Chapter 16

DIVIDEND POLICY

Brealey, Myers, and Allen

Principles of Corporate Finance
11th Global Edition
McGraw-Hill Education Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
DIVIDEND PAYOUT POLICY

Facts about dividends

Information content
Dividends or repurchases
Theories on dividends
Irrelevance
Rightists
Leftists

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16-1 FACTS ABOUT PAYOUT
Cash Dividend versus Stock Repurchase
Cash dividends and share repurchases are two
alternative ways to distribute cash to
shareholders
Cash Dividend
Dividends are rarely cut back, managers do not
increase dividends unless confident that the new level
can be maintained
Stock Repurchase
Repurchases are more flexible and tax-advantaged, if
dividend tax and capital gains tax are different.
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FIGURE 16.1 DIVIDEND AND STOCK
REPURCHASES

Note: In Malaysia, repurchases was allowed beginning from Sep 1997.

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16-1 FACTS ABOUT PAYOUT
Dividend Payment
Cash Dividend
Payment of cash by firms to shareholders

Ex-Dividend Date
Date that determines when stockholder is entitled to
dividend payment
Record Date
Person who owns stock on this date receives dividend

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16-1 FACTS ABOUT PAYOUT
Dividend Payment
Stock Dividend
Distribution of additional shares to firms stockholders

Stock Splits
Issue of additional shares to firms stockholders

Stock Repurchase
Firm buys back stock from its shareholders

16-6
FIGURE 16.2 EXXON MOBIL'S DIVIDEND
January 5, February 8, February 10, March 9,
2012 2012 2012 2012
Exxon Mobil Dividend
Shares start Dividend will be
declares checks
to paid
quarterly mailed
trade ex- to shareholders
dividend to
dividend registered
of $.42 per shareholders
share on this date

Declaration Ex-dividend Record Payment

date date date date

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16-1 FACTS ABOUT PAYOUT
Types of Dividends
Cash Dividend vs stock dividend
Interim and final dividends
Regular Dividend (cash)
Special Dividend (cash)
Stock Repurchase (4 methods)
Buy in the open market
Tender Offer to shareholders
Dutch auction
Private negotiation (greenmail) 16-8
FIGURE 16.3 Dividend policy survey 2004,
views of US financial executives

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16-2 INFORMATION CONTENT OF DIVIDEND
AND REPURCHASES
Payout Decision
Managers are reluctant to make dividend
changes that may be reversed
Managers worry about rescinding dividend
increases and raising new funds to maintain
payout

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16-2 INFORMATION CONTENT OF DIVIDEND
AND REPURCHASES
Payout Decision
Dividend smoothing: to avoid risk of reduction in
payout, managers smooth dividends over time
Dividend changes follow shifts in long-run
sustainable earnings
Transitory earnings changes unlikely to affect
dividend payouts

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16-2 INFORMATION CONTENT OF DIVIDEND
AND REPURCHASES
Payout Decisions
Managers focus on dividend changes over
absolute levels
Paying a dividend of $2.00 per share is
important if last year's dividend was $1.50
Paying a dividend of $2.00 is not important if
last year's dividend was $2.00

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16-2 INFORMATION CONTENT OF DIVIDEND
AND REPURCHASES
Information Content of Dividends
Dividend and stock repurchase decisions contain
information
The degree of information contained in decisions
vary, largely determined by the degree of
information asymmetry
Signal varies based on prior information about
company
Dividend increases could mean increase in future
profits
Repurchase may convey underpricing of stocks
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16-3 DIVIDENDS OR REPURCHASES? PAYOUT
CONTROVERSY (PAGE 407)

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FIGURE 16.4 DIVIDEND POLICY

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FIGURE 16.5 DIVIDEND POLICY

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16-4 DIVIDEND THEORIES
Dividend Theories
MM Theory
Irrelevance
Dividends do not affect firm value
Rightists
Dividends increase firm value
Leftists
Dividends reduce firm value

16-17
MILLER AND MODIGLIANI HYPOTHESIS OR
THE MM APPROACH
Dividends are irrelevant and has no effect
on the firms share value.
It is the investment policy that increases the
value of the shares and not how profits are
paid out to shareholders.
Homework: Study the proof of MM dividend
hypothesis.

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16-4 DIVIDEND IRRELEVANCE
Dividend Policy Is Irrelevant. Why?
Dividends are not mandatory. Investors know this.
If firms dont pay dividends, investors can make
their own dividends by selling shares.
Therefore:
Investors will not pay higher prices for firms
with higher dividend payouts
Dividend policy will have no impact on value
of firm
This is consistent with M-M proposition
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16-4 THE RIGHTISTS
Market Imperfections Clientele Effect
Investors prefer dividend. High dividend results in
high stock value
Clients for high-payout stocks include institutions,
pensioners they need income from their
investments
These clients will increase prices of high-dividend
stocks through their demand (for high-dividend
stocks)
Clientele Effect: High-tax clients will choose low-
dividend stocks; Low-tax clients will choose high-
dividend stocks
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16-4 THE RIGHTISTS
Dividends Signaling
Dividend increases send good news to the market
(about cash-flow and earnings)
Dividend cuts send bad news
High-dividend payout policy will be costly to firms
that do not have cash flow to support it
Dividend increases signal managers confidence
regarding future cash flows of the company

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16-5 TAXES AND RADICAL LEFT
Taxes and Dividend Policy
Capital gains taxed at lower rate than dividend
income so companies should pay lowest
dividend possible
Dividend policy should adjust to changes in tax
code

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TABLE 16.1 TAXES DIVIDEND POLICY

Returns to Shareholders Taxed Twice

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TABLE 16.2 TAXES DIVIDEND POLICY
Australian Tax Credit to Shareholders: the
imputation system

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HOMEWORK
ABC is considering a change in the companys dividend policy. EPS for last
year were $0.20 and dividends were $0.10 per share. The Finance Director
expects EPS to increase to $0.215 next year. Five years ago the company paid
a dividend of $0.08 per share. The FD proposed that 70% of earnings for next
and subsequent years be retained for investment in new product development.
It is expected that the after tax return on this investment will be 14%. ABCs
cost of equity capital is estimated to be 13%.
Using the constant growth formula, calculate the share price of ABC if it
decides to continue with the current dividend policy. What would the price be
if it decides to change dividend policy as proposed by the MD?

Answer:
Po1 = 1.43
Po2 = 1.53

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RESEARCH ON DIVIDENDS

Market reaction on dividend announcement

Information content of dividends
Dividends and signaling hypothesis
The relationship between dividends and
share value
Dividends versus share repurchase
Ex-dividend day price anomaly
Dividend clientele effect
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