Chap. 2 - Dividends and Dividend Policy

Addis Ababa University
Financial Management II (AcFn 3042)
A REVIEW OF
DIVIDENDS AND
Comp. By Alem H (PhD) and Habtamu B.

4/25/2023 (PhD) - 2023 1
Dividend and dividend types?
◼ Dividend:
❑ Is the share of profits that is distributed to shareholders in the
company and the return that shareholders receive for their
investment in the company.
◼ Dividend decisions are important because it determines
outflow of the fund to the investor and mount of the fund to
be retained for future. Hence it is related with other
decisions (i.e. investment and financing)
◼ Dividend Can be:
❑ Cash Dividend: is a dividend that is paid out in cash and
results a reduction in the cash reserves of a company
❑ Bonus Shares: refer to shares in the company are distributed
to shareholders at no cost.

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Cash Dividends
◼ Regular cash dividend – cash payments made directly
to stockholders, usually each quarter
◼ Extra cash dividend – indication that the “extra” amount
may not be repeated in the future
◼ Special cash dividend – similar to extra dividend, but
definitely won’t be repeated
◼ Liquidating dividend – some or all of the business has
been sold

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Bonus Shares
◼ Bonus paid to shareholders can either be:
cash bonus or capital bonus
◼ Cash Bonus:
❑ Is paid to shareholders only when the company
has larger reserves and sufficient cash to pay
bonus.
❑ It is also seen that the payment of cash bonus
does not affect the working capital of the company

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Bonus Shares
◼ Capital Bonus:
❑ It is paid when the company wants to share the
accumulated reserves with the shareholders but it
is not in a position to pay cash bonus because it
adversely affects the working capital of the
company.
❑ Capital bonus is given either:
◼ by making partly paid shares as fully paid shares without
getting cash from the shareholders or
◼ by the issuance of free fully paid shares known as bonus
shares.

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When Bonus shares can be issued?
◼ When a company has accumulated large reserves (capital
or revenue) and it wants to capitalize these reserves by
issuing bonus shares
◼ When the company is not in a position to give cash bonus
because it adversely affects its working capital.
◼ More importantly;
❑ When the value of fixed assets far exceeds the amount of
capital
❑ When the higher rate of dividend is not advisable for the
distribution of the accumulated reserves because

shareholders will demand the same rate of dividend in
future which may not be possible.
❑ When there is a big difference between the market value
and paid value of shares of the company
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Important Dividend-Related Dates
◼ When the board of directors announces dividend
payouts, there are several important dates that
come into play:
◼ #1 Dividend declaration date
◼ #2 Dividend record date
◼ #3 Ex-dividend date
◼ #4 Dividend payment date

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◼ #1 Dividend declaration date
◼ This date is when the board of directors (BoD) announces
that they will pay a dividend to shareholder.
◼ On this date, the BoDs also set the record date and ex-
dividend date.
◼ New shareholders who buy shares at this time will get a
share of the dividends.
◼ #2 Dividend record date
◼ This date is the date on which the company distributing
dividends records the names of all investors holding shares.
◼ Shareholders who do not buy shares before this date do not
participate in the company’s dividend distribution.

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◼ #3 Ex-dividend date
◼ This date is one or two days before the record date, so that
buy and sell information is captured before the record date.
◼ It is the responsibility of The Security Exchange Commission
(SEC or its equivalent) setting this date.
◼ The time difference between the dividend record date and
ex-dividend date allows the necessary time to prepare
paperwork and electronic records.
◼ #4 Dividend payment date
◼ Is the date when the dividends are paid out to the
shareholders.
◼ The cash reflects in the shareholder’s brokerage or checking
account or when the check is received or credited SH’s a/c
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What is the Ex-Dividend Date?

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Dividend Related Dates

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Ex-Dividend date

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Example : Ex Dividend Date
◼ On September 8, 2017, Company XYZ declares a dividend

payable on October 3, 2017 to its shareholders. XYZ also
announces that shareholders of record on the company's
books on or before September 18, 2017 are entitled to the
dividend. The stock would then go ex-dividend one
business day before the record date.
◼ Required:
Declaration date Ex Dividend Date Record Date Payable Date
? ? ? ?

