Lecture 11 Distributions

Learning Objectives
Explain what is dividend policy.
Discuss the different dividend theories and
explain whether dividend policy matters.
MMs dividend irrelevance theory
Bird-in-hand theory
Tax advantages of capital gains
Signalling theory
Clientele effects
Discuss what is Dividend Reinvestment Plan
(DRIP) and its different forms.
Understand the difference between cash
dividends and stock repurchases and discuss the
trade-offs.
Differentiate between stock splits and stock
dividends.
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 AB1201: Financial
Management

Lecture 11 Distributions to Shareholders

By: Angie Low

Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

Wharton Research Data Services (WRDS) was used in preparing the chart Cash versus dividends
(Apple Inc)
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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

Wharton Research Data Services (WRDS) was used in preparing the chart Cash versus dividends
(AT&T Inc)
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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

Outline of Lecture
What is dividend policy?
Does dividend policy affect shareholders wealth?
Theories on investors preferences for dividends versus
capital gains
Signalling and clientele effects
Other forms of distributions
Dividend Reinvestment Plans
Stock Repurchases
Stock Dividends and Stock Splits
Omit section 16-3a on residual dividend
model.

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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

What is Dividend Policy?

Pay off debt Retain and reinvest in new Capital

holders projects gains
Cash flows
yield
from
operations For equity
holders Cash Dividend
dividends yield
Pay out

Dividend policy has to do with Repurchase

the decision of whether to pay shares
dividends versus retaining
funds to reinvest, and also the
decision to pay back using cash
dividends or repurchase shares
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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

Optimal Dividend Policy

The
optimal dividend policy should maximise
stock price.

Increasing dividend has two opposing effects on

the stock price:
Increase D1 Upward pressure on stock price
Decrease g Downward pressure on stock price
How about rs?
What is the net effect? Does dividend policy
affect stock price?

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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

A Hypothetical Scenario
Imagine a perfect world in which
Dividends do not impact rs
No taxes are paid on capital gains and dividends
No information asymmetry exists between managers
and investors
No flotation costs are incurred when firms issue shares
Stocks can be sold and bought with no transaction costs
Agency problems are non-existent
Would how a firm split its earnings between
capital gains and dividends affect the stock price?
Yes
No

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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

Dividend Irrelevance Theory

Proposed by Modigliani and Miller (1961)
Stock price is determined only by the earning
power and risk of its assets (investments).
Investors are indifferent between dividends
and retention-generated capital gains.
Investors can create their own dividend policy
If they want cash, they can sell stock.
If they do not want cash, they can use dividends to
buy stock.
Implication: Any payout is okay.

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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

Bird-in-Hand Theory: Investors Prefer

Dividends
Investors may think dividends obtained today are
less risky than potential future capital gains,
hence investors prefer dividends.

Shareholders
Stocks with high require lower High stock
Less risky
dividends return, rs price

Implication: Set a high payout.

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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

Tax Issues: Investors Prefer Capital

Gains
Avoid transaction costs from reinvesting of
dividends
Tax advantages of capital gains:
Capital gains are usually taxed at a lower rate than
dividends but this differs depending on tax regimes.
Taxes on dividends are due in the year they are received,
taxes on capital gains are due when the stock is sold.
Favorable capital gains tax treatment on inherited stock.
To the extent that dividends have a tax
disadvantage relative to capital gains,
shareholders prefer capital gains.
Implication: Set a low payout.

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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion
Stock Price Reactions to Dividend
Changes

Figure 1. Daily Cumulative Average Abnormal Returns. From Quarterly Dividend and Earnings
Announcements and Stockholders' Returns: An Empirical Analysis, by J. Aharony, and I. Swary, 1980,
Journal of Finance 36(1), 8.
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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

Signalling (Information Content)

Hypothesis
Investors view dividend changes as signals of
managements view of the future.
Since managers hate to cut dividends, they will not raise
dividends unless they think the raise is sustainable.

Dividend
Dividend Decrease
Increase Bad future
Good future prospects
prospects

Therefore, a stock price increase at the time of a

dividend increase could reflect higher expectations
for future EPS, not a preference for dividends.

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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

Clientele Effect
Different groups of investors, or clienteles, prefer
different dividend policies. For example,
Working adults with regular salaries may prefer capital
gains.
Retired individuals without regular salaries may prefer
dividends.
Firms past dividend policy determines its current
clientele of investors.
Implication: Clientele effects impede changing
dividend policy. Taxes and brokerage costs hurt
investors who have to switch companies.

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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

Lessons Learnt 1
Do investors prefer high or low dividend
payouts?
Dividend irrelevance: Investors do not care about
payout.
Bird-in-the-hand: Investors prefer a high payout.
Tax issues: Investors prefer a low payout.

