DIVIDEND REINVESTMENT PLANS

Today, many firms offer dividend reinvestment plans (DRIPs), which enable stockholders to use dividends received on the firm’s stock to acquire additional shares—even fractional shares—at little or no transaction cost. Some companies even allow investors to make their initial purchases of the firm’s stock directly from the company without going through a broker. With DRIPs, plan participants typically can acquire shares at about 5 percent below the prevailing market price. From its point of view, the firm can issue new shares to participants more economically, avoiding the underpricing and flotation costs that would accompany the public sale of new shares. Clearly, the existence of a DRIP may enhance the market appeal of a firm’s shares.

dividend reinvestment plans (DRIPs)

Plans that enable stockholders to use dividends received on the firm’s stock to acquire additional shares—even fractional shares—at little or no transaction cost.

STOCK PRICE REACTIONS TO CORPORATE PAYOUTS

What happens to the stock price when a firm pays a dividend or repurchases shares? In theory, the answers to those questions are straightforward. Take a dividend payment for example. Suppose that a firm has $1 billion in assets, financed entirely by 10 million shares of common stock. Each share should be worth $100 ($1 billion ÷ 10,000,000 shares). Now suppose that the firm pays a $1 per share cash dividend, for a total dividend payout of $10 million. The assets of the firm fall to $990 million. Because shares outstanding remain at 10 million, each share should be worth $99. In other words, the stock price should fall by $1, exactly the amount of the dividend. The reduced share price simply reflects that cash formerly held by the firm is now in the hands of investors. To be precise, this reduction in share price should occur not when the dividend checks are mailed but rather when the stock begins trading ex dividend.

For share repurchases, the intuition is that “you get what you pay for.” In other words, if the firm buys back shares at the going market price, the reduction in cash is exactly offset by the reduction in the number of shares outstanding, so the market price of the stock should remain the same. Once again, consider the firm with $1 billion in assets and 10 million shares outstanding worth $100 each. Let’s say that the firm decides to distribute $10 million in cash by repurchasing 100,000 shares of stock. After the repurchase is completed, the firm’s assets will fall by $10 million to $990 million, but the shares outstanding will fall by 100,000 to 9,900,000. The new share price is therefore $990,000,000 ÷ 9,900,000, or $100, as before.

In practice, taxes and a variety of other market imperfections may cause the actual change in share price in response to a dividend payment or share repurchase to deviate from what we expect in theory. Furthermore, the stock price reaction to a cash payout may be different than the reaction to an announcement about an upcoming payout. For example, when a firm announces that it will increase its dividend, the share price usually rises on that news, even though the share price will fall when the dividend is actually paid. The next section discusses the impact of payout policy on the value of the firm in greater depth.

REVIEW QUESTIONS

14–4Who are holders of record? When does a stock sell ex dividend?

14–5What effect did the Jobs and Growth Tax Relief Reconciliation Act of 2003 have on the taxation of corporate dividends? On corporate dividend payouts?

14–6What benefit is available to participants in a dividend reinvestment plan? How might the firm benefit?

14.3 Relevance of Payout Policy

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The financial literature has reported numerous theories and empirical findings concerning payout policy. Although this research provides some interesting insights about payout policy, capital budgeting and capital structure decisions are generally considered far more important than payout decisions. In other words, firms should not sacrifice good investment and financing decisions for a payout policy of questionable importance.

The most important question about payout policy is this one: Does payout policy have a significant effect on the value of a firm? A number of theoretical and empirical answers to this question have been proposed, but as yet there is no widely accepted rule to help a firm find its “optimal” payout policy. Most of the theories that have been proposed to explain the consequences of payout policy have focused on dividends. From here on, we will use the terms dividend policy and payout policyinterchangeably, meaning that we make no distinction between dividend payouts and share repurchases in terms of the theories that try to explain whether these policies have an effect on firm value.

RESIDUAL THEORY OF DIVIDENDS

The residual theory of dividends is a school of thought that suggests that the dividend paid by a firm should be viewed as a residual, that is, the amount left over after all acceptable investment opportunities have been undertaken. Using this approach, the firm would treat the dividend decision in three steps as follows:

residual theory of dividends

A school of thought that suggests that the dividend paid by a firm should be viewed as a residual,the amount left over after all acceptable investment opportunities have been undertaken.

Step 1 Determine its optimal level of capital expenditures, which would be the level that exploits all a firm’s positive NPV projects.
Step 2 Using the optimal capital structure proportions (see Chapter 13), estimate the total amount of equity financing needed to support the expenditures generated in Step 1.
Step 3 Because the cost of retained earnings, rr, is less than the cost of new common stock, rn, use retained earnings to meet the equity requirement determined in Step 2. If retained earnings are inadequate to meet this need, sell new common stock. If the available retained earnings are in excess of this need, distribute the surplus amount—the residual—as dividends.

According to this approach, as long as the firm’s equity need exceeds the amount of retained earnings, no cash dividend is paid. The argument for this approach is that it is sound management to be certain that the company has the money it needs to compete effectively. This view of dividends suggests that the required return of investors, rs, is not influenced by the firm’s dividend policy, a premise that in turn implies that dividend policy is irrelevant in the sense that it does not affect firm value.