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Sixth Edition
19
Chapter Nineteen
Dividends and Other
Payouts
McGraw-Hill Ryerson
2005 McGrawHill Ryerson Limited
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Chapter Outline
19.1 Different Typesof Dividends
19.2 StandardMethodof CashDividendPayment
19.3 The Benchmark Case: An Illustration of the Irrelevance of
DividendPolicy
19.4 Repurchaseof Shares
19.5 Personal Taxes, IssuanceCosts, andDividends
19.6 ExpectedReturn, Dividends, andPersonal Taxes
19.7 Real-WorldFactorsFavouringaHigh-DividendPolicy
19.8TheClienteleEffect: AResolutionof Real-WorldFactors
19.9What WeKnowandDoNot KnowAbout Dividend Policy
19.10SummaryandConclusions
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19.1Different Typesof Dividends
Companiesusuallypayaregularcashdividend.
Publiccompaniesoftenpayquarterly(four timesayear)
Sometimesfirmswill throwinanextracashdividend.
Theextremecasewouldbealiquidatingdividend.
Stockdividends.
Nocashleavesthefirm.
Thefirmincreasesthenumber of sharesoutstanding.
Dividendinkind.
WrigleysGumsendsaroundaboxof chewinggum.
Dundee Crematoria offers shareholders discounted
cremations.
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Timingof CashDividendPayment
25 Oct. 1 Nov. 2 Nov. 6 Nov. 7 Dec.
Declaration
Date
Cum-
dividend
Date
Ex-
dividend
Date
Record
Date
Payment
Date

DeclarationDate: The company/ board of directors declares


anamount, dateof payment, dareof record, ex-dividenddate.
Cum-DividendDate: The last day that the buyer of a stock is
entitledtothedividend.
Ex-DividendDate: The first dayyou can sell stock and still be
entitledtothedividend.
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Timing of Cash Dividend Payment
Date of Payment: Checks mailed.
Immediateeffect of dividendonprices
- pricesharefallsbydividend/ shareonex-dividenddate
[otherwise there would be an arbitrage opportunity;]
price either adjusted automatically or falls within
secondsof trading
Date of Record (= ex-dividend date + 2 days): The
corporation prepares a list of all shareholders as of ex-
dividenddate.
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Price Behaviour around the Ex-Dividend
Date
In a perfect world, the stock price will fall by the amount
of the dividend on the ex-dividend date.
$P
$P - div
Ex-
dividend
Date
The price drops
by the amount of
the cash
dividend
-t

-2 -1 0 +1 +2

Empirically, the price drop is less than the


dividend and occurs within the first few
minutes of the ex-dividend day.
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Caveat: Taxes maymatter here. If sayinvestors
are in 30%dividend tax bracket, price should
fall by 70 cents after an $1 dividend [same
arbitrageargument asalways]
Price changes from dividend
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19.3 The Benchmark Case: An Illustration of
theIrrelevanceof DividendPolicy
A compellingcase can be made that dividend
policyisirrelevant.
Since investors do not need dividends to
convert shares to cash, they will not pay
higher prices for firms with higher dividend
payouts.
In other words, dividend policy will have no
impact on the shareholders value because
investors can create whatever income stream
theyprefer byusinghomemadedividends.
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Example
Two identical firms A, B same assets, cash-flows (in all
states). $10 of spare cash (that will earn risk-free rate,
nobetter insidethefirmthaninacheckingaccount)
A, B: 10shareworth$10each.
Aannouncesdividend$1/ share($10total)
Bdoesnot, but insteadhomemadedividends: sell oneshare
at $10,
Ex-post:
Asshareholdersown100%of firmwithout $10lesscash
Bspast-shareholdersown90%of firmwith$10morecash.
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Example continued
Replicatingportfoliofor BinvolvingA:
Sell 1share, invest $9risklessly
Replicatingportfoliofor AinvolvingB:
Borrow$10, buytheextrashare, repay$10interest rateper
year
Youshouldbeindifferent betweenthetwo
Idea: dividends like transferring $ from one pocket to
another. Whether it stays in the firm or is paid out as
dividendshouldbeirrelevant
Inbothcasesit stayswithininvestorsportfolio
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Dividends vs Share Repurchasing
Another payout alternative:
C: Firmbuysback(andretires) 1shareat $10; 10
$9shares; C: 9$10shares.
