 Pth Edition4 0c/raw#Hill International Edition4 +7(7') "rticlesE () /raham4 Harvey and 0ichaely4 SPayout policy in the +(st CenturyT4 Rournal of Financial Economics JJ4 Septem2er +7754 ppE&K-#5+J) +) U) /rinstein and R) 0ichaely4 SInstitutional Holdin s and Payout PolicyT4 Rournal of Finance P74 %Rune +775'4 ppE (-K?#(&+P) -) R)R) /raham and ") Qumar4 S Do Dividend Clienteles E!istD Evidence on Dividend Preferences of Retail InvestorsT4 Rournal of Finance P( %Rune +77P'4 ppE (-75#(--P)