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How are dividends paid and how do companies decide on dividend payments?

Dividends come in many forms. The most common is the regular cash dividend, but sometimes companies pay an extra cash dividend, and sometimes they pay a stock dividend. A firm is not free to pay dividends at will. For example, it may have accepted restrictions on dividends as a condition for borrowing money.

Most managers seem to have a target dividend payout ratio. But if firms simply applied this target payout rate to each year's earnings, dividends could fluctuate wildly. Managers therefore try to smooth dividends by moving only partway toward the target payout in each year. Also, they don't look just at past earnings: they try to look into the future when they set the payment. Investors are aware of this and they know that a dividend increase is usually a sign of optimism on the part of management.

Why would dividend policy not affect firm value in an ideal world?

If we hold the company's investment policy and capital structure constant, then dividend policy is a trade-off between cash dividends and the issue or repurchase of common stock. In an ideally simple and perfect world, the choice would have no effect on market value. This is the MM dividend-irrelevance proposition. The dividend controversy centers on the effects of dividend policy in our flawed world. A common—though by no means universal—view is that high payout enhances share price. While there are natural clienteles for high-payout stocks, we find it difficult to explain a general preference for dividends except as an irrational prejudice.

How might differences in the tax treatment of dividends and capital gains affect dividend policy?

20 If the stock is willed to your heirs, capital gains escape taxation altogether.

21 Suppose the discount rate is 8 percent, and an investor in a 20 percent capital gains tax bracket has a $100 capital gain. If the stock is sold today, the capital gains tax will be $20. If sale is deferred 1 year, the tax due on that $100 gain still will be $20, but by virtue of delaying the sale for a year, the present value of the tax falls to $20/1.08 = $18.52. The effective tax rate falls to 18.52 percent. The longer the sale is deferred, the lower the effective tax rate.

22 Actually, the percentage of dividend income on which tax is paid depends on the firm's ownership share in the company paying the dividend. If the share is less than 20 percent, taxes are paid on 30 percent of dividends received.

Brealey-Myers: I V. Capital Structure and I 16. Dividend Policy I I © The McGraw-Hill

Fundamentals of Corporate Dividend Policy Companies, 2001

Finance, Third Edition chapter 16 Dividend Policy 477

Instead of paying dividends, the company can repurchase its own stock. The Internal Revenue Service taxes shareholders only on the capital gains that they realize as a result of the repurchase.

Capital gains are taxed at lower rates than dividend income. If dividend income is seriously tax-disadvantaged, we would expect investors to demand a higher before-tax return on high-payout stocks. Instead of paying high dividends, companies should use the cash to repurchase shares or to reduce the amount of share issues. In this way the company would in effect convert dividend income into capital gains. This is one reason a low-dividend policy might be preferred.

Why may dividends be used by management to signal the prospects of the firm?

A firm that chooses a high-dividend policy without the cash flow to back it up will find that it ultimately has to either cut back on investments or turn to capital markets for additional debt or equity financing. Because this is costly, managers do not increase dividends unless they are confident that the firm is generating enough cash to pay them. This is the principal reason that we say that there is an information content of dividends—that is, dividend changes are liable to be interpreted as signals of a change in the firm's prospects.

If a sharp dividend change is necessary, then the company should provide as much forewarning and explanation as possible. Moreover, a firm should adopt a target payout that is sufficiently low to minimize its reliance on external equity. Why pay out cash to stockholders if that requires issuing new shares to get the cash back? It's better to hold on to the cash in the first place.

RELATED ^VEB www.cfonews.com Current dividend news

www.e-analytics.com/splitd.htm Information about stock dividends during the last year and a Links discussion of cash versus stock dividends

www.dripcentral.com/ Information about dividend reinvestment plans

KEY TERMS cash dividend stock split MM dividend-irrelevance proposition ex-dividend date stock repurchase information content of dividends stock dividend dividend payout ratio

QUIZ 1. Dividend Sequence. Cash Cow International paid a regular quarterly dividend of $.075 a share.

a. Connect each of the following dates to the correct term:

May 7 Record date

June 6 Payment date

June 7 Ex-dividend date

June 11 Last with-dividend date

July 2 Declaration date b. On one of these dates the stock price is likely to fall by about the value of the dividend. Why?

c. The stock price in early January was $27. What was the prospective dividend yield?

d. The earnings per share were forecast at around $1.90. What was the percentage payout rate?

