Chapter 14
Dividend Policy
Del Hawley
FIN 634
Fall 2003
Dividend Fundamentals
• Relevant dates for dividend payments
– Announcement date: information is released to the public
– Date of record: Listed as owner on this day – get dividend
– Ex dividend date: Stock sells without dividend – several (3)
days before date of record
– Payment date: When the dividend is actually paid
The stock price should drop by the amount of the dividend
on the ex-dividend date, other things equal.
Dividend Fundamentals
• Legal factors affecting dividend policy
– Capital impairment constraint: Cannot pay dividends that
exceed “legal capital”
• The par value of the outstanding common stock in most
states
• The par value plus paid-in capital in excess of par (all of
the funds collected from the sale of the shares) in a few
states.
– Nothing prohibits a company from paying more than its
current earnings as dividends
– Cannot accumulate earnings so owners can escape taxes
Calculating The Maximum Amount a Firm
Can Pay in Cash Dividends
Where legal capital is defined as the par value of the
common stock, maximum payout is $340,000 (Paid-in
capital + RE)
Alpha Corporation’s Stockholders’ Equity
Common stock at par
$100,000
Additional paid-in capital
200,000
Retained earnings
140,000
Total stockholders’ equity
$440,000
In states where legal capital includes all paid-in capital, the
maximum payout is $140,000 (only Retained Earnings)
Dividend Fundamentals
• Contractual constraints on dividend payments
– Loan covenants restrict, but don’t prevent, dividend
payments
– May establish a “pool” of earnings that can be paid out
Types of Dividends
• Types of dividend policies
– Constant payout ratio policy (almost never
observed)
– Constant nominal payments (standard worldwide)
• Maintain steady dividends
• Increase only after a proven and continuing
increase in earnings
– Low regular and extra dividend
Types of Dividends
• Stock dividends and stock splits
– Are the same thing except for the accounting
method used to record them
– Neither should affect the total value of equity
– Stock dividends assume that shareholders are
stupid (they aren’t)
• Signaling rationale
• Make your own cash dividend rationale
• Stock repurchase – a substitute for a cash dividend
– Buy shares in the open market
– Make tender offer to shareholders
– Enter into private negotiation (Green Mail)
Patterns Observed In Dividend Policies
• Dividend policies have pronounced industry patterns, and
these are the same worldwide
– profitable firms in mature industries tend to pay out much
larger fractions of their earnings
• Within industries, dividend payout tends to be directly
related to
– asset intensity (tangible vs intangible assets)
– presence of regulation
• Within industries, dividend payout tends to be inversely
related to
– The growth rate of sales and earnings
The Fraction of All Publicly Traded U.S.
Firms Paying Cash Dividends - 1926-1999
Frame A
100
Percent
80
60
40
20
0
1926
1936
1946
1956
1966
Year
1976
1986
1996
Fraction of Publicly Traded U.S. Firms
Paying Dividends, By Exchange
Frame B
100
NYSE
Percent
80
60
AMEX
40
NASDAQ
20
0
1926
1936
1946
1956
1966
Year
1976
1986
1996
Market Value of Share Repurchase
Announcements, 1980-1999
250
$US
Bns
200
150
100
50
0
80
82
84
86
88
90
92
94
96
98
CUMULATIVE MEAN RATE OF RETURN
Average Stock Market Reaction to Share
Repurchase Announcements
25%
20%
15%
10%
5%
0%
-5%
-10%
-60 -50 -40 -30 -20
-10
0
+10 +20 +30 +40 +50 +60
TRADING DAY
Aggregate Dividend Payout Ratio for the
U.S. Corporate Sector, 1970-2000
%
90
80
70
60
50
40
30
20
10
0
70
72
74
76
78
80
82
84
86
88
90
92
94
96
98
2000
Dividend Payout Ratios For Selected U.S.
Industries
Industry
Biotechnology
Airlines
Payout
Ratio Industry
0%
0
Household non-durables
Industrial metals
Payout
Ratio
41%
46
Computer software
2
Pharmaceuticals
47
Semiconductors
7
Banking
47
Computer hardware
14
Basic chemicals
48
Commcl Transportation
15
Foods & non-alcohol bev
51
Prop & cas Insurance
20
Autos & auto parts
42
Aerospace & defense
28
Electric utilities
65
Paper & forest products
28
Alcohol bev & tobacco
70
Telecommunications
39
Oil & gas product & mktg
75
41
Source: Standard & Poors Industry Reports, various issues (2001)
Dividend Ratios for Selected U.S.
Corporations in 2002
Company
Microsoft
Cisco Systems
IBM
Wal Mart
Boeing
ExxonMobil
Merck
BellSouth
Procter & Gamble
Southern Company
Amer Electric Power
Annual Dividend
Div/share yield %
0
0
$0.60
0.30
0.68
0.92
1.40
0.76
1.52
1.34
2.40
0
0
0.8%
0.5
1.6
2.4
2.7
2.4
1.7
5.1
5.9
Payout
ratio %
Market to
book ratio
0
0
14%
20
20
42
45
56
73
74
77
5.5
3.9
5.5
7.2
3.7
3.7
7.2
3.2
10.1
2.3
1.6
Generally, high Market-to-Book firms have low dividend payouts & yields
Relationship Between Dividend Policy and
Earnings Growth
• Growth is influenced by the dividend policy in a very direct
way:
Growth of earnings = ROE x (1 – Payout Ratio)
This is an estimator of earnings growth, but in general:
Higher retention ratios will produce higher earnings
growth as long as the firm has profitable projects in
which to invest.
Patterns Observed In Dividend Policies
(Continued)
• Almost all firms maintain constant nominal dividend
payments per share for long periods of time
– Companies tend to "smooth" dividends, and these are far
less variable than are corporate profits
• Taxes clearly influence dividend payouts, but the net effect
is ambiguous. Taxes neither cause nor prevent dividends
– Firms paid dividends before and after income tax
– Clearly influences pay-out, though perhaps perversely (tax
increases lead to higher payouts, rather than lower)
Market Reactions to Dividend Policies
• The stock market reacts positively to dividend initiations
and increases
– 2-3% abnormal announcement period return
• Market reacts even more (negatively) to dividend decreases
or cuts
• Dividend changes clearly convey information about
