Types of Dividends

¤  Cash Div
¤  Regular Cash Div
¤  Special Cash Div
¤  Stock Div
¤  Stock Repurchase
Buy shares on the market
Tender Offer to Shareholders
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.
 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
 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.
 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
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.
Taxes and Dividend Policy
l  Since capital gains are taxed at a lower rate
than dividend income, companies should pay
the lowest dividend possible.
l  Dividend policy should adjust to changes in
the tax code.
 DIVIDEND POLICY : STABILITY
Stable Dividend Payout Ratio
Earnings/Dividends

Earnings

Dividends

Time
 DIVIDEND POLICY : STABILITY
Steadily Changing Dividends
Earnings/Dividends

Earnings

Dividends

Time
 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.