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Cash Dividend Example
◼

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Cash Dividend Example
◼

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What is “dividend policy”?
◼ A dividend policy can be defined as the dividend distribution
guidelines provided by the BoDs of a company.
◼ It sets the parameter for delivering returns to the equity
shareholders, on the capital invested by them in the
business.
◼ This policy dictates the amount of dividends paid out to its
shareholders and the frequency with which the dividends
are paid.
◼ It’s the decision to pay out earnings versus retaining and
reinvesting them. Includes these elements:
1. High or low payout?
2. Stable or irregular dividends?
3. How frequent?
4. Do we announce the policy?
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Does Dividend Policy Matter?
◼ Dividends matter – the value of the stock is based
on the present value of expected future dividends.
◼ Dividend policy may not matter

❑ Dividend policy is the decision to pay dividends
versus retaining funds to reinvest in the firm

❑ In theory, if the firm reinvests capital now, it will
grow and can pay higher dividends in the future

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Dividend Policy Types

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◼ Regular Dividend:
❑ Under this policy the company pay out dividends to
its shareholders every year.
❑ In case of abnormal (high) profits, the excess will
be held as RE.
❑ In case of loss, dividends will still be paid.
❑ Appropriate to companies:
◼ that have a steady CF and stable earnings
◼ Considered low-risk investments

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◼ Stable Dividend:
❑ Under this policy, the percentage of profits paid out
as dividend is fixed.
❑ E.g. 5% payout rate [POR = D/NI] may be set
❑ So, whether a company makes Br. 1mill or Br. 100
mill, a fixed dividend will be paid out.
❑ Investing in a company that follows such a policy is
risky as dividends fluctuate with the level of
profits.
❑ Shareholders face a lot of uncertainty as they are
not sure of the exact dividend they will receive

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◼ Irregular Dividend:
❑ Under this policy, the company is under no obligation to
pay its shareholders and the BoD can decide what to do
with the profits.
❑ If they make abnormal profit in a certain year, they can
decide to distribute it to the shareholders or not to pay out

any dividends at all and instead keep the profit as RE for
business expansion and future projects
❑ This policy is common for companies facing uncertainty of
earnings, unsuccessful business operations, lack of liquid
resources and fear of adverse effects.
❑ Investors who invest in a company that follows this policy
face very high risk as there is a possibility of not receiving

any dividends during the financial year.
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◼ No Dividend:
❑ Under this policy, the company doesn’t distribute
dividends to shareholders.
❑ It is because any profits earned is retained and
reinvested into the business for future growth.
❑ Companies that don’t give out dividends are constantly
growing and expanding, and shareholders invest in
them because the value of the company stock
appreciates.
❑ For the investor, the share price appreciation is more
valuable than a dividend payout.

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Divided Theories

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Dividend Theories
◼ The relevant dividends theories are from two main classes:
◼ Irrelevance of Dividend Theory
and
◼ Relevance of Dividend Theory.

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Dividend Irrelevance Theory
◼ Investors are indifferent between dividends and
retention –generated capital gains.
◼ Investors can create their own dividend policy:
❑ If they want cash, they can sell stock
❑ If they don’t want cash, they can use dividends to

buy stock
◼ Proposed by M & M based on unrealistic
assumptions (no taxes or brokerage costs, hence
may not be true.
◼ Need an empirical test.
◼ Implication: any payout is OK
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Illustration of Irrelevance
◼ Consider a firm that can either pay out dividends of
Br.10,000 per year for each of the next two years
or can pay Br.9,000 this year, reinvest the other
Br.1,000 into the firm and then pay Br.11,120 next
year. Investors require a 12% return.
❑ Market Value with constant dividend = Br.16,900.51
❑ Market Value with reinvestment = Br.16,900.51
◼ If the company will earn the required return, then it
doesn’t matter when it pays the dividends

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Dividend RELEVANCE Theories
◼ Dividends paid by the firms are viewed positively
both by the investors and the firms.
◼ The firms which do not pay dividends are rated in
oppositely by investors thus affecting the share
price.
◼ General argument:
❑ These theories consider dividend decisions to be an

active variable in determining the value of the firm.
❑ Therefore, the dividend decision is relevant.
◼ Models:
❑ Walter Model (James E. Walter)

❑ Gordon Model (Myron Gordon)
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Dividend Relevance Theories
◼Walter Model:
❑ This model says investment policy of a firm cannot be
separated from its dividend policy (both interlinked)
❑ Key argument: the relationship between the return of
firm’s investment (r) and its cost of capital (ke)

❑ dividend policy is a precursor of the value of a company
❑ is based on the relationship between a company's
Internal Rate of Return (IRR) and the Cost of Capital

