Chapter Nineteen:

Dividends and Other Payouts

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Chapter Outline
19.1 Different Types of Dividends
19.2 Standard Method of Cash Dividend Payment
19.3 The Benchmark Case: An Illustration of the Irrelevance
of Dividend Policy
19.4 Repurchase of Shares
19.5 Personal Taxes, Issuance Costs, and Dividends
19.6 Expected Return, Dividends, and Personal Taxes
19.7 Real-World Factors Favouring a High-Dividend Policy
19.8 The Clientele Effect: A Resolution of Real-World Factors
19.9 What We Know and Do Not Know About Dividend
Policy
19.10 Summary and Conclusions

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19.1 Different Types of Dividends

• Many companies pay a regular cash dividend.

– Public companies often pay quarterly.
– Sometimes firms will throw in an extra cash dividend.
– The extreme case would be a liquidating dividend.
• Often companies will declare stock dividends.
– No cash leaves the firm.
– The firm increases the number of shares outstanding.
– Increasing the stock number will dilute earnings.

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19.2 Standard Method of Cash Dividend Payment

Cash Dividend - Payment of cash by the firm

to its shareholders.
除息日

Ex-Dividend Date - Date that determines

whether a stockholder is entitled to a dividend
payment; anyone holding stock before this
date is entitled to a dividend; after is not.

Record Date - Person who owns stock on this

date receives the dividend.

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Procedure for Cash Dividend Payment

25 Oct. 2 Nov. 6 Nov. 7 Dec.
…

Declaration Ex- Record Payment

Date dividend Date Date
Date

Declaration Date: The board of directors declares a payment

of dividends.
Ex-Dividend Date: The first day that the seller of a stock is
entitled to the dividend.
Record Date: The corporation prepares a list of all individuals
believed to be stockholders as of 6 November.

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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.

-t … -2 -1 0 +1
$P +2 …

$P - div
The price drops Ex-
by the amount of dividend
the cash Date
dividend Taxes complicate things a bit. Empirically, the
price drop is less than the dividend and occurs
within the first few minutes of the ex-date.
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19.3 The Benchmark Case: An Illustration
of the Irrelevance of Dividend Policy
• A compelling case can be made that dividend policy
is irrelevant.
• 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 value of the firm because investors can create
whatever income stream they prefer by using
homemade dividends.

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The Benchmark Case: An Illustration of the
Irrelevance of Dividend Policy
Example: York Corporation , an all-equity firm
• At date 0, the managers are able to forecast cash flows
perfectly.
• The firm will receive a cashflow of $10,000 at date 0
and $10,000 at date 1
• The firm will dissolve解散 at date 1.
• The firm has no additional +ve NPV projects

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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 :

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An Illustration of the Irrelevance of
Dividend Policy (cont.)
• Assume 1,000 shares are outstanding, then:

• After the imminent迫近的 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) Alternative Policy: Initial dividend > cash flow

• Pay $11 per share immediately i.e., $11 X 1000 shares =

$11,000 as total dividend.
• The extra $1,000 must be raised by issuing new stock.
Date 0 Date1
Total dividends to old shareholders $11,000 $8,900
Dividends per share $11 $8.9

Note: at date1, the new shareholders will get $1,100 of the total cashflow
leaving only $8,900 to old shareholders.

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An Illustration of the Irrelevance of
Dividend Policy (cont.)
• The PV of dividends per share with the alternative policy:

• 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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Modigliani and Miller (MM) proposition

MM proposition: Investors are indifferent to dividend
policy

Assumptions:
1) No taxes, brokerage fees, etc.
2) Homogeneous expectations
3) The investment policy of the firm is set ahead of time

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Homemade Dividends 自制股利

• ABC Inc. is a $42 stock about to pay a $2 cash dividend.

• Bob Investor owns 80 shares and prefers $3 cash dividend.
• Bob’s homemade dividend strategy:
– Sell two shares ex-dividend

homemade dividends $3 Dividend

Cash from dividend $160 $240
Cash from selling stock $80 $0
Total Cash $240 $240
Value of Stock Holdings $40 × 78 = $39 × 80 =
$3,120 $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:

• 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
many shares will be outstanding after the dividend is paid?
A 50% stock dividend will increase the number of shares by
50%:
2 million×1.5 = 3 million shares
After the stock dividend what is the new price per share and
what is the new value of the firm?
The value of the firm was $2m × $15 per share = $30 m. After
the dividend, the value will remain the same.
Price per share = $30m/ 3m shares = $10 per share

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Dividends and Investment Policy

• Firms should never forgo positive NPV projects to

increase a dividend (or to pay a dividend for the
first time).
• Recall that one of the assumptions underlying the
dividend-irrelevance arguments was “The
investment policy of the firm is set ahead of time
and is not altered by changes in dividend policy.”
• A final note:
-Dividends are relevant
-Dividend policy is irrelevant

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19.4 Repurchase of Stock

• Instead of declaring cash dividends, firms can rid

itself of excess cash through buying shares of
their own stock.
• Recently share repurchase has become an important
way of distributing earnings to shareholders.
• When tax avoidance避 is important, share
repurchase is a potentially useful adjunct附件 to
dividend policy.

