Chapter 14

The word residual implies

"leftover," and the residual policy implies that dividends are paid out of "leftover" earnings.

What happens under old stock?

"old stock" plan, the company gives the money that stockholders who elect to use the DRIP would have received to a bank, which acts as a trustee. Then the bank uses the money to purchase stock in the corporation.

The firm follows these four steps to establish its target payout ratio:

(1) It determines the optimal capital budget. (2) Given its target capital structure, it determines the amount of equity needed to finance that budget. (3) It uses retained earnings to meet equity requirements to the extent possible. (4) It pays dividends only if more earnings are available than are needed to support the optimal capital budget.

For a given firm, the optimal payout ratio is a function of four factors:

(1) management's opinion about its investors' preferences for dividends versus capital gains, (2) the firm's investment opportunities, (3) the firm's target capital structure, (4) the availability and cost of external capital.

There are three principal types of stock repurchases:

(1) situations where the firm has cash available for distribution to its stockholders, and it distributes this cash by repurchasing shares rather than by paying cash dividends; (2) situations where the firm concludes that its capital structure is too heavily weighted with equity, and it sells debt and uses the proceeds to buy back its stock; and (3) situations where the firm has issued options to employees, and it uses open market repurchases to obtain stock for use when the options are exercised.

Two issue that affect Dividend Policy

(1) the information content, or signaling, hypothesis (2) the clientele effect.

Suppose you have 100 common shares of Tillman Industries. The EPS is $4.00; the DPS is $2.00; and the stock sells for $60 per share. Now Tillman announces a twofor-one split. Immediately after the split, how many shares will you have; what will be the adjusted EPS and DPS; and what would you expect the stock price to be?

(200 shares, $2.00, $1.00, probably a little over $30)

A firm has a capital budget of $30 million, net income of $35 million, and a target capital structure of 45% debt and 55% equity. If the residual dividend policy is used, what is the firm's dividend payout ratio?

(52.86%)

Target Payout Ratio Adjustment Model

-A gradual adjustment in dividend payout ratio -Expected Dividend = Previous Dividend + (Expected EPS Increase * Target Payout Ratio * Adjustment Factor)

Constraints pg 537

1. Bond indentures 2. Preferred stock restrictions 3. Impairment of capital rule 4. Availability of cash 5. Penalty tax on improperly accumulated earnings

n. These factors may be grouped into four broad categories:

1. Constraints 2. Investment opportunities 3. Availability and cost of alternative sources of capital 4. effects of dividend policy on rs.

Alternative sources of capital pg 538

1. Cost of selling new stock. 2. Ability to substitute debt for equity 3. Control

Investment opportunities pg 538

1. Number of profitable investments opportunities 2. Possibility of accelerating or delaying projects.

14-1 Dividends versus Capital Gains: What Do Investors Prefer? pg 523

1. Target Payout Ratio 2. Optimal Dividend Policy When deciding how much cash to distribute, financial managers must keep in mind that the firm's objective is to maximize shareholder value. Do investors want dividends or would they agree to have the capital gain reinvested to produce more gains.

When a firm is deciding how much cash to distribute to stockholders, it should consider two points:

: (1) The overriding objective is to maximize shareholder value. (2) The firm's cash flows really belong to its shareholders, so management should not retain income unless they can reinvest those earnings at higher rates of return than shareholders can earn themselves.

There are two types of DRIPs:

: (1) plans that involve only old, already-outstanding stock and (2) plans that involve newly issued stock.

14-6B STOCK DIVIDENDS pg 539

A dividend paid in the form of additional shares of stock rather than in cash.

Residual Dividend Model

A model in which the dividend paid is set equal to net income minus the amount of retained earnings necessary to finance the firm's optimal capital budget.

Catering Theory

A theory that suggests investors' preferences for dividends vary over time and that corporations adapt their dividend policies to cater to the current desires of investors.

What happens under new stock?

A"new stock"DRIPinvests the dividendsin newlyissued stock; hence, these plans raise new capital for the firm

Stock splits

An action taken by a firm to increase the number of shares outstanding, such as doubling the number of shares outstanding by giving each stockholder two new shares for each one formerly held.

14-3C PAYMENT PROCEDURES pg 534

Companies normally pay dividends quarterly, and if conditions permit, the dividend is increased once each year 1. Declaration Date 2. Holder of Record Date 3. Ex- Dividend Date 4. Payment Date

stock dividend

Corporation's distribution of its own stock to its stockholders without the receipt of any payment.

Clinteles

Different groups of stockholders who prefer different dividend payout policies.

14-4 Dividend Reinvestment Plans pg 536

During the 1970s, most large companies instituted dividend reinvestment plans (DRIPs), under which stockholders can automatically reinvest their dividends in the stock of the paying corporation.1

Holder-of-record date

If the company lists the stockholder as an owner on this date, then the stockholder receives the dividend.

