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CHAPTER ONE: Dividend policy and theories

Meaning of Dividend
Dividend refers to the portion of business concerns net profits which is distributed among the
shareholders. It may also be termed as the part of the profit after tax and interest of a business
concern, which is distributed among its shareholders.

TYPES OF DIVIDEND/FORMS OF DIVIDEND

Dividend may be distributed among the shareholders in different forms. Hence, Dividends are
classified into:
A. Cash dividend
B. Stock dividend
C. Bond dividend
D. Property dividend

Cash Dividend
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid
periodically out the business concerns EAIT (Earnings after interest and tax). Cash dividends are
common and popular types followed by majority of the business concerns.

Stock Dividend
Stock dividend is paid in the form of the company stock due to rising of more finance. Under this
type, cash is retained by the business concern. Stock dividend may be bonus issue. This issue is
given only to the existing shareholders of the business concern.

Bond Dividend
Bond dividend is also known as script dividend. If the company does not have sufficient funds to
pay cash dividend, the company promises to pay the shareholder at a future specific date with the
help of issue of bond or notes.

Property Dividend
Property dividends are paid in the form of some assets other than cash. It will distribute under the
exceptional circumstance. This dividend is one of tax escaping mechanism because there is no
tax on property dividend in many countries including Ethiopia.
Dividend payment chronology
Relevant dates associated with dividends are as follows:

1. Declaration date. This is the date on which the board of directors declares the dividend. On
this date, the payment of the dividend becomes a legal liability of the firm. On this day the
border of director announce important information like:
 Amount of dividend per share
 Record day and all needed document to be recorded
 Payment date

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2. Ex-dividend dates. The ex-dividend dates are the dates when the right to the dividend leaves
the shares. The right to a dividend stays with the stock until 2 business days before the date of
record. On these two business days prior to the record date, the right to the dividend is no longer
with the shares, and the seller is the one who will receive the dividend. The buyer who acquires
within these two days can’t enjoy from the declared dividend. The market price of the stock
reflects the fact that it has gone ex-dividend and will decrease by approximately the amount of
the dividend. The ex-dividend days are business days, not a calendar days. For example, if the
record day is Monday, the two days before this day are Saturday and Sunday but these days are
not business days thus the ex-dividend days are Friday and Thursday of last week.

3. Date of record. This is the date upon which the believed stockholders are entitled to receive
the dividend. All necessary information of the believed stockholders are identified and recorded,
like address, bank account number and so on.

4. Date of payment. This is the date when the company distributes its dividend checks to its
stockholders. Dividends are usually paid in cash. A cash dividend is typically expressed in
dollars and cents per share.

Dividend policy

A finance manager’s objective for the company’s dividend policy is to maximize owner wealth
while providing adequate financing for the company. When a company’s earnings increase,
management does not automatically raise the dividend. Generally, there is a time lag between
increased earnings and the payment of a higher dividend. Only when management is confident
that the increased earnings will be sustained will they increase the dividend. Once dividends are
increased, they should continue to be paid at the higher rate. But, all company hasn’t similar
dividend payment culture. The various types of dividend policies are discussed below:

1. Stable per-share dividend policy: Many companies use a stable dividend-per-share policy
since it is looked upon favorably by investors. Dividend stability implies a low-risk company.
Even in a year that the company shows a loss rather than profit the dividend should be
maintained to avoid negative connotations to current and prospective investors. By continuing to
pay the dividend, the shareholders are more apt to view the loss as temporary. Some stockholders
rely on the receipt of stable dividends for income. A stable dividend policy is also necessary for a
company to be placed on a list of securities in which financial institutions (pension funds,
insurance companies) invest. Being on such a list provides greater marketability for corporate
shares.
2. Constant dividend-payout-ratio policy: With this policy a constant percentage of earnings is
paid out in dividends. Because net income varies, dividend paid will also vary using this
approach. The problem this policy causes is that if company’s earnings drop drastically or there
is a loss, the dividends paid will be sharply curtailed or nonexistent. This policy will not
maximize market price per share since most stockholders do not want variability in their
dividend receipts.

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3. Compromise dividend policy. A compromise between the policies of a stable dollar amount
and a percentage amount of dividends is for a company to pay a low dollar amount per share plus
a percentage increment in good years. While this policy affords flexibility, it also creates
uncertainty in the minds of investors as to the amount of dividends they are likely to receive.
Stockholders generally do not like such uncertainty. However, the policy may be appropriate
when earnings vary considerably over the years. The percentage, or extra, portion of the dividend
should not be paid regularly; otherwise it becomes meaningless.

4. Residual-dividend policy. When a company’s investment opportunities are not stable,

management may want to consider a fluctuating dividend policy. With this kind of policy the
amount of earnings retained depends upon the availability of investment opportunities in a
particular year. Dividends paid represent the residual amount from earnings after the company’s
investment needs are fulfilled.

