Chapter 17: Dividends and Dividend Policy

Dividend Policy: pay out shareholders or invest it for later

Cash Dividends and Dividend Payment
Dividend: payment made out of a firms earnings to its owners, either in the form of
cash or stock
Distribution: used in place of dividend when payment made by a firm to its owners
from sources other than current or accumulated earnings

Distribution from earnings -> dividend

Distribution from capital -> liquidating dividend

Types of Cash Dividends:

1.
2.
3.
4.

Regular cash dividends

Extra dividends
Special dividends
Liquidating dividends

Cash Dividends
Regular cash dividend: cash payment made by a firm to its owners in the normal
course of business, usually made 4 times a year
Extra cash dividend: by calling it extra management is indicating that it may or
may not be repeated in the future
Special dividend: viewed as truly unusual or one-time event and wont be repeated
Liquidating dividend: some or all of the business has been liquidated or sold of
Debt covenants: (imposes restrictions of the borrower) ofers firms creditors
protection against liquidating dividends that could violate their prior claim against
assets and cash flows
Cash dividends reduces corporate cash and retained earnings, except for liquidating
dividend (where capital may be reduced)
Standard Method of Cash Dividend Payment
Dollars per share -> dividends per share
Percentage of market price -> dividend yield
Percentage of earnings per share -> dividend payout

Dividend Payment: A Chronology

1. Declaration date: date on which the board of directors passes a resolution to
pay a dividend
2. Ex-dividend date: date that is 2 business days before the date of record,
establishing those individuals entitled to a dividend (removes any ambiguity
of who receives the dividend)
3. Date of record: date on which holders of record are designated to receive a
dividend
4. Date of payment: date of the dividend payment
More on the Ex-dividend Date
Expect value of a share of stock to go down by about the dividend amount when the
stock goes ex-dividend

Since dividends are taxed. The actual price drop might be closer to some
measure of the after-tax value of the dividend

Researchers have argued that due to personal taxes. Stock prices should fall by less
than the dividend
Does Dividend Policy Matter?
Dividend policy: the time pattern of a dividend payout
An Illustration of the Irrelevance of Dividend Policy
Current policy: dividends set equal to cash flow

Value of stock = present value of future dividends

PV of a share of stock =

Alternative policy: initial dividend is greater than cash flow

Issue new shares to raise amount for dividend, but new shareholders also
receive dividends
Using same formula but with 2 diferent dividend amount for date 1 and date
2 will give you the same PV

No matter what pattern of dividend payout is used, the value of the stock is always
the same some examples

Dividend policy makes no diference

Any increase in a dividend at some point in time is exactly ofset by a decrease

somewhere else, so the net efect, once we account for time value, is zero
Homemade dividends: idea that individual investors can undo corporate dividend
policy by reinvesting dividends or selling shares of stock

Many corporations actually assist shareholders with this by ofering

automatic dividend reinvestment plans
Gives discounts on new stock or the ability to buy without a brokers
commission

Stripped common shares: common stock on which dividends and capital gains are
repackaged and sold separately

Holders either receive all the dividends from one or a group of well-known
companies or an installment receipt that packages only capital gain in the
form of a call option

If the dividend per share at a given date is raised while the dividend per share at
each other date is held constant, the stock price rises (PV of future dividends must
go up if this occurs)
Dividend policy merely establishes the trade-of between dividends at one date and
dividends at another date
Real World Factors favoring a Low Payout
Taxes and flotation costs lead to preference of a low dividend payout
Taxes
In Canada, both dividends and capital gains are taxed at efective rate less than
marginal tax rates
Individual investors face a lower tax rate due to the dividend tax credit
Individual capital gains are taxed at 50% of marginal tax rate
Taxation only occurs when capital gains are realized

So capital gains are very lightly taxed in Canada

Capital gains are subject to lower taxes than dividends

Low payout means money is reinvested which increases the value of the firm and of
the equity

Net efect is that the capital gain portion of return is higher in the future

If the firm has excess cash after selecting all positive NPV projects, it may consider
the following alternatives:
1. Select additional capital budgeting projects: investing in negative NPV
projects; example of agency costs of equity
Are ripe for takeover, leverage buyouts, and proxy fights (attempts to
gain control of a firm by soliciting a sufficient number of shareholder
votes to replace existing board of directors)
2. Repurchase shares: in Canada and the US, investors can treat profits on
repurchased stock in public companies as capital gains and pay somewhat
lower taxes than they would if the cash were distributed as a dividend
3. Acquire other companies: acquire profitable assets, incur heavy costs, made
above market price, 20% - 80% premiums, not profitable most of the time
4. Purchase financial assets: dividend payout decision depends on personal and
corporate tax rates
Personal tax rate > corporate tax rate, firm has incentive to reduce
dividend payout
Personal tax rate < corporate tax rate, firm has incentive to payout
any excess cash , in dividends