If commissions, taxes, other imperfections are
absent, shareholdersareindifferent
Managers of A, B, C follows different dividend
policiesbut shareholdersareindifferent.
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Dividends vsShare Repurchasing
- Share buybacks are an open market operation (buyer not
revealed)
- Sometimes firm makes a tender offer above market price
Dividends dominated 30 years ago
Roughly equal role these days of the two
Benefits of using share repurchases:
- flexibility: firmsreluctant to reduceexistingdividend, stock
repurchasesmaybetimedarbitrarily
Implication: if permanent increaseincashflowincreased
dividend; if temporary increase in cashflow one time
sharerepurchase.
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Dividends and Share Repurchasing
Management with stock options prefers share
buybacks(thesekeepnominal sharevaluehigh)
Buybacksoffset dilution, keepownershipstructure
moreefficient.
Dividends equal to all investors, buybacks
redistributecashtoonlysomeof them
Repurchase is an investment of sorts. If
management has private information about
profitability and thinks current price is depressed.
Hence: repurchaseworksasasignal
Taxes: capital gainstaxversusdividendtax
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Another Illustration of the Irrelevance
of Dividend Policy
Example: YorkCorporation, anall-equityfirm
At date 0, the managers are able to forecast cash flows
perfectly.
Thefirmwill receiveacashflowof $10,000at date0and
$10,000at date1
Thefirmwill dissolveat date1.
Thefirmhasnoadditional positiveNPVprojects
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An Illustration of the Irrelevance of
Dividend Policy (cont.)
I ) Current Policy: Dividends set equal to cashflow
Dividends (Div.) at each date =$10000
The firm value will be :
s r
DIV
DIV V


1
1
0 0
91 . 19090 $
1 . 1
10000 $
10000 $ 0 V
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An Illustration of the Irrelevance of
Dividend Policy (cont.)
Assume 1,000 shares are outstanding, then:
09 . 19 $
1 . 1
10 $
10 $ 0 P
After the imminent dividend is paid, the stock price will fall
to $9.09 (19.09-10)
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An Illustration of the Irrelevance of
Dividend Policy (cont.)
I I) AlternativePolicy: Initial dividend>cashflow
Pay $11 per share immediately i.e., $11 X 1000 shares =
$11,000astotal dividend.
Theextra$1,000must beraisedbyissuingnewstock.
Date0Date1
Total dividendstooldshareholders $11,000 $8,900
Dividendsper share $11 $8.9
Note: at date1, thenewshareholderswill get $1,100of thetotal
cashflow
leavingonly$8,900tooldshareholders.26
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An Illustration of the Irrelevance of
Dividend Policy (cont.)
The PV of dividends per share with the alternative policy:
09 . 19 $
1 . 1
9 . 8 $
11 $ 0 P
The indifference proposition:
-The PV of the stock in both scenarios is the same.
-The change in dividend policy did not affect the value of a
share.
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Summary: Irrelevance of Dividend
Policy
Dividendsaffect shareprice
Dividendpolicyirrelevant toshareholder value
Anincreaseby$1at timezero has to beaccompaniedbyan
equivalent decreaselater
Stock=PV(futuredividends)
Higher Dividendsarelower thanthelower dividends
Assumptions:
Notaxes
Cashearnsthesamereturnoutsideof thefirm
Firmis transparent: act of demanding dividends conveys
nosignal about cashflows.
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Modigliani and Miller (MM)
proposition
MM proposition: Investors are indifferent with regard to
dividend policy
Assumptions:
1) No taxes, brokerage fees, etc.
2) Homogeneous expectations
3) Firms investment policy is set ahead of time
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Homemade Dividends
ABC Inc. is a $42 stock about to pay a $2 cash dividend.
Bob Investor owns 80 shares and prefers $3 cash dividend.
