CONTEMPORARY FINANCIAL

MANAGEMENT

Chapter 14:
Dividend Policy
INTRODUCTION
 This chapter examines the factors that influence a
company’s choice of dividend policy

 The pros and cons of dividend policies

 The mechanics of dividend payments

 Stock dividends

 Share repurchase plans

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DIVIDENDS
 When a company earns a profit, there are only two things
it can do with the earnings:
 Pay a dividend to the shareholders
 Retain the earnings in the form of Retained Earnings

 The choice as to how to divide firm earnings between

Retained Earnings and Dividends and the implications of
the choice made is the subject of this chapter.

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INFLUENCING THE VALUE OF THE FIRM
 Investment Decisions
 Determine the level of future earnings and future potential
dividends

 Financing Decisions
 Influence the cost of capital, which can determine the number
of acceptable investment opportunities

 Dividend Decisions
 Influence the amount of equity in a firm’s capital structure
and the cost of capital

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DETERMINANTS OF DIVIDEND POLICY
 Legal Constraints
 A firm’s capital cannot be used to pay dividends (capital
impairment restriction)
 Dividends can only be paid out of past & present net earnings
(net earnings restriction)
 Dividends cannot be paid when a firm is insolvent
(insolvency restriction)

 Restrictive Covenants & Sinking Funds

 Usuallyimposed by creditors to prevent excessive
withdrawals by owners
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DETERMINANTS OF DIVIDEND POLICY
 Tax considerations
 Investment income can be received as a capital gain or as a
dividend
 The marginal tax rate will determine which form of income is
preferred by investors

 Liquidity and Cash Flow Considerations

 Dividends represent an outflow of cash

 Access to New Equity and Debt Capital

 A firmmay decide to pay dividends and simultaneously issue
new equity or borrow
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DETERMINANTS OF DIVIDEND POLICY
 Variability of Earnings (stable vs. growth)
 The more stable the earnings pattern, the greater the
percentage of earnings the firm can safely pay out as a
dividend

 Inflation
 During periods of high inflation, the firm may need to retain
more earnings to fund the replacement of fixed assets

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DETERMINANTS OF DIVIDEND POLICY
 Shareholder Preference
 Firms often develop “clienteles” that are attracted to the
firm’s stated dividend policy

 Protection Against Dilution

 Ifthe firm pays dividends and issues new equity, existing
shareholders will be diluted if they do not purchase a portion
of the new equity sold

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DIVIDEND IRRELEVANCE
 Miller & Modigliani (MM) argue that dividends are
irrelevant (under certain assumptions)

 MM argue that firm value is determined by the firm’s

investment policy, not dividend policy

 MM’s assumptions for dividend irrelevance

 No taxes
 No transaction costs
 No issuance costs (for selling new equity)
 Existence of a fixed investment policy
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DIVIDEND IRRELEVANCE
 MM recognize that changes in dividend policy affect
share prices
 They argue this is due to the informational content conveyed
by the change, not the change itself

 Changes in dividend policy have a signaling effect – it

signals management beliefs about future firm prospects

 The existence of clienteles should not affect share price,

since one clientele is as good as another clientele

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ARE DIVIDENDS RELEVANT?

MM probably correct,
given their restrictive

?
assumptions.

What happens when the

assumptions are relaxed?

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ARE DIVIDENDS RELEVANT?
 Risk aversion (Bird in the Hand Theory)
 Dividends represent a regular, certain return, thereby
lowering risk and increasing firm value

 Transaction costs
 With no transaction costs, investors can sell a portion of their
shares to “create” a dividend
 In reality, transactions costs are real and significant

 Taxes
 Investorscare only about their after-tax return
 Thus taxes affect the preferred form of income
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RELEVANCE OF DIVIDENDS
 Issuance (Flotation) costs
 The existence of issuance costs reduces the attractiveness of
paying dividends and issuing equity

 Agency costs are reduced when management is subjected

to market scrutiny

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CONCLUSIONS REGARDING DIVIDEND
POLICY
 Empirical evidence is mixed
 Some studies found that, due to tax effects, investors require
a higher pretax return on high-dividend shares
 Other studies found no difference

 Many practitioners believe that dividends are important

due to:
 Theirinformational content
 External equity is expensive

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PASSIVE RESIDUAL POLICY
 Suggests that a firm should retain its earnings as long as
it has investment opportunities that promise higher rates
of return than the shareholder’s required return

 Would imply that dividends fluctuate significantly, based

on earnings & investment opportunities
 In practice, firms can smooth their dividends payments
by using debt and varying their earnings retention policy

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STABLE DOLLAR DIVIDEND POLICIES
 Firms are reluctant to reduce dividends; shareholders like
a stable dividend stream

 Increases in dividends tend to lag earnings

 Investors prefer stable dividends because:

 Dividend changes convey information
 Many shareholders depend on dividend income
 Stability tends to reduce uncertainty, thereby lowering the
firm’s cost of capital
 Certain institutions can only hold the shares of firms with a
record of continuous and stable dividends
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OTHER DIVIDEND PAYMENT POLICIES

 Constant Payout Ratio

 Paysa constant percent of earnings as dividends
 Causes the dividend to fluctuate

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OTHER DIVIDEND PAYMENT POLICIES

 Small Regular Dividends Plus Extras

 Shareholders can depend on regular payout
 Accommodates changing earnings and investment
requirements

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OTHER DIVIDEND PAYMENT POLICIES

 Small Firms and Dividends

 Tend to pay out a smaller percent of earnings
 Rapid growth requires capital; small firms retain more of
their income to fund growth
 Small firms have limited access to capital markets

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MULTINATIONAL FIRMS & DIVIDENDS
 Primary means of transferring funds to parent company

 Important issues to consider include:

 Tax
 Foreign Exchange
 Political risk
 Funds availability
 Financing needs

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PAYING DIVIDENDS

Declaration Payment
Date Date
Two Usually
Days Four Weeks

Ex-Dividend Record
Date Date

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DIVIDEND REINVESTMENT PLAN
 Cash dividends reinvested automatically into additional
shares

 Purchase new or existing shares

 Purchasing new shares raises new equity capital for the firm

 No brokerage commissions

 Income tax liability

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STOCK DIVIDENDS
 Stock dividends are similar to stock splits

 Both increase the number of shares outstanding

 Accounting transaction
 Transfer pre-dividend market value from retained earnings to
other stockholder’s equity

 Market price of common shares should decline in

proportion to the number of new shares issued

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REASONS FOR STOCK DIVIDENDS
 Broaden the ownership of the firm’s shares

 May result in an effective increase in cash dividends,

provided the level of cash dividends per share is not
reduced
 Reduction in share price may broaden the appeal of the
stock to investors
 Thus may result in a real increase in market value

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SHARE REPURCHASE
 By Tender Offer in the open market or by negotiation with
large holders

 Acquired shares may be cancelled or held as Treasury stock

 Reduces the number of shares outstanding

 Increases EPS for the remaining shareholders

 Stock repurchase programs are usually publicly announced

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SHARE REPURCHASE
 Advantages
 Converts dividend income into capital gains
 Greater financial flexibility
 Greater control over timing
 Signaling effect

 Disadvantages
 Company may overpay for the stock
 Tax avoidance
 Some current shareholders may be unaware

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MAJOR POINTS
 Firm profits are split into Retained Earnings and Dividends.
Dividend policy explicitly states how the firm intends to
make this split.
 In a perfect world, it would not matter whether the firm paid
dividends or not.
 In the real world, where taxes and transaction costs exist,
dividends probably do matter.
 Dividends can be paid in cash or stock. In both cases, stock
price declines on ex-dividend date
 Share repurchases reduce shares outstanding, thereby pushing
up the future price of the stock. 27