FIN 451

CORPORATE FINANCE II

LECTURE FIVE:
DIVIDEND POLICY I

Uses of Free Cash Flow

A firm can retain its free cash flow, either investing or accumulating it, or
pay out its free cash flow through a dividend or share repurchase. The
choice between these options is determined by the firm’s payout policy.

Important Dates for Microsoft’s

Special Dividend

Microsoft declared the dividend on July 20, 2004, payable on

December 2 to all shareholders of record on November 17.
Because the record date was November 17, the ex-dividend
date was two days earlier, or November 15, 2004.

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 How Dividends are Paid

Some legal limitations on dividends

The company does not have the full liberty to declare whatever dividend it
chooses. Suppose that an unscrupulous board decided to sell all the firm’s
assets and distribute the money as dividends. This would leave nothing to
pay the company’s debts. Hence, some restrictions may be imposed by
lenders, who are concerned that excess dividend payments would result in
cashflow difficulties.

Laws are also in place to protect creditors from excessive dividend payments.
Most countries have laws that prohibit a company from paying dividends if
doing so would make the company insolvent.

How Dividends are Paid

Stock dividends and Stock splits

In the US, companies often declare stock dividends, e.g.5 extra shares for 10
shares currently owned. The stock dividend is very much like a stock split.
In both cases, the shareholder is given a fixed number of new shares for
each share held. For e.g., in a 2-for-1 split, each investor would receive one
additional share for each share already held. The investor ends up with 2
shares rather than one.

This is similar to a 100% stock dividend, both result in a doubling of the number
of outstanding shares, but neither changes the total assets held by the firm.
In this case, we would expect that the stock price would fall by half, leaving
the total market value of the firm (price per share x outstanding shares)
unchanged.

Share Repurchase
Stock dividends and Stock splits (cont’d)
More often than not, the announcement of a stock split does result in a rise in
the market value of the firm, even though investors are aware that the
company’s assets and business are not affected. Investors take the decision
to split as a signal of management’s confidence in the company’s prospects.
A study has shown that almost 94% of splits are motivated by managers’
desire to bring the stock price to an acceptable trading range.

Share repurchase
When a company wants to pay cash to its shareholders, it usually declares a
cash dividend. But an alternative method is for the firm to repurchase its
own stock. In a stock repurchase, the company pays cash to repurchase the
stock from its shareholders. These shares are kept in the company’s
treasury and then resold if the company needs money.

To see why share repurchases are similar to a dividend, we shall look at the
following slide. Shareholders hold 100,000 shares worth in total $1m, so
price per share quals $1million/100,000 = $10

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 Share Repurchase
Assets Liabilities and Shareholders’ Equity
Original balance sheet
Cash $150,000 Debt $0
Other assets 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

Scenario 1: After cash dividend $100,000 paid out

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

Scenario 2: After $100,000 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 per share = $900,000/90,000 = $10

Share Repurchase
From the table overleaf:
Suppose that before the dividend payment you owned 1,000 shares worth
$10,000. After the dividend payment, you would have $1,000 in cash and
1,000 shares worth $9,000.

Rather than paying out $100,000 as a dividend, the company could use the
cash to buy back 10,000 shares at $10 each. Scenario 2 shows what
happens. The firm’s assets fall to $900,000 but only 90,000 of shares
remain outstanding, so price per share remains at $10. If you owned 1,000
shares before the repurchase, you would own 1% of the company. If you
then sold 100 shares to the company, you would still own 1% of the
company. Your sale would put $1,000 cash into your pocket and you would
keep 900 shares worth $9,000. This is the same position that you would
have been in if the company had paid a dividend of $1 per share.

It is not surprising that a cash dividend and a share repurchase are equivalent
transactions. In both cases, the firm pays out some of its cash which then
goes into the shareholders’ pockets. The assets that are left in the company
are the same regardless of whether the cash was used to pay a dividend or
to buy back shares.

Share Repurchases
The Role of share repurchases
Since the 1980s, stock repurchases have increased sharply and are now larger
in total value than dividend payments in the US.

Repurchases are like bumper dividends; they cause large amounts of cash to
be paid to investors. But they don’t substitute for dividends. Most
companies that repurchase stock are mature, profitable companies that also
pay dividends. When a company announces repurchase program, it is not
making a long term commitment to distribute more cash. Repurchases are
more volatile than dividends and tend to rise during boom times as firms
accumulate excess cash, and vice versa in downturns.

Suppose that a company has a large amount of unwanted cash or wishes to

change its capital structure by replacing equity with debt. It will usually do so
by repurchasing stock rather than by paying out large dividends.
Shareholders often worry that excess cash will be spent on unviable
investments, so when firms announce that they will use the cash to
repurchase shares, the stock price generally rises.

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 Share Repurchases
A crucial difference is in the taxation of dividends and stock repurchase.
Dividends are taxed as ordinary incomes but shareholders who sell shares
back to the firm pay tax only on capital gains realized from the sale. As such
tax authorities are on the lookout for companies that disguise dividends as
repurchases, and it may decide that regular or proportional repurchases
should be taxed as dividend payments.
There are 3 main ways to repurchase stocks:
• firm announces plans to buy its stocks in open market, like any investor
• firm offer to buy back a stated number of shares at a fixed price, typically set
about 20% above the current market level
• firm can negotiate with a major shareholder

In recent years, a number of countries like Japan and Sweden, have allowed
repurchases for the first time. Some countries however continue to ban
them entirely, while in many other countries, repurchases are taxed as
dividends, often at very high rates. In these countries, firms that have
amassed large amounts of cash may prefer to invest it on very low rates of
return rather than to hand it back to shareholders, who could reinvest it in
other firms that are short of cash.

How do Companies decide on

Dividend Payments?
Lintner’s Model
What does the board of directors think about when it sets the dividends? To
help answer this question, John Lintner’s conducted a classic series of
interviews with corporate managers about their dividend policies. He
discovered the following:
• firms have long-run target dividend payout ratios. Mature companies with
stable earnings generally pay out a high proportion of earnings; growth
companies have low payout (if they pay any dividends at all)
• managers focus more on dividend changes than on absolute levels. Thus
paying $2.00 dividend is an important financial decision if last year’s
dividend was $1.00 but it would be no big deal if last year’s dividend was
$2.00
• dividend changes follow shifts in long-run, sustainable earnings. Managers
are unlikely to change dividend policy in response to temporary variations in
earnings. Instead, they “smooth” dividends.
• managers are reluctant to make dividend changes that might have to be
reversed. They are conservative and are particularly worried about having to
rescind a dividend increase

How do Companies decide on

Dividend Payments?
Managers in Lintner’s survey were disinclined to change its dividend policy
whenever earnings changed. They believed that shareholders prefer a
steady progression in dividends and therefore, even if circumstances
appeared to warrant a large increase in their company’s dividend, they
would move only partway toward their target payment.

If managers are reluctant to make dividend changes that might have to be

reversed. We should also expect them to take future prospects into account
when setting the payment. Studies have showed that when companies pay
unexpectedly low dividends, earnings on average subsequently decline.
When they pay unexpectedly high dividends, earnings subsequently
increase. This is why investors pay close attention to the dividend decision.

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 GM’s Earnings and Dividends per
Share, 1985–2006

Compared to GM’s earnings, its dividend payments have remained

relatively stable. (Data adjusted for splits, earnings exclude extraordinary
items.)
Source: Compustat and CapitallQ.

FIN 451
CORPORATE FINANCE II

END OF LECTURE FIVE

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