Distributions

to
Shareholders:
Dividend Policy
Overview
▪ Dividend: Dividend is that part/portion of the net profit which is distributed
among the shareholders.

▪ Target Payout Ratio:

The target percentage of net income is paid out as cash dividends as desired
by the firm.

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 Optimal Dividend Policy
▪ The dividend policy that strikes a balance between current dividends and future
growth and maximizes the firm’s stock price.

▪ If the company increases the payout ratio, this will raise D1, which, taken alone,
will cause the stock price to rise. However, if D1 is raised, less money will be
available for reinvestment, which will cause the expected growth rate to decline;
and that will tend to lower the stock’s price. Therefore, any change in the payout
policy will have two opposing effects. As a result, the optimal dividend policy must
strike the balance between current dividends and future growth that maximizes
the stock price.

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 Theories of Dividend Policy

▪ The following theories are related to dividend policy and financial

performance, and they include:
1. Dividend irrelevance theory (Modigliani &Miller, 1961),
2. Signal effect theory (Ross,1990),
3. bird in the hand theory (Gordon,1962),
4. Tax preference theory.

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 Dividend Irrelevance Theory
▪ This theory originated from Modigliani &Miller (1961). According to this theory,
Value of the firm depends solely on its earning power resulting from investment
policy and not influenced by the way its earnings are split between dividend and
retained earnings.
▪ This theory suggests that use of dividend policy by a firm is no significance as
such a policy has no consequence on the organizations cost of capital or
company’s financial performance.
▪ The following assumptions forms the basis of the MM argument: There exists a
perfect capital market (i.e., IRR=k), information is freely available, lending rate
and borrowing rate is equal, floatation cost & income tax doesn’t exist.

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 Signal effect theory
▪ This theory was put forth by Stephen Ross in 1990. Stephen Ross hypothesized that
management’s view on the prospects of the firm and their earning power is reflected in
the changes in the dividend payout ratio.
▪ According to Ross (1990), capital gains are referred to dividends by the investors of the
firms. The increase in the dividend payment by the firms act as a good positive signal
that the management is optimistic of higher future earnings to cater for the dividend
payout increase.
▪ On the contrary, the increases of dividend reduction implies that the management is
interested in the prospects of the company by doing reinvestment.

▪ According to the theory, investor’s reaction to change following actions on the dividend
is clear indication of some crucial information regarding how the company has
performed. Where high dividend implies the firm was profitable at a particular period
and no payment of dividends implies a loss. Therefore, this is called Information
Content (Signaling)
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 Bird in the hand theory (Investors’ preference for
dividend)
▪ Early critics of MM theory by Myron Gordon (1962) and John Linter suggested that
investors preferred a sure dividend today to an uncertain future capital gain.
▪ MM called the Gordon-Linter argument the bird in the hand fallacy because in MM’s
view, most investors plan to reinvest their dividends in the stock of the same or
similar firms and in any event the riskiness of the firm’s cash flows to investors in the
long run is determined by the riskiness of operating cashflow.

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 Tax preference theory
▪ According to this theory low dividend payout ratios lowers the cost of capital and
increases the stock price and thus increases the firm value.
▪ This argument assumes that dividends are taxed at higher rates than capital gains.
In addition, dividends are taxed immediately, while taxes on capital gains are
deferred until the stock is sold.
▪ These tax advantages of capital gains over dividends made the investors to prefer
companies that retain most of their earnings rather than pay them out as dividends
and are willing to pay low tax.
▪ Therefore, a low dividend payout ratio will lower the cost of equity and increases the
stock price.

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 Clientele Effect
▪ Clientele: Different groups of stockholders that prefer different dividend payout
policies.
▪ For example, retired individuals, pension funds, and university endowment funds
generally prefer cash income; so they often want the firm to pay out a high
percentage of its earnings. Such investors are frequently in low or even zero tax
brackets, so taxes are of little concern. On the other hand, stockholders in their peak-
earning years might prefer reinvestment because they have less need for current
investment income.
▪ Clientele Effect: The tendency of a firm to attract a set of investors that like its
dividend policy. hence, that a change in dividend policy might upset the majority
clientele and have a negative effect on the stock’s price. This suggests that a company
should follow a stable, dependable dividend policy so as to avoid upsetting its
clientele.
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 Residual Dividend Model
▪ For a given firm, the optimal payout ratio is a function of four factors: (1)
management’s opinion about its investors’ preferences for dividends versus capital
gains, (2) the firm’s investment opportunities, (3) the firm’s target capital structure,
and (4) the availability and cost of external capital. These factors are combined in
what we call the residual dividend model.
▪ A model in which the dividend paid is set equal to net income minus the amount of
retained earnings necessary to finance the firm’s optimal capital budget.
▪ If a firm rigidly follows the residual dividend policy, dividends paid in any given
year can be expressed in the following equation:

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 Payment Procedures
▪ Declaration Date The date on which a firm’s directors issue a statement declaring a
dividend.
▪ Holder-of-Record Date If the company lists the stockholder as an owner on this date,
then the stockholder receives the dividend.
▪ Ex-Dividend Date The date on which the right to the current dividend no longer
accompanies a stock; it is usually 2 business days prior to the holder-of-record date.
▪ Payment Date The date on which a firm actually mails dividend checks.

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 Stock Split Vs Stock Dividend
▪ Stock Splits:
An action taken by a firm to increase the number of shares outstanding, such as doubling the
number of shares by giving each stockholder two new shares for each one formerly held. Each
stockholder would have more shares but each share would be worth less.
▪ Stock Dividend:
A dividend paid in the form of additional shares of stock rather than in cash. Again, the total
number of shares is increased; so, earnings, dividends, and price per share all decline.

When firms use stock splits & when stock dividends?

When price of any share becomes too high and illiquid, then firm uses stock split. Thus,
making it tradable and liquid. However, firm use stock dividend mostly at the time of cash
crisis.

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 Effect on Stock Prices
▪ If a company splits its stock or declares a stock dividend, will this increase the market value of its
stock? Several empirical studies have addressed this question. Here is a summary of their findings:
1. On average, the price of a company’s stock rises shortly after it announces a stock split or
dividend.
2. One reason that stock splits and stock dividends may lead to higher prices is that investors often
take stock splits/dividends as signals of higher future earnings. Thus, the price increases
associated with stock splits/dividends may be the result of a favorable signal for earnings and
dividends.
3. If a company announces a stock split or dividend, its price will tend to rise. However, if during the
next few months it does not announce an increase in earnings and dividends, the stock price
generally will drop back to the earlier level.
4. By creating more shares and lowering the stock price, stock splits may also increase the stock’s
liquidity. This tends to increase the firm’s value.

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Thank you!

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