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8.11. Dividend policy

Dividend policy refers to the firm's decision whether to plough back earnings as retained earnings or payout earnings to shareholders. Moreover, in case the latter is preferred the firm has to decide how to payback the shareholders: As dividends or capital gains through stock repurchase.

Dividend policy in practice

Earnings can be returned to shareholders in the form of either dividends or capital gain through stock repurchases. For each of the two redistribution channels there exists several methods:

Dividends can take the form of

- Regular cash dividend

- Special cash dividend

Stock repurchase can take the form of

- Buy shares directly in the market

- Make a tender offer to shareholders

- Buy shares using a declining price auction (i.e. Dutch auction)

- Through private negotiation with a group of shareholders

8.11.1. Dividend payments in practice

The most common type of dividend is a regular cash dividend, where "regular" refers to expectation that the dividend is paid out in regular course of business. Regular dividends are paid out on a yearly or quarterly basis. A special dividend is a one-time payment that most likely will not be repeated in the future.

When the firm announces the dividend payment it specifies a date of payment at which they are distributed to shareholders. The announcement date is referred to as the declaration date. To make sure that the dividends are received by the right people the firm establishes an ex-dividend date that determines which shareholders are entitled to the dividend payment. Before this date the stock trades with dividend, whereas after the date it trades without. As dividends are valuable to investors, the stock price will decline around the ex-dividend date.

8.11.2. Stock repurchases in practice

Repurchasing stock is an alternative to paying out dividends. In a stock repurchase the firm pays cash to repurchase shares from its shareholders with the purpose of either keeping them in the treasury or reducing the number of outstanding shares.

Over the last two decades stock repurchase programmes have increased sharply: Today the total value exceeds the value of dividend payments. Stock repurchases compliment dividend payments as most companies with a stock repurchase programme also pay dividends. However, stock repurchase programmes are temporary and do therefore (unlike dividends) not serve as a long-term commitment to distribute excess cash to shareholders.

In the absence of taxation, shareholders are indifferent between dividend payments and stock repurchases. However, if dividend income is taxed at a higher rate than capital gains it provides a incentive for stock repurchase programmes as it will maximize the shareholder's after-tax return. In fact, the large surge in the use of stock repurchase around the world can be explained by higher taxation of dividends. More recently, several countries, including the United States, have reformed the tax system such that dividend income and capital gains are taxed at the same rate.

8.11.3. How companies decide on the dividend policy

In the 1950'ties the economist John Lintner surveyed how corporate managers decide the firm's dividend policy. The outcome of the survey can be summarized in five stylized facts that seem to hold even today.

Lintner's "Stylized Facts": How dividends are determined

1. Firms have longer term target dividend payout ratios

2. Managers focus more on dividend changes than on absolute levels

3. Dividends changes follow shifts in long-run, sustainable levels of earnings rather than short-run changes in earnings

4. Managers are reluctant to make dividend changes that might have to be reversed

5. Firms repurchase stocks when they have accumulated a large amount of unwanted cash or wish to change their capital structure by replacing equity with debt.

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