(COC).
❑ shows clearly the importance of the relationship
between the firm’s IRR (r) and its COC (ke) in
determining the dividend policy that will maximize the
wealth of shareholders.
4/25/2023 (PhD) - 2023 31
◼ Hence,
◼ If r > ke, (growing firms) the firm should retain the earnings
or D/P (ratio should be zero) as it is able to earn higher than
what the shareholders could by investing on their own
◼ If r < ke, (declining firms) it implies that shareholders can
earn a higher return by investing elsewhere. Therefore, the
entire earnings (D/P ratio should be 100%) should be
distributed to them.
◼ If r = ke (normal firms), it is a matter of indifference whether
earnings are retained or distributed. This is so because for
all D/P ratios (ranging between zero and 100) the market
price of shares will remain constant. For such firms, there is
no optimum dividend policy (D/P ratio)

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◼

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Walter Model: Illustration
Particulars Assumption I Assumption II Assumption III
R 20% 15% 10%
K 15% 15% 15%
E Br. 4 Br. 4 Br. 4
If D = (a) Br. 4 Br. 4 Br. 4
If D = (b) Br. 2 Br. 2 Br. 2
Compute the price of the share under each of the above assumptions
and show the implication
Assumption I: a. P = Br. 26.67, b. P = Br. 31.11

Assumption II: a. P = Br. 26.67, b. P = Br. 26.67
Assumption III: a. P = Br. 26.67, b. P = Br. 22.22

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◼Gordon Model:
❑Myron J. Gordon (1962) is another model of share
valuation which is based on the idea that dividend
policy and value of a share are interrelated.
❑ This model claims that dividend policy of a firm
affects its value.

❑ Like Walter’s Model value of the firm under this
method also depends upon reinvestment rate (r)

and shareholder’s expectations (ke).

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◼ Assumptions of Gordon’s Model
❑ No Debt
❑ the company is an all-equity company, with no proportion of debt
in the capital structure.

❑ No External Financing
❑ retained earnings finance all investments of the company, and no

external financing is required.
❑ Constant IRR
❑ a constant Internal Rate of Return (r), ignoring the diminishing

marginal efficiency of the investment.
❑ Constant Cost of Capital
❑ a constant cost of capital (k), implying the business risk of all the
investments to be the same.

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◼ Assumptions of Gordon’s Model
❑ Perpetual Earnings
◼ Gordon’s model believes in the theory of perpetual earnings for
the company.
❑ No Corporate Taxes
◼ This model does not account for corporate taxes.
❑ Constant Retention Ratio
◼ The model assumes a constant retention/plowback (b) once it is
decided by the company. Since the growth rate (g) = b*r, the
growth rate is also constant by this logic.
❑ k>g
◼ Gordon’s model assumes that the cost of capital (k) > growth rate
(g). This is important for obtaining the meaningful value of the
company’s share.
◼ The above argument underlying Gordon’s model of dividend is also
described as Bird-i-the-hand argument
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Gordon's basic valuation formula

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Implications of Gordon’s Model
◼ Gordon’s model believes that the dividend policy impacts the company
in various scenarios as follows:
◼ Growth Firm
❑ A growth firm’s internal rate of return (r) > cost of capital (k).
❑ It benefits the shareholders more if the company reinvests the
dividends rather than distributing them.
❑ So, the optimum payout ratio for growth firms is zero.
❑ Therefore, to maximize the market price, the company needs to
retain all its earnings, otherwise its price will decline.
◼ Normal Firm
❑ A normal firm’s internal rate of return (r) = cost of the capital (k).
❑ So, it does not make any difference if the company reinvests the
dividends or distributes them to its shareholders.
❑ Hence, there is no optimum dividend payout ratio for normal firms.

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Implications of Gordon’s Model
◼ Declining Firm
❑ The internal rate of return (r) < cost of the capital (k) in the
declining firms.
❑ The shareholders will get more benefits if the company distributes
the dividends rather than reinvesting them.
❑ So, the optimum dividend payout ratio for declining firms is 100%

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Illustration:
◼ Example
◼ The EPS of the company is Birr 15.
◼ The market rate of discount applicable to the company is 12%. And it
expects dividends to grow at 10% annually.
◼ The company retains 70% of its earnings.
◼ Required: Calculate the market value of the share using Gordon’s

model.
◼ Solution:
◼ Market price of the share (P)
◼ P = [Br. 15 * (1-.70)] / (0.12 - 0.10)
◼ P = (Br. 15*0.30) / 0.02
◼ P= Br. 225
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Gordon Model: Illustration
Particulars Assumption I Assumption II Assumption III
R 20% 15% 10%
K 15% 15% 15%
E Br. 4 Br. 4 Br. 4
i. If b = 0.25 0.25 0.25
ii. If b = 0.50 0.50 0.50
Compute the price of the share under each of the above assumptions and
show the implication
Assumption I:
i) P = Br. 30, ii) P = Br. 40
Assumption II:
i)P=Br.26.67, ii) P = Br. 26.67
Assumption III:
i)P=Br. 24.00, ii)P = Br. 20.00
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Critics on Walter and Gordon Models
◼ When all investment is via RE and no debt or equity,
either the investment policy or dividend policy or
both will be substandard.
◼ Although they assume (r) is constant, it decreases

with more investments (for all equity financed firms).
◼ Their assumption noted (k) remains constant,

however, it is not realistic since it ignores the
business risk of the firm which has direct impact on
the firm’s value

