Chapter 15

DISTRIBUTIONS TO SHAREHOLDERS: DIVIDENDS AND SHARE

REPURCHASES

Learning Objectives

After reading this chapter, students should be able to:

Explain why some investors like the firm to pay more dividends while
other investors prefer reinvestment and the resulting capital gains.
Discuss the various trade-offs that companies face when trying to
establish their optimal dividend policy.
Differentiate between stock splits and stock dividends.
List the advantages and disadvantages of stock repurchases vis--vis
dividends from both investors and companies perspectives.

Overview
Dividend policy involves the decision to pay out earnings as dividends or to
retain and reinvest them in the firm. If the decision is made to distribute
income to stockholders, three key issues arise: (1) How much should be
distributed? (2) Should the distribution be in the form of dividends or should
the cash be passed on to shareholders by buying back stock? (3) How
stable should the distribution be?
Any change in dividend policy has both favorable and unfavorable effects on
the firms stock price: higher dividends mean higher immediate cash flows to
investors, which is good, but lower future growth, which is bad. The optimal
dividend policy balances these opposing forces and maximizes stock price.
Theories regarding the relationship between dividend payout and stock price
have been proposed: (1) dividend irrelevance, which states that dividend
policy has no effect on the firms stock price, and (2) the bird-in-the-hand
theory, which states that investors prefer dividends because they are less
risky than potential capital gains. In addition, the Tax Code encourages
many individual investors to prefer capital gains to dividends. Since 2003,
the maximum tax rate on dividends and long-term capital gains has been set
at 15%. This change lowered the tax disadvantage of dividends, but
reinvestment and the accompanying capital gains still have tax advantages
over dividends.
Dividend policy is further complicated due to signaling and clientele effects.
It is simply not possible to state that any one dividend policy is correct, and
hence it is impossible to develop a precise model for use in establishing
dividend policy. Thus, financial managers must consider a number of factors
when setting their firms dividend policies.
Outline

