5/20/2011

Topic: Dividends and Dividend Policy

Lecture12: Objectives
• Describe how cash dividends are paid.

• Explain dividend policy irrelevance in the M&M world

• Show how shareholders’ wealth is not affected if cash

dividends are funded by issuing stocks

• Explain some real-world factors affecting company payout

• Learn how to establish a prudent dividend policy

• Distinguish between cash dividends, stock dividends and

stock repurchases

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Kinds of Distributions

• Regular Cash Dividends:  periodic cash payments to shareholders 
in normal course of business

• Extra Cash Dividends:  non‐periodic cash payment

• Special Dividends:  one time cash payment

• Liquidating Dividends:  cash payment after sale of an asset

• Stock Dividends: issuance of stocks to existing shareholders

• Share repurchases:  cash payment to shareholders by means of 
purchasing a portion of shares outstanding

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How Dividends Are Paid

• Cash dividends: Payment of cash by the firm to its shareholders

– The payment of cash by the firm to shareholders, is declared by

the board of Directors on the declaration date

– The dividend is paid on the payment date to all shareholders of

record as of the record date (which is usually 2‐3 weeks prior to
the payment date)

– The record date is the date on which holders of record are

designated to receive a dividend

– To be a shareholder of record, and thus receive the dividend,

one must have bought the stock before the ex‐dividend date.
The ex‐dividend date is 4 business days before the record date

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Timeline of Dividend Payments

4 business 
days 2‐3 weeks

Declaration  Ex‐dividend  Record  Payment 

Date Date Date Date

stock trades “cum dividend” stock trades “ex dividend”

The stock price drops by the amount of the dividend on the ex‐dividend 
date. 

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Share Price Drop on Ex‐Dividend Date

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M&M Dividend Policy Irrelevancy Proposition

• Dividend policy: The time pattern of dividend payouts. Div. Policies 
address the question “Should the firm pay out cash to its 
shareholders now, or should it invest that money and pay out later? “

• M&M Assumptions: no taxes, no transaction or bankruptcy costs

• Proposition: dividend policy is irrelevant in the M&M world

Vdividend‐paying firm  = Vnon dividend‐paying firm 

• M&M’s Intuition: If investors can raise cash themselves by selling

shares (homemade dividends), they do not need firms to provide
them with cash through dividend payments.

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MM Dividend Policy Irrelevancy Example

XYZ Corporation, an all equity firm has 1,000 shares outstanding.
The firm will be dissolved in one year (remaining assets are worth 
zero). Managers know that the firm will receive a cash flow of 
$10,000 today, and another $10,000 next year. The firm’s cost of 
capital is 10%. 
Current dividend policy is to pay all cash as dividends each year.

$10, 000
Dividend per share is   $10 per share each year
1, 000
D $10
Price per share =D0 + 1 =$10+ =$19.09
1 r 1.1
$10,000
Firm value = $10,000 +  =$19,090.91
1.1

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MM Dividend Policy Irrelevancy Example Cont’d

Alternative dividend policy:
Pay a dividend of $11 per share immediately (a total dividend of $11,000). 
This is $1,000 more than the cash flow in the current period.

Suppose the firm raises the extra $1,000 by issuing stock. Assuming that 
new shareholders require 10% on their investment, they would demand 
$1,100 of the last period cash flow, leaving $8,900 for the old shareholders.
                                                              Today                One year later   
Total dividends to old s/holders           $11,000             $8,900
Dividends per share                                  $11.00               $8.90

$8.90
Price per share = $11 +  = $19.09
1.1
$8,900
Firm value       = $11,000+ =$19,090.91
1.1
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MM Dividend Policy Irrelevancy Example Cont’d: Homemade dividends

Suppose Brian owns one share of XYZ and he prefers the current dividend policy 
($10 now and $10 next year). However XYZ adopts the alternative dividend 
policy ($11 and $8.90).

According to the new policy, Ryan gets $11, keeps $10, and invests the extra 
dollar at 10% to get $1.1 next year.  Next year he gets $8.90 in dividends plus 
the return in the $1 invested ($1.1), a total of $10.
                                                    today                              one year later
current div. policy                        $11                                        $8.90
preferred div. policy                    $10                                        $10

Brian's Trading Strategy
keep $10                                       $10                                        $8.90
invest $1                                       ‐$1                    + $1  (1.1)=$1.10
homemade dividends                $10                                          $10
Brian can replicate his cash flows under the original dividend policy.
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M&M Dividend Irrelevance: Firm Value and Shareholders’ Wealth

Consider an all equity firm with 100,000 shares.  Total market is 
$10 million.  The firm wants to pay a dividend of $10/share by 
issuing stocks. 

