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Chapter 17

COMMERCE 3FA3 Chapter Notes - Chapter 17: Leaseback, Stock Split, Dividend Yield

Course Code
Trevor Chamberlain

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Dividend Policy
Should firm pay out money to its shareholders or should firm take money and
invest it for its shareholders?
Many good reasons to pay high dividends
Also many good reasons to pay low or no dividends
Cash Dividends and Dividend Payment
Dividend: payment made out of firm’s earnings to its owners in the form of cash
or stock
Distribution: payment made by firm to its owners from sources other than current
or accumulated earnings
Three basic types of cash dividends:
1. Regular cash dividends
2. Extra dividends
3. Liquidating dividends
Cash Dividends
Most common type of dividend
Regular cash dividend: cash payment made by firm to its owners in the normal
course of business (usually 4 times a year)
Sometimes pay an extra cash dividend (indicate it may not be paid in the future)
Liquidating dividend: some or all of business has been liquidated
A cash dividend reduces corporate cash and retained earnings except in the case
of a liquidating dividend (where capital may be reduced)
Dividend Payment: A Chronology
1. Declaration date: date on which board of directors passes a resolution to pay a
2. Ex-dividend date:
oDate two business days before date of record
oIf buy stock before this date then are entitled to dividend (cum dividend)
oIf buy on this date or after then do not get dividend (ex-dividend)
3. Date of record: date on which holders of record are designated to receive a
4. Date of payment: date on the dividend cheques (when they are mailed out)
More on the Ex-Dividend Date
Expect the value of a share of stock to go down by about the dividend amount
when the stock goes ex dividend
Goes down by about the dividend amount because of personal taxes
Will actually drop by a bit less because shareholders would be taxed on the
dividend and not receive the full amount

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Does Dividend Policy Matter?
An Illustration of the Irrelevance of Dividend Policy
Homemade Dividends:
oHomemade dividends: individual investors can undo corporate dividend
policy by reinvesting dividends or selling shares of stock
oNo particular advantage to any one dividend policy that the firm might
oCorporations offer automatic dividend reinvestment plans (ADPs or
DRIPs) to help shareholders create homemade dividend policies
oInvestors can reinvest all or some of cash dividends in shares of stock
oStripped common shares: common stock on which dividends and capital
gains are repackaged and sold separately
A Test:
1. Dividends are irrelevant (FALSE – investors prefer higher dividends to lower
dividends at any date if dividend level is held constant at every other date)
2. Dividend policy is irrelevant (TRUE – dividend policy cannot raise dividend
at one date while keeping it the same at all other dates)
Real-World Factors Favouring a Low Payout
In Canada dividends and capital gains are taxed at lower rates than marginal tax
Investors face a lower tax rate due to dividend tax credit
Capital gains are taxed at 50% of tax rate
Low-dividend payout means firm reinvests money instead of paying it out
Will increase capital gains portion of the return so investors may prefer this
Alternatives to a dividend if firm has excess cash:
1. Select additional capital budgeting projects
oFirm has already taken all positive NPV projects already
oMust invest excess cash in negative NPV projects
oManagers who do this are subject to takeover, LBOs and proxy fights
2. Repurchase shares
oFirm may use excess cash to repurchase stock
oProfits on repurchased stock can be treated as capital gains
3. Acquire other companies:
oAdvantage of acquiring profitable assets
oDisadvantage because acquisitions are usually made at 20-80%
premiums above the market price
oCompany making acquisition to avoid a dividend is not likely to
4. Purchase financial assets:
oPurchasing financial assets in lieu of a dividend

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oDividends are the same after taxes whether the firm pays them now or
later (after investing in financial assets)
oThe same because the firm invests exactly as profitably as
shareholders on an after-tax basis
When personal tax rates > corporate tax rates  firm has incentive to reduce
dividend payments
If personal tax rates < corporate ax rates -> firm has incentive to pay out excess
cash in dividends
Some Evidence on Dividends and Taxes in Canada
An investor who waits for the stock to go ex dividends buys at a lower price
Will have a larger capital gain when the stock is sold later
Individual investors look for higher pre-tax returns on dividend paying stocks
Flotation Costs
Value of the stock decreases when we sell new stock if include flotation costs
May have lower payout since selling stock is expensive
Real-World Factors Favouring a High Payout
Argue high-dividend payouts because:
1. Discounted value of near dividends is higher than present value of distant
2. Between two companies with same earning power and position in an industry
the one with larger dividend will sell at a higher price
Desire for Current Income
Simple case:
oIndividual desiring high current cash flow but holding a low-dividend
stock could just sell shares to get necessary funds
oIndividual desiring low current cash flow but holding high-dividend stocks
can just reinvest dividend
oHigh current dividend policy would be of no value to shareholder in a
world of no transaction costs
Real world:
oSale of low-dividend stocks would involve brokerage fees and transaction
oDirect expenses cold be avoided by investing in high-dividend securities
Uncertainty Resolution
Investors price a security by forecasting and discounting future dividends
Forecasts of dividends to be received in the distant future have greater uncertainty
Stock price will be lower for companies that pay low dividends now to pay higher
dividends later (because investors do not like uncertainty)
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