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Dividends are payments that firms make to their shareholders.  Historically dividends were a major portion of returns to stockholders.  Since the late 1980s dividends are taken a back seat to capital gains.  After the Enron collapse and the Corporate Governance Crisis that followed, DIvidends came back into vogue.  Why?  It is harder to fake dividends than it is earning.  



There are several types of dividends. Generally dividends are cash payments, but as we see with stock dividends it is not always the case.
 

• Ordinary (or regular) dividends-Regular dividends are paid in cash at regular intervals.  Most firms pay these out quarterly, but there are firms that pay at other intervals (monthly or annually).
• Special (or extra) Dividends-A one-time dividend that is not expected to be reoccurring.
• Stock Dividends-Stock dividends are really mini-stock splits.  The company gives new shares to existing shareholders.
• Other types of dividends-These are special benefits such as free cruises and the like.

Dividend decisions are made by the company's Board of Directors.  They are faced with the decision to pay out dividends or to reinvest the cash into new projects. 

In a perfect world dividend policy would not matter since the return that investors would earn would be the same as the return that the firm would receive if the cash were reinvested.  (this is the idea behind Nobel Prize winners Modigliani and Miller's work in the field).

However, the real world is not perfect.  There are taxes, information asymmetries, and conflicts of interest.  In this world dividend policy may matter.  For example, if you think managers will waste any cash they have, you would prefer larger dividends even though your taxes will rise.

The classic work in this area is by Lintner (1956).  He found that managers hate to cut dividends (because investors see cuts as a signal that things are going poorly).  Thus once the Board of Directors decides to raise dividends they want to be sure they do not need to cut them in the future.  This leads to "sticky dividends."  Sticky dividends refers to the idea that dividends track earnings but with a lag since management wants to be sure the earnings are sustainable.

Announcement date (aka Declaration date)-this is the date that the board of directors announces that a dividend will be paid.  If the dividends is good news, this is the date that the stock price will rise on.

Shareholder of Record date- this is the day that the firms decides who gets paid a dividend.  You can imagine a firm opening up "their books" and seeing who owns stock.  WHoever is listed will get paid.  Remember however that it takes a few days to be listed.  Thus, you may own stock on the Record date and still not get a dividend.

Cum Dividend date-This is the last day that you can buy the stock and still get the dividend.  (in other words if you buy today the firm still has time to get you listed on their books by the Record date.)

Ex-dividend date-This is the first day that you can buy and NOT get the dividend.  (In other words you are too close to the Record date for the firm to record your owning the shares.)  On this day the price of the stock will open down by the amount of the dividend.  Why?  The day before the stock was worth more because those who bought it would get a dividend, now the dividend is not included.

Payment date- This is the day the firm actually pays the dividend.
 

Dividends and Taxes

Dividends are paid out of earnings.  These earnings were already taxed.   When a dividend is received, the investor must pay taxes on the dividend.  This dividend is generally taxed as ordinary income.  This double taxation is a big problem when paying dividends.

In many nations the Stock Buybacks can be used as an alternative to dividends.  The rationale behind this is that the investor need not sell.  Thus, investors can "time" their taxes.  Further, in many nations capital gains are taxed at a lower rate than is ordinary (dividend) income.   However, if a firm uses stock buybacks exclusively to avoid taxes, the IRS will intervene and disallow the lower tax.

An additional point is worth noting: corporations that receive dividends can exempt 70% of the dividend for tax purposes.  This is aimed at preventing triple taxation. (Hint: remember this when wondering why preferred stock exists)

Because of the advantage of timing the tax as well as the lower capital gains tax rate, most people believe there is a disadvantage to paying out large dividends.  This view has really caught on in recent years as firms have not raised dividends but rather reinvested and/or done stock buybacks.
 
The market response to dividend and buyback announcements from The New Corporate Finance , pp 489-490, by Donald Chew.  (a great book.  I definitely recommend it!

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