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2/10/2010

WHAT IS A DIVIDEND?

FINS 1613 Week 11 Lecture Notes Dividend Policy: Theory and Evidence

Definition: A payment made by a firm out of its current or accumulated retained earnings to its owners. Broad types: 1. Cash 2. Stock

Chapter 14 Dividends and Dividend Policy

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Key Concepts and Skills

Cash Dividend Types

Understand dividend types and how they are paid Understand the issues surrounding dividend policy decisions Understand the difference between cash and share dividends Understand why share repurchases are an alternative to dividends

Regular cash dividend – cash payments made directly to shareholders, usually each quarter Extra cash dividend – indication that the “extra” “ t ” amount may not be repeated in the t tb t d i th future Special cash dividend – similar to extra dividend, but definitely won’t be repeated Liquidating dividend – some or all of the business has been sold 2 5

Chapter 14 Outline

Cash Dividends and Dividend Payment Does Dividend Policy Matter? Establishing a Dividend Policy Share Repurchase: An Alternati e to Cash Rep rchase Alternative Dividends Bonus Issues and Share Splits

HOW ARE CASH DIVIDENDS PAID? The distribution process is governed by law.

Declaration date: Directors announce dividend payment Cum-dividend: Share trades with dividend entitlement Ex-dividend date: Date from which share trades without dividend entitlement Record date: Date by which shareholder must be on firm’s records to receive dividend payment Payment Date: Date on which dividend is paid to shareholders on record. 3 6

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Figure 14.2 The Ex-Day Price Drop

SHOULD THE FIRM PAY DIVIDENDS?

Decision rule: Firm should pay dividends if and only if it increases firm value Issue: Do dividends increase firm value

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WHAT IS DIVIDEND POLICY?

Does Dividend Policy Matter?

Definition: The firm’s decision regarding how much of its earnings it will pay out to its shareholders in the form of dividends. Who makes the decision: This decision is made by the Board of Directors. Quantifying the decision: This decision is quantified by the firm’s dividend payout ratio = DPS/ EPS.

Dividends matter – the value of the share is based on the present value of expected future dividends Dividend policy may not matter – Dividend policy is the decision to pay dividends versus retaining funds to reinvest in the firm – In theory, if the firm reinvests capital now, it will grow and can pay higher dividends in the future 8 11

DIVIDEND POLICY ISSUES

DIVIDEND IRRELEVANCE THEORY

1. Should the firm pay dividends? Dividend policy and firm value Empirical evidence (Fama and French, 2001) 2. How much should the firm pay? Types of Policies Empirical and Survey evidence

Miller and Modigliani, [i.e., MM] (1961) Propose that: Dividend policy does not affect the value of the firm or its cost of capital Firm value determined by the earning power and risk of its assets Dividend policy establishes a trade-off between dividends at different times. Dividend policy is, therefore, irrelevant Shareholders indifferent between dividends now versus future capital gain once time value of money is considered. 9 12

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DIVIDEND IRRELEVANCE THEORY (CONTINUED)

DIVIDEND IRRELEVANCE THEORY (CONTINUED)

Theory assumes that a perfect capital market exists:
Frictionless market
• no taxes or transaction costs • I f Information is costlessly available ti i tl l il bl

Investors are rational and price takers Investors have homogeneous expectations Investment decision set ahead of time and is not affected by dividend policy changes Perfect compensation contracts (no agency issues) 13

Alternative Rationale: Shareholders can change a firm’s dividend payout to suit their needs by reinvesting dividends or selling shares themselves. This is called a homemade dividend policy Shareholders will therefore not pay more for a share that pays high dividends than a share...
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