14-3 Establishing the Dividend Policy in Practice pg 527

Investors may or may not prefer dividends to capital gains; ? In particular, how should a company establish the specific percentage of earnings it will distribute, the form of that distribution, and the stability of its distributions over time? In this section, we describe how most firms answer those questions.

Are taxes paid on dividends?

MM assumed, among other things, that no taxes are paid on dividends, that stocks can be bought and sold with no transactions costs, and that everyone—investors and managers alike—has the same information regarding firms' future earnings.

14-1B REASONS SOME INVESTORS PREFER DIVIDENDS pg 524

MM called the Gordon-Lintner argument the bird-in-thehand fallacy because in MM's view, most investors plan to reinvest their dividends in the stock of the same or similar firms and, in any event, the riskiness of the firm's cash flows to investors in the long run is determined by the riskiness of operating cash flows, not by dividend payout policy.

Bird-in-the-Hand Fallacy

MM's name for the Gordon-Lintner theory that a firm's value will be maximized by setting a high dividend payout ratio

Some advantages of Dividends and Capital Gain.

One key advantage is that taxes must be paid on dividends the year they are received, but taxes on capital gains are not paid until the stock is sold.

Dividend Reinvestment plans (DRIPs)

Plans that enable stockholders to automatically reinvest dividends received back into the stocks of the paying firms.

Who advanced the Dividend Irrelevance Theory

Professors Merton Miller and Franco Modigliani (MM)

Stock Dividends and Stock Splits

Stock dividends and stock splits received are not "taxable events." When a stock dividend or stock split is "paid"; the issuer sends extra shares to the stockholder, with each share having a reduced real value. For tax purposes, the cost basis of the stock is adjusted for the stock split or stock dividend; no tax is due until the security is sold (if it is sold at a gain). Example: if a stock has a cost basis of $60 per share; and there is a 20% stock dividend; the cost basis is adjusted to $60 / 1.2 = $50 per share for the stock dividend. Notice that this is the same adjustment as that made to the market price of the stock on the ex date. Under IRS rules, stock dividends are not taxable at the time of receipt. The stock dividend results in the cost basis per share being reduced, with the number of shares held increased proportionately. In aggregate, the customer's cost basis remains the same.

14-6 Stock Dividends and Stock Splits pg 539

Stock dividends were originally used in lieu of regular cash dividends by firms that were short of cash.

If a firm wants to reduce its stock price, should it use a stock split or a stock dividend?

Stock splits are generally used after a sharp price run-up to produce a large price reduction. Stock dividends used on a regular annual basis keep the stock price more or less constrained.

What is the purpose of stock split?

Stock splits have a similar purpose as stock dividends.

Profitable companies regularly face three important questions

Successful companies earn income. That income can be reinvested in operating assets, used to retire debt, or distributed to stockholders. (1) How much of our free cash flow should we pass on to shareholders? (2) Should we provide this cash to stockholders by raising the dividend or by repurchasing stock? (3) Should we maintain a stable, consistent payment policy; or should we let the payments vary as conditions change?

Payment Date

The date on which a firm actually mails dividend checks.

declaration date

The date on which a firm's directors issue a statement declaring a dividend.

Ex Dividend Date

The date on which the right to the current dividend no longer accompanies a stock; it is usually two business days prior to the holderof-record date.

Effects of Dividend Policy on rs

The effects of dividend policy on rs may be considered in terms of four factors: (1) stockholders' desire for current versus future income, (2) the perceived riskiness of dividends versus capital gains, (3) the tax advantage of capital gains, and (4) the information (signaling) content of dividends. We discussed each of those factors earlier, so we only note here that the importance of each factor varies from firm to firm depending on the makeup of its current and possible future stockholders.

Low-RegularDividend-Plus-Extras

The policy of announcing a low, regular dividend that can be maintained no matter what and then, when times are good, paying a designated "extra" dividend.

Tax rate on Dividends and Capital Gain.

The tax rate on dividends has often been higher than the tax rate on capital gains.

Clientele affect

The tendency of a firm to attract a set of investors who like its dividend policy

Dividend Irrelevance Theory pg 523

The theory that a firm's dividend policy has no effect on either its value or its cost of capital

Information (Signaling) Content

The theory that investors regard dividend changes as signals of management's earnings forecasts.

Stock Repurchases

Transactions in which a firm buys back shares of its own stock, thereby decreasing shares outstanding, increasing EPS, and, often, increasing the stock price.

What is treasury stock?

Treasury stock is stock a corporation has issued and subsequent;y repurchased from the public.

14-1C REASONS SOME INVESTORS PREFER CAPITAL GAINS pg 524

While dividends reduce transactions costs for investors who are looking for steady income from their investments, dividends increase transactions costs for other investors who are less interested in income and more interested in saving money for the long-term future

What is the purpose of stock dividends?

s is to increase the number of shares outstanding and thus to lower the stock's price in the market.

optimal dividend policy

the dividend policy that strikes a balance between current dividends and future growth and maximizes the firm's stock price

stock split

the division of each single share of a company's stock into more than one share

Target Payout Ratio

the target percentage of net income paid out as cash dividends