Bobs homemade dividend strategy:
Sell two shares ex-dividend
homemade dividends
Cash from dividend $160
Cash from selling stock $80
Total Cash $240
Value of Stock Holdings $40 78 =
$3,120
$3 Dividend
$240
$0
$240
$39 80 =
$3,120
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Dividend Policy is Irrelevant
Since investors do not need dividends to convert shares to
cash, dividend policy will have no impact on the value of the
firm.
In the above example, Bob Investor began with total wealth
of $3,360:
share
42 $
shares 80 360 , 3 $
240 $
share
39 $
shares 80 360 , 3 $
80 $ 160 $
share
40 $
shares 78 360 , 3 $
After a $3 dividend, his total wealth is still $3,360:
After a $2 dividend, and sale of two ex-dividend shares,his
total wealth is still $3,360:
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Irrelevance of Stock Dividends:
Example
XYZ Inc. has two million shares currently outstanding at $15
per share. The company declares a 50%stock dividend. How
manyshareswill beoutstandingafter thedividendispaid?
A 50% stock dividend will increase the number of shares by
50%:
2million1.5 =3millionshares
After the stock dividend what is the new price per share and
what isthenewvalueof thefirm?
Thevalueof thefirmwas $2m$15per share=$30m. After
thedividend, thevaluewill remainthesame.
Priceper share=$30m/ 3mshares=$10per share
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Dividends and Investment Policy
Firms should never forgo positive NPVprojects to increase
adividend(or topayadividendfor thefirst time).
Recall that oneof theassumptionsunderlyingthedividend-
irrelevance arguments was The investment policy of the
firmis set ahead of time and is not altered by changes in
dividendpolicy.
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19.4Repurchaseof Stock
Insteadof declaringcashdividends, firmscanriditself
of excess cash through buying shares of their own
stock.
Recently share repurchase has become an important
wayof distributingearningstoshareholders.
Whentaxavoidanceis important, sharerepurchaseis
apotentiallyuseful adjunct todividendpolicy.
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Stock Repurchase versus Dividend
$10 = /100,000 $1,000,000
=
Price per share
100,000
=
outstanding Shares
1,000,000 Value of Firm 1,000,000 Value of Firm
1,000,000 Equity 850,000 assets Other
0 Debt $150,000 Cash
sheet balance Original A.
Equity & Liabilities Assets
Consider afirmthat wishestodistribute$100,000toitsshareholders.
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Stock Repurchase versus Dividend
$9 = 00,000 $900,000/1 = share per Price
100,000 = g outstandin Shares
900,000 Firm of Value 900,000 Firm of Value
900,000 Equity 850,000 assets Other
0 Debt $50,000 Cash
dividend cash share per $1 After B.
Equity & s Liabilitie Assets
If they distribute the $100,000 as cash dividend, the balance sheet
will look like this:
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Stock Repurchase versus Dividend
Assets Liabilities & Equity
C. After stock repurchase
Cash $50,000 Debt 0
Other assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding= 90,000
Price per share = $900,000/ 90,000 =$10
If they distribute the $100,000 through a stock repurchase, the
balance sheet will look like this:
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Share Repurchase (Real-World
Considerations)
Lower tax
Tender offers
If offer priceisset wrong, somestockholderslose.
Open-market repurchase
Targetedrepurchase
Greenmail
Gadflies
Repurchaseasinvestment
Recent studies have shown that the long-term stock
price performance of securities after a buyback is
significantlybetter thanthestockpriceperformanceof
comparablecompaniesthat donot repurchase.
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In Canada, individual investors face a lower dividend
taxrateduetothedividendtaxcredit.
Capital gains for individuals are taxed at 50%of the
marginal taxrate, andtheeffectivetaxrateondividend
incomeishigher thanthetaxrateoncapital gains.
19.5 Personal Taxes, Issuance Costs, and
Dividends
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Firms Without Sufficient Cash to Pay a
Dividend
In a world of personal taxes,
firms should not issue stock
to pay a dividend.