I. Dividend policy involves the decision to pay out earnings or to

retain them for reinvestment in the firm.
A. The target payout ratio is defined as the percentage of net income
paid out as cash dividends as desired by the firm, and it should be
based in large part on investors preferences for dividends versus
capital gains.
1. The constant growth stock model, P0 = D1/(rs g), shows that
paying out more dividends will increase stock price.
2. However, if D1 is raised then less money will be available for
reinvestment, that will cause the expected growth rate to
decline, and that would tend to lower the stocks price.
3. The optimal dividend policy strikes a balance between current
dividends and future growth and maximizes the firms stock
price.
B. A number of theories have been proposed to explain how factors
interact to determine a firms optimal dividend policy. These
theories include: (1) the dividend irrelevance theory and (2) the
bird-in-the-hand theory.
1. Modigliani and Miller (MM), the principal proponents of the
dividend irrelevance theory, argue that the value of the firm
depends only on the income produced by its assets, not on how
this income is split between dividends and retained earnings.
a. MM prove their proposition, but only under a set of restrictive
assumptions including the absence of taxes and brokerage
costs.
b. Obviously, taxes and brokerage costs do exist, so the MM
conclusions on dividend irrelevance may not be valid under
real-world conditions.
c. In defense of their theory, MM noted that many stocks are
owned by institutional investors who pay no taxes and who
can buy and sell stocks with very low transactions costs. For
such investors, dividend policy might well be irrelevant. If
these investors dominate the market and represent the
marginal investor, MMs theory could be valid in spite of its
unrealistic assumptions.
2. The principal conclusion of MMs dividend irrelevance theory is
that dividend policy does not affect stock prices and thus the
 required rate of return on equity, rs. Relaxing this assumption
provides the basis for the bird-in-the-hand theory.
a. Myron Gordon and John Lintner argue that rs decreases as the
dividend payout is increased because investors are less
certain of receiving the capital gains that are supposed to
result from retaining earnings than they are of receiving
dividend payments.
b. MM call the Gordon-Lintner argument the bird-in-the-hand
fallacy because Gordon and Lintner believe that investors
view dividends in the hand as being less risky than capital
gains in the bush.
c. In MMs view, however, most investors plan to reinvest their
dividends in the stock of the same or similar firms, and the
riskiness of the firms cash flows to investors in the long run
is determined by the riskiness of operating cash flows, not by
dividend payout policy.
d. In reality, many investors face transactions costs when they
sell stock; so investors who are looking for a steady stream of
income would logically prefer that companies pay regular
dividends.
C. The Tax Code encourages many individual investors to prefer
capital gains to dividends.
1. Since 2003, the maximum tax rate on dividends and long-term
capital gains has been set at 15%.
2. The new tax treatment of dividends lowered the tax
disadvantage of dividends, but reinvestment and the
accompanying capital gains still have two tax advantages over
dividends.
a. Taxes must be paid on dividends the year they are received,
whereas taxes on capital gains are not paid until the stock is
sold. Due to time value effects, a dollar of taxes paid in the
future has a lower effective cost than a dollar of taxes paid
today.
b. If a stock is held by someone until he or she dies, there is no
capital gains tax at allthe beneficiaries who receive the
stock can use the stocks value on the death date as their
cost basis, which permits them to completely escape the
capital gains tax.
3. Because of these tax advantages, some investors prefer to have
companies retain most of their earnings, and those investors
 might be willing to pay more for low-payout companies than for
otherwise similar high-payout companies.
II. There are two other issues that have a bearing on optimal
dividend policy: (1) the information content, or signaling,
hypothesis and (2) the clientele effect.
A. It has been observed that a dividend increase announcement is
often accompanied by an increase in the stock price, while a
dividend cut generally leads to a stock price decline.
1. This might be interpreted by some to mean that investors prefer
dividends over capital gains, thus supporting the Gordon-Lintner
hypothesis.
a. A signal is an action taken by a firms management that
provides clues to investors about how management views the
firms prospects.
2. However, MM argue that a dividend increase is a signal to
investors that the firms management forecasts good future
earnings.
a. Thus, MM argue that investors reactions to dividend
announcements do not necessarily show that investors prefer
dividends to retained earnings.
b. Rather, the fact that the stock price changes merely indicates
that there is important information content in dividend
announcements. This is referred to as the information
content, or signaling, hypothesis.
c. Signaling effects should definitely be considered when a firm
is contemplating a change in dividend policy. Managers
should consider signaling effects when they set dividend
policy.
B. MM also suggest that a clientele effect might exist.
1. Clienteles are different groups of stockholders who prefer
different dividend payout policies.
2. A clientele effect is the tendency of a firm to attract a set of
investors who like its dividend policy.
3. Some stockholders (for example, retirees) prefer current
income; therefore, they would want the firm to pay out a high
percentage of its earnings as dividends.
4. Other stockholders have no need for current income (for
example, doctors in their peak earning years) and they would
simply reinvest any dividends received, after first paying income
 taxes on the dividend income. Therefore, they would want the
firm to retain most of its earnings.
5. All of this suggests that a clientele effect exists, which means
that firms have different clienteles and that the clienteles have
different preferenceshence, that a change in dividend policy
might upset the majority clientele and have a negative effect on
the stocks price.
6. This suggests that a company should follow a stable, dependable
dividend policy so as to avoid upsetting its clientele.
C. Borrowing from the ideas of behavioral finance, some recent