management’s expectations regarding firm’s prospects
– Dividend changes are deemed to be informative about the
firm’s current and future earnings
• In spite of intensive research, it is unclear how dividends
affect the required return on a firm's common stock
– Some studies show positive relationship, others none at all
Note on the effect of dividends on the
required return on common stock
Recall that we can write the required return on common
stock as:
Re = (Div1/Price0) + g
You can think of (Div1/Price0) as the current dividend yield
and g as the price appreciation or capital gains rate on the
shares.
The dividend irrelevance hypothesis says that investors
don’t care how Re is composed – all dividend yield, all
capital gains, or any mix in between. Return is return.
Can make your own dividend or growth…
Note on the effect of dividends on the
required return on common stock
Arguments that favor the relevance of dividends:
Tax differences: For a long time, capital gains were taxed at a lower
rate than dividend income. Therefore, some investors may have
preferred low-dividend high-gain stocks. Now, dividends are taxed at a
lower rate, too.
Risk (Bird-in-the-Hand Theory): Return that comes from capital gains
is riskier than return that comes from dividends since you have the
dividend but must wait for the uncertain capital gain.
Clienteles: There may be groups of investors who prefer the steady
income provided by dividends and others who prefer no dividends in
lieu of long term growth in value.
Liquidity: Stocks that are traded in blocks (100 or 1000 shares) are
more readily bought and sold than odd-lot trades. Less of an issue now
than 10 or 20 years ago.
The Agency Cost / Contracting Model Of
Dividend Payments
It’s very hard to explain all of the observed patterns of
dividend policy in one theory, so several competing
theories have been advanced.
Mainstream favorite: The Agency Cost/Contracting Model
– Dividends exist to overcome agency problems between
managers and diffuse shareholders. Managers “commit” to
paying out free cash flow as dividends. Dividends force the
company to be monitored by the capital markets.
• Partly based on ownership structure: Private and
closely held firms rarely pay dividends; big public firms
have high payouts
• Partly based on investment opportunity set (IOS):
mature firms have high payout; high-growth firms have
low payouts
The Signaling Model Of Dividend Payments
Major competitor: the Signaling Model of Dividends
– Firms pay dividends to “burn money” that is not needed for
internal investments
– This signals the market that earnings are expected to remain
high, or if dividends are increased, that earnings are
expected to remain at the higher level at least
– Dividends separate a company from its weaker rivals
The Residual Model Of Dividend Payments
The most correct model in theory: the Residual Model of
Dividends
– Firms make a long-term capital budget to take advantage of
all positive-NPV projects that are within the strategic niche of
the company
– Earnings are projected over the term of the planning horizon
– The expected excess of earnings over the amount needed
for investments is paid out as dividends – smoothly or with a
built-in rate of increase
If most companies followed this model, dividends would be
higher and more volatile than we see.
Dividend Policy Irrelevance In A World
Without Market Imperfections
• Miller & Modigliani (1961) showed dividend policy cannot
impact firm value in a world without market frictions
– Value is determined solely by investment policy
– If Investment is fixed, you can set dividends at any level
desired
– Must be sure to compare equal investment levels
• Assume two firms, initially equal in size, value, profitability
– Both have total assets worth $235 million today (YE 2002)
– Both are in the same industry, with 10% profitability rate
– Both will earn $23.5 million during period 1 (year 2003)
– Both expect to invest $23.5mn in +NPV projects at YE2003
– Both have 25 million shares now, worth $9.40/share
Can Differing Dividend Policies Impact
Valuations Of Firms Payout And Retention?
• If the firms differ in dividend preferences of shareholders
– Retention S/Hs want $23.5 mn profits earned during 2003 to
be re-invested in firm at YE 2003 (for subsequent year 2004)
– Payout S/Hs want $23.5mn profits earned during 2003 to be
paid out as a dividend at YE 2003
• Cash needed for $23.5 mn investment at YE 2003 (for
2004) to be raised through $24.5 mn share issue to new
investors
• The firms thus differ regarding the use of Year 2003 profits
and the funding of YE 2003 investments
– Retention will finance investment with retained profits
– Payout will finance with new shares
• Absent taxes or market imperfections, the choice doesn’t
impact the relative values of the two firms
Can Differing Dividend Policies Impact
Valuations Of Firms Payout And Retention?
Retention
Before
Assets (Millions)
Equity (Millions)
Shares (Millions)
Price per Share
Investment Needs (Millions)
Profitabilty Rate
Period 1 Earnings (Millions)
Total Dividend (Millions)
Divdend per Share
Retained Earnings (Millions)
New Equity Issued ($Millions)
Number of New Shares (Millions)
Dividend Yield
Price Appreciation
Total Return
Payout
After
$ 235.0 $ 258.5
$ 235.0 $ 258.5
25.0
25.0
$9.40
$10.34
$
23.5
10%
$
23.5
$
$
$
23.5
$
-
Before
After
$ 235.0 $ 258.5
$ 235.0 $ 235.0
25.0
27.5
$9.40
$9.40
$
23.5
10%
$
23.5
$
23.5
$
0.94
$
$
23.5
$
2.5
0%
10%
10%
0%
10%
10%
Valuation Of Firm Retention
•
Retention: Issues no new shares at YE2003, and earns $23.5m profit
– Will retain and invest $23.5mn profits, so at YE 2003, will have total
assets of $258.5 mn;
– Equity will be worth $10.34/share at EOY 2003; still 25 mn O/S so
total market value will be $258.5 mn
– Return earned by Retention’s S/Hs during 2003:
 D1 + P1 - P0   0 + $258.5 - $235 
r=
= 
 = 10%
P
$2
35