478 part five Capital Structure and Dividend Policy e. Suppose that the company paid a 10 percent stock dividend. What would be the expected fall in the stock price?

2. Institutional Background. True or false? If false, correct the statement.

a. A company may not generally pay a dividend out of legal capital.

b. A company may not generally pay a dividend if it is insolvent.

c. The effective tax rate on capital gains can be less than the stated tax rate on such gains.

d. Corporations are not taxed on dividends received from other corporations.

3. Splits and Dividends. Shares in Raven Products are selling for $40 per share. There are 1 million shares outstanding. What will be the share price in each of the following situations? Ignore taxes.

a. The stock splits five for four.

b. The company pays a 25 percent stock dividend.

c. The company repurchases 100,000 shares.

4. Dividend Irrelevance. You own 1,000 shares of Patriot Corporation, which is about to raise its dividend from $.75 to $1.00 per share. The share price is currently $50. You would prefer that the dividend remain at its current level. What would you do to offset the effects of the increase in the dividend?

5. DRIPs. A firm considers initiating an aggressive dividend reinvestment plan (DRIP) in which it allows its investors to use dividends to buy shares at a discount of 40 percent from current market value. The firm's financial manager argues that the policy will benefit shareholders by giving them the opportunity to buy additional shares at a deep discount and will benefit the firm by providing a source of cash. Is the manager correct?

Practice Problems

6. Dividends and Repurchases. While dividend yields in the United States in the late 1990s were at historically low levels, share repurchases were at historical highs. Was this a coincidence?

7. Dividend Irrelevance. Respond to the following comment: "It's all very well saying that I can sell shares to cover cash needs, but that may mean selling at the bottom of the market. If the company pays a regular dividend, investors avoid the risk."

8. Cash Dividends. The stock of Payout Corp. will go ex dividend tomorrow. The dividend will be $1.00 per share, and there are 20,000 shares of stock outstanding. The market-value balance sheet for Payout is shown below.

a. What price is Payout stock selling for today?

b. What price will it sell for tomorrow? Ignore taxes.

Assets

Liabilities and Equity

Cash

Fixed assets

$100,000 900,000

Equity $1,000,000

9. Repurchases. Now suppose that Payout from problem 8 announces its intention to repurchase $20,000 worth of stock instead of paying out the dividend.

a. What effect will the repurchase have on an investor who currently holds 100 shares and sells 2 of those shares back to the company in the repurchase?

b. Compare the effects of the repurchase to the effects of the cash dividend that you worked out in problem 8.

Brealey-Myers: I V. Capital Structure and I 16. Dividend Policy I I © The McGraw-Hill

Fundamentals of Corporate Dividend Policy Companies, 2001

Finance, Third Edition chapter 16 Dividend Policy 479

Stock Dividend. Now suppose that Payout again changes its mind and decides to issue a 2 percent stock dividend instead of either issuing the cash dividend or repurchasing 2 percent of the outstanding stock. How would this action affect a shareholder who owns 100 shares of stock? Compare with your answers to problems 8 and 9.

Dividend Irrelevance. Suppose Mr. Dente from Example 16.2 changes his mind and cuts out Consolidated's Year 1 dividend entirely, instead spending $10 million to buy back stock. Are shareholders any better or worse off than if Consolidated had paid out $10 million as cash dividends? Hints: How many shares will be repurchased? The purchase price at Year 1 will be $110.

Dividends and Taxes. Suppose that the tax rate on dividends is 28 percent, and the tax rate on capital gains is zero. Eagle Net Resources is about to pay a $2 per share dividend.

a. By how much will Eagle Net's share price fall when the stock goes ex dividend?

b. Will anything happen to the share price on the payment date when the dividend checks are sent out?

13. Stock Dividends and Splits. Suppose that you own 1,000 shares of Nocash Corp. and the company is about to pay a 25 percent stock dividend. The stock currently sells at $50 per share.

a. What will be the number of shares that you hold and the total value of your equity position after the dividend is paid?

b. What will happen to the number of shares that you hold and the value of your equity position if the firm splits five for four instead of paying the stock dividend?

