The process of paying coupon interest on bonds is rather straightforward; it is a legally required payment under the terms of the bond’s indenture. Only when a firm contacts the trustee that it will be unable to pay the required interest because of financial difficulty does the process become complex and legalistic.
Dividends, as we’ve learned, are not a legal obligation of the firm and may be skipped, decreased, increased, stopped, and started according to the collective wisdom of the corporation’s board of directors. When they are paid, they are typically paid on a quarterly basis, four times over the course of a year.
Many firms offer shareholders the choice to receive a check for the amount of their dividends or to reinvest the dividends in the firm’s stock. Dividend reinvestment plans (DRIPs) allow shareholders to purchase additional shares automatically with all or part of the investor’s dividends. Fractional shares can be purchased and DRIP purchases have no or low commissions.
Suppose an investor owns sufficient shares to receive $10 in dividends on a stock from its quarterly declared dividend. If the stock price is $25, the DRIP program allows the investor to purchase $10/$25, or a 0.40 share of the firm’s stock. If the stock price is $8, the investor’s reinvested dividends will purchase $10/$8 or 1.25 shares of the stock.
If the investor favors the stock and wants to continue holding it, participating in a DRIP is an easy way of purchasing additional shares over time without any direct cash outlay. It allows income returns to be reinvested to facilitate compounding returns over time.
However, as with all dividends, the declared dividend is taxable as income. Whether the dividends are received as cash or reinvested, the investor must pay taxes on them.
How Do Firms Decide on the Dollar Amount of Dividends?
Most firms that issue dividends try to maintain a consistent dividend payout ratio, which is dividends per share divided by earnings per share (EPS).
A key component of the “how much?” decision is what level of dividends is sustainable over time? A firm does not want to announce it will begin paying dividends and then have to reduce or eliminate the dividend at a later time due to the need to conserve cash.
Dividends are thought to send a signal to investors about management’s view of the future cash-generating ability of the firm. Managers and the board of directors have private information about the strategies, competitive responses, and opportunities facing the firm that are not known to the investing public.
Thus, if the firm increases dividends, that is a positive signal or indicator to the financial markets that management believes the future looks stable, or improving, for the firm. A reduction in dividends is taken to be a pessimistic indicator of the firm’s future, so firms set dividend levels so future reductions are unlikely given their current perspective on the firm’s future.
Studies have indicated that U.S. firms are increasing their dividends to their shareholders and reducing spending on new assets and research. This may be a dangerous sign for future profitability as future profits (and dividends) will be created from new products and innovation.
Most firms that start paying dividends will do so at a rather low level, perhaps just a penny a share. The fact that management and the board are sufficiently confident to issue a dividend is a positive signal to the financial markets.
As the firm generates more cash, the firm will increase its dollar amount of dividends per share as well as its dividend payout ratio. After a while, the firm will determine a “target” dividend payout ratio that it seeks to maintain over time.
However, dividends will not automatically rise along with earnings. If future earnings rise, dividends will not increase until the board feels the higher level of earnings are sustainable. (Remember, firms do not want to ever cut the dollar amount of the dividends per share if they can avoid it.)
If the higher earnings appear to be sustainable, the firm will adjust the dividends per share accordingly toward the “target” dividend payout ratio.24 Some call this the target dividend payout policy.
Some firms follow a different dividend strategy of consistently paying a low regular dividend but declaring a special dividend when times are particularly good. For a firm in a cyclical industry, with highly variable sales and earnings, this may be a strategy to conserve cash during industry recessions while maintaining the low but stable regular dividend.
Shareholders are rewarded when rising earnings allow the company to declare an extra or special dividend. While such a dividend policy may help management control their cash balance, investors, who generally prefer certainty to uncertainty, do not favor such a strategy.
Other dividend payment strategies suffer from the same drawback of creating investor uncertainty due to variable dividend levels. The residual dividend policy states that dividends will vary based upon how much excess funds the firm has from year to year.
Under a constant payout ratio strategy, the firm pays a constant percentage of earnings as dividends; as earnings rise and fall, so does the dollar amount of dividends. Please note that this is not the same as the target payout policy.
The firm adjusts dividends around the target over time, depending on earnings sustainability; during some years, the actual payout ratio will exceed the target, and during others, it will be under it in order to have stable, predictable changes in dividends.
The constant payout ratio maintains the payout ratio at the expense of a varying dollar amount of dividends per share.
The board of directors and management will consider several factors as they examine the level of dividend payout. Some of these factors are the following:
The ability of the firm to generate cash to sustain the level of dividends. Recall that investors react badly to reductions in dividends. If a dividend level is thought to be unsustainable, the firm’s stock price will fall as investors sell the stock.
- Legal and contractual considerations. Dividends, when they are repaid, reduce a firm’s equity. A firm cannot pay dividends if doing so will reduce the firm’s equity below the par value of the common stock. In addition, a bond’s indenture (or loan agreement with a bank) may restrict the dollar amount of dividends to ensure adequate cash is available to pay loan interest and principal.
- Growth opportunities. Growing firms require capital, and they will likely want to reinvest all profits into the company to finance expansion and move into new products or markets. Growing firms may seek additional funds from loans, bond issues, and new issues of stock. It is unlikely firms facing growth opportunities will want to initiate or significantly increase their dividends.