0

 
• Retention: What about Year 2004 and later years?
– At YE 2003, has $258.5mn assets. With 10% profits rate will
earn $25.85 mn during Year 2004, which it will retain
– At YE 2004, equity will be worth $284.35 mn ($258.5mn +
$25.85mn)
– Still 25mn shares, so each worth $11.374; Yr 2004 return 10%
Valuation Of Firm Payout
• Payout: Also earns $23.5mn during 2003, pays this out to
existing shareholders at YE 2003
– At EOY 2003, before issuing new shares but after paying
dividends, will have total assets of $235 mn
– Still have 25mn shares, each worth $9.4/share
– Return earned by Retention’s old S/Hs during 2003:
 D1 + P1 - P0   $23.5 + $235 - $235 
r=
= 10%
= 

$235

P0

 
• To finance $23.5mn new investment, must sell 2.5mn shares
at $9.4/share, so total assets are $258.5 mn at the start of year
2004
– Will earn 10% profit, or $25.85 mn on assets during 2004; at
YE 2004 assets worth $284.35 mn before paying dividends
– Will then pay out $25.85 mn Year 2004 profits as dividends, so
27.5 mn shares outstanding worth $9.40 each
– Raise $25.85 mn cash by selling 2.75mn share @ $9.4/share
Real-World Influences On Dividends
Companies operate in the real world, with many frictions. Most
of them should discourage dividends
– Personal taxes on dividends should discourage payments
• Empirical evidence is ambiguous
• Dividends were paid before 1936 (no taxes) and after
– Security issuance costs should discourage dividends
• If costly to issue new stocks & bonds, firm should retain cash
– Investor trading costs argue in favor of dividends
• But cost of selling shares for income has fallen steadily
– Dividends might be a “residual” after funding investments
• But dividends are most stable of all CF series
– May convey information in markets with info asymmetries
• But what specific info & Isn’t there a cheaper way to signal?
• Latest empirical evidence: div signals the past, not the future.
How Do Corporations Really Set Dividend
Payments?
Dividends determined today as they were for Lintner (1956)
– Managers believe investors value steady dividend payments
– Managers seem to have a target payout ratio, but only on
average over time
– Managers will allow the payout ratio to vary in the short term
to keep dividends the same
– Managers will only increase dividends if permanent earnings
increase
– Managers will only cut dividends if the firm is facing financial
disaster
How Do Corporations Really Set Dividend
Payments?
Managerial reluctance to change nominal dividend
payments gives rise to the partial adjustment model
– Assume the target payout ratio = 0.50, with profits initially at
$2.00/share
– Implies an annual dividend of $1.00/share and a quarterly
dividend of $0.25/share
– Suppose permanent earnings suddenly rise to $3.00/share
– Managers will not increase dividends to $1.50/year
immediately. Instead,
– May do so in $0.05 quarterly increments, over 2.5 yrs
A Checklist For Dividend Payouts
The Agency Cost/Contracting Model, and empirical evidence, support
these relationships between “optimal” payout levels and key variables
Increases in this variable:
Do what to Dividends?
Firm’s asset growth
Reduce
Positive NPV investment opportunities
Reduce
Level of free cash flow generated
Increase
Number of individual shareholders
Increase
“Tightness” of ownership structure
Reduce
Size & number of bloc holders
Reduce
State (vs private) ownership
Reduce
Personal tax rates on income
Ambiguous
(seems to increase)