Firm
Stock
Holders
Cash: stock issue
Cash: dividends
Gov.
Taxes
Investment Bankers
The direct costs of
stock issuance will
add to this effect.
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Consider a firm that has $1 million in cash after
selectingall availablepositiveNPVprojects.
Thefirmhasseveral options:
Select additional capital budgeting projects (by
assumption, thesearenegativeNPV).
Acquireother companies
Purchasefinancial assets
Repurchaseshares
Firms With Sufficient Cash to Pay Dividend
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Capital gainstax=50%of marginal taxrate
<DividendTax
<Personal Incometax
Implication: Donot raisenewsharestopaydividends
NoTaxes Firm
Payout asdividend Issuenewshares
($100) ($100)
Shareholders
Taxes, Issuance Costs, and Dividends
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Alternatives for firm with spare cash
Select new projects [Problem: Spare cash by definition
meanspositiveNPVprojectsunavailable]
Acquire other companies [problem: unless there is
synergy, takeover targetswill tradeat premium]
Purchase Financial Assets [This is tax-neutral if tax on
corporateinterest isthesameastaxonindividual interest
income]. But thosearenot equal.
Example: firmcaneither invest $100or payout.
(i) Firmpays out $100dividend, shareholders invest in T-bill
for oneyear at rater.
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Example
(ii) Firm invests in T-bill, then pays out the proceed after 1
year;
T
o
: Tax on dividends
T
c
: corporate tax rate
(i) $100 $100 (1 T
d
)
t-bill
$100 (1 T
d
)(1+r)
Next Year pre-tax
Post-tax
$100 (1 T
d
)(1+r (1 T
p
))
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Example contd..
Choicebetween(i) and(ii) dependsoninvestorspersonal
taxrate(onwhether T
p
islessor morethanT
c
)
Example: Ontario corporate rate =36%; Individual Tax
rate=40%or morefor income72kor more
(ii) $100
t-bill
$100 (1 +r)
tax
$100 (1+r (T T
c
))
in firm at t =0 in firm pre-tax at t=1 in firm next year post tax
Dividend
$100 (1 T
d
) (1+r (1 T
c
))
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Inthepresenceof personal taxes:
1. Afirmshouldnot issuestocktopayadividend.
2. Managers have an incentive to seek alternative uses
for fundstoreducedividends.
3. Thoughpersonal taxesmitigateagainst thepayment of
dividends, these taxes are not sufficient to lead firms
toeliminateall dividends.
Personal Taxes, Issuance Costs, and
Dividends
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19.6 Expected Return, Dividends, and
Personal Taxes
What is the relationship between the expected
returnonthestockanditsdividendyield?
The expected pretax return on a security with a
high dividend yield is greater than the expected
pretax return on an otherwise-identical security
withalowdividendyield.
After tax is a different story; otherwise-identical
securitiesshouldhavethesamereturn.
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Evidence on Dividends and Taxes in Canada
Prior to 1972, capital gains were untaxed in
Canada
In1985, alife-timeexemptiononcapital gains
wasintroduced.
Anticipation of the tax break on capital gains
caused investors to bid up prices of low-
dividendyieldstocks.
Firms responded by lowering their dividend
payouts.
The dividend taxcredit works to reduce taxes
ondividendsreceivedfromCanadianfirms.
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Example
Example: Two identical firms G, D; zero interest
rate: current price $100, next years price $120; if
not dividend, returnis20%.
Assumezero capital gainstax[it isalwayslower than
dividend tax, if you postpone your gain it may
criticallybezeroif your retirement incomelow];
D: paysout $20dividendnext year
- Post dividendprice$100
- Dividendtaxed30%
- $14toinvestor, $6togovernment
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Example continued
Ds investors value post tax $114
Assume G pays no dividend and no tax.
