2.8.

Pay Out Policy

14-2 The Basics of Payout Policy:
Elements of Payout Policy
The term payout policy refers to the decisions that a firm
makes regarding whether to distribute cash to shareholders,
how much cash to distribute, and the means by which cash
should be distributed.
 The Mechanics of Payout Policy:
14-3 Cash Dividend Payment Procedures

 At quarterly or semiannual meetings, a firm’s board of directors decides

whether and in what amount to pay cash dividends.
 If the firm has already established a precedent of paying dividends, the
decision facing the board is usually whether to maintain or increase the
dividend, and that decision is based primarily on the firm’s recent
performance and its ability to generate cash flow in the future.
 Boards rarely cut dividends unless they believe that the firm’s ability to
generate cash is in serious jeopardy.
 The Mechanics of Payout Policy:
14-4
Cash Dividend Payment Procedures
 The date of record (dividends) is set by the firm’s directors, the date on
which all persons whose names are recorded as stockholders receive a
declared dividend at a specified future time.
 A stock is ex dividend for a period, beginning 2 business days prior to the
date of record, during which a stock is sold without the right to receive the
current dividend.
 The payment date is set by the firm’s directors, the actual date on which
the firm mails the dividend payment to the holders of record.
14-5

© 2012 Pearson Prentice Hall. All rights reserved.

 The Mechanics of Payout Policy:
14-6
Stock Price Reactions to Corporate Payouts

What happens to the stock price when a firm pays a dividend or

repurchases shares?
In theory, when a stock begins trading ex dividend, the stock price
should fall by exactly the amount of the dividend.
In theory, when a firm buys back shares at the going market price, the
market price of the stock should remain the same.
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.
14-7
Relevance of Payout Policy:
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—the amount
left over after all acceptable investment opportunities have been
undertaken.
 Relevance of Payout Policy:
14-8
Residual Theory of Dividends

Using the residual theory of dividends, the firm would treat the dividend
decision in three steps, as follows:
 Determine its optimal level of capital expenditures, which would be the level that
exploits all of a firm’s positive NPV projects.
 Using the optimal capital structure proportions, estimate the total amount of equity
financing needed to support the expenditures generated in Step 1.
 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.
 Relevance of Payout Policy:
14-9
The Dividend Irrelevance Theory
The dividend irrelevance theory is Miller and Modigliani’s theory that in a
perfect world, the firm’s value is determined solely by the earning power and
risk of its assets (investments) and that the manner in which it splits its
earnings stream between dividends and internally retained (and reinvested)
funds does not affect this value.
 In a perfect world (certainty, no taxes, no transactions costs, and no other market
imperfections), the value of the firm is unaffected by the distribution of dividends.
 Of course, real markets do not satisfy the “perfect markets” assumptions of Modigliani
and Miller’s original theory.
14-10
Relevance of Payout Policy:
The Dividend Irrelevance Theory

The clientele effect is the argument that different payout policies attract
different types of investors but still do not change the value of the firm.
 Tax-exempt investors may invest more heavily in firms that pay dividends because
they are not affected by the typically higher tax rates on dividends.
 Investors who would have to pay higher taxes on dividends may prefer to invest in
firms that retain more earnings rather than paying dividends.
 If a firm changes its payout policy, the value of the firm will not change—what will
change is the type of investor who holds the firm’s shares.
 Relevance of Payout Policy:
14-11
Arguments for Dividend Relevance

 Dividend relevance theory is the theory, advanced by Gordon and Lintner,

that there is a direct relationship between a firm’s dividend policy and its
market value.
 The bird-in-the-hand argument is the belief, in support of dividend
relevance theory, that investors see current dividends as less risky than
future dividends or capital gains.
 Relevance of Payout Policy:
14-12
Arguments for Dividend Relevance

