CP

Dividend Reinvestment Plans 523

ex-dividend date.In this case, the ex-dividend date is two days prior to December 6,

or December 4:

Dividend goes with stock: December 3

Ex-dividend date: December 4

December 5

Holder-of-record date: December 6

Therefore, if Buyer is to receive the dividend, she must buy the stock on or

before December 3. If she buys it on December 4 or later, Seller will receive the

dividend because he will be the official holder of record.

Katz’s dividend amounts to $0.50, so the ex-dividend date is important. Barring

fluctuations in the stock market, one would normally expect the price of a stock to

drop by approximately the amount of the dividend on the ex-dividend date. Thus,

if Katz closed at $30.50 on December 3, it would probably open at about $30 on

December 4.^6

4.Payment date.The company actually mails the checks to the holders of record on

January 3, the payment date.

Explain the logic of the residual dividend model, the steps a firm would take to

implement it, and why it is more likely to be used to establish a long-run payout

target than to set the actual year-by-year payout ratio.

How do firms use planning models to help set dividend policy?

Explain the procedures used to actually pay the dividend.

Why is the ex-dividend date important to investors?

Dividend Reinvestment Plans

During the 1970s, most large companies instituted dividend reinvestment plans

(DRIPs),under which stockholders can automatically reinvest their dividends in the

stock of the paying corporation.^7 Today most larger companies offer DRIPs, and

although participation rates vary considerably, about 25 percent of the average firm’s

shareholders are enrolled. There are two types of DRIPs: (1) plans that involve only

“old stock” that is already outstanding and (2) plans that involve newly issued stock. In

(^6) Tax effects cause the price decline on average to be less than the full amount of the dividend. Suppose you
were an investor in the 40 percent federal-plus-state tax bracket. If you bought Katz’s stock on December 3,
you would receive the dividend, but you would almost immediately pay 40 percent of it out in taxes. Thus,
you would want to wait until December 4 to buy the stock if you thought you could get it for $0.50 less per
share. Your reaction, and that of others, would influence stock prices around dividend payment dates. Here
is what would happen:

1. Other things held constant, a stock’s price should rise during the quarter, with the daily price increase
   (for Katz) equal to $0.50/90
   $0.005556. Therefore, if the price started at $30 just after its last
   ex-dividend date, it would rise to $30.50 on December 3.


2. In the absence of taxes, the stock’s price would fall to $30 on December 4 and then start up as the next
   dividend accrual period began. Thus, over time, if everything else were held constant, the stock’s price
   would follow a sawtooth pattern if it were plotted on a graph.


3. Because of taxes, the stock’s price would neither rise by the full amount of the dividend nor fall by the full
   dividend amount when it goes ex-dividend.


4. The amount of the rise and subsequent fall would depend on the average investor’s marginal tax rate.

(^7) See Richard H. Pettway and R. Phil Malone, “Automatic Dividend Reinvestment Plans,” Financial Man-
agement,Winter 1973, 11–18, for an old but still excellent discussion of the subject.

Distributions to Shareholders: Dividends and Repurchases 519