FACTORS DETERMINING DIVIDEND POLICY

Profitable Position of the Firm: Dividend decision depends on the profitable position of the
business concern. When the firm earns more profit, they can distribute more dividends to the
shareholders and the reverse is true
Income expectation: Future income is a very important factor, which affects the dividend policy.
When the shareholder needs regular income, the firm should maintain regular dividend policy.
Legal Constrains: The Companies Act and income tax Act has put several restrictions regarding
payments and declaration of dividends.
Liquidity Position: Liquidity position of the firms leads to easy payments of dividend. If the
firms have high liquidity, the firms can provide cash dividend otherwise, they have to pay stock
dividend.
Sources of Finance: If the firm has finance sources, it will be easy to mobilize large finance.
The firm shall not go for retained earnings.
Growth Rate of the Firm: A company that is rapidly growing, even if profitable, may have to
restrict its dividend payments in order to keep needed funds within the company for growth
opportunities.
Restrictive covenants: Sometimes there is a restriction in a credit agreement that will limit the
amount of cash dividends that may be paid.
Earnings stability: A company with stable earnings is more likely to distribute a higher
percentage of its earnings than one with unstable earnings.
Maintenance of control: Management that is reluctant to issue additional common stock because
it does not wish to dilute its control of the firm will retain a greater percentage of its earnings.
Internal financing enables control to be kept within.
Degree of financial leverage: A company with a high debt-to-equity ratio is more likely to retain
earnings so that it will have the needed funds to meet interest payments and debts at maturity.
Ability to finance externally: A company that is capable of entering the capital markets easily
can afford to have a higher dividend payout ratio. When there is a limitation to external sources
of funds, more earnings will be retained for planned financial needs.
Uncertainty: Payment of dividends reduces the chance of uncertainty in stockholders’ minds
about the company’s financial health.

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Age and size: The age and size of the company bear upon its ease of access to capital markets.
Tax Policy: Tax policy of the government also affects the dividend policy of the firm. When the
government gives tax incentives, the company pays more dividends.
Tax penalties: Possible tax penalties for excess accumulation of retained earnings may result in
high dividend payouts.
Capital Market Conditions: Due to the capital market conditions, dividend policy may be
affected. If the capital market is prefect, it leads to improve the higher dividend.

The Bird-In-The-Hand Argument

This argument is based on the assumption that under condition of uncertainty, investors tend to
discount distant dividends (capital gain) at higher rate than they discount near dividends.
Investors behaving rationally are risk-averse and, therefore, have a preference for near dividends
to future dividends. The logic underlying the dividend effect on the value of the share can be
described as the Bird-In-The-Hand argument.
kirshman , first of all, put forward the bird in hand argument in the following words :
Of two stocks with identical earning and, prospects but the one pay a large dividend than the
other, the former will undoubtedly command higher price merely because stock holder prefer
present to future values. Myopic vision plays apart in price making process. Stockholders often
act upon the principle that a bird in the hand is more worth than two in the bush and for this
reason stockholders willing to pay premium for stock with higher dividend rate the typical
investor would most certain prefer to have his dividend today and let tomorrow take care of
itself.

The Clientele Effect

In our earlier discussion, we saw that some groups (wealthy individuals, for example) have an
incentive to pursue low-payout (or zero payout) stocks. Other groups (corporations, for example)
have an incentive to pursue high-payout stocks. Companies with high payouts will thus attract
one group, and low-payout companies will attract another. These different groups are called
clienteles, and what we have described is a clientele effect. The clientele effect argument states
that different groups of investors desire different levels of dividends. When a firm chooses a
particular dividend policy, the only effect is to attract a particular clientele. If a firm changes its
dividend policy, then it just attracts a different clientele.
What we are left with is a simple supply and demand argument. Suppose 40 percent of all
investors prefer high dividends, but only 20 percent of the firms pay high dividends. Here the
high-dividend firms will be in short supply; thus, their stock prices will rise. Consequently, low-
dividend firms will find it advantageous to switch policies until 40 percent of all firms have high
payouts. At this point, the dividend market is in equilibrium. Further changes in dividend policy

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are pointless because all of the clienteles are satisfied. The dividend policy for any individual
firm is now irrelevant. To see if you understand the clientele effect, consider the following
statement: In spite of the theoretical argument that dividend policy is irrelevant or that firms
should not pay dividends, many investors like high dividends; because of this fact, a firm can
boost its share price by having a higher dividend payout ratio. True or false? The answer is
“false” if clienteles exist. As long as enough high-dividend firms satisfy the dividend-loving
investors, a firm won’t be able to boost its share price by paying high dividends. An unsatisfied
clientele must exist for this to happen, and there is no evidence that this is the case.

Dividend signaling hypothesis

It suggests that dividends have an impact on share price because they communicate information,
or signals, about the firm’s profitability. Presumably, firms with good news about their future
profitability will want to tell investors. Rather than make a simple announcement, dividends may
be increased to add conviction to the statement. When a firm has a target dividend-payout ratio
that has been stable over time, and the firm increases this ratio, investors may believe that
management is announcing a positive change in the expected future profitability of the firm. The
signal to investors is that management and the board of directors truly believes that things are
better than the stock price reflects. Accordingly, the price of the stock may react favorably to this
increase in dividends. The idea here is that the reported accounting earnings of a company may
not be a proper reflection of the company’s economic earnings. To the extent that dividends
provide information on economic earnings not provided by reported earnings, share price will
respond. Put another way, cash dividends speak louder than words. Thus dividends are said to be
used by investors as predictors of the firm’s future performance. Dividends convey
management’s expectations of the future.