14. Dividends and Taxes. Good Values, Inc., is all-equity financed. The total market value of the firm currently is $100,000, and there are 2,000 shares outstanding.

a. The firm has declared a $5 per share dividend. The stock will go ex dividend tomorrow. At what price will the stock sell today? Ignore taxes.

b. Now assume that the tax rate on dividend income is 28 percent, and the tax rate on capital gains is zero. At what price will the stock sell today?

Repurchases and Taxes. Now suppose that instead of paying a dividend Good Values (from problem 14) plans to repurchase $10,000 worth of stock.

a. What will be the stock price before and after the repurchase?

b. Suppose an investor who holds 200 shares sells 20 of her shares back to the firm. If there are no taxes on dividends or capital gains, show that she should be indifferent between the repurchase and the dividend.

c. Show that if dividends are taxed at 28 percent and capital gains are not taxed, the value of the firm is higher if it pursues the share repurchase instead of the dividend.

0 16. Dividends and Taxes. Investors require an after-tax rate of return of 10 percent on their stock investments. Assume that the tax rate on dividends is 28 percent while capital gains escape taxation. A firm will pay a $2 per share dividend 1 year from now, after which it is expected to sell at a price of $20.

a. Find the current price of the stock.

b. Find the expected before-tax rate of return for a 1-year holding period.

c. Now suppose that the dividend will be $3 per share. If the expected after-tax rate of return is still 10 percent, and investors still expect the stock to sell at $20 in 1 year, at what price must the stock now sell?

d. What is the before-tax rate of return? Why is it now higher than in part (b)?

Brealey-Myers: I V. Capital Structure and I 16. Dividend Policy I I © The McGraw-Hill

Fundamentals of Corporate Dividend Policy Companies, 2001

Finance, Third Edition

480 part five Capital Structure and Dividend Policy

17. Dividends and Taxes. The expected pretax return on three stocks is divided between dividends and capital gains in the following way:

Stock Expected Dividend Expected Capital Gain

a. If each stock is priced at $100, what are the expected net returns on each stock to (i) a pension fund that does not pay taxes, (ii) a corporation paying tax at 35 percent, and (iii) an individual paying tax at 36 percent on investment income and 20 percent on capital gains?

b. Suppose that before the 1986 Tax Reform Act stocks A, B, and C were priced to yield an 8 percent after-tax return to individual investors paying 50 percent tax on dividends and 20 percent tax on capital gains. What would A, B, and C each sell for?

18. Dividends and Taxes. Suppose all investments offered the same expected return before tax. Consider two equally risky shares, Hi and Lo. Hi shares pay a generous dividend and offer low expected capital gains. Lo shares pay low dividends and offer high expected capital gains. Which of the following investors would prefer the Lo shares? Which would prefer the Hi shares? Which wouldn't care? Explain. Assume that any stock purchased will be sold after 1 year.

a. A pension fund b. An individual c. A corporation

19. Signaling. It is well documented that stock prices tend to rise when firms announce an increase in their dividend payouts. How then can it be said that dividend policy is irrelevant?

20. Dividend Policy. Here are several assertions about typical corporate dividend policies. Which of them are true? Write out a corrected version of any false statements.

a. Most companies set a target dividend payout ratio.

b. They set each year's dividend equal to the target payout ratio times that year's earnings.

c. Managers and investors seem more concerned with dividend changes than dividend levels.

d. Managers often increase dividends temporarily when earnings are unexpectedly high for a year or two.

21. Dividend Policy. For each of the following four groups of companies, state whether you would expect them to distribute a relatively high or low proportion of current earnings and whether you would expect them to have a relatively high or low price-earnings ratio.

a. High-risk companies b. Companies that have recently experienced a temporary decline in profits c. Companies that expect to experience a decline in profits d. "Growth" companies with valuable future investment opportunities

22. Dividend Policy. "Risky companies tend to have lower target payout ratios and more gradual adjustment rates." Explain what is meant by this statement. Why do you think it is so?

Challenge 23. problem

Dividends versus Repurchases. Big Industries has the following market-value balance sheet. The stock currently sells for $20 a share, and there are 1,000 shares outstanding. The firm will either pay a $1 per share dividend or repurchase $1,000 worth of stock. Ignore taxes.

