15 Dividend Policy 2006 ThomsonSouthWestern Introduction n This

15 Dividend Policy © 2006 Thomson/South-Western

Introduction n This chapter examines the factors that influence a company’s choice of dividend policy. n Pros and cons of dividend policies n Mechanics of dividend payments n Stock dividends n Share repurchase plans 2

Influencing the Value of the Firm n Investment Decisions q n Financing Decisions q n Determine the level of future earnings and future potential dividends Influence the cost of capital, which can determine the number of acceptable investment opportunities Dividend Decisions q Influence the amount of equity capital in a firm’s capital structure and the cost of capital 3

Determinants of Dividend Policy n n n Variations in payout Legal constraints Restrictive covenants Tax considerations Liquidity and CF considerations Borrowing capacity n n n Access to capital markets Earnings stability Growth prospects Inflation Shareholder preference Protection against dilution 4

Irrelevance of Dividends n Assumptions q q n n No taxes No Transactions costs No Issuance costs Fixed investment policy Wealth of a shareholder is not affected by dividend policy. Dividend can have informational content. Signaling effect Clientele effect 5

Relevance of Dividends n Assumptions q Relaxed assumptions and dividend policy becomes important. n Risk aversion n Transaction costs n Taxes 6

Relevance of Dividends n Issuance (Flotation) costs n Agency costs n Empirical evidence is mixed. n Many practitioners believe that dividends are important. q Informational content q Expensive external equity 7

Passive Residual Policy n n Suggests that a firm should retain its earnings as long as it has investment opportunities that promise higher rates of return than the required rate. Dividends can fluctuate significantly. q n n Depends on the firm’s investment opportunities In practice, dividends can be smoothed. Growth firms will have low-dividend payouts. 8

Stable Dollar Dividend Policies n n n Reluctance to reduce dividends Increases in dividends tend to lag earnings. Desirability q q Information content Many shareholders depend on dividends. Stability tends to reduce uncertainty. Legally desirable n Legal list 9

Other Dividend Payment Policies n Constant Payout Ratio q q n Small Regular Dividends Plus Extras q q n Pays a constant percent of earnings as dividends Fluctuating dividends Stockholders can depend on regular payout. Accommodates changing earnings and investment requirements Small Firms and Dividends q q Tend to pay out a smaller percent of earnings Rapid growth and limited access to capital markets 10

Multinational Firms & Dividends n Primary means of transferring funds to parent company q Tax q Foreign Exchange q Political risk q Funds availability q Financing needs 11

How are Dividends Paid ? n Declaration Date q n Record Date q n n Board of directors announce a dividend. Shareholders of record will receive dividends. Ex-dividend Date q 2 business days before record date q Stock trades ex-dividends Payment Date q 4 weeks after the record date q Dividend checks mailed or direct deposited 12

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Dividend Reinvestment Plan n Cash dividend reinvested automatically into additional shares n Purchase new or existing shares q Purchasing new shares raises new equity capital for the firm. n No brokerage commissions n Income tax liability 15

Information on Dividend Reinvestment n Do a search on the Internet for dividend reinvestment. q n Check out the various reinvestment plans. Check out CSX Corporation’s dividend reinvestment plan: http: //www. csx. com/docs/dividprx. html 16

Stock Dividends: Payment of additional shares of C/S n n n Stock splits are similar to stock dividends. Increases the number of shares outstanding Accounting transaction q n Transfer pre-dividend market value from retained earnings to other stockholders equity Market price of C/S should decline in proportion to the number of new shares issued. 17

Reasons for Declaring a Stock Dividend n n Broaden the ownership of the firm’s shares May result in an effective increase in cash dividends q n Provided the level of cash dividends is not reduced Reduction in share price may broaden the appeal of the stock to investors. q Resulting in a real increase in market value 18

Stock Repurchase n By a tender offer in the open market or by negotiation with large holders n Treasury stock n Reduces the number of shares outstanding n Increases EPS n Usually announced 19

Stock Repurchase n Advantages q Converts dividend n Disadvantages q for the stock income into capital q Company may overpay gains q Trigger IRS scrutiny Greater financial q Tax avoidance flexibility q Some current q Timing q Signal effect stockholders may be unaware 20