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Chapter 19 Dividends and Other Payouts Notes
19.1 Different Types of Dividends
•regular cash dividends cash payments by a firm to its shareholders, usually four times a year
•stock dividend payment of a dividend in the form of stock rather than cash; a stock dividend comes from treasury stock,
increasing the number of shares outstanding, and reduces the value of each share
•stock split the increase in the number of outstanding shares of stock while making no change in shareholders’ equity
19.3 The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy
Current Policy: Dividends Set Equal to Cash Flow
•the NPV of the firm can be calculated by discounting these dividends
•the firm’s value can be expressed as V0 = DIV0 + (DIV1 / 1 + rS)
The Indifference Proposition
•MM makes the following assumptions:
1) There are neither taxes nor brokerage fees, and no single participant can affect the market price of the security through his
or her trades. Economists say that perfect markets exist when these conditions are met.
2) All individuals have the same beliefs concerning future investments, profits, and dividends.
3) The investment policy of the firm is set ahead of time, and is not altered by changes in dividend policy.
•homemade dividends an individual investor can undo corporate dividend policy by reinvesting excess dividends or selling off
shares of stock to receive a desired cash flow
•many corporations assist their shareholders in creating homemade dividend policies by offering automatic dividend reinvestment
plans, which allows shareholders have option of automatically reinvesting some or all of their cash dividend in shares of stock
•stripped common shares entitle shareholders to receive either all the dividends from one or a group of well-known companies
or an instalment receipt that packages any capital gain in the form of a call option
•the call option gives the investor the right to buy the underlying shares at a fixed price and so is valuable if the shares appreciate
beyond that price; and the implications can be summarized in 2 sentences:
1) By varying dividend policy, the managers can achieve any payout along the diagonal line.
2) Either by reinvesting excess dividends at date 0 or by selling off shares of stock at this date, any individual investor can
achieve any net cash payout along the diagonal line.
19.4 Repurchase of Stock
Dividends Versus Repurchases: Real-World Considerations
•5 reasons why firms choose repurchases over dividends are:
1) Flexibility. It is well known that firms view dividends as a commitment to their shareholders and are quite hesitant to
reduce an existing dividend. Repurchases do not represent a similar commitment. Thus, a firm with a permanent increase in
cash flow is likely to increase its dividend. Conversely, a firm whose cash flow increase is only temporary is likely to
repurchase shares of stock.
2) Executive compensation. Executives are frequently given stock options as part of their overall compensation. Firms
offering significant executive stock options tend to prefer repurchasing shares over paying dividends.
3) Offset to dilution. In addition, the exercise of stock options increases the number of shares outstanding. In other words,
exercise causes dilution of the stock. Firms frequently buy back shares of stock to offset this dilution.
4) Repurchase as investment. Many companies buy back stock because they believe that a repurchase is their best
investment. This occurs more frequently when managers believe that the stock price is temporarily depressed. Here, it is
likely thought that (1) investment opportunities in nonfinancial assets are few, and (2) the firm’s own stock price should rise
with the passage of time.
The fact that some companies repurchase their stock when they believe it is undervalued does not imply that the
management of the company must be correct; only empirical studies can make this determination. The immediate stock
market reaction to the announcement of a stock repurchase is usually quite favourable. In addition, some empirical work has
shown that the long-term stock price performance of securities after a buyback is better than the stock price performance of
comparable companies that do not repurchase.
5) Taxes. Repurchases provide a tax advantage over dividends.
19.7 Real-World Factors Favouring a High-Dividend Policy
Information Content of Dividends and Dividend Signalling
•information content effect the rise in the stock price following the dividend signal
•cash flow = capital expenditures + dividends
19.8 The Clientele Effect: A Resolution of Real-World Factors?
•the clientele effect implies that the two sets of factors are likely to cancel each other out after all