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Background
Dividends as a Basis for Value
Dividends are important in determining stock value
Individual investors buy stocks expecting dividends and price
appreciation
D1 D2 Dn Pn
P0 ...
(1 k ) (1 k ) 2
(1 k ) (1 k ) n
n
a) to find EPS:
d=dividend per share/EPS
.4=$2.5/EPS
EPS=$2.5/4=$6.25
to find price:
P/E= price/EPS
19=price/6.25
Price=19(6.25)=118.75
b) At 55% payout ratio, the per-share dividend would be
Dividend per share= (d)(EPS)=.55(6.25)=$3.44
for a dividend increase of
$3.44 - $2.50=$0.94
multiply by the shares held for Stockholders additional
dividend income (500)($0.94)=$470
c) Total earnings: ($6.25)(3,500,000)=$21,875,000
The funds available for each case
d=40%: $21,875,000(.6) = $13,125,000
d=55%: $21,875,000(.45)=$ 9,843,750
-----------------
Difference $3,281,250
Understanding the Dividend Decision
6
The Dividend Controversy
Does paying or not paying dividends affect stock
price?
Do stockholders prefer current or deferred
income?
Three arguments regarding investors
preferences for or against dividends
1. Dividend Irrelevance
2. Dividend Preference
3. Dividend Aversion
7
Dividend Irrelevance
Most theorists say dividends matter very little to stock
price
Value of eliminated early dividends is offset by
growth-created value in the future
D1 D2 Dn Pn
P0 ...
(1 k ) (1 k ) 2 (1 k ) n (1 k ) n
9
Concept Connection Example 15-3
Tailoring the Income Stream
Original value of the Winters AJAX shares
$10 10,000 shares = $100,000.
Eliminated dividend
10,000 shares $0.50 = $5,000.
After one year of 5% growth, AJAX should sell for
$10 1.05 = $10.50.
To maintain their income the Winters must sell
$5,000 $10.50 = 476 shares
After which they would have
10,000 476 = 9,524 shares
Worth $10.50 x 9,524 = $100,002.
Dividend Irrelevance
Transaction costs
The more significant the transactions costs, the
less valid the irrelevance theory becomes
Income taxes
Dividends are taxed as ordinary income
Appreciation is taxed as a capital gain
The View from Within the Company
Dividends represent a cash outflow
Firms prefer not paying dividends if it avoids
selling new stock
11
Dividend Preference
12
Dividend Aversion
13
Other Theories and Ideas
The Clientele Effect
Investors choose stocks for dividend policy so any
change in payments policy is disruptive
The Residual Dividend Theory
Dividends are paid from earnings only after viable
projects are funded
The Signaling Effect of Dividends
Cash dividends signal managements confidence
The Expectations Theory
A refinement of the signaling effect
Dividends that fail to fulfill stockholders expectations
send a negative message even if the payment is good
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Problem 1
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Dividend Policy
Dividend policy: Rationale for determining dividend payouts
Payout ratio
States dividends as a fraction of earnings
Stability
The constancy of dividends over time
A stable dividend is non-decreasing
A dividend with a stable growth rate increases at a fairly
constant growth rate
Alternate Policies
20
The Mechanics of Dividend Payments
21
Figure 15.1 The Dividend Declaration
and Payment Process
22
Dividend Reinvestment Plans
23
Example 15-5 Reinvestment Plan
27
Rationale for Stock Splits and
Stock Dividends
Stock Split Stock Dividend
Trading Range Argument Giving Something that
for splits Doesnt Cost Anything
Splits keep stock Stock dividends are an
prices in a trading attempt at signaling
range: accessible to
Employed to send a
small investors
positive message
Stock usually split when
prices are increasing Doesnt really give
May give false shareholders anything
impression that price
increase is from split
Effect On Price And Value
29
Accounting for a Stock Split
Accounting for a Stock Dividend
Stock Repurchases
Alternative to Dividend
Firms with cash on hand can pay dividends
or repurchase their own stock
Repurchase reduces the number of shares
outstanding and increases EPS
Remaining shares will increase in value if the
market maintains the P/E ratio after the
repurchase
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Concept Connection Example 15-
6
Stock Repurchases
The Johnson Company has 2,500,000 shares of common stock
outstanding, net income of $5 million, and a P/E ratio of 10.
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Stock Repurchases
34
Stock Repurchases
35
Other Repurchase Issues
Opportunistic Repurchase
Stock is temporarily undervalued
Repurchase to Dispose of Excess Cash
Distributes cash without a signaling effect
36
Other Repurchase Issues
Taxes
Occasional stock repurchases can benefit
stockholders because capital gains tax rates may
be lower than ordinary rates
Repurchases to Restructure Capital
Borrowing money to repurchase stock raises
leverage level and debt ratio
37