Brealey-Myers: I V. Capital Structure and I 16. Dividend Policy I I © The McGraw-Hill

Fundamentals of Corporate Dividend Policy Companies, 2001

Finance, Third Edition chapter 16 Dividend Policy 481

Assets Liabilities and Equity

Fixed assets 28,000_Equity 20,000

a. What will be the price per share under each alternative (dividend versus repurchase)?

b. If total earnings of the firm are $2,000 a year, find earnings per share under each alternative.

c. Find the price-earnings ratio under each alternative.

d. Adherents of the "dividends-are-good" school sometimes point to the fact that stocks with high dividend payout ratios tend to sell at above-average price-earnings multiples. Is this evidence convincing? Discuss this argument with regard to your answers to parts (a)-(c).

Solutions to

Self-Test

Questions

16.1 The ex-dividend date is June 1. Therefore, Mick buys the stock ex-dividend and will not receive the dividend. The checks will be mailed on June 30.

16.2 Assets

Liabilities and Equity

After cash dividend

Other assets 850,000 Equity 850,000

Value of firm $850,000 Value of firm $850,000

Shares outstanding = 100,000

After stock repurchase

Other assets 850,000 Equity 850,000

Value of firm $850,000 Value of firm $850,000

Shares outstanding = 85,000

If a dividend is paid, the stock price falls by the amount of the dividend. If the company instead uses the cash for a share repurchase, the stock price remains unchanged, but with fewer shares left outstanding, the market value of the firm falls by the same amount as if the dividend had been paid. If a shareholder wants to receive the same amount of cash as if the firm had paid a dividend, he or she must sell shares, and the market value of the remaining stock will be the same as if the firm had paid a dividend. 16.3 The total value of the firm remains at $100 million. Since the firm issues $10 million in new preferred stock and the total value of the firm is fixed, the total value of common equity must fall by $10 million, which translates into the same $1 per share price drop as when equity was issued. If the firm starts out all-equity financed, the market-value balance sheet of the firm will be as follows (in millions):

Assets

Liabilities and Equity

Assets

$100

Preferred stock Common equity Value of firm

Value of firm $100 Shares outstanding = 1 million Price per share = $90 million/1 million = $90

$100

Brealey-Myers: I V. Capital Structure and I 16. Dividend Policy I I © The McGraw-Hill

Fundamentals of Corporate Dividend Policy Companies, 2001

Finance, Third Edition

482 part five Capital Structure and Dividend Policy

16.4 An investor who prefers a zero-dividend policy can reinvest any dividends received. This will cause the value of the shares held to be unaffected by payouts. The price drop on the ex-dividend date is offset by the reinvestment of the dividends. However, if the investor had to pay brokerage fees on the newly purchased shares, she would be harmed by a high-payout policy since part of the proceeds of the dividends would go toward paying the broker. On the other hand, if the firm offers a dividend reinvestment plan (DRIP) with a 5 percent discount, she is better off with a high-dividend policy. The DRIP is like a "negative trading cost." She can increase the value of her stock by 5 percent of the dividend just by participating in the DRIP.

16.5 The stock price dropped by more than the dividend because investors interpreted the news as a signal that in addition to omitting the current dividend Con Ed would have to reduce future dividends. The omitted dividend conveyed bad news about the future prospects of the firm.

16.6 The price of the stock will equal the after-tax cash flows discounted by the required (aftertax) rate of return:

Notice that the after-tax proceeds from the stock would increase by the amount that previously went to pay capital gains taxes, .20 x $4.72 - $.944. The present value of this tax saving is $.944/1.10 - $.86. Therefore, the price increases to $97.78 + $.86 - $98.64. The pretax rate of return falls to (102.50 - 98.64 + 10)/98.64 - .1405, or 14.05 percent, but the after-tax rate of return remains at 10 percent.

Brealey-Myers: I VI. Financial Planning I 17. Financial Statement I I © The McGraw-Hill

Fundamentals of Corporate Analysis Companies, 2001

Finance, Third Edition

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  • segan
    Why would payout policy dividendirrelevance proposition not affect firm value in an ideal world?
    8 months ago

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