Topic 9 | BBMF2093 Corporate Finance

TOPIC 9: DIVIDEND POLICY

Overview

1. Successful companies earn income and income can be used to:

• Reinvested in operating assets
• Acquire securities
• Retire debt
• Distributed dividends to stockholders
➢ How much should be distributed?
➢ Should the distribution be as cash dividends, or should the cash be
passed on to shareholders by buying back some of the stock they hold?
➢ How stable should the distribution be?
➢ Which type of dividend stockholders would probably prefer?

2. Dividend Policy is the decision to pay out earnings versus retaining and
reinvesting them.

3. Dividend policy includes:

• High or low dividend payout?
• Stable or irregular dividends?
• How frequent to pay dividends?
• Announce the policy?

4. Dividends versus Capital Gains

• Company’s objective is to maximize shareholders’ value
• Do investors prefer to receive dividends or capital gains?
• Target dividend Payout Ratio is the target percentage of net income paid out
as cash dividends
• Profit = Dividend Payout + Plowback
• Payout ratio = (Total dividend paid / Net profit)
• Any change in the dividend payout policy will have two opposing effects.

• Optimal dividend policy - Strike a balance between current dividends and

future growth and maximizes the firm’s stock price.

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Dividend Policy Theories

1. Do investors prefer high or low payouts? There are three theories:

• Dividends are irrelevance (Dividend irrelevance (Modigliani Miller)): Investors
don’t care about dividend payout.
• Bird in the hand: Investors prefer a high payout.
• Tax preference: Investors prefer a low payout, hence growth.

2. Dividend irrelevance theory BPP212 - 214

• Investors are indifferent between dividends and retention-generated capital
gains.
• Investors can create their own dividend policy
a. If they want cash, they can sell stock.
b. If they don’t want cash, they can use dividends to buy stock.
• Proposed by Modigliani and Miller and based on unrealistic assumptions (no
taxes or brokerage costs), hence may not be true. Need an empirical test.
• Miller & Modigliani
➢ “If the dividend irrelevance theory is correct, there exist no optimal
dividend policy because dividend policy does not affect the value of the
firm”
➢ Firm’s value is determined only the riskiness of operating cash flows, not
by dividend payout policy
➢ Modigliani-Miller (MM): Dividend-irrelevant argument- Dividend policies
are irrelevant to firm’s value/stock price
Suppose firm has $100 million cash and an investment project.
Choose:
✓ Use $100 million cash to reinvest in the project.
✓ Distribute $100 million as dividend to shareholders and issue new
shares to finance the project.
No matter how you use the $100 million, the cash flow of the project is
not affected. Value of the firm stays unchanged

3. Bird-in-the-Hand Theory
• Why investors might prefer dividends?
➢ Investors think dividends are less risky than potential future capital gains,
hence they like dividends.
• If so, investors would value high payout firms more highly, i.e., a high payout
would result in a high P0. High dividend increases stock value

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• Clientele effect- Companies with high payouts tend to attract investors who
prefer high dividends
• Myron Gordon and John Lintner developed the bird-in-hand theory as a
counterpoint to the Modigliani-Miller dividend irrelevance theory.

4. Tax Preference Theory

• Retained earnings lead to long-term capital gain.
• Low payouts mean higher capital gains. Capital gains taxes are deferred.
• This could cause investors to prefer firms with low payouts, i.e., a high payout
results in a low P0.
• Why investors might prefer capital gains?
➢ May want to avoid transactions costs
➢ Maximum tax rate is the same as on dividends, but …
✓ Taxes on dividends are due in the year they are received, while taxes
on capital gains are due whenever the stock is sold.
✓ If an investor holds a stock until his/her death, beneficiaries can use
the date of the death as the cost basis and escape all previously
accrued capital gains.

5. Possible Stock Price Effects - Implications of 3 Theories for Managers

Theory Implication
Irrelevance Any payout OK
Bird in the Hand Set high payout
Tax Preference Set low payout

6. Which theory is most correct?

• Empirical testing has not been able to determine which theory, if any, is
correct.

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• Thus, managers use judgment when setting policy.

• Analysis is used, but it must be applied with judgment.

Forms of Dividend BPP215

1. Stock dividends: Corporations distribute dividends in the form of new shares to

existing shareholders

2. Stock split: Issue new shares to existing shareholders by splitting existing

shares

3. Cash dividends

4. Example 9.1
Amoeba Products has 2 million shares currently outstanding at a price of $15 per
share. The company declares a 50% stock dividend. How many shares will be
outstanding after the dividend is paid?
2 mil x 0.5 = 1 mil new shares
1 mil new shares + 2 mil old shares = 3 mil shares

After the stock dividend what is the new price per share and what is the new
value of the firm?
The value of the firm was 2 mil x $15 per share, or $30 mil. After the dividend the new
value will remain the same.
New Price per share = $30 mil / 3 mil shares = $10 per share OR $15 / 1.5 = $10
*One old share is given 0.5 share, so new share will be 1.5

5. Example 9.2

If ABC has 1 million shares outstanding and selling at $4 per share. If it declares
a stock spilt of two for one, how many shares will be outstanding after the stock
split?
This means for every one share now is replace by 2 new shares, therefore 100%
increase in number of shares.
1,000,000 x 2 = 2,000,000 shares outstanding

After the stock split what is the new price per share and what is the new value
of the firm?