(a) What is the total amount needed to be raised to pay the 
dividend?

The firm needs to raise $10 x 100,000 = $1M in cash

(b) How many new shares must it issued?

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M&M Dividend Irrelevance: Firm Value and Shareholders’ Wealth

$10M
The current price per share is  =$100
100,000
The ex‐dividend share price is $100‐$10=$90

$1M
# of new shares issued =    11,111.11
$90

(c) What is the firm value before and after the dividend issue?

Firm Value before: $10 m = 100,000 shares x $100/share

Firm Value after: $10 m = 111,111.11 shares x $90/share

No change in firm value! Shareholders have funded their own 
dividends.
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M&M Dividend Irrelevance: Firm Value and Shareholders’ Wealth

(d) Consider a shareholder with 100 shares.  Has his wealth 
changed?

Wealth before dividend: 100 shares x $100/share = $10,000

Wealth after dividend:

– Cash: $10 x 100 = $1,000
– Stock = 100 x $90 = $9,000
– Total = $1,000 + $9,000 = $10,000

Conclusion: the shareholder has paid for her own dividend as the 
drop in share price exactly offsets the dividend

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Dividend Cuts to Finance Positive NPV Projects

Assume an all equity firm with 500,000 shares trading at $36/share.

Dividends of $3.60/share have been paid for several years. The firm
has an investment opportunity which will generate $450,000 every
year from the third year onwards. The firm will have to stop paying
dividends for 2 years to fund the project. Should the firm undertake
the project? What will be the effect on the share price?

Using the dividend discount model the return on equity is

R = RA = RE = dividend yield = $3.60/$36 = 10%

If the firm does not adopt the project, share price is $36= $3.6/.1, as
given.

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Dividend Cuts to Finance Positive NPV Projects
If the firm adopts the project, the project’s NPV is:

1  (1  .1)2 1  $450, 000 

NPV   $3.60  500, 000   
.1 (1  .1)2  .1 
 $595, 041  0
Conclusion: the firm should stop dividends for 2 years and invest in the 
project.

The increase in the share price is: $595,041/500,000 = $1.19
The share price increases to $37.19 even though there was a dividend 
cut.  Investors are better off.

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Real‐world Factors for Low Payout

• Taxes: When the marginal tax rate for individuals exceeds that for
firms, investors may prefer that earnings be retained rather than
paid out as dividends

• Capital Gains taxes are usually lower than taxes on dividend

income (Classical Tax System)

• Flotation costs: Firms that pay high dividends and simultaneously

sell stock to fund growth will incur higher flotation costs than
comparable low payout firms

• Dividend restrictions: Most bond indentures and some federal and

state laws limit the dividends a firm can pay

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Real‐world Factors for High Payout

• Desire for current income (widows and orphans): the firm paying a
larger dividend will sell at a higher price. But not all investors desire
high current income and they may self‐select into different clienteles

• Uncertainty resolution: distant dividends are more uncertain than

near dividends, so firms with near dividends should sell at a higher
price. The uncertainty over future income is not changed by a firm’s
dividend policy

• Taxes and legal benefits from high dividends: Dividend income to

firms are tax‐exempt, as well as to pension and trust funds which are
usually not allowed to spend their principal.

• Australians may prefer high pay out (Dividend Inputation Tax System)

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A Resolution of Real‐World Factors?

• Information content of dividends: In markets where there is little

information, dividend policy becomes an important form of
communication about firms’ future prospects

• Note: stock prices rise/fall when dividends is unexpectedly

increased/decreased

‐ Firm value is not affected by changes in dividend policy. Rather, firm

value increases if management’s increase in dividends signals the
presence of high positive NPV opportunities. Stock prices fall after
dividend cuts, which signal bad future prospects.

• The clientele effect: Different groups of investors desire different levels

of dividends. If clienteles are satisfied with current dividends, dividend
policy changes are pointless

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Establishing a Dividend Policy

• Residual dividend approach: Policy where a firm pays dividends

each period only after meeting its investment needs while
maintaining a desired debt‐to‐equity ratio (selling stock to pay a
dividend is expensive)
– problem: dividends can be very unstable
• Dividend stability: Payout ratio is established based on long
term averages of projected earnings, an optimal range for
capital structure, and capital budgeting requirements.

A stable dividend policy is in the interest of the shareholders as it

reduces uncertainty.
But the residual approach grants the manager flexibility.

