Dividend Policy: Principles & Applications

Financial Management:
Principles & Applications

Thirteenth Edition
Chapter 16
Dividend Policy
Copyright © 2018, 2014, 2011 Pearson Education,

Copyright © 2018, Inc.Education,
2014, 2011 Pearson All Rights Reserved
Inc. All Rights Reserved
Slide Contents
• Learning Objectives
• Principles Applied in This Chapter
1. How Do Firms Distribute Cash to Their
Shareholders?
2. Does Dividend Policy Matter?
3. Cash Distribution Policies in Practice
Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-2

Learning Objectives
1. Distinguish between the use of cash

dividends and share repurchases.
2. Understand the tax treatments of
dividends and capital gains, and stock
dividends and stock splits, and the
conditions under which dividend policy is
an important determinant of stock value.
3. Describe corporate dividend policies that
are commonly used in practice.

Introduction
When a firm generates cash from operations,

what can the firm do with the cash?
1. Use the cash to fund new investments,
2. Use the cash to pay off some of the firm’s
debt, and/or
3. Distribute the cash back to the firm’s
shareholders either as a cash dividend or as
stock repurchases.

Introduction (cont.)
This chapter provides answers to three questions

regarding a firm’s dividend policy:
1. What are the pros and cons of the methods the
firm can use to distribute cash?
2. Why should the firm’s shareholders care about
the firm’s dividend policy given that they can
generate cash when they need it by selling
some of their shares?
3. What cash distribution policies do most firms
use in practice?

16.1 HOW DO FIRMS
DISTRIBUTE CASH TO THEIR
SHAREHOLDERS?

How Do Firms Distribute Cash to
their Shareholders?
Cash distributions can take two basic forms:
1. Cash dividend - cash is paid directly to

the shareholders.
2. Share repurchase - a company uses cash
to buy back its own shares from the market
place, thereby reducing the number of
outstanding shares.

How Do Firms Distribute Cash to
their Shareholders? (cont.)
The impact on the balance sheet will be as

follows:
– Assets side - cash will be reduced due to cash

dividend or share repurchase.
– Equity side - there will be a corresponding

decrease.

Figure 16.1 Historical Distributions to
Shareholders through Dividends and Share
Repurchases

Cash Dividends
A firm’s dividend policy determines how

much cash it will distribute to its shareholders
and when these distributions will be made.
Dividend policy has two main attributes:
– dividend payout ratio, and
– the pattern of dividends followed over
time.

Dividend Payment Procedures
Date Explanation Calendar Date

Announcement Dividend is declared. March 15
Date
Ex-Dividend Date Shares begin trading May 17
ex-dividend.
Record Date Dividend will be paid May 19
to shareholders who
own the stock on this
date.
Payment Date Dividends are May 27
distributed to the
shareholders of
record on the record
date.

Stock Repurchases (Stock Buyback)
Stock repurchase is when a firm uses its

cash to repurchase some of its own stock.
This results in a reduction in the firm’s cash
balance as well as the number of shares of
stock outstanding.

How do Firms Repurchase Their
Shares?
• Open Market Repurchase - Here the firm

acquires the stock on the market, often
buying a relatively small number of shares
everyday. Most common.
• Tender Offer - Here the company makes a

formal offer to buy a large specified number
of shares at a stated price. The price is set
above the market price to attract sellers.

How do Firms Repurchase Their
Shares? (cont.)
Direct Purchase from a large investor -

Here the firm purchases the stock from one
or more major stockholders on a negotiated
basis. This method is not used frequently.

Non-Cash Distributions: Stock
Dividends and Stock Splits
• A stock dividend is a pro-rata distribution

of additional shares of stock to the firm’s
current stockholders.
• Stock split is essentially a very large stock

dividend.

Rationale for a Stock Dividend or
Split
One rationale is that there is an optimal

trading price range for the firm’s stock. If
the price exceeds that optimal range, it can
be brought back to the optimal range by
doing a stock split or paying stock dividend.

16.2 DOES DIVIDEND POLICY
MATTER?

Does Dividend Policy Matter?
• Modigiliani and Miller suggest that without

taxes and transaction costs, cash dividends
and share repurchases are equivalent and
the timing of the distribution is
unimportant.
• This is known as the Modigiliani and Miller

dividend irrelevancy proposition.

The Irrelevance of the Distribution
Choice
The distribution choice is irrelevant under the

following conditions or assumptions:
1. There are no taxes.

2. No transaction costs are incurred in either
buying or selling shares of stock.
3. The firm’s operating and investment policies
are fixed.

The Irrelevance of the Distribution
Choice (cont.)
The dividend irrelevancy proposition can be

illustrated in two ways:
1. Timing of dividend distributions does not affect

firm value.
2. In the absence of taxes and transaction costs,

a cash dividend is equivalent to a share
repurchase.

Figure 16.2 Dividend Policy Choices
Faced by Clinton Enterprises

Figure 16.2 Dividend Policy Choices
Faced by Clinton Enterprises (cont.)

The Timing of Dividend is Irrelevant
(cont.)
Figure 16-2 considers two alternatives:
1. Pay $35M now and $135M in one year

2. Pay $52.5M now and $114.875M in one year
• In both cases, the value of share remains

the same at $15.24 per share.

CHECKPOINT 16.1:
CHECK YOURSELF
Stock Price and the Timing of Dividend

Payments

The Problem
Consider Alternative #3 in which Northwest Wire and

Cable decides to increase its current period dividend
to only $8 million. Show that the firm’s equity under
this scenario would be $30.79 million.