research suggests that investors preference for dividends varies
over time.
1. Catering theory suggests that investors preference for dividends
varies over time and that corporations adapt their dividend
policy to cater to the current desires of investors.
III. When deciding how much cash should be distributed to
stockholders, two points should be kept in mind: (1) The
overriding objective is to maximize shareholder value, and (2)
the firms cash flows really belong to its shareholders, so
management should not retain income unless they can reinvest
those earnings at higher rates of return than shareholders can
earn themselves. On the other hand, internal equity is cheaper
than external equity, so if good investments are available, it is
better to finance them with retained earnings than with new
stock.
A. When establishing a dividend policy, one size does not fit all.
1. Over the past few decades, there has been an increasing number
of young, high-growth firms trading on the stock exchanges.
a. A study by Fama and French shows that the proportion of
firms paying dividends has fallen sharply over time.
b. As a result of the 2003 tax changes, which lowered the tax
rate on dividends, many companies initiated dividends or
increased their payouts.
2. Dividend payouts and dividend yields for large corporations vary
considerably.
B. Firms in stable, cash-producing industries pay relatively high
dividends, whereas companies in rapidly growing industries tend to
pay lower dividends.
1. Average dividends also differ significantly across countries.
C. The optimal payout ratio is a function of four factors: (1)
managements opinion about its investors preferences for dividends
versus capital gains, (2) the firms investment opportunities, (3) the
firms target capital structure, and (4) the availability and cost of
external capital.
1. These factors are combined in the residual dividend model.
D. The residual dividend model is based on the premise that investors
are indifferent between dividends and capital gains.
1. A firm using the residual model would follow these four steps:
a. Determine the optimal capital budget.
b. Determine the amount of equity required to finance the
optimal capital budget given its target capital structure.
c. To the extent possible, use retained earnings to meet equity
requirements.
d. Pay dividends only if more earnings are available than are
needed to support the optimal capital budget.
2. The word residual implies leftover, and the residual policy
implies that dividends are paid out of leftover earnings.
E. If a firm rigidly follows the residual dividend policy, then dividends
paid in any given year can be expressed as follows:
Dividends = Net income [(Target equity ratio)(Total capital budget)]
F. Since investment opportunities and earnings will surely vary from
year to year, strict adherence to the residual dividend policy would
result in fluctuating, unstable dividends.
1. Firms should use the residual policy to help set their long-run
target payout ratios, but not as a guide to the payout in any one
year.
G. Companies use the residual dividend model in a conceptual sense,
then implement it with a computerized financial forecasting model.
1. Most companies use the computer model to find a dividend
pattern over the forecast period that will provide sufficient equity
to support the capital budget without having to sell new common
stock or move the capital structure ratio outside the optimal
range.
H. Some companies, especially those in cyclical industries, have
difficulty maintaining a dividend in bad times that would be too low
in good times.
 1. These companies set a very low regular dividend and then
supplement it with an extra dividend when times are good.
This is called a low-regular-dividend-plus-extras policy.
a. Investors recognize that the extras might not be maintained
in the future, so they do not interpret them as a signal that
the companies earnings are increasing permanently, nor do
they take the elimination of the extra as a negative signal.
I. Dividends clearly depend more on cash flows, which reflect the
companys ability to pay cash dividends, than on current earnings,
which are heavily influenced by accounting practices and which do
not necessarily reflect the firms cash position.
J. Firms usually pay dividends on a quarterly basis in accordance with
the following payment procedures.
1. Declaration date. This is the day on which the board of directors
declares the dividend.
a. At this time they set the amount of the dividend to be paid,
the holder-of-record date, and the payment date.
b. For accounting purposes, the declared dividend becomes an
actual liability on the declaration date.
2. Holder-of-record date. This is the date the stock transfer books
of the corporation are closed.
a. Those shareholders who are listed on the companys books on
this date are the holders of record and they receive the
announced dividend.
3. Ex-dividend date. The date on which the right to the current
dividend no longer accompanies a stock.
a. This date is two business days prior to the holder-of-record
date.
b. This practice is a convention of the brokerage business that
allows sufficient time for stock transfers to be made on the
books of the corporation.
4. Payment date. This is the day when dividend checks are actually
mailed to the holders of record.
IV. Many firms have instituted dividend reinvestment plans
(DRIPs) whereby stockholders can automatically reinvest
dividends received in the stock of the paying corporation.
Income taxes on the amount of the dividends must be paid
even though stock rather than cash is received.
 A. There are two types of DRIPs.
1. Plans that involve only old stock that is already outstanding.
2. Plans that involve newly issued stock. Hence, this type of plan
raises new capital for the firm.
B. Stockholders choose between continuing to receive dividend checks
and having the company use the dividends to buy more stock in the
corporation.
C. One interesting aspect of DRIPs is that they are forcing corporations
to reexamine their basic dividend policies.
1. A high participation rate in a DRIP suggests that stockholders
might be better off if the firm simply reduced cash dividends,
which would save stockholders some personal income taxes.
D. Companies switch from old stock to new stock DRIPs depending on
their need for equity.
E. Some companies have expanded their DRIPs by moving to open
enrollment whereby anyone can purchase the firms stock directly
and bypass brokers commissions.