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A Compromise Dividend Policy

• In practice, many firms appear to follow what amounts to a

compromise dividend policy. Such policy is based on the
following goals:

‐ Avoid cutting back on positive NPV projects to pay a dividend

‐ Avoid dividend cuts
‐ Avoid the need to sell equity
‐ Maintain a target debt‐to‐equity ratio
‐ Maintain a target dividend (relative to earnings) payout ratio

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Stock Dividends and Stock Splits

• Stock Dividend: Distribution of additional shares to a firm’s

shareholders, diluting the value of each share outstanding. The cash is
kept in the firm for investment; shareholders receive additional
shares. A 10% stock dividend would issue one share per ten shares
outstanding.
• Stock Split: Issuance of additional shares to a firm’s shareholders,
without changing owner’s equity. No cash is exchanged, only a change
in the number of shares issued and a change in the value of a share
occurs.
• A stock dividend is a mini stock split. No cash is involved and the book
value of equity does not change. With more shares outstanding,
market value per share drops, but total market value of the firm stays
the same

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Share Repurchases as a Kind of Distribution

• Share Repurchase: a firm buys back stock from its shareholders

• A share repurchase has the same effect as a cash dividend: the

cash account in the firm is reduced and the shareholders as a
group have more cash. The book value of the equity is reduced
in both cases

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Share Repurchases as a Kind of Distribution: Example

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. Today’s market value balance sheet for Payout
is shown below:

Assets Liabilities and Equity

Cash $100,000 Equity $1,000,000
Fixed assets $900,000 Debt $0

a. What price is Payout stock selling for today?

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

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Share Repurchases as a Kind of Distribution: Example Cont’d

a. today’s price = $1,000,000/20,000 = $50 per share
for reference, a shareholder A with 100 shares has $5,000

b. tomorrow’s price = $50 ‐ $1 = $49

After the dividend payment, the market value balance sheet

is:

Assets Liabilities and Equity
Cash $80,000 Equity $980,000
Fixed assets $900,000 Debt       $0

Shareholder A has $ 5,000 = $100 in cash + 100 x $49 in shares
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Share Repurchases as a Kind of Distribution: Example Cont’d

Now suppose that Payout from Example A announces its intention to

repurchase $20,000 worth of stock instead of paying out the dividend.
What effect will the repurchase have on shareholder A, who currently
holds 100 shares and sells 2 of those shares back to the company in the
repurchase?

After the repurchase, the market value balance sheet is:

Assets Liabilities and Equity
Cash $80,000 Equity $980,000
Fixed assets $900,000 Debt       $0

Since $20,000/$50 = 400 shares were repurchased, the price per share
after the repurchase is $980,000/[20,000 ‐ 400] = $50

A’s wealth will be: $5,000= 98 x $50 (in shares) + 2x$50 (in cash)
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Share Repurchases as a Kind of Distribution: Example Cont’d

Comparing the effects of the repurchase with the effects of the

cash dividend, we reach the following conclusion:

If there are no imperfections, and taxes are ignored, then a cash

dividend and a share repurchase are essentially the same thing.

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Stock Dividends: Example

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
should this action affect a shareholder who owns 100 stock?
Compare with the answers from the cash dividend and share
repurchase examples.

With a 2% stock dividend, each shareholder receives 2 new shares 
every 100 previously held. So our shareholder’s wealth after the 
stock dividend will be:

102 shares x price per share after stock dividend 

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Stock Dividends: Example Cont’d

What is the share price after the stock dividend is paid?

# of shares after stock dividend = 1.02 x 20,000 = 20,400

Since the combined market value of equity does not change, 
the price per share will be $1,000,000 / 20,400 = $49.02

So our shareholder’s wealth after the tax would be:
102 x $49.019608 = $5,000

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Summary Table of Distributions
In summary,
Shareholder Shareholder Share
wealth portfolio price
Cash dividend
Before $5,000 100 shares $50
After $5,000 100 shares + $100 cash $49
Share Repurchase
Before $5,000 100 shares $50

After $5,000 98 shares + $100 cash $50

Stock dividend

Before $5,000 100 shares $50

After $5,000 102 shares, no cash $49.02

Without taxes, there is no change in shareholder wealth under all three cases.

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Conclusions
• All else equal high dividends is better than low dividends because it 
means firm is more profitable.  
• Dividend policy is related to timing pattern of dividends, not size of 
dividends.
• Dividend policy is irrelevant in a perfect capital market without 
imperfections and taxes.
• Managers should not forego positive NPV projects to pay dividends.
• Investors differ in their investment objectives creating a clientele for 
high or low dividend payout.
• Share repurchases are similar to cash dividends.
• Stock dividends are not similar to cash dividends.  They are more like 
stock splits.

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