Chapter 13Dividend Policy and Internal FinancingChapter ObjectivesDividend PolicyDividend TradeoffsDoes Dividend Policy Affect Stock Price?View 1: Dividend Policy is IrrelevantPerfect Capital MarketsAdditional AssumptionsView 2: High Dividends Increase Stock ValueView 3: Low Dividends Increase Stock ValueExtensions of Dividend TheoryResidual Dividend TheoryClientele EffectInformation EffectAgency CostsExpectations TheoryDividend Theories: ConclusionsDividend ConsiderationsAlternative Dividend PoliciesDividend Payment ProceduresStock Dividends and Stock SplitsRationale for Stock Dividend or SplitStock RepurchasesRationale for Stock RepurchasesRepurchase ProcedureChapter 13Chapter 13Dividend Policy and Internal Dividend Policy and Internal FinancingFinancingChapter ObjectivesChapter ObjectivesTrade-offs between paying dividends and retaining profitsRelationship between a corporation’s dividend policy and the market price of its common stockPractical considerations important to dividend policyTypes of dividend policiesProcedures for dividend payoutNon cash dividendsStock repurchasesLow dividend payments and international capital budgeting opportunitiesDividend PolicyDividend PolicyTwo Key Elements:1. Dividend payout ratioamount of dividends paid relative to the company’s earnings2. Dividend stability over timeDividend TradeoffsDividend TradeoffsPaying large dividends means simultaneously deciding to retain little profits. Greater reliance on external financingPaying small dividends corresponds to high profit retention and less need for externally generated equity fundsDoes Dividend Policy Affect Does Dividend Policy Affect Stock Price?Stock Price?View 1: Dividend policy is irrelevantView 2: High dividends increase stock valueView 3: Low dividends increase stock priceView 1:View 1:Dividend Policy is Dividend Policy is IrrelevantIrrelevantAssumption: Investment and borrowing decisions will not be altered by the amount of any dividend paymentPerfect capitals markets are assumed to exist which means:Perfect Capital MarketsPerfect Capital MarketsInvestors can buy and sell stocks without incurring any transaction costs–Companies can issue stock without any cost–No corporate or personal taxes–Complete information is readily available–No conflicts on interest between management and stockholders–Financial distress and bankruptcy are nonexistentAdditional AssumptionsAdditional AssumptionsThere is no relationship between dividend policy and stock value. One dividend policy is as good as anotherInvestors are concerned only with total returns—they are indifferent whether these returns come from capital gains or dividend incomeView 2:View 2:High Dividends High Dividends Increase Stock ValueIncrease Stock ValueDividends are more predictable than capital gains—management can control dividends but can not dictate price of stock.Bird-in-the-hand theory: Dividends are more certain than capital gains.Trade-off of uncertain capital gains for a “safe” asset (a cash dividend)View 3:View 3:Low Dividends Low Dividends Increase Stock ValueIncrease Stock ValueTaxpayers seek to maximize after-tax return on investment relative to the risk assumed Minimize the effective tax rate on the income by deferring the payment of taxesStocks that allow tax deferral (low dividends-high capital gains) will possibly sell at a premium.Extensions of Dividend TheoryExtensions of Dividend TheoryResidual Dividend TheoryClientele EffectInformation EffectAgencyExpectations TheoryResidual Dividend TheoryResidual Dividend TheoryDividends paid only if profits are not completely used for investment purposes—only when there are “residual earnings” after the financing of new investments.Clientele EffectClientele EffectFirms draw a certain clientele given their stated dividend policy.The possibility that clienteles of investors exist might indicate that the dividend policy matters.Information EffectInformation EffectDividends are important as a communication tool about future earningsInformation asymmetry–Difference in accessibility to information between management and investors may result in a lower stock priceAgency CostsAgency CostsThe stock price of a company with investors who are separate from management may be less than the stock value of a closely held firm. The Potential difference in price is the cost of the conflict to the owners or agency costsA firm’s dividend policy may be perceived as a tool to minimize agency costsExpectations TheoryExpectations TheoryRegardless of the decision, how the market price responds to management’s actions is not determined entirely by the action itself; it is also affected by investors’ expectations about the ultimate decision to be made by management.If there is a difference between actual and expected dividends, stock price should changeDividend Theories: Dividend Theories: ConclusionsConclusionsAs a firm’s investment opportunities increase, the dividend payout ratio should decreaseDividend policy appears to be importantIf dividends influence stock price, this influence is based on investors desire to minimize and defer taxesManagement should avoid surprising investors when it comes to the firm’s dividends decisionDividend ConsiderationsDividend ConsiderationsLegal RestrictionsLiquidity PositionAbsence or lock of other sources of financingEarnings predictabilityOwnership ControlInflationAlternative Dividend PoliciesAlternative Dividend PoliciesConstant dividend payout ratio–Percentage of earnings paid out in dividends is held constant Stable Dollar Dividend per share–Policy maintains a relatively stable dollar dividend over time. The most common of the dividend policies Small, regular dividend plus a year-end extra–Pays a small, regular dollar dividend plus a year-end extra dividend in prosperous years.Dividend Payment ProceduresDividend Payment ProceduresDeclaration date–The date when the dividend is formally declared by the board of directorsDate of record–When the stock transfer books are to be closed– the person who owns the stock on this date receives the dividendPayment date–The date the company mails the dividend checkStock Dividends and Stock Stock Dividends and Stock SplitsSplitsBoth increase the number of shares outstanding.Stock
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