Chapter 19

Dividends and Other Payouts

 Many companies pay a regular cash dividend.
◦ Public companies often pay half-yearly.
◦ Sometimes firms will pay an extra cash dividend.
◦ The extreme case would be a liquidating dividend.
 Companies will often declare stock dividends (bonus
shares).
◦ No cash leaves the firm.
◦ The firm increases the number of shares outstanding.
 Other companies use stock buybacks.

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19-2
Cash Dividend - Payment of cash by the firm
to its shareholders.

Ex-Dividend Date - Date that determines

whether a stockholder is entitled to a dividend
payment; anyone holding stock immediately
before this date is entitled to a dividend.

Record Date – Date on which company

determines existing shareholders.

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19-3
 25 Oct. 1 Nov. 2 Nov. 5 Nov. 7 Dec.
…

Declaration Cum- Ex- Record Payment

Date dividend dividend Date Date
Date Date

Declaration Date: The Board of Directors declares a payment

of dividends.
Cum-Dividend Date: Buyer of stock still receives the dividend.
Ex-Dividend Date: Seller of the stock retains the dividend.
Record Date: The corporation prepares a list of all individuals
believed to be stockholders as of 5 November.

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19-4
 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 +2 …

$P

$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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 Lee Ann Inc, has declared a $7.50 per share
dividend. Suppose capital gains are not
taxed, but dividends are taxed at 15%. New
regulations require that taxes be withheld
when the dividend is paid. The company’s
stock sells for $93 per share and is about to
go ex-dividend. What do you think the ex-
dividend price will be?

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 Since dividends are paid out of profits, the
alternative to the payment of dividends is the
retention of earnings/profits.

 There is an inverse relationship between RE

and Cash dividends.

 A firm should be guided by the consideration

as to which alternative use is consistent with
the goal of wealth maximization.

 There are conflicting opinions regarding the

impact of dividends on the valuation of a firm.
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 1. Irrelevance of Dividends
a. Residual Theory
b. MM Theory

2. Relevance of Dividends
a. Walter’s Model
b. Gordon’s Model

19-8
 Dividend policy of a firm is residual decision and not
an active decision.

 A firm should retain its earnings when it has

profitable investment projects and should favour its
dividend distribution when such opportunities are
lacking.

 The rationale is sound as firms would retain profits

when they can earn higher than what the equity
holders can and prefer distribution of earnings when
shareholders can earn higher.

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 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 argument is: “The investment

policy of the firm is set ahead of time and is not
altered by changes in dividend policy.”

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19-10
Given the investment decision, a firm has two
alternatives:
(i) It can retain its earnings to finance the
investment programme,
(ii) or distribute the earnings to the shareholders
as dividend and raise an equal amount externally
through the sale of new shares/bonds for the
purpose.

If the firm selects the second alternative,

arbitrage process is involved.

19-11
 In arbitrage process, the payment of
dividends is associated with raising funds
through other means of financing.

 The effect of dividend payment on

shareholders’ wealth will be exactly offset by
the effect of raising additional share capital.

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 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 dividends.
 In other words, dividend policy will have no impact

on the value of the firm

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19-13
 Instead of declaring cash dividends, firms can rid
themselves of excess cash through buying shares of
their own stock.
 Recently, share repurchase has become an important

way of distributing earnings to shareholders.

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19-14
Consider a firm that wishes to distribute $100,000 to its
shareholders.
Assets Liabilities & Equity
A.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

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19-15
If they distribute the $100,000 as a cash dividend, the balance
sheet will look like this:
Assets Liabilities & Equity
B. After $1per 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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19-16
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

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19-17
 Flexibility
 Keeps stock price higher

◦ Good for insiders who hold stock options

 As an investment of the firm (undervaluation)
 Tax benefits

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19-18
 Consider a firm that has $1 million in cash after
selecting all available positive NPV projects.
◦ Select additional capital budgeting projects.
◦ Acquire other companies
◦ Purchase financial assets
◦ Repurchase shares

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19-19
 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 against the payment of
dividends, these taxes are not sufficient to lead firms to
eliminate all dividends.

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19-20
 Desire for Current Income
 Behavioral Finance
◦ It forces investors to be disciplined.
 Agency Costs
◦ High dividends reduce free cash flow.

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19-21
 The theory supports the relevance of dividend.

 The choice of an appropriate dividend policy

affects the value of a firm.

 Thus, the model relates the distribution of

dividends to available investment opportunities.
 If r>k, then firm should go for investments.
 If r<k, then firm should distribute dividends.
 If r=k, it is a matter of indifference.

19-22
Gordon’s argument is a two-fold
assumptions:
1.Investors are risk averse
2. They put premium on certain returns and
discount/penalize uncertain returns.

The retained earnings are evaluated by the

investors as a risky promise. In case the
earnings are retained, the market price of the
shares would be adversely affected.

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 Pay additional shares of stock instead of cash
 Increases the number of outstanding shares
 Small stock dividend
◦ Less than 20 to 25%
◦ If you own 100 shares and the company declared a 10%
stock dividend, you would receive an additional 10 shares.
 Large stock dividend – more than 20 to 25%

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19-24
 Stock splits – essentially the same as a stock dividend
except it is expressed as a ratio
◦ For example, a 2 for 1 stock split is the same as a 100%
stock dividend.
 Stock price is reduced when the stock splits.
 Common explanation for split is to return price to a
“more desirable trading range.”

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19-25
 Equity portion after the bonus
Equity share capital Rs 30,00,000 issue (1:2 ratio)
(30,000 share @ Rs
100 each) Equity share capital Rs 45,00,000
(45,000 share @ Rs
100 each)

Share premium (@ Rs 7,50,000 Share premium 11,25,000

25 per share) (45,000 @ Rs 25 per
share)

Retained earnings 43,75,000

Retained earnings 62,50,000 (62,50,000 – 15,000
shares x 125 per
share)
Total equity 1,00,00,000
Total equity 1,00,00,000

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Equity share capital Rs 30,00,000
(30,000 share @ Rs Equity portion after the share
100 each) split (10:1 ratio)

Equity share capital Rs 30,00,000

(300,000 share @ Rs
10 each)
Share premium (@ 7,50,000
Rs 25 per share)
Share premium 7,50,000

Retained earnings 62,50,000

Retained earnings 62,50,000
Total equity 1,00,00,000
Total equity 1,00,00,000

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 2. The owner’s equity accounts for Hexagon International are shown here:

Common stock ($1 par value) $ 40,000

Capital surplus 155,000
a. If the company’s
Retained stock currently sells for $39 per share
earnings and a 10% stock dividend
538,400
is declared, how many new shares will be distributed? Show how the equity
Total owners’ equity $733,400
accounts would change.

b. If the company declared a 25% stock dividend, how would the accounts change?

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19-28
 3. For the company is Problem 1, show how the
equity accounts will change if:

a. The company declares a four-for-one stock split.

How many shares are outstanding now? What is the
new par value per share?

a. The company declares a one-for-five reverse stock

split. How many shares are outstanding now? What
is the new par value per share?

19-29
4. Roll Corporation currently has 465,000
shares of stock outstanding that sell for $73
per share. Assuming no market imperfections
or tax effects exist, what will the share price be
after:
a.RC has a five-for-three stock split?
b.RC has a 15% stock dividend?
c.RC has a 42.5% stock dividend?
d.RC has a four-for-seven reverse stock split?

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