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Bird-in-the-Hand Theory
◼ This theory states that:

❑ Investors prefer dividends from stock
investing to potential capital gains because
of the inherent uncertainty associated with
capital gains.
❑ Investors prefer the certainty of dividend
payments to the possibility of substantially
higher future capital gains.
◼ If so, investors would value high payout

firms more highly, i.e., a high payout
would result in a high P0.

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Tax Preference Theory
◼ This theory claims that investors prefer lower payout companies
for tax reasons.
◼ This theory states that:
❑ Some investors prefer long-term capital gains to current
dividend yield and will pay more for the stock of a firm that
plows back its earnings into capital appreciating projects
instead of paying these earnings out as dividends.
❑ In other words, retained earnings lead to long-term capital
gains, which are taxed at lower rates than dividends: 20%
vs. up to 39.6%. Capital gains taxes are also deferred.
◼ This could cause investors to prefer firms with low payouts, i.e.,
a high payout results in a low P0.

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Further implications of the Tax Preference Theory
◼ First, investors in high tax brackets may prefer lower
payout companies because they can avoid paying the
higher taxes associated with dividends.
◼ Second, investors may also prefer lower payout
companies because they can avoid the double taxation
of dividends.
◼ Third, Investors may prefer lower payout companies
because the reinvested earnings can potentially
generate higher returns.

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Implications of 3 Theories for Managers
Theory Implication
Irrelevance Any payout OK
Bird in the hand Set high payout
Tax preference Set low payout
But which, if any, is correct???

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Possible Stock Price Effects
Stock Price ($)

Bird-in-Hand
40
30 Irrelevance
20
Tax preference
10
0 50% 100% Payout

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Possible Cost of Equity Effects
Cost of equity (%)

Tax Preference
20
15 Irrelevance
10 Bird-in-Hand
0 50% 100% Payout

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Which theory is most correct?
◼ Empirical testing has not been able to
determine which theory, if any, is correct.
◼ Thus, managers use judgment when setting

policy.
◼ Analysis is used, but it must be applied with

judgment.

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What’s the “information content,” or
“signaling,” hypothesis?
◼ Managers hate to cut dividends, also won’t raise
dividends unless they think raise is sustainable. So,
investors view dividend increases as signals of
management’s view of the future.
◼ Therefore, a stock price increase at time of a dividend

increase could reflect higher expectations for future
dividends themselves, not to a change in the dividend
payout policy.

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Reading Assignment
◼ What are the advantages of Tax Preference

Theory?
◼ Identify the limitations of Tax Preference
Theory

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Clientele effect and Residual Dividend Model
(Irrelevance Dividend Policy)

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What is a Dividend Clientele?
◼ Dividend clientele is the name for a group of a
company’s stockholders who share a similar view about
the company’s dividend policy.
◼ Shareholders in a dividend clientele generally base their
preferences for a particular dividend payout ratio on
comparable income level, personal income tax
considerations, or their age.
◼ For example,
❑ retired investors likely prefer stability and may have a preference
for stocks with high dividend payout and yields.
❑ young investors with a long investment horizon, may prefer
stocks that reinvest their earnings for long-term stock price
appreciation

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What’s the “clientele effect”?
◼ The clientele effect theory states that: different
policies attract different types of investors, and
changes to those policies shift the clientele and
impact the company’s share price.
❑ “high-tax bracket investors (like individuals) prefer low
dividend payouts and low tax bracket investors (like
corporations and pension funds) prefer high dividend
payouts.”
❑ So different groups desire different levels of dividends.
◼ Clientele effects impede/hamper changing dividend
policy.
◼ Taxes & brokerage costs hurt investors who have to
switch companies.
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What’s the “residual dividend model”?
◼ Find the retained earnings needed for the

capital budget.
◼ Pay out any leftover earnings (the residual) as

dividends only if more earnings are available
than are needed to support the optimal capital
budget.
◼ This policy minimizes flotation and equity

signaling costs, hence minimizes the WACC.