Step 1: Picture the Problem
The firm is considering two alternatives:
– Pay $4 million today and $30million in year 1 as

liquidating dividend; or
– Pay $12 million today and pay $21.04 in year 1

($30 million - $8million*1.12 paid to new
shareholders)

Step 2: Decide on a Solution
Strategy
The value of Northwest Wire and Cable

company’s equity is equal to the present
value of the firm’s expected cash dividends.
We can estimate the value using equation 16-
1.

Step 3: Solve
Value – Alternative 1
Value = $4 million + $30 million /(1.12)1
Value = $30.79 million

Step 3: Solve (cont.)
Value – Alternative 2
Value = $12 million + $21.04 million /(1.12)1

Value = $30.79 million

Step 4: Analyze
• This example illustrates that the timing of

dividend payment does not affect the value
of the firm.
• This was true because we held constant the

firm’s investment cash flows. We also
assumed that the new shares could be
issued under the same terms as the
existing shares.

The form of Payment (Cash Dividend
Versus Share Repurchase) is Irrelevant
Table 16-1 illustrates two possibilities for the

use of $1,000,000 in cash flows:
1. A $1,000,000 cash dividend.

2. A $1,000,000 stock repurchase.
• It is observed that the value is the same so

an investor will be indifferent between the
two options.

Table 16.1 Wealth Effects of Cash Distributions:
Dividends and Share Repurchases

Individual Wealth Effects:
Personal Taxes
What are the tax rules with regard to

dividends and share repurchases?
1. 100% of cash dividends are taxable in the year
in which they are received.
2. When individuals sell shares, tax is assessed
only on the capital gain.
3. If investor does not sell the shares to the
company making stock repurchase, there will
be no taxable gain.

Why Dividend Policy is Important?
Transactions are costly

– Since taxes are incurred when dividends are
received and transactions costs are incurred
when buying and selling shares, investors will
prefer to select companies whose dividend policy
match up with their own preferences. Because
firms with different dividends attract different
dividend clienteles, it is important that
dividend policy remain somewhat stable.

(cont.)
The Information Conveyed by Dividend and

Share Repurchase Announcement
– Information can affect future valuation.
– Firms tend to increase their dividends when

dividends can be sustained in the future. In
such cases, dividend increase is clearly good
news.

(cont.)
Share repurchases are also viewed very

favorably as it reveals that:
– the firm has generated more money than it

currently needs, and/or
– the equity is currently underpriced.

(cont.)
The Information Conveyed by Stock

Dividends and Stock Splits
– The announcement of stock dividends and stock

splits tend to generate positive stock returns.
Some have suggested that firms have a
preferred trading range and stock splits help
bring stock prices to that trading range.

16.3 CASH DISTRIBUTION
POLICIES IN PRACTICE

Cash Distribution Policies in Practice
Stable Payout
In a survey of CEOs, most CEOs recognized the

importance of maintaining consistency and
stability in dividend policy (see figure 16.3)

Figure 16.3 Survey of CFO Opinions
Regarding Dividend Policy Issues

Figure 16.3 Survey of CFO Opinions
Regarding Dividend Policy Issues

Cash Distribution Policies in Practice
(cont.)
• Figure 16-4 reveals that stock repurchase

decisions are driven by executive’s feeling
that the stock is a good investment relative
to its true value and that there are a lack of
good investment opportunities to invest in.
• Table 16.3 summarizes the views of

financial executives about payout policy.

Figure 16.4 Factors Important to Your
Company’s Repurchase Decision

Table 16.3 Summary of Financial
Executives’ Views about Payout Policy

Residual Dividend Policy
With a residual dividend policy, the firm first

finances its investments using its own
earnings. Dividends are paid out of the
residual earnings that are not needed to
finance new investment opportunities.

Other Factors Playing a Role in
How Much to Distribute
• Liquidity Position
• Lack of Other Sources of Financing
• Earnings Predictability

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Financial Management:

Principles & Applications

Copyright © 2018, 2014, 2011 Pearson Education,

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-2

1. Distinguish between the use of cash

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-3

When a firm generates cash from operations,

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-4

This chapter provides answers to three questions

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-5

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-6

Cash distributions can take two basic forms:

1. Cash dividend - cash is paid directly to

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-7

The impact on the balance sheet will be as

– Assets side - cash will be reduced due to cash

– Equity side - there will be a corresponding

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-8

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-9

A firm’s dividend policy determines how

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-10

Date Explanation Calendar Date

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-11

Stock repurchase is when a firm uses its

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-12

• Open Market Repurchase - Here the firm

• Tender Offer - Here the company makes a

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-13

Direct Purchase from a large investor -

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-14

• A stock dividend is a pro-rata distribution

• Stock split is essentially a very large stock

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-15

One rationale is that there is an optimal

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-16

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-17

• Modigiliani and Miller suggest that without

• This is known as the Modigiliani and Miller

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-18

The distribution choice is irrelevant under the

1. There are no taxes.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-19

The dividend irrelevancy proposition can be

1. Timing of dividend distributions does not affect

2. In the absence of taxes and transaction costs,

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-20

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-21

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-22

Figure 16-2 considers two alternatives:

1. Pay $35M now and $135M in one year

• In both cases, the value of share remains

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-23

Stock Price and the Timing of Dividend

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-24

Consider Alternative #3 in which Northwest Wire and

Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-25

The firm is considering two alternatives:

– Pay $4 million today and $30million in year 1 as

– Pay $12 million today and pay $21.04 in year 1