Studies have shown that large changes in dividends do affect share

price.
Informational content is the information provided by the dividends of a
firm with respect to future earnings, which causes owners to bid up or
down the price of the firm’s stock.
The agency cost theory says that a firm that commits to paying
dividends is reassuring shareholders that managers will not waste their
money.
Although many other arguments related to dividend relevance have been
put forward, empirical studies have not provided evidence that
conclusively settles the debate about whether and how payout policy
affects firm value.
14-13 Factors Affecting Dividend Policy
Dividend policy represents the firm’s plan of action to be
followed whenever it makes a dividend decision.
First consider five factors in establishing a dividend policy:
1. legal constraints
2. contractual constraints
3. the firm’s growth prospects
4. owner considerations
5. market considerations
14-14
Factors Affecting Dividend Policy:
Legal Constraints
 Most states prohibit corporations from paying out as cash dividends any
portion of the firm’s “legal capital,” which is typically measured by the
par value of common stock.
 Other states define legal capital to include not only the par value of the
common stock, but also any paid-in capital in excess of par.
 These capital impairment restrictions are generally established to provide
a sufficient equity base to protect creditors’ claims.
 Factors Affecting Dividend Policy:
14-15
Legal Constraints

If a firm has overdue liabilities or is legally insolvent or

bankrupt, most states prohibit its payment of cash dividends.
In addition, the Internal Revenue Service prohibits firms from
accumulating earnings to reduce the owners’ taxes.
14-16
Factors Affecting Dividend Policy:
Contractual Constraints
Often the firm’s ability to pay cash dividends is constrained by
restrictive provisions in a loan agreement.
Generally, these constraints prohibit the payment of cash
dividends until the firm achieves a certain level of earnings, or
they may limit dividends to a certain dollar amount or
percentage of earnings.
Constraints on dividends help to protect creditors from losses
due to the firm’s insolvency.
14-17
Factors Affecting Dividend Policy:
Growth Prospects
A growth firm is likely to have to depend heavily on internal
financing through retained earnings, so it is likely to pay out
only a very small percentage of its earnings as dividends.
A more established firm is in a better position to pay out a large
proportion of its earnings, particularly if it has ready sources of
financing.
 Factors Affecting Dividend Policy:
14-18
Owner Considerations
Tax status of a firm’s owners:
 If a firm has a large percentage of wealthy stockholders who have sizable incomes, it may
decide to pay out a lower percentage of its earnings to allow the owners to delay the
payment of taxes until they sell the stock.
Owners’ investment opportunities:
 If it appears that the owners have better opportunities externally, the firm should pay out a
higher percentage of its earnings.
Potential dilution of ownership:
 If a firm pays out a high percentage of earnings, new equity capital will have to be raised
with common stock. The result of a new stock issue may be dilution of both control and
earnings for the existing owners.
14-19
Factors Affecting Dividend Policy:
Market Considerations
Catering theory is a theory that says firms cater to the preferences
of investors, initiating or increasing dividend payments during
periods in which high-dividend stocks are particularly appealing to
investors.
 Types of Dividend Policies:
14-20
Constant-Payout-Ratio Dividend Policy

A firm’s dividend payout ratio indicates the percentage of each

dollar earned that a firm distributes to the owners in the form of
cash. It is calculated by dividing the firm’s cash dividend per
share by its earnings per share.
A constant-payout-ratio dividend policy is a dividend policy
based on the payment of a certain percentage of earnings to
owners in each dividend period.
14-21 Types of Dividend Policies:
Regular Dividend Policy
Regular dividend policy is a dividend policy based on the
payment of a fixed-dollar dividend in each period.
A regular dividend policy is often build around a target
dividend-payout ratio, which is a dividend policy under
which the firm attempts to pay out a certain percentage of
earnings as a stated dollar dividend and adjusts that
dividend toward a target payout as proven earnings
increases occur.
 Types of Dividend Policies:
14-22
Low-Regular-and-Extra Dividend Policy

A low-regular-and-extra dividend policy is a dividend

policy based on paying a low regular dividend, supplemented
by an additional (“extra”) dividend when earnings are higher
than normal in a given period.
An extra dividend is an additional dividend optionally paid
by the firm when earnings are higher than normal in a given
period.
14-23 Other Forms of Dividends

A stock dividend is the payment, to existing owners, of a dividend in the

form of stock.
 In a stock dividend, investors simply receive additional shares in proportion to the
shares they already own.
 No cash is distributed, and no real value is transferred from the firm to investors.
 Instead, because the number of outstanding shares increases, the stock price
declines roughly in line with the amount of the stock dividend.
 In an accounting sense, the payment of a stock dividend is a shifting of funds
between stockholders’ equity accounts rather than an outflow of funds.