Types of Dividends

 Cash Div
 Stock Div
 Stock Repurchase
Buy shares on the market
Tender Offer to Shareholders
Dividend Payments
Cash Dividend - Payment of cash by the firm
to its shareholders.

Ex-Dividend Date - Date that determines

whether a stockholder is entitled to a dividend
payment; anyone holding stock before this
date is entitled to a dividend.

Record Date - Person who owns stock on this

date received the dividend.
Dividend Payments
Stock Dividend - Distribution of additional
shares to a firm’s stockholders.

Stock Splits - Issue of additional shares to

firm’s stockholders.

Stock Repurchase - Firm buys back stock

from its shareholders.
 MM ASSUMPTIONS

• There is no tax advantage or disadvantage associated

with dividends.

• Investment and dividend decisions are independent.

• Firms can issue stock without incurring any floatation or

transaction costs.
 MILLER AND MODIGLIANI (MM) POSITION

MM have argued that the value of a firm depends solely on its

earning power and is not influenced by the manner in which
earnings are split between dividends and retained earnings

Current
Dividends
Income

Earnings

Retained Capital
Earnings Apprec’n
Dividend Policy
Dividend financed No dividend, no
by stock issue stock issue
New stockholders New stockholders
Shares
Cash

Firm Cash Shares

Cash

Old stockholders Old stockholders

Dividend Policy
Before After
Dividend Dividend

New
stockholders
Total value of firm

Each share
worth this
before … … and
worth
this
after Old
stockholders

Total number Total number

of shares of shares

Example of 1/3rd of worth paid as dividend and raising money via new shares
Dividend Policy is Irrelevant

 Since investors do not need dividends to

convert shares to cash they will not pay
higher prices for firms with higher dividend
payouts. In other words, dividend policy will
have no impact on the value of the firm.
Dividend Policy is Irrelevant
- Assume A company has no extra cash, but declares a $1,000
dividend. They also require $1,000 for current investment needs.
Let us see how the value of the firm is not altered when new
shares are issued to pay for the dividend.
.

Record Date Pmt Date

Cash 1,000 0
Asset Value 9,000 9,000
Total Value 10,000 + 9,000
New Proj NPV 2,000 2,000
# of Shares 1,000 1,000
price/share $12 $11
Dividend Policy is Irrelevant
Assume A company has no extra cash, but declares a $1,000
dividend. They also require $1,000 for current investment needs.
Let us see how the value of the firm is not altered when new
shares are issued to pay for the dividend.

Record Date Pmt Date Post Pmt

Cash 1,000 0 1,000 (91 sh @ $11)
Asset Value 9,000 9,000 9,000
Total Value 10,000 + 9,000 10,000
New Proj NPV 2,000 2,000 2,000
# of Shares 1,000 1,000 1,091
price/share $12 $11 $11

NEW SHARES ARE ISSUED

Dividend Policy
Dividend financed No dividend, no
by stock issue stock issue
New stockholders New stockholders
Shares
Cash

Firm Cash Shares

Cash

Old stockholders Old stockholders

Dividend Policy
Before After
Dividend Dividend

New
stockholders
Total value of firm

Each share
worth this
before … … and
worth
this
after Old
stockholders

Total number Total number

of shares of shares

Example of 1/3rd of worth paid as dividend and raising money via new shares
Dividend Policy is Irrelevant
Example - continued - Shareholder Value

Record
Stock 12,000
Cash 0

Total Value 12,000

Stock = 1,000 sh @ $12 = 12,000

Dividend Policy is Irrelevant
Example - continued - Shareholder Value

Record Pmt
Stock 12,000 11,000
Cash 0 1,000

Total Value 12,000 12,000

Stock = 1,000sh @ $11 = 11,000

 CRITICISMS OF MM POSITION

Critics of MM argue that, under the assumptions made by

MM, dividends are irrelevant. However, they dispute the

validity of the ‘dividend irrelevance’ theorem by

challenging the assumptions used by MM.

