Chapter 13

1. Chapter 13 Distribution of Retained Earnings: Dividends and Stock Repurchases

2. Learning Outcomes Chapter 13 • Describe the views that have been proposed to explain why firms follow particular dividend policies and why investors react when firms change dividend policies. • Discuss (a) the types of dividend payments and (b) payment procedures that firms follow in practice. • Discuss factors that firms consider when making dividend policy decisions. • Describe stock dividends and stock splits, and discuss how stock prices are affected by these activities. • Describe stock repurchases and discuss reasons firms use repurchases.

3. Dividend Policy • Dividends • Payments made to stockholders from the firm’s earnings, whether those earnings were generated in the current period or in previous periods • Dividends affect capital structure: • Retaining earnings increases common equity relative to debt. • Financing with retained earnings is cheaper than issuing new common equity.

4. Dividend Policy and Stock Value • Dividend Irrelevance Theory • Theory states that a firm’s dividend policy has no effect on either its value or its cost of capital • Investors value dividends and capital gains equally • Optimal Dividend Policy • Strikes a balance between current dividends and future growth that maximizes the firm’s stock price • Dividend Relevance Theory • A firm’s value is affected by its dividend policy • The optimal dividend policy is the one that maximizes the firm’s value

5. Investors and Dividend Policy • Information Content, or Signaling • Signaling hypothesis says that investors regard dividend changes as signals of management’s earnings forecasts. • Clientele Effect • The tendency of a firm to attract the type of investor who likes its dividend policy • Free Cash Flow Hypothesis • All else equal, firms that pay dividends from cash flows that cannot be reinvested in positive net present value projects (free cash flows), have higher values than firms that retain free cash flows.

6. Types of Dividend Payments in Practice • Residual Dividend Policy: • A policy in which the dividend paid is set equal to the actual earnings minus the amount of retained earnings necessary to finance the firm’s optimal capital budget • Stable, Predictable Dividend Policy • Payment of a specific dollar dividend each year, or periodically increasing the dividend at a constant rate • The annual dividend is somewhat predictable by investors.

7. Types of Dividend Payments in Practice • Constant Payout Ratio • Percentage of earnings, such as 50 percent • Must watch out for reductions, which may seem to signal permanent earnings decline • Low Regular Dividend Plus Extras • A low regular dividend plus a year-end extra in good years

8. Dividend Payments in Practice • Declaration Date • Date on which a firm’s board of directors issues a statement declaring a dividend • Holder-of-Record Date • The date on which the company opens the ownership books to determine who will receive the dividend

9. Dividend Payments in Practice • Ex-Dividend Date • The date on which the right to the next dividend no longer accompanies a stock • Usually two business days prior to the holder-of-record date • Payment Date • The date on which the company actually mails dividend checks

10. Dividend Reinvestment Plans (DRIPs) • Plans that enable stockholders to automatically reinvest dividends received back into the stock of the paying firm • Firms either repurchase existing shares or issue new shares that are part of DRIPs

11. Factors Influencing Dividend Policy • Constraints on dividend payments: • Debt contract restrictions • Cannot exceed “retained earnings” • Cash availability • IRS restrictions on improperly accumulated retained earnings

12. Factors Influencing Dividend Policy • Investment opportunities • Large capital budgeting projects affect dividend-payout ratios. • Alternative sources of capital • Ownership dilution • Effects of dividend policy on rS

13. Stock Dividends and Stock Splits • Both stock dividends and stock splits increase the number of shares outstanding, so “the pie is divided into smaller pieces.” • Unless the stock dividend or stock split conveys information, or is accompanied by another event like higher dividends, the stock price falls so as to keep each investor’s wealth unchanged. • But splits/stock dividends may help firm reach an “optimal price range.”

14. Balance Sheet Effects of a Stock Split Before a Stock Split Common stock (5 million shares outstanding, $1 par value) $ 5.0 Additional paid-in capital 10.0 Retained earnings 285.0 Total common stockholders’ equity $300.0 Book value per share = $300/5 $ 60.0 After a 2-for-1 Stock Split Common stock (10 million shares outstanding, $0.50 par value) $ 5.0 Additional paid-in capital 10.0 Retained earnings 285.0 Total common stockholders’ equity $300.0 Book value per share = $300/10 $ 30.0

15. Balance Sheet Effects of Stock Dividends Before a Stock Split of Stock Dividend Common stock (5 million shares outstanding, $1 par value) $ 5.0 Additional paid-in capital 10.0 Retained earnings 285.0 Total common stockholders’ equity $300.0 Book value per share = $300/5 $ 60.0 After a 20 Percent Stock Dividend Common stock (6 million shares outstanding, $1 par value)a $ 6.0 Additional paid-in capitalb99.0 Retained earningsb195.0 Total common stockholders’ equity $300.0 Book value per share = $300/6 $ 50.0 a Shares outstanding are increased by 20 percent, from 5 million to 6 million. b A transfer equal to the market value of the new shares is made from the retained earnings account to the additional paid-in capital and common stock accounts: Transfer = [(5,000,000 shares)(.020)]$90 = $90,000,000 Of this $90 million, $1,000,000 = ($1 par)(1,000,000 shares) goes in the Common stock account and the remaining $89 million goes in the Paid-in capital account.

16. Reasons for Stock Repurchases • To distribute excess funds to stockholders • To adjust the firm’s capital structure • To acquire shares needed for employee options or compensation • To protect against a takeover attempt

17. Advantages of Stock Repurchases • A company can use a stock repurchase to distribute excess cash (free cash flows) without increasing the amount of the dividends that might otherwise be paid during the year. • A repurchase is an effective method to immediately change the firm’s capital structure when the proportion of equity is substantially higher than the target capital structure prescribes. • When a firm expects managers and other employees to exercise stock options that have been paid to them as compensation in previous years, a repurchase can be used to minimize the “dilution effect” associated with exercising the options.

18. Advantages of Stock Repurchases • Stockholders do not have to sell their shares to the company during a repurchase period. • Many investors believe that a stock repurchase program is a signal from management that the firm’s stock is undervalued in the financial markets, and thus it is a bargain to purchase.

19. Disadvantages of Stock Repurchases • The company might pay too much for stock that is repurchased. • The interval between one stock repurchase and another one generally is irregular, which means that participating investors cannot rely on the cash that they receive from stock repurchases.

20. Capital Structures and Dividend Policies Around the World • Companies in Italy and Japan use more debt than companies in the United States or Canada, but companies in the United Kingdom use less than any of these. • Different accounting practices make comparisons difficult. • Gap has narrowed in recent years. • Dividend-payout ratios vary greatly also.

21. Capital Structures and Dividend Policies Around the World • Tax codes generally favor use of debt in developed countries. • In countries where capital gains are not taxed, investors should show a preference for stocks compared with countries that have capital gains taxes. • Investor preferences should lead to relatively low equity capital costs in those countries that do not tax capital gains.

22. Capital Structures and Dividend Policies Around the World • What about risk, especially bankruptcy costs? • Foreign banks are closely linked to corporations that borrow from them, and have substantial influence over the management of the debtor firms • Equity monitoring costs are comparatively low in the United States • These low monitoring costs indicate that U.S. firms should have more equity and less debt than firms in countries like Japan and Germany