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Stock Repurchase versus Dividend

Consider a firm that wishes to distribute $100,000 to its
shareholders.
Assets Liabilities & Equity
A.Original balance sheet
Cash $150,000 Debt 0
Otherassets 850,000 Equity 1,000,000
Value of Firm 1,000,000 Value of Firm 1,000,000
Shares outstanding = 100,000
Price per share= $1,000,000 /100,000 = $10

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Stock Repurchase versus Dividend

If they distribute the $100,000 as cash dividend, the balance
sheet will look like this:

Assets Liabilities & Equity

B. After $1 per share cash dividend
Cash $50,000 Debt 0
Other assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding = 100,000
Price per share = $900,000/100,000 = $9

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Stock Repurchase versus Dividend

If they distribute the $100,000 through a stock repurchase,
the balance sheet will look like this:

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 pershare = $900,000 / 90,000 = $10

value ↓ & shares outs. ↓ => price unchanged

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Share Repurchase (Real-World Considerations)

• Lower tax
• Tender offers股权收购要约
– If offer price is set wrong, some stockholders lose.
• Open-market repurchase
• Targeted repurchase
• Repurchase as investment
– Recent studies have shown that the long-term stock
price performance of securities after a buyback is
significantly better than the stock price performance of
comparable companies that do not repurchase.

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19.5 Personal Taxes, Issuance Costs, and
Dividends
• To get the result that dividend policy is irrelevant,
we needed three assumptions:
– No taxes
– No transactions costs
– No uncertainty
• In Canada, individual investors face a lower
dividend tax rate due to the dividend tax credit.
• Capital gains for individuals are taxed at 50% of the
marginal tax rate, and the effective tax rate on
dividend income is higher than the tax rate on
capital gains.

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Firms Without Sufficient Cash to Pay a
Dividend
The direct costs of
Investment Bankers stock issuance will
add to this effect.

Cash: stock issue

Stock
Firm
Holders
Cash: dividends

Taxes
In a world of personal taxes,
firms should not issue stock
Gov. to pay a dividend.
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Firms With Sufficient Cash to Pay a Dividend

• The above argument does not necessarily apply to

firms with excess cash.
• Consider a firm that has $1 million in cash after
selecting all available positive NPV projects.
• The firm has several options:
– Select additional capital budgeting projects (by
assumption, these are negative NPV).
– Acquire other companies
– Purchase financial assets
– Repurchase shares

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Personal Taxes, Issuance Costs, and
Dividends
• In the presence of personal taxes:
1. A firm should not issue stock to pay a dividend.
2. Managers have an incentive to seek alternative uses
for funds to reduce dividends.
3. Though personal taxes mitigate 轻 against the payment
of dividends, these taxes are not sufficient to lead firms
to eliminate all dividends.

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19.6 Expected Return, Dividends, and
Personal Taxes
• What is the relationship between the expected
return on the stock and its dividend yield?
– The expected pretax return on a security with a high
dividend yield is greater than the expected pretax return
on an otherwise-identical security with a low dividend
yield.
– After tax is a different story; otherwise-identical
securities should have the same return.

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Evidence on Dividends and Taxes in Canada

• Prior to 1972, capital gains were untaxed in Canada
• In 1985, a life-time exemption on capital gains was
introduced.
• Anticipation of the tax break 税 on capital gains
caused investors to bid up prices of low-dividend 低股
息率yield stocks.

• Firms responded by lowering their dividend

payouts.
• The dividend tax credit works to reduce taxes on
dividends received from Canadian firms.

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19.7 Real World Factors Favouring a High
Dividend Policy

• 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 firm’s overall cash flows are not necessarily
affected by dividend policy—as 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 dividends
as tax-disadvantaged.
• There is some evidence that tax arbitrage does occur
in Canada but not to the extent necessary to
eliminate taxes on dividends completely.

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Agency Costs

• Agency Cost of Debt

– Firms in financial distress财务困境 are reluctant不情愿的 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-specified levels.
• Agency Costs of Equity
– Managers will find it easier to squander funds浪费资金 if
they have a low dividend payout.

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19.8 The Clientele Effect: A Resolution of
Real-World Factors?
• Reasons for Low Dividend
– Personal Taxes
– High Issuing Costs
• Reasons for High Dividend
– Information Asymmetry
• Dividends as a signal about firm’s future performance
– Lower Agency Costs
• capital market as a monitoring device
• reduce free cash flow, and hence wasteful spending
– Desire for Current Income
• Clientele Effect客户群

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Real-World Factors? (cont.)
• Clienteles客户群 for various dividend payout policies
are likely to form in the following way:
Group Stock

High Tax Bracket Individuals Zero to Low payout stocks

Low Tax Bracket Individuals Low-to-Medium payout
Tax-Free Institutions Medium Payout Stocks
Corporations 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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19.9 What We Know and Do Not Know
About Dividend Policy
• Corporations “Smooth” Dividends.
• Dividends Provide Information to the Market.
• Firms should follow a sensible dividend policy:
– Don’t forgo positive NPV projects just to pay a dividend.
– Avoid issuing stock to pay dividends.
– Consider share repurchase when there are few better
uses for the cash.

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19.10 Summary and Conclusions

• The optimal payout ratio cannot be determined
quantitatively.
• In a perfect capital market, dividend policy is
irrelevant due to the homemade dividend concept.
• A firm should not reject positive NPV projects to
pay a dividend.
• Personal taxes and issue costs are real-world
considerations that favour low dividend payouts.
• Many firms appear to have a long-run target
dividend-payout policy. There appears to be some
value to dividend stability and smoothing.
• There appears to be some information content in
dividend payments.
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