Establishing the Dividend Policy

Robelle Althea R. Galay

Two points to keep in mind when deciding how much cash to distribute to stockholders:
1. The overriding objective is to maximize shareholder value
2. The firm’s cash flows belong to its shareholders
- unless they can reinvest earnings at higher rates of return than shareholders could earn
themselves, the company should not retain income

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. Its target capital structure
4. The availability and cost of external capital

Setting the Target Payout Ratio: The Residual Dividend Model

- Dividends are paid out of “leftover” earnings
- Under this model a firm follows these four steps when establishing its target payout ratio:
1. It determines the optimal capital budget
2. It determines the amount of equity needed to finance that budget, given its target
capital structure
3. It uses retained earnings to meet equity requirements to the extent possible
4. It pays dividends only if more earnings are available than are needed to support the
optimal capital budget
- Formula:

Dividends = Net income - Retained earnings required to help finance new investments
Dividends = Net income - (Target equity ratio x Total capital budget)

Example #1:

A company generates a net profit of P10 million. However, the company identifies several lucrative
investment opportunities that require P6 million to fund research and development for innovative
products and P2 million for upgrading its production facilities.

Dividends = Net income - Retained earnings required to help finance new investments
= P 10,000,000.00 – (6,000