Expected return, dividends, and personal taxes

Efect of personal taxes by considering situation with dividends taxed and capital
gains not taxed

A firm that provides more return in the form of dividends has a lower value
(or higher pre-tax required return) than those whose return is in the form of
untaxed capital gains

Floatation Costs
Firm can sell new stock to pay dividend, if we include floatation costs, then value of
stock decreases if we sell new stock
Firm with higher payout has to sell stock to catch-up to firm with lower payout, as it
has faster growing equity
Dividend Restrictions
Common feature of a bond indenture is a covenant prohibiting dividend payments
above some level
Real World Factors favoring a High Payout
Firms should generally have high dividend payouts because:
1. Discounted value of near dividends is higher than the present worth of
distant dividends
2. Between two companies with the same general earning power and same
general position in an industry, the one paying the larger dividend will almost
always sell at a higher price
Desire for Current Income
Classic examples are retired people and others living on fixed incomes; orphans and
widows
They are willing to pay premium to get a higher dividend yield
In a world of no transaction costs, a high current dividend policy would be of no
value to the shareholder
In the real world, the sale of low dividend stocks would involve brokerage fees and
other transaction costs and maybe even capital gains taxes
Expenditure of the shareholders own time when selling securities and the fear of
consuming out of principles might lead investors to buy high dividend securities
Financial intermediaries such as mutual funds can perform these repackaging
transactions for individuals at very low costs
Uncertainty Resolution

High dividend policy also benefits shareholders because it resolves uncertainty

Investors price a security by forecasting and discounting future dividends
Forecasts of dividends to be received in the distant future have greater uncertainty
than forecasts of near-term dividends
Stock price low for those that pay small dividends now in order to remit higher
dividends later
Tax and Legal Benefits from High Dividends
Dividends taxed more heavily than capital gains for individual investors
Corporate Investors
Significant tax break occurs when corporation owns stock in another corporation
Corporate shareholder receiving either common or preferred dividends is granted
100% dividend exclusion

So taxed unfavorably on capital gain

Tax Exempt Investors

Includes pension funds, endowment funds, and trust funds
Managers of such places have fiduciary responsibility to invest money prudently
so they favor high dividend yields
Some are prohibited from spending any of the principles such as university
endowment funds
A Resolution of Real World Factors
Information Content of Dividends
1. Based on homemade dividend argument, dividend policy is irrelevant
2. Because of tax efects for individual investors and new issue costs, a lowdividend policy is the best
3. Because of the desire for current income and related factors, a higherdividend policy is the best
Stock prices rise when current dividend unexpectedly increases and stock prices fall
when current dividend unexpectedly decreases

Consistent with only #3

Dividend cut is often a signal that firm is in trouble, not voluntary, also signals that
management does not think the current dividend policy can be maintained

As a result expectations of future dividends should generally be revised down

The PV of expected future dividends falls and so does the stock price
Stock price declines after dividend cut because future dividends are lower
NOT because the firm changes the percentage of its earnings it will pay out in
the form of dividends

Cannot pay shares for a little while -> stock prices will drop

Dividend Signaling in Practice

Information content effect: the markets reaction to a change in corporate dividend
payout

Stock price reacts to dividend change, not to a change in dividend payout

policy
The fact that dividend changes covey information about the firm to the
market makes it difficult to interpret the efect of dividend policy of the firm

The Clientele Effect

Wealthy people pursue low-payout or zero-payout while corporations pursue highpayout stocks
Clientele: groups of investors attracted to diferent payouts
Clientele Effect: stocks attract particular groups based on dividend yield and the
resulting tax efects

argument that states that diferent groups of investors desire diferent levels
of dividends

Firm chooses specific dividend policy to attract specific clientele

This now becomes a supply and demand problem where equilibrium is the goal
Establishing a Dividend Policy
Residual Dividend Approach
Firms with higher dividend payouts have to sell stock more often

we assume the firm wishes to minimize the need to sell new equity and
wishes to maintain its current capital