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The value of the firm was 1 mil x $4 per share, or $4 mil. After the dividend the new value
will remain the same.
Price per share = $4 mil / 2mil shares = $2 per shares OR $4 x 1/2 = $2

6. Example 9.3

ABC Co Balance sheet before stock spilt/stock dividend

Common stock RM
Par value 1,000,000 shares @$2 2,000,000
Paid up capital 8,000,000
Retained earnings 15,000,000
Total equity 25,000,000

Stock Split

If ABC declared a stock spilt of two for one

This means for every one share now is replace by 2 new shares, therefore 100%
increase in number of share

ABC Co Balance sheet after stock spilt/stock dividend

Common stock RM
Par value 2,000,000 shares @$1 2,000,000
Paid up capital 8,000,000
Retained earnings 15,000,000
Total equity 25,000,000

Stock Dividend

If ABC declared a stock dividend of 15%, the stock is selling at $14

This means new additional shares is 1,000,000 x 15% = 150,000 shares. Market
value of this increase 150,000 X 14 = $2,100,000. To record this transaction
$2,100,000 will be transferred from retained profit. Total par value increased
by 300,000 (150,000 X 2). Therefore, paid up capital increased by 2,100,000 –
300,000 = 1,800,000

ABC Co Balance sheet after stock spilt/stock dividend

Common stock RM
Par value 1,150,000 shares @$2 2,300,000
Paid up capital 9,800,000
Retained earnings 12,900,000
Total equity 25,000,000

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7. Example 9.4

The equity of XYZ Co is show as below

Common stock RM
Par value 4,000,000 shares @$2 8,000,000
Paid up capital 22,000,000
Retained earnings 40,000,000
Total equity 70,000,000
The company stock is now trading at $20 per share.
Show how equity will change if

(1) XYZ declares a two for one stock spilt

The equity of XYZ Co is show as below
Common stock RM
Par value 8,000,000 shares @$1 8,000,000
Paid up capital 22,000,000
Retained earnings 40,000,000
Total equity 70,000,000

(2) XYZ declares a 5 per cent stock dividend

The equity of XYZ Co is show as below
Common stock RM
Par value 4,200,000 shares @$2 8,400,000
Paid up capital 25,600,000
Retained earnings 36,000,000
Total equity 70,000,000

Increased in shares = 4,000,000 x 5% = 200,000 shares

Market value of share = 200,000 X 20 = 4,000,000
Increased in par value = 200,000 x 2 = 400,000
Transfer 4,000,000 from Retained Profit
Paid up capital increased by 4,000,000- 400,000=3,600,000

Dividend Payout Policy

1. If Company XYZ has a payout ratio of 50% and the EPS is $8, what is the dividend
amount to be declared?
$8 x 0.5 = $4

2. Dividends as Signals → Dividends increase value

• Dividend increases send good news about cash flows and earnings. Dividend
cuts send bad news.

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• 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.

3. Residual Dividend Model

• 4 steps when establishing target payout ratio:

i. Determine the optimal capital budget.
ii. Determine the amount of equity needed to finance that budget, given its
target capital structure.
iii. Use retained earnings to meet equity requirements to the extent possible.
iv. Pays dividends only if more earnings are available than are needed to
support the optimal capital budget.
• Find the retained earnings needed for the capital budget.
• Pay out any leftover earnings (the residual) as dividends.
• This policy minimizes flotation and equity signaling costs, hence minimizes the
WACC.
• Dividend = Net Income – Retained earnings required to finance new investment
 Target   Total 
   
Dividends = Net Income -  equity    capital 
 ratio   budget
 



• Example 9.5

Capital budget – $800,000

Target capital structure – 40% debt, 60% equity
Forecasted net income – $600,000
How much of the forecasted net income should be paid out as dividends?
Calculate portion of capital budget to be funded by equity (retained earnings).
Of the $800,000 capital budget, 0.6($800,000) = $480,000 will be funded with
equity(retain earning).
Calculate left over earnings.
There will be $600,000 - $480,000 = $120,000 left over to pay as dividends.
Calculate dividend payout ratio
$120,000 / $600,000 = 0.20 = 20%.

If Net Income = $400,000 …

➔ Dividends = $400,000 – (0.6)($800,000) = -$80,000.

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➔ Since the dividend results in a negative number, the firm must use all of
its net income to fund its budget, and probably should issue equity to
maintain its target capital structure.

Payout = $0 / $400,000 = 0%.

If Net Income = $800,000 …

➔ Dividends = $800,000 – (0.6)($800,000) = $320,000.
➔ Payout = $320,000 / $800,000 = 40%.

• Comments on Residual Dividend Policy

➢ Advantage
i. Minimizes new stock issues and flotation costs.
➢ Disadvantages
i. Results in variable dividends (depend on NI)
ii. Sends conflicting signals (high,low dividend)
iii. Doesn’t appeal to any specific clientele (stockholder).
• Conclusion – Consider residual policy when setting long-term target payout,
but don’t follow it rigidly from year to year.

• For other payout policy, please refer to BPP 212 (2.4)

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