STOCK DIVIDEND AND STOCK SPLIT

Stock Dividend: A payment of additional or bonus shares of stock to existing shareholders, often
used in place of or in addition to a cash dividend. Stock dividend declare in percent of
outstanding shares e.g , A 5% stock dividend means five percent of outstanding shares are issued
as bonus share, if there is 100,000 outstanding shares, new additional 5,000 shares are to be print
out to cover the declared dividend. These additional shares are print out from unissued portion of
their authorized share or from treasury stock (share which is already issued but hold by the
company itself).

Why firms pay stock dividend?

There are many reasons that make the firms to pay stock dividend instead of cash dividend these
includes:
 To avoid double taxation (corporate tax 30% and dividend income tax 10%) if dividend
is paid in stock there is no dividend income tax.

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 Stock dividend is great means to pay dividend under financial difficulty, when the
company facing stringent cash situation the best way to replace cash dividend is the
issuing of bonus shares.
 Conservation cash even if there is shortage cash of cash firms pay stock dividend if
they need it for other profitable investment
 To increase future dividend, if the company pay fixed amount per share and if that
amount is not decrease for the next dividend period then dividend of shareholder will
increase b/c their share is increased.
 Is bell or indication of higher future profit, as we said above the next dividend of
shareholder will increase if dividend per share will not change, so the next dividend
amount to be paid for the shareholder become more to cover this amount there should
be high profit.
 To make the share price more attractive, when the stock is divided instead of cash share
holder may sold out this new additional shares to secure their current cash at less price
in this time small investor can acquire the share b/c the price attractive for those kind of
investor.

What is the effect of stock dividend? ON

 EPS (earning per share) is decrease why?

 Outstanding share is increase why?
 Equity of shareholder is not affected, about this we have more detail below

Classification of stock dividend

As indicated above stock dividend is declare in percent of outstanding share, thus based on the
percent that declare stock dividend is classified as

 Small scale/percentage stock dividend: when it is less than or 25% of outstanding shares
 Large scale/percentage stock dividend: when it is greater than equals to 25% of
outstanding share

Both have no effect on the equity of the shareholder but accounting treatment for the two kind of
stock dividend is not the same, let’s look how it is:

Small-percentage stock dividends

Typically less than 25% of previously outstanding common stock

Assume a company with 400,000 shares of $5 par common stock outstanding pays a 5% stock
dividend. The pre-dividend market value is $40. How does this impact the shareholders’ equity
accounts?

 $800,000 ($40 x 20,000 new shares) transferred (on paper) “out of” retained earnings.
 $100,000 transferred “into” common stock account @ par.
 $700,000 ($800,000 - $100,000) transferred “into” additional paid-in-capital in excess of
par.
“Total shareholders’ equity” remains unchanged at $10 million.

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Before 5% Stock Dividend

Common stock
($5 par; 400,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000

After 5% Stock Dividend

Common stock
($5 par; 420,000 shares) $ 2,100,000
Additional paid-in capital 1,700,000
Retained earnings 6,200,000
Total shareholders’ equity $10,000,000

After a small-percentage stock dividend, what happens to EPS and total earnings of individual
investors?
Assume that investor SP owns 10,000 shares and the firm earned $2.50 per share.
Total earnings = $2.50 x 10,000 = $25,000.
After the 5% dividend, investor SP owns 10,500 shares and the same proportionate
earnings of $25,000.
EPS is then reduced to $2.38 per share because of the stock dividend ($25,000 / 10,500
shares = $2.38 EPS).

Large-percentage stock dividends

Typically 25% or greater of previously outstanding common stock
The material effect on the market price per share causes the transaction to be accounted for
differently. Reclassification is limited to the par value of additional shares rather than pre-stock-
dividend value of additional shares.

Assume a company with 400,000 shares of $5 par common stock outstanding pays a
100% stock dividend. The pre-stock-dividend market value per share is $40. How does
this impact the shareholders’ equity accounts?

 $2 million ($5 x 400,000 new shares) transferred (on paper) “out of” retained earnings.
 $2 million transferred “into” common stock account.

Before 100% Stock Dividend

Common stock
($5 par; 400,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000

After 100% Stock Dividend

Common stock

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($5 par; 800,000 shares) $ 4,000,000

Additional paid-in capital 1,000,000
Retained earnings 5,000,000
Total shareholders’ equity $10,000,000

Stock Split
Stock split means dividing old outstanding share in to small new shares, this increase the number
of shares outstanding by reducing the par value of the stock. Unlike that of stock dividend it
expressed in terms of ratio. Stock split has similar economic consequences as a 100% stock
dividend. Stock split primarily used to move the stock into a more popular trading range and
increase share demand. Also stock split has no effect on equity of shareholder let’s look

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