To avoid new equity sales, firm has to rely on internally generated equity to finance
new, NPV projects
Residual dividend approach: policy where a firm pays dividends only after meeting
its investment needs while maintaining a desired debt-to-equity ratio
Implementing residual dividend policy:
1. determine the amount of funds that can be generated without selling new
equity
have to borrow or invest to keep debt-equity ratio the same
2. decide whether or not a dividend will be paid
to do this you compare total amount that can be generated without
selling new equity with planned capital spending
if funds needed > funds available no dividend is paid -> firm will then
have to sell new equity to raise the needed finance or else postpone
some planned capital spending

Higher ratio = more equity than debt -> mature, older, more established companies
Dividend Stability
Dividends are only paid after all profitable investment opportunities are exhausted
A strict residual approach might lead to very unstable dividend policy
Cyclical dividend policy: dividends vary throughout the year, ex. quarterly
Stable dividend policy: fixed fraction of yearly earnings, all dividends are equal
Dividend stability complements investor objectives of information content, income,
and reduction in uncertainty
Dividend policy might also depend on class of shares
A Compromise Dividend Policy
Compromise dividend policy: many firms actually follow this; it is based on these
goals:
1.
2.
3.
4.
5.

avoid cutting back on positive NPV projects to pay a dividend

avoid dividend cuts
avoid the need to sell equity
maintain a target debt/equity ratio
maintain a target dividend payout ratio

Target payout ratio: a firms long-term desired dividend-to-earnings ratio

dividend payments a proportion of income, investors are entitled to a fair

share of corporate income
fraction of earnings that the firms expects to pay as dividends under ordinary
circumstances

In the long-run earnings growth is followed by dividend increases

To minimize problem of dividend instability by creating regular dividends (relatively
small fraction of permanent earnings) and extra dividends (granted when an
increase in earnings was expected to be temporary)
Some Survey Evidence of Dividends
Firms should disclose to investors reasons for changing the cash dividend
Stock Repurchase: An Alternative to Cash Dividends
Repurchase: another method used to pay out a firms earnings to its owners, which
provides more preferable tax treatment than dividends
Cash Dividends vs. Repurchase
Cash dividends do not afect a shareholders wealth if there are no imperfections

If there are no imperfections a cash dividend and a share repurchase are essentially
the same thing
Real World Considerations in a Repurchase
Diference between cash dividend and a cash repurchase is in the tax treatment;
Shares Repurchase

Cash Dividend

A repurchase has a significant tax

advantage over a cash dividend

Many firms repurchase shares

because management believes the
stock is undervalued

In a repurchase, a shareholder pays

taxes only if: (1) the shareholder
actually chooses to sell and (2) the
shareholder has a taxable capital
gain on the sale
Share repurchases can be used to
achieve other corporate goals such
as altering the firms capital
structure or as a takeover defense

Share Repurchases and EPS

Share repurchase is beneficial because EPS increases because share
repurchase reduces the number of outstanding shares, but it has no efect on
total earnings
Increase in EPS is exactly tracked by the increase in the price per share

increase in EPS is just an accounting adjustment that reflects

(correctly) the change in the number of shares outstanding

P/E ratio = stock price / EPS

Stock Dividends and Stock Splits
Stock dividend: payment made by a firm to its owners in the form of stock,
diluting the value of each share outstanding
A stock dividend is not a true dividend because it is not paid in cash
The efect of a stock dividend is to increase the number of shares that each
owner holds
Usually expressed in percentage; 20% = 1 new share for every 5 currently
owned
Every shareholder owns 20% more stock -> total number of shares
outstanding rises by 20% -> each share of stock is worth 20% less
Stock split: an increase in a firms shares outstanding without any change in
owners equity