V. Dividend policy decisions are based more on informed
judgment than on quantitative analysis. Regardless of the
debate on the relevancy of dividend policy, it is possible to
identify several factors that influence dividend policy. These
factors are grouped into four broad categories.
A. Constraints on dividend payments: (1) Bond indentures, (2)
preferred stock restrictions, (3) impairment of capital rule, (4)
availability of cash, and (5) penalty tax on improperly accumulated
earnings.
B. Investment opportunities: (1) Number of profitable investment
opportunities and (2) possibility of accelerating or delaying projects.
C. Availability and cost of alternative sources of capital: (1) Cost of
selling new stock, (2) ability to substitute debt for equity, and (3)
control.
D. Effects of dividend policy on rs: (1) Stockholders desire for current
versus future income, (2) perceived riskiness of dividends versus
capital gains, (3) the tax advantage of capital gains, and (4) the
information content of dividends (signaling).
VI. Stock dividends and stock splits are often used to lower a
firms stock price and, at the same time, to conserve its cash
resources.
A. The effect of a stock split is an increase in the number of shares
outstanding and a reduction in the par, or stated, value of the
shares. For example, if a firm had 1,000 shares of stock
outstanding with a par value of $100 per share, a 2-for-1 split
would reduce the par value to $50 and increase the number of
shares to 2,000.
1. The total net worth of the firm remains unchanged.
2. The stock split does not involve any cash payment, only
additional certificates representing new shares.
3. Stock splits often occur due to the widespread belief that there is
an optimal price range for each stock.
a. Optimal means that if the price is within this range, the
price/earnings ratio, hence the firms value, will be
maximized.
4. Stock splits are generally used after a sharp price run-up to
produce a large price reduction.
5. By creating more shares and lowering the stock price, stock
splits may also increase the stocks liquidity. This tends to
increase the firms value.
6. There is also evidence that stock splits change the mix of
shareholders.
a. The proportion of trades made by individual investors tends to
increase after a stock split, whereas the proportion of trades
made by institutional investors tends to fall.
B. A stock dividend requires an accounting entry transfer from
retained earnings to common stock.
1. Again, no cash is involved with this dividend. Net worth
remains unchanged, and the number of shares is increased.
2. Stock dividends used on a regular annual basis will keep the
stock price more or less constrained.
C. Unless the total amount of dividends paid on shares is increased,
any upward movement in the stock price following a stock split or
dividend is likely to be temporary.
1. The price will normally fall in proportion to the dilution in
earnings and dividends unless earnings and dividends rise.
D. Stock dividends and splits provide management with a relatively
low-cost way of signaling that the firms prospects look good.
Because small stock dividends create bookkeeping problems and
 unnecessary expenses, firms use stock splits far more often than
stock dividends.
VII. Stock repurchases are an alternative to dividends for
transmitting cash to stockholders.
A. There are three principal types of repurchases: (1) Situations in
which the firm has cash available for distribution to its stockholders,
and it distributes this cash by repurchasing shares rather than by
paying cash dividends; (2) situations where the firm concludes that
its capital structure is too heavily weighted with equity, and it sells
debt and uses the proceeds to buy back its stock; and (3) situations
where the firm has issued options to employees and it uses open
market repurchases to obtain stock for use when the options are
exercised.
B. Stock repurchased by the issuing firm is called treasury stock.
C. Assuming that the repurchase does not adversely affect the firms
future earnings, the earnings per share on the remaining shares will
increase, resulting in a higher market price per share. As a result,
capital gains will have been substituted for dividends.
D. Advantages of repurchases include:
1. The repurchase is often motivated by managements belief that
the firms shares are undervalued.
2. The stockholder is given a choice of whether or not to sell his
stock to the firm.
3. The repurchase can remove a large block of stock overhanging
the market.
4. If an increase in cash flow is temporary, the cash can be
distributed to stockholders as a repurchase rather than as a
dividend, which could not be maintained in the future.
5. The company has more flexibility in adjusting the total
distribution than it would if the entire distribution were in the
form of cash dividends, because repurchases can be varied from
year to year without giving off adverse signals.
6. Repurchases can be used to produce large-scale changes in
capital structures.
7. Companies that use stock options as an important component of
employee compensation can repurchase shares and then use
those shares when employees exercise their options.
E. Disadvantages of repurchases include:
 1. Repurchases are not as dependable as cash dividends; therefore,
the stock price may benefit more from cash dividends.
2. Selling stockholders may not be fully aware of all the
implications of a repurchase; therefore, repurchases are usually
announced in advance.
3. If a firm pays too high a price for the repurchased stock, it is to
the disadvantage of the remaining stockholders.
F. Conclusions on repurchases may be summarized as follows:
1. Because of the deferred tax on capital gains, repurchases have a
tax advantage over dividends as a way to distribute income to
stockholders.
2. Because of signaling effects, companies should not pay
fluctuating dividendsthat would lower investors confidence in
the company and adversely affect its cost of equity and its stock
price.
3. Repurchases are also useful when a firm wants to make a large,
rapid shift in its capital structure, wants to distribute cash from a
one-time event such as the sale of a division, or wants to obtain
shares for use in an employee stock option plan.
G. Increases in the size and frequency of repurchases in recent years
suggest that companies are doing more repurchases and paying out
less cash as dividends.
VIII. Web Appendix 15A illustrates a computerized financial
forecasting model that uses the residual dividend model to help
set long-run target payout ratios.