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Introduction:
The dividends are decided by the firms board of directors and paid to the
shareholders who are registered on the record date.
Types of dividends:
1. Cash Dividends: These Dividends are paid in cash, usually quarterly.
2. Companies can declare both regular and extra dividends. Regular
dividends usually remain unchanged in the future, but extraordinary
or special dividends are unlikely to be repeated.
3. Stock dividend: Shareholders receive new stock in the corporation as
a form of a dividend. Like a stock split, the number of shares
increases, but no cash changes hands.
Both cash and stock dividends reduce the value per share.
4. An alternative way to distribute cash is with share repurchases. The
firm buys back its own shares. This can be done:
On the Open Market
Tender offer
Buying stock from major shareholders.
under the M&M assumptions, there is no reason to believe that the payment
of dividends will change the discount rate.
1. M&M (1961)
Asymmetries of Information
M&M (61) irrelevance policy argues that in perfect markets dividend
policy is irrelevant. One of the assumptions of the model is that all
individuals have the same information.
Managers and insiders have access to private information. Managers
of firms that expect a high stream of cash flows (good type of firms) would
want to convey this information to the market. Remember that good and bad
firms have the incentive to signal that they are good firms, so we need a
binding signal that allow us to separate the good from the bad firms.
We already indicate that the use of debt conveys this positive signal to
the market. This signal is credible because good firms can issue debt but
bad firms cannot because they will have financial problems in the future.
The market understands the signal, (Firms that issue debt are good firms)
and will reward those firms that issue debt with an increases in value.
Dividends can be used in a similar way to convey good (or bad)
information. A firm that increases dividends signals that it expects future
cash flows because the dividend policy tends to remain steady over the
years. Bad firms can also increase dividends, but they are bad firms and in
the future they will need to cut dividends, and the market will penalize them.
Agency Costs.
Share repurchases
Share repurchases are an alternative way to pay cash to current
shareholders. What do you think will happen to the value of the firm when
it announces a share repurchase plan?
On average the price of the sock increases when the firm announces a
stock repurchase.
You need to think about the different theories that we saw to justify this
increase in value.
1. Increase in value of the firm because managers are signaling that the
shares are undervalued (otherwise they might not want to buy them)
2. Increase in value if they use debt to repurchase shares because of the
tax benefits of debt
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