No arbitrage condition
Return (G) =Return (D)
Price (D). (1+20%) =$114
Ds current price $95
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Example continued
high-dividend stocks ceteris paribus have higher
expectedreturn
[if you somehow not pay dividends taxes, high dividend
stocksbetter
Highdividendstocksbetter for RRSP(taxsheltered) no-
dividendbetter kept outsideof RRSP
Evidence: Before 1972 capital gains tax =0
Before 1972: Dividend paying stocks pretax return
Pre-tax return after 1972
No individual stocks pre-tax return
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19.7 Real World Factors Favouring a
HighDividendPolicy
Desire for Current Income
Resolution of Uncertainty
Tax Arbitrage
Agency Costs
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Desire for Current Income
The homemade dividend argument relies on
no transactions costs.
To put this in perspective, mutual funds can
repackage securities for individuals at very low
cost: they could buy low-dividend stocks and
with a controlled policy of realizing gains, pay
their investors at a specified rate.
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Resolution of Uncertainty
It would be erroneous to conclude that
increased dividends can make the firm less
risky.
A firms overall cash flows are not necessarily
affected by dividend policyas long as capital
spending and borrowing are not changed.
Thus, it is hard to see how the risks of the
overall cash flows can be changed with a
change in dividend policy.
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Tax Arbitrage
Investors can create positions in high
dividend-yield securities that avoid tax
liabilities.
Thus, corporate managers need not view
dividendsastax-disadvantaged.
Thereissomeevidencethat taxarbitragedoes
occur in Canada but not to the extent
necessary to eliminate taxes on dividends
completely.
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Agency Costs
AgencyCost of Debt
Firms in financial distress are reluctant to cut
dividends. To protect themselves, bondholders
frequently create loan agreements stating
dividends can only be paid if the firm has
earnings, cash flow, and working capital above
pre-specifiedlevels.
AgencyCostsof Equity
Managers will find it easier to squander funds if
theyhavealowdividendpayout.
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19.8 The Clientele Effect: A Resolution of
Real-WorldFactors?
Reasons for Low Dividend
Personal Taxes
High Issuing Costs
Reasons for High Dividend
Information Asymmetry
Dividends as a signal about firms future performance
Lower Agency Costs
capital market as a monitoring device
reduce free cash flow, and hence wasteful spending
Bird-in-the-hand: Theory or Fallacy?
Uncertainty resolution
Desire for Current Income
Clientele Effect
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The Clientele Effect
Clientele Effect
Payout policy depends on shareholder's
dividendtaxrate
if different shareholders face different rates,
conflict occurs
Remedy: different shareholders of a given
companyshouldbeinsimilar dividendtaxand
capital gainssituation.
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19.8 The Clientele Effect: A Resolution of
Real-WorldFactors? (cont.)
Clienteles for various dividend payout policies are
likely to form in the following way:
Investors Companies
High Tax Bracket Individuals
Low Tax Bracket Individuals
Tax-Free Institutions
Corporations
Zero to Low payout stocks
Low-to-Medium payout
Medium Payout Stocks
High Payout Stocks
Once the clienteles have been satisfied, a corporation is
unlikely to create value by changing its dividend policy.
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Dividend Policy
Reasonsfavouringhighdividendpolicy:
Desire for current income (widows and
orphansonfixedincome)
- Doesnot makesenseunder MM
- Manager canrepackageit or sellingpartsof
nodividendstockportfolio
Investor psychology: someprefer tonever
use up the principal and therefore do not
want tosell stocksoff
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19.9What WeKnowandDo Not Know
About DividendPolicy
Corporations tend to favor smooth dividend
stream
Dividends provide information to the market.
Sensible ideas for dividend policy:
Dont forgo positive NPV projects just to pay a
dividend.
Avoid issuing stock to pay dividends.
Consider payouts when there are few better uses
for the cash.
Buy back shares when price depressed
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19.10SummaryandConclusions
The optimal payout ratio cannot be determined
quantitatively.
In a perfect capital market, dividend policy is irrelevant due
tothehomemadedividendconcept.
A firm should not reject positive NPV projects to pay a
dividend.
Personal taxes and issue costs are real-world considerations
that favour lowdividendpayouts.
Manyfirmsappear tohavealong-runtarget dividend-payout
policy. There appears to be some value to dividend stability
andsmoothing.
There appears to be some information content in dividend
payments.