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ECON 2560 (71)
Chapter 18

Chapter 18 ECON 2560

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University of Guelph
ECON 2560
Tahsin Mehdi

Chapter 18 ECON 2560 Payout Policy HOW DIVIDENDS ARE PAID Cash Dividends Cash Dividend: Payment of cash by the firm to its shareholders  The firm’s records of who owns its shares can never be fully up to date but will send dividend cheque to all shareholders recorded in its books = record date Ex-Dividend Date: Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend  If dividend is sent to wrong person, that person is obligated to pass it on to new owner Example of key dates for quarterly dividend Some Legal Limitations on Dividends  Say a board decides to sell firms assets & distribute money as dividends  Wouldn’t leave any money to pay the firm’s debts  Bondholders will protect against this by placing limits on dividend payments  Federal law & provincial acts ,ay include provisions prohibiting firms from paying dividends under certain conditions  This is to protect firm’s creditors against excessive dividend payments  Essentially… dividends should be paid from retained earnings  Under certain condition firms are allowed to pay a “liquidating dividend” Stock Dividends, Stock Splits & Reverse Splits Stock Dividends: Distribution of additional shares to a firm’s shareholders  Example: Say a firm declares a stock dividend of 10%... it would send shareholders 1 additional share for every 10 currently owned Stock Split: Issue of additional shares to firm’s shareholders  Such as 2-for-1 split  Won’t change total assets held by firm Reverse Split: Issue of new shares in exchange for old shares which results in the reduction of outstanding shares  These are infrequent  E.g. reverse 2 for one split, shareholders would exchange 2 existing shares for 1 new share  Important consideration is an expectation of the resultant increase in share price Dividend Reinvestment Plans & Share Purchase Plans Dividend Reinvestment Plan: Enables shareholders to reinvest dividends into additional new shares  Many firms will offer their as an additional means of investing new shares to their shareholders  The reinvested proceeds may initially translate only into new fractions shares but those shareholders who continue to reinvest over a period of time could acquire sizeable amounts of new shares  By investing through a DRIP, the shareholder doesn’t necessarily get any tax advantage since reinvested amounts are treated on par w/ cash dividends for tax purposes and taxed as ordinary income Share Purchase Plan: Allows shareholders to make cash contributions toward the acquisition of new shares  Through both of these options, investors are able to save on brokerage costs  Also costs related to administering plans are typically borne by the firm SHARE REPURCHASE  When a firm wants to pay cash to shareholders, an alternative to declaring a cash dividend is... Share Repurchase: Firm buys back stock from its shareholders 4 Main ways to repurchase stock 1. Open-Market Repurchase: Firm announces it wants to buy stock in the secondary market  Most common method  Limits on how many of its own shares a firm can buy on a given day so repurchases are spread out over several months or years 2. Tender Offer: Firm offers to buy back stated # of shares at a fixed price 3. Auction: Firm states a range of prices at which is prepared to repurchase  Shareholders submit offers of how many shares they are willing to sell at each price  Firm calculates lowest price at which it can buy desired # of shares 4. Direct Negotiation: The firm may negotiate repurchase of a block of shares from a major shareholder HOW DO COMPANIES DECIDE ON HOW MUCH TO PAY OUT? 1. Managers are reluctant to make dividend changes that may have to be reversed and they are willing to raise new financing if necessary to maintain payout 2. Managers “smooth” dividends & hate to cut them back. Dividends tend to follow trends in long-run sustainable earnings  Transitory fluctuations in earnings rarely affect dividend payouts  Firms appear to have long-run target dividend payout ratios which Is the fraction of earnings paid out as dividends 3. Managers focus more on dividend changes than on absolute levels  Corporations that pay regular dividends sometimes act as though they have a target payout ratio  Eg. 40% of earnings  Think of target dividend as a % of expected or normal earnings, not this year’s actual earnings  If current divided in less than the target, then the dividend is increased gradually toward the target The Role of Share Repurchase Decisions  Repurchases are like special or bumper dividends they cause large amounts of cash to be paid to investors  They don’t substitute for dividends  Most companies that repurchase stock are mature, profitable companies that also pay dividends  When a company announces a repurchase program, it’s not making a long-term commitment to distribute more cash  Therefore repurchases are much more unstable than dividends  Tend to happen during boom times  Happen when firm has accumulated a large amount of unwanted cash or wish to change their capital structure by replacing equi
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