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Using the Residual Model to Calculate Dividends Paid
Dividend = Net Income – [Target Equity Ratio x Total

Capital Budget]
Exercise:
If, EBT is Br. 2,500,000, target equity ratio, 65% and total
capital expenditure budget Br. 1,800,000, compute the
dividend payout ratio at a tax rate of 40%
Answer = 0.22 or 22%

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Exercise II
◼ How would
❑ A decrease of EBT to Br. 1,950,000 would affect
the dividend?
❑ A further increase of EBT to Br. 2,750,000 would

affect dividend?

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Advantages and Disadvantages of the Residual
Dividend Policy
◼ Advantages: Minimizes new stock issues and
flotation costs.
◼ Disadvantages: Results in variable dividends,
sends conflicting signals, increases risk, and
doesn’t appeal to any specific clientele.
◼ Conclusion: Consider residual policy to help set
their long-run target payout ratios, but not as a
guide to the payout in any one year.

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Factors influencing Dividend Policy
◼ Legal Restrictions
◼ Size of earnings
◼ Shareholders Preferences:
◼ Liquidity Position
◼ Management Attitude
◼ Condition of Capital Market
◼ Stability of earnings
◼ Trade cycle
◼ Ability to borrow
◼ Past dividend rate
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Stock Repurchases
▪ A stock or share repurchase is a transaction
whereby a company buys its own shares from the
market place.
Reasons for repurchases:
◼ As an alternative to distributing cash as
dividends.
◼ To dispose of one-time cash from an asset sale.
◼ To make a large capital structure change.

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Advantages of Repurchases
◼ Stockholders may take as a positive signal--
management thinks stock is undervalued.
◼ With a cash dividend, stockholders must accept
the payment and pay the taxes.
◼ Helps avoid setting a high dividend that cannot
be maintained.
◼ Can be used in take-overs or resold to raise
cash as needed.
◼ Income received is capital gains rather than
higher-taxed dividends.

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Disadvantages of Repurchases
◼ Tax authority could impose penalties if

repurchases were primarily to avoid taxes on
dividends.
◼ Selling stockholders may not be well informed,

hence be treated unfairly.
◼ Firm may have to bid up price to complete

purchase, thus paying too much for its own
stock.
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Stock Dividends vs. Stock Splits
◼ Stock dividend: Firm issues new shares in

lieu of paying a cash dividend. If 10%, get 10
shares for each 100 shares owned.
◼ Stock split: Firm increases the number of

shares outstanding, say 2:1, but the price of
each share will drop to half.

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Quick Quiz
◼ What are the different types of dividends, and how is a dividend
paid?
◼ What is the clientele effect, and how does it affect dividend policy
relevance?
◼ What is the information content of dividend changes?
◼ What are stock dividends, and how do they differ from cash
dividends?
◼ How are share repurchases an alternative to dividends, and why
might investors prefer them?

4/25/2023 (PhD) - 2023 75 17-75
End of Chapter Two

4/25/2023 (PhD) - 2023 77

Chap. 2 - Dividends and Dividend Policy

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Chap. 2 - Dividends and Dividend Policy

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Addis Ababa University

Financial Management II (AcFn 3042)

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

distribution of the accumulated reserves because

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

◼ On September 8, 2017, Company XYZ declares a dividend

Declaration date Ex Dividend Date Record Date Payable Date

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

◼ Dividend policy may not matter

versus retaining funds to reinvest in the firm

grow and can pay higher dividends in the future

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

decide to distribute it to the shareholders or not to pay out

face very high risk as there is a possibility of not receiving

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

❑ If they don’t want cash, they can use dividends to

Comp. By Alem H (PhD) and Habtamu B.

❑ These theories consider dividend decisions to be an

❑ Walter Model (James E. Walter)

firm’s investment (r) and its cost of capital (ke)

❑ is based on the relationship between a company's

Internal Rate of Return (IRR) and the Cost of Capital

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

Assumption I: a. P = Br. 26.67, b. P = Br. 31.11

Comp. By Alem H (PhD) and Habtamu B.

affects its value.

method also depends upon reinvestment rate (r)

Comp. By Alem H (PhD) and Habtamu B.

❑ the company is an all-equity company, with no proportion of debt

in the capital structure.

❑ retained earnings finance all investments of the company, and no

❑ a constant Internal Rate of Return (r), ignoring the diminishing

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

◼ Required: Calculate the market value of the share using Gordon’s

◼ Although they assume (r) is constant, it decreases

◼ Their assumption noted (k) remains constant,

Comp. By Alem H (PhD) and Habtamu B.

◼ This theory states that:

◼ If so, investors would value high payout

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

Comp. By Alem H (PhD) and Habtamu B.

But which, if any, is correct???

Stock Price ($)