Other dividend theories

Signalling hypothesis: Changes in dividend policy signals
information about the firms future prospects.
Clientele effect: Certain types of investors are attracted
to companies with specific dividend policies.

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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

Other Distributions
Other than cash dividends, other forms of
distributions include:
Dividend reinvestment plans (DRIPs)
Stock repurchase
Stock dividends
Stock split

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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

Dividend Reinvestment Plan (DRIP)

Shareholders choose to receive the cash dividends

or to have the company use the dividends to buy
more stock in the firm on behalf of the investor.
Shareholders can automatically reinvest their dividends in
shares of the companys common stock.
Get more stock than cash.
There are two types of plans:
Open market
New stock

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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion
Company
Dividend Reinvestment announces
cash
Plan (DRIP) dividends

No Cash
Investors
Yes dividends to
enrol in DRIP? $$ shareholders
$$

Open market New stock

plan plan

Company
Cash given to
issues new
trustee
stock

Trustee buys Stock

stock in open allocated to
market shareholder

Stock
allocated to
shareholder
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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

DRIP: Open Market Purchase Plan vs.

New Stock Plan
Open market purchase plan: Dollars to be
reinvested are turned over to the trustee who
buys shares on the open market.
Brokerage costs are reduced by volume purchases.
Convenient, easy way to invest thus useful for
investors.
New stock plan: Firm issues new stock to DRIP
enrollees (usually at a discount from the market
price), keeps money and uses it to buy assets.
Helps conserve cash.
Companies that need capital use new stock plans.

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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

Stock Repurchases
When companies decide to pay out cash instead
of retaining it, they can choose to pay cash
dividends or buy back their own stock from
stockholders.
Shares outstanding is reduced. The shares
bought back are held as treasury stock and can
be resold in the future to raise capital.

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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits

Advantages and Disadvantages of

and stock dividends > Conclusion

Repurchases, Relative to Cash

Dividends
May be viewed as a positive signal that the
management thinks stock is undervalued.
Shareholders can choose to sell or hold.
Advantages Repurchases can be used to dispose off temporary
excess cash flows and avoid setting high dividend
payout.
Can be used to make large capital changes.

May be viewed as a negative signal that the firm has

poor investment opportunities.
Disadvantage Cash dividends are dependable but repurchases are
not.
s Firm may have to bid up price to complete purchase,
thus paying too much for its own stock.

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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

Stock Dividends and Stock Splits

Stock dividend: Firm issues new shares in lieu of
paying a cash dividend.
If a 10% stock dividend is announced, shareholders get 10
shares for each 100 shares owned.
Shares outstanding increases.
Stock split: Firm increases the number of shares
outstanding, say 2:1. Shareholders get more shares.
Example: Assume a company has 100 shares outstanding
and each share is trading at $10. The company announces
a 2-for-1 stock split. After the split, the company would
have 200 shares outstanding and each share should be
worth $5.
Market value of equity remains at $1,000.

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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

Stock Dividends and Stock Splits

Stock dividends and stock splits increase the
number of shares outstanding, so the pie is
divided into smaller pieces.
Unless the stock dividend or split conveys
information, the stock price falls so as to keep
each investors wealth unchanged.
But splits/stock dividends may get us to an
optimal price range.
Optimal price range for stocks is $20 to $80. Stock splits
and stock dividends can be used to keep the price in this
optimal range.

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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

Effects of Stock Splits and

Stock Dividends on Firms Value
Stock splits and stock dividends are viewed as
positive signals that the management is confident
about future earnings. Therefore stock price may
increase as a result.
On average, stocks tend to outperform the market in the
year following a split.
By creating more shares and lowering the stock
price, stock splits may increase the stocks
liquidity and may tend to increase the firms
value.

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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

Other Considerations when Setting

Dividend Policies

Investment Other
Constraints opportunitie sources of Effect on rs
s capital
Bond Availability of Cost of Shareholders
covenants profitable selling new preference
Preferred projects stock for dividends
stock Possibility of Ability to sell
restrictions accelerating debt
Availability of or delaying Control
cash projects

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Introduction > What is dividend policy? > Dividend irrelevance theory > Preference for dividends > Preference for
capital gains > Signaling effects > Clientele effects > Dividend reinvestment plan > Stock repurchases > Stock splits
and stock dividends > Conclusion

Where Do We Stand? Distributions to

Shareholders
Different theories on why investors may be
indifferent to dividends, prefer dividends, or
prefer capital gains
Signalling effect of dividend changes
Clientele effects
Other than cash dividends, other forms of
distribution include:
Dividend reinvestment plans (DRIPs)
Stock repurchase
Stock dividends (not exactly a distribution)
Stock split (not exactly a distribution)

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