17.1 Cash Dividends and Dividend Payment
A dividend is a cash payment made by a corporation to its shareholders, typically out of its earnings. There are several types of cash dividends:
- Regular cash dividend: A cash payment made in the regular course of business.
- Extra dividend: A payment that may or may not be repeated in the future.
- Special dividend: A payment viewed as a truly one-time event.
- Liquidating dividend: A payment made from the sale of a portion of the business.
The Dividend Payment Chronology
The payment of a cash dividend follows a specific timeline:
- Declaration Date: The board of directors declares the dividend.
- Ex-Dividend Date: One business day before the record date. To receive the dividend, you must buy the stock *before* this date. On the ex-dividend date, the stock price will drop by approximately the amount of the dividend.
- Date of Record: The corporation prepares a list of all shareholders entitled to the dividend.
- Date of Payment: The dividend checks are mailed to the shareholders of record.
17.2 Does Dividend Policy Matter?
The key question of dividend policy is whether the firm should pay out a large percentage of its earnings now or a small percentage. A powerful argument can be made that dividend policy is irrelevant in a world with no taxes, no transaction costs, and no other market imperfections.
The reason is that any increase in a dividend at one point in time is exactly offset by a decrease at another time (e.g., by issuing new stock to fund the dividend), so the net present value of the cash flows is unchanged.
Homemade Dividends
The concept of homemade dividends demonstrates the irrelevance of dividend policy. An investor who desires a different dividend stream than the one the company provides can create their own. An investor wanting more current cash can sell some shares. An investor wanting less can use the dividend to buy more shares. Because investors can create their own dividend policy, they will not pay a premium for any particular corporate dividend policy.
17.3-17.4 Real-World Factors and Dividend Policy
In the real world, factors like taxes and flotation costs make dividend policy relevant.
Factors Favoring a Low Dividend Payout
- Taxes: For individual investors, capital gains are often taxed at a lower effective rate than dividends, and the tax on capital gains can be deferred until the stock is sold. This provides a tax advantage to a low dividend payout.
- Flotation Costs: If a firm pays a high dividend, it may need to issue new stock to fund its investments. Issuing new stock is expensive due to flotation costs, which favors a policy of financing with internally generated funds (i.e., a low payout).
Factors Favoring a High Dividend Payout
- Desire for Current Income: Some investors, like retirees, may prefer a steady stream of cash and be willing to pay a premium for high-dividend stocks.
- Tax-Exempt Investors: For tax-exempt institutions like pension funds, there is no tax disadvantage to dividends.
- Corporate Investors: Corporations that own stock in other corporations can exclude at least 50% of the dividends they receive from their taxable income, creating a strong preference for high-dividend stocks.
17.5 A Resolution of Real-World Factors
Two concepts help resolve the debate on dividend policy:
- Information Content of Dividends: An unexpected increase in dividends is often seen as a positive signal that management expects strong future earnings. Conversely, a dividend cut is a very negative signal. The stock price reacts to the *information* conveyed by the dividend change, not just the change in payout policy itself.
- The Clientele Effect: The argument that different groups of investors (clienteles) desire different dividend policies. High-tax-bracket individuals will prefer low-payout stocks, while tax-exempt institutions and corporations will prefer high-payout stocks. A firm's dividend policy attracts a specific clientele. In equilibrium, all clienteles are satisfied, and the dividend policy of any single firm becomes irrelevant.
17.6-17.8 Alternatives to Cash Dividends
Firms can distribute cash to shareholders through means other than cash dividends.
Stock Repurchases
A stock repurchase (or buyback) is when a firm buys back its own stock. In a world with no taxes or other imperfections, a repurchase is essentially the same as a cash dividend. However, in the real world, a repurchase has a significant tax advantage for shareholders because they only pay capital gains tax if they choose to sell, and only on the profit.
Stock Dividends and Stock Splits
A stock dividend is a payment made in the form of additional shares of stock. A stock split is essentially the same thing, expressed as a ratio (e.g., a 2-for-1 split is a 100% stock dividend). These are not true dividends because no cash is paid out. They increase the number of shares outstanding but decrease the value per share, leaving the total value of a shareholder's position and the total value of the firm unchanged. A reverse stock split is the opposite, reducing the number of shares and increasing the price per share.
Chapter Review and Critical Thinking Questions
Solution: Dividends are important because the value of a stock depends on its expected future dividends. Dividend policy, however, is the time pattern of the dividend payout. The irrelevance argument states that in a perfect market, the specific pattern of dividends does not matter because investors can create their own desired dividend stream through homemade dividends (selling shares for current income or reinvesting dividends).
Solution: A stock repurchase reduces equity while leaving debt unchanged. Therefore, the firm's debt-to-equity ratio will rise. This suggests that a firm could use a share repurchase to change its capital structure, for example, to move to a target debt-equity ratio.
Solution: The ex-dividend date is one business day before the date of record. The date of record is Wednesday, January 3, so the ex-dividend date is Tuesday, January 2. If a shareholder buys the stock before January 2, the buyer will receive the dividend.
Solution: Probably not. Mutual funds are financial intermediaries that are owned by their fundholders. The fundholders would not be able to benefit from the in-kind services, so such a dividend has no value to them. The fund would be better off investing in a company that pays cash dividends that can be distributed to the fundholders.
Solution: This is due to the information content of dividends. An unexpected dividend increase is a positive signal to the market about the firm's future prospects. The stock price rises because of this new information, which revises expectations about future cash flows, not because of a simple change in the firm's payout pattern.
Solution: The stock price drop is a result of the negative information conveyed by the dividend suspension. It signals that the company is in financial distress and that its future earnings and cash flows are likely to be lower than previously expected. It is a signal of the firm's poor prospects, not just a change in dividend policy.
Solution: A DRIP with a discount is a benefit to shareholders as it allows them to acquire new shares at below-market price. This is a form of a small stock dividend combined with a rights offering. It will likely increase shareholder wealth for those who participate. The disadvantage is that it increases the number of shares outstanding, which can have a small dilution effect on EPS for non-participating shareholders.
Solution: Firms that have just gone public are typically young, growing companies with many profitable investment opportunities. They need to retain their earnings to fund this growth. Paying dividends would mean they would have to raise more capital externally, which is expensive due to flotation costs.
Solution: The 2003 tax law change lowered the tax rate on dividends to be equal to the tax rate on capital gains for most investors. This would make the after-tax value of a dividend higher. As a result, we would expect the ex-dividend stock price drop to be closer to the full amount of the dividend, as the tax disadvantage of receiving a dividend was largely eliminated.
Solution: The tax law change made dividends more attractive than they were previously, which reduced the relative tax advantage of stock repurchases. However, repurchases still retain the advantage that the capital gains tax can be deferred. So, while the change narrowed the gap, repurchases likely remained more tax-efficient for many investors.