- Cost of other financing sources. Dividends are paid, for the most part, from internally generated funds, meaning cash that remains after the firm’s bills, interest, and taxes are paid. If a firm has the ability to easily raise low-cost external financing sources, it will be better able to maintain a higher level of dividends. Firms that can raise outside financing by paying high-interest rates or by issuing new shares of stock will likely have lower levels of dividends.
- Tax rates. Prior to 2003, dividend income was viewed as unattractive by some investors. Why? Because dividend income was taxed as income, at the investors’ marginal income tax rate, which exceeded 30 percent (combined federal and state tax rates) for many. But the Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the top federal tax rate on dividends from 38 to 15 percent, the same as the top rate on long-term capital gains. Although surveys of financial officers indicate that tax rates are not a first-order concern when setting dividends, in the aggregate, firms markedly increased dividends after the law was passed. As noted above, President Obama’s desire for the top dividend tax rate of 15 percent to rise to 39.6 percent caused some firms to accelerate their early 2013 dividend payments into late 2012.
In addition to giving cash dividends to shareholders, the firm’s board of directors can announce other decisions, such as a stock dividend or stock split, that, at first glance, appear to give extra shares and wealth to shareholders.
In reality, as we shall see in the next section, their effect on the value of a firm’s stock and the wealth of shareholders is zero. But the board can make one other decision with respect to the firm’s shares that will positively affect shareholders: a stock buyback or share repurchase program. We’ll examine stock dividends, splits, and repurchases next.
Stock Dividends and Stock Splits
A stock dividend is what it sounds like: a dividend paid with shares of stock rather than cash. Rather than mention a dollar figure, the announcement will state that the firm is distributing a 5 percent (or “X” percent) stock dividend. But a stock dividend has no net effect on the wealth of the shareholders. To see why, consider the following.
Suppose CUL8R Incorporated stock is currently priced at $10 a share, and there are 100,000 shares outstanding; the total market value of the firm is $10 × 100,000 or $1 million. Suppose you own 1,000 shares, meaning you own 1 percent of the shares outstanding and the value of your holdings is $10 × 1,000 shares or $10,000. CUL8R’s board has declared a 10 percent stock dividend, so now you own 1,100 shares.
Are you any richer? The answer is no; you still own 1 percent of the shares outstanding, and the value of your CUL8R holdings is still $10,000. You own 1,100 shares, but the number of shares outstanding is 10 percent larger, too.
There are 110,000 total shares, and you own 1 percent of this total. Nothing has happened to the value or the earnings ability of the firm with this paper transaction, so the firm’s stock price will fall and will equal $1 million/110,000 shares, or approximately $9.09.
There are some accounting entries that will affect the firm’s equity account, but the total amount of equity in the accounting statements will remain the same.25 The bottom line is a stock dividend distributes nothing to shareholders and removes nothing from the firm. No value is transferred.
A stock split has a similar effect. The firm distributes extra shares for every share owned in a stock split. For example, a firm may announce a two-for-one stock split; this has the effect of doubling the number of shares outstanding and doubling the holdings of each investor, but as in the case of a stock dividend, the net effect on investor wealth is zero.
You may own twice as many shares, but the stock price will be cut in half, leaving your ownership stake (both in terms of value and percentage owned) the same as it was before the stock split.
Occasionally, a firm will announce a “reverse split” in which multiple shares are combined to form one new share. For example, a one-for-four reverse split means four old shares are equal to one new share. When this happens, the stock price will change so again the investor’s wealth remains the same.
You may have noted that there is not much of a difference between a stock split and a stock dividend. They involve paper transactions in which the number of shares is increased but prices adjust downward to maintain investor wealth at a constant level.
In terms of accounting, the distribution of five shares for four (a 25 percent stock dividend) is considered to be a stock split; a distribution of less than five for four (less than a 25 percent stock dividend) is considered to be a stock dividend.
Rather than distribute funds to shareholders in the form of earnings, a firm can repurchase its shares. Why would a firm repurchase its shares of stock? A firm doing a small purchase (relative to the total amount of shares outstanding) can acquire shares used in management stock option incentive programs, in which managers can purchase shares of stock at pre-specified prices.
Other firms purchase shares of their own stock to use in stock-based acquisitions of other firms. That is, they repurchase shares from current shareholders and then distribute them to owners of a newly acquired firm.
A major reason for doing this is to reward longer-term shareholders by enhancing the value of the firm’s shares. Increases in stock prices are not taxed until the shares are sold, and if the shares have been held longer than one year, the maximum tax on the increase in value (called a capital gain) is 15 percent for most investors.
These tax savings are thought to be a major reason by some researchers for the increase in stock repurchases in recent years.
Another reason for stock repurchases is that the firm has the cash and sees its own stock as one of its most attractive investment alternatives. Rather than investing in expanding the business to new markets, the firm’s board of directors and top managers believe the firm’s stock is undervalued and offers potential returns.
The stock can be purchased at what is perceived to be a low price and re-issued later, after the stock price rises. This is a firm “putting its money where its mouth is.”
This was a popular reason given for stock repurchases during the 2000–2002 stock market decline. On the other hand, it is an indicator that management is doing a poor job in identifying new corporate strategies for increasing the stock’s value.