same as a stock dividend except that the split is expressed as a ratio

Some Details on Stock Splits and Stock Dividends

Both have the same impact on a corporation; increase the number of shares
outstanding and reduce the value per share
Both will also have a similar impact on future cash dividends
When stocks split, cash dividend per share is reduced accordingly
Stock dividends are taxable while stock splits are not
Total owners equity is unafected when no cash has come in or out
Value of Stock Splits and Stock Dividends
The Benchmark Case
Stock splits and stock dividends do not change either the wealth of any
shareholder or the firm as a whole
Trading Range
Proponents of stock dividends and stock splits argue that a security has a
proper trading range
Trading range: price range between highest and lowest prices at which a
stock is traded
When security is priced above this level, many investors do not have the
funds to buy common trading unit called a round lot (usually 100 shares)
There is evidence that stock splits might actually decrease the liquidity of the
companys shares
Reverse Splits
Reverse split: procedure where a firms number of shares outstanding is
reduced
Given real world imperfections, reasons for reverse splits:
1. transaction costs to shareholders may be less after the reverse split
2. the liquidity and marketability of a companys stock might be improved
when its price is raised to the popular trading range
3. stocks selling below a certain level are not considered respectable,
meaning that investors underestimate these firms earnings, cash
flow, growth, and stability
4. stock exchanges have minimum prices per share requirements, reverse
split may bring the price up to such a minimum
5. companies sometimes perform reverse splits, and at the same time,
buy out any shareholders who end up with less than a certain number
of shares

Chapter 22: Leasing

This chapter mostly focuses on long-term leasing; more than 5 years
Leasing an asset on long-term basis is much like borrowing the needed funds
and simply buying the asset
Leases and Lease Types
A lease is a contractual agreement between two parties, the lessee and the
lessor
Lessee: the user of an asset in a leasing agreement and makes payments to
lessor
Lessor: the owner of an asset in a leasing agreement and received payment
from the lessee
1. the company decides on the asset it needs
2. decides how to finance the asset
3. if firm decides to lease, it then negotiates a lease contract with a lessor
for use of that asset
The lease agreement establishes that the lessee has the right to use the
asset and, in return, must make periodic payments to the lessor
The lessor is usually either the assets manufacturer or an independent
leasing company (must buy asset from a manufacturer)
Leasing vs. Buying
Direct leases: leasing company buying from manufacturer
Captive finance companies: wholly owned subsidiaries so manufacturers can
leas out their products
Buying -> company arranges the financing, purchases the asset, and holds
title to the asset
Leasing -> leasing company arranges the financing, purchases the asset, and
holds title to it
Operating Leases
Operating lease: usually a shorter-term lease where the lessor is responsible
for insurance, taxes, and upkeep

often cancellable on short notice

Characteristics of operating leases:

1. Payments received by the lessor are usually not enough to fully
recover the cost of the asset

2. Operating lease frequently requires that the lessor maintain the asset,
and is responsible for any taxes or insurance (which can be passed
onto lessee in the form of higher lease payments)
3. Cancellation option with payments ceased
Financial Leases
Financial leases: typically, a longer-term, fully amortized lease under which
the lessee is responsible for upkeep

Usually not cancellable without penalty

Characteristics of financial leases:

1. Payments made are usually sufficient to cover fully the lessors cost of
purchasing the asset and pay the lessor a return on the investment
2. In both operating and financial leases, the formal, legal ownership lies
with the lessor
3. In financial leases, the lessee enjoys the risk/reward of ownership
4. Lessee is responsible for insurance, maintenance, and taxes
Types of Financial Leases:
Tax-Oriented Leases:
Tax-oriented lease: a financial lease in which the lessor is the owner for tax
purposes (also called a true lease or a tax lease)
Conditional sales agreement leases: not a true lease as the lessee is the
owner for tax purposes, are secured loans
Tax-oriented leases make the most sense when the lessee is not in a position
to use tax credits or depreciation deductions; tax lease passes the benefits
on
Lessee can benefit because lessor may return a portion of the tax benefits to
the lessee in the form of lower lease costs
Sale and Leaseback Agreements:
Sale and leaseback: a financial lease in which the lessee sells an asset to the
lessor and then leases it back
1. Lessee receives cash from the sale of the asset
2. Lessee continues to use the asset
Lessee may have the option of repurchasing the leased assets at the end of
the lease
Leveraged Leases:
Leverage lease: a financial lease where the lessor borrows a substantial
fraction of the cost of the leased asset
Tax-oriented lease with 3 parties: lessor, lessee, and lender
1. Lessee selects the asset, gets the value using the asset, and makes
the periodic payments

2. Lessor usually puts up no more than 40% - 50% of the financing, is

entitled to the lease payments, has title to the asset, and pays interest
to the lenders
3. Lenders supply the remaining financing and receive interest payments
Lenders in a leveraged lease use a non-recourse loan (lender cannot turn to
the lessor in cause of a default)
Lender is protected in 2 ways:
1. Lender has a firs t lien on the asset
2. Lender may actually receive the lease payments from the lessee
(lender deducts the principal and interest due, and forwards the rest to
the lessor)
Taxes, Canada Revenue Agency (CRA), and Leases
Lessee can deduct lease payments for income tax purposes if the lease is
qualified by CRA
CRA requires leases be primarily for business purposes and not merely for tax
avoidance
CRA looks out for conditional sales agreements as only the interest portion of
the payment is deductible rather than the full lease
CRA detects one of the following; it disallows the lease:
1. Lessee automatically acquires title to the property after payment of a
specified amount in the form of rentals
2. Lessee is required to buy the property from the lessor during or at the
termination of the lease
3. Lessee has the right during or at the expiration of the lease to acquire
the property at a price less than fair market value
These rules also apply to sale-leaseback agreements
After qualification, lessor must still be aware of further tax regulations limiting
their use of CCA tax shields on leased assets
Lease or Buy?
Steps in analysis:
1. Calculate the incremental after-tax cash flows from leasing instead of
borrowing
2. Use these cash flows to calculate the implicit after-tax rate on the
lease
3. Compare this rate to the companys after-tax borrowing cost and
choose the cheaper source of financing
Three Potential Pitfalls
1. Implicit rate on lease can be interpreted as the internal rate of return
(IRR) on the decision to lease instead of buy
2. Calculated the advantage of leasing instead of borrowing

3. Implicit rate is based on net cash flows of leasing instead of borrowing

NPV Analysis
Discount cash flows using borrowing rate
Net advantage to leasing (NAL): the NPV of the decision to lease an asset
instead of buying it
NAL = investment PV (after-tax lease payments) PVCCATS PV (salvage)
A Leasing Paradox
Lessors perspective: buys the car, depreciates it to obtain CCA tax shields,
and receives lease payments each year on which it pays taxes
Lease has positive NPV to one party, it has negative NPV to other, so one
party must lose or both parties break even
Resolving the Paradox
Efective tax rates difer
Any tax benefits from leasing can be split between the two parties by setting
the lease payments at the appropriate level, both parties win (shareholders
from both benefit), CRA loses
CCA tax shields are accelerated deductions reducing the tax burden in early
years
Lease payments reduce taxes by the same amount every year
Ownership tax shields have a greater PV provided the firm is fully taxed
Low tax (or untaxed) firms are lessees because they are not able to use the
tax advantages of ownership, such as CCA and debt financing
These ownership tax shields are worth less because the lessee faces a lower
tax rate or may not have enough taxable income to absorb the accelerated
tax shields in the early years
Overall, less tax is paid by the lessee and lessor combined and this tax
savings occurs sooner rather than later (lessor gains on taxes, lessee loses
amount less than lessor gains but lessor passes on some tax savings as lower
lease payments)
Reasons for Leasing
Good Reasons for Leasing
1. Taxes may be reduced by leasing (because firms are in diferent tax
brackets so potential tax shield that cannot be used by one firm can be
transferred to another by leasing)
2. The lease contract may reduce certain types of uncertainty that might
otherwise decrease the value of the firm (uncertainty transferred from
lessee to lessor who is better able to bear the rick for the residual
value)

3. Transaction costs can be lower for a lease contract than for buying the
asset (reason for short-term leases)
4. Fewer restrictions and security requirements
Bad Reasons for Leasing
1. Leasing and accounting income (leasing has significant efect on
financial statements, operating leases are of-the-book result in an
expense for the lease payment)
2. 100% financing (no down payment or security deposit, firms cant
aford debt financing so have no choice but operating leases)

Chapter 23: Mergers and Acquisitions

Special problems:
1. Benefits from acquisition can depend on such things as strategic fits;
which are difficult to define precisely and it is not easy to estimate the
value using discounted cash flow techniques
2. There can be complex accounting, tax, and legal efects that must be
considered when one firm is acquired by another
3. Acquisitions are an important control device for shareholders. Some
acquisitions are a consequence of an underlying conflict between the
interests of existing managers and shareholders, agreeing to
acquisition is one way for shareholders to remove managers
4. Mergers and acquisitions sometimes involve unfriendly transactions,
sought after firm often resists takeover and may resort to defensive
tactics
The Legal Forms of Acquisition
3 basic legal procedures to acquire a firm:
1. Merger or consolidation
2. Acquisition of stock
3. Acquisition of assets