 CRITICISMS OF MM POSITION
• Information about Prospects
• Uncertainty and Fluctuations
• Offering of Additional Equity at Lower Prices
• Issue Cost
• Transaction Costs
• Differential Rates of Taxes
• Rationing
• Unwise Investments
The Dividend Decision
Lintner’s “Stylized Facts”
(How Dividends are Determined)
1. Firms have longer term target dividend payout ratios.
2. Managers focus more on dividend changes than on absolute
levels.
3. Dividends changes follow shifts in long-run, sustainable levels of
earnings rather than short-run changes in earnings.
4. Managers are reluctant to make dividend changes that might
have to be reversed.
5. Firms repurchase stock when they have accumulated a large
amount of unwanted cash or wish to change their capital
structure by replacing equity with debt.
Dividends Increase Value

Market Imperfections and Clientele Effect

There are natural clients for high-payout stocks, but
it does not follow that any particular firm can benefit
by increasing its dividends. The high dividend
clientele already have plenty of high dividend stock
to choose from.

These clients increase the price of the stock through

their demand for a dividend paying stock.
Dividends Increase Value

Dividends as Signals
Dividend increases send good news about cash
flows and earnings. Dividend cuts send bad news.

Because a high dividend payout policy will be costly

to firms that do not have the cash flow to support it,
dividend increases signal a company’s good fortune
and its manager’s confidence in future cash flows.
Dividends Decrease Value

Tax Consequences
Companies can convert dividends into capital gains
by shifting their dividend policies. If dividends are
taxed more heavily than capital gains, taxpaying
investors should welcome such a move and value
the firm more favorably.
In such a tax environment, the total cash flow
retained by the firm and/or held by shareholders will
be higher than if dividends are paid.
Dividend policy should adjust to changes in the tax
code.
Taxes and Dividend Policy
 Since capital gains are taxed at a lower rate
than dividend income, companies should pay
the lowest dividend possible.
 Dividend policy should adjust to changes in
the tax code.
Taxes and Dividend Policy
Firm A Firm B
(no dividend) (high dividend)
Next year' s price 112.50 102.50
Dividend 0 10
Total pretax payoff 112.50 112.50
Today' s stock price 100
Capital gain 12.50
100  100  12.5
12.5
Pretax rate of return (%)
Tax on div @ 40% 0
Tax on Cap Gain @ 20% .20  12.50  2.50
Total After Tax income
(0  12.50)  2.50  10
(div  cap gain - taxes)
100  100  10.0
10
After tax rate of return (%)
 Let Price today be P
 Next Year Price = 102.50
 Capital Gain = 102.50-P
 Dividend = 10

 POST TAX CAPITAL GAIN = 0.8(102.5-P)

 POST TAX DIVIDEND = 0.6(10) = 6
 TOTAL POST TAX RETURN = 0.8(102.5-P) + 6
 SO 0.8(102.5-P) + 6 = 0.10P
 P = 97.78
Taxes and Dividend Policy
Firm A Firm B
(no dividend) (high dividend)
Next year' s price 112.50 102.50
Dividend 0 10
Total pretax payoff 112.50 112.50
Today' s stock price 100 97.78
Capital gain 12.50 4.72
100  100  12.5 97.78  100  15.05
12.5 14.72
Pretax rate of return (%)
Tax on div @ 40% 0 .40 10  4.00
Tax on Cap Gain @ 20% .20 12.50  2.50 .20  4.72  0.94
Total After Tax income
(0  12.50)  2.50  10 (10  4.72)  (4  0.94)  9.78
(div  cap gain - taxes)
100  100  10.0 100  10.0
10 9.78
After tax rate of return (%) 97.78
The Dividend Decision
Lintner’s “Stylized Facts”
(How Dividends are Determined)
1. Firms have longer term target dividend payout ratios.
2. Managers focus more on dividend changes than on absolute
levels.
3. Dividends changes follow shifts in long-run, sustainable levels of
earnings rather than short-run changes in earnings.
4. Managers are reluctant to make dividend changes that might
have to be reversed.
5. Firms repurchase stock when they have accumulated a large
amount of unwanted cash or wish to change their capital
structure by replacing equity with debt.
 DIVIDEND POLICY : STABILITY
Stable Dividend Payout Ratio
Earnings/Dividends

Earnings

Dividends

Time
 DIVIDEND POLICY : STABILITY
Steadily Changing Dividends
Earnings/Dividends

Earnings

Dividends

Time
 DIVIDEND STREAM UNDER
DIFFERENT POLICIES

1 2 3 4 5 6 Total
Earnings Et 150.0 190.0 140.0 220.0 280.0 250.0 1230.0
Investment budget 137.0 160.0 180.0 200.0 210.0 220.0 1107.0
External investment Ite 68.5 80.0 90.0 100.0 105.0 110.0 553.5
Pure residual dividends Dt 81.5 110.0 50.0 120.0 175.0 140.0 676.5
Fixed dividend payout ratio 82.5 104.0 77.0 121.0 154.0 137.5 676.5
Dt (pt = 0.55)
Smoothed residual dividends 105.0 105.0 106.5 120.0 120.0 120.0 676.5
 WHY FIRMS PAY DIVIDENDS

Plausible Reasons

• Investor preference for dividends

• Information signaling

Dubious Reasons for Paying Dividends

• Bird-in-hand fallacy

• Temporary excess cash

 DIVIDEND POLICY : PAYOUT RATIO

The considerations relevant for determining the dividend

payout ratio are:
• Funds requirement
• Liquidity
• Access to external sources of financing
• Shareholder preferences
• Difference in the cost of external equity and retained
earnings
• Control
• Taxes
 KEY CONSIDERATIONS IN FORMULATING
THE DIVIDEND POLICY

• Investment decisions have the greatest impact on value creation.

• External equity is more expensive than internal equity (retained

earnings) because of issue costs and underpricing.

• Most promoters are averse to dilute their stake in equity and

hence are reluctant to issue external equity.

• There is a limit beyond which a firm would have real difficulty in

raising debt financing.

• The dividend decision of the firm is an important means by which

the management conveys information about the prospects of the
firm.
 GUIDELINES FOR DIVIDEND POLICY

• Don’t pay dividends at the expense of positive NPV projects.

• Minimise the need to sell external equity.

• Define a target dividend payout ratio along with a target

debt-equity ratio, taking into account the investment needs,
managerial preferences, capital market norms, and tax code.
• Accept temporary departures from the target dividend payout
ratio and the target debt-equity ratio.
• Avoid dividend cuts.
In essence, the above guidelines imply that a firm should pursue a
smoothed residual dividend policy and not a pure residual
dividend policy or a fixed dividend payout policy.
 Bonus Shares
• Conservation of Cash and Signalling: Cash may be used
to finance the profitable investment opportunities enabling
company to maintain liquidity.
• Under Financial Difficulty and Contractual Restrictions:
Company facing stringent cash difficulty or debt
covenants have dividend payment restrictions.
Confidence of the shareholders maintained through issue
of bonus shares.
• Remedy for Under-Capitalisation: Rate of divided is very
much high if company is under-capitalised
• Widening the Share Market: Increase liquidity and bring
down prices to enable trading to boost volumes.
• Economical Issue of Securities: No underwriting
commission, brokerage etc.
• Not required to be maintained in future unlike dividends.
 Share Repurchase

• Company purchases its own stock, either on the open

market, or directly from its shareholders

• Company can implement a share repurchase:

by purchasing its own shares on the open market
by issuing a tender offer
by negotiating a private buyback
 Share Repurchase
• Undervalued Shares: Serves as a signal that the company has
great confidence in itself, that it believes its shares have been
unfairly discounted as far as their intrinsic worth is concerned,
• Cash Distribution to Shareholders: Companies usually pay a
premium to buy back stock from their shareholders
• Reduced Cash Outflow: Viable way for companies to reduce
their cash outflow, without actually having to cut their
dividends. Fewer outstanding shares mean fewer dividends to
be paid, Company saves a significant amount of money. This
outweighs the cost to repurchase the shares.
• Change in Capital Structure: Effectively changes the capital
structure and increases ROE and EPS (viewed positively by
the market)
• Shareholder Liquidation: Large shareholder or seller of a
specific stock is looking to liquefy their holdings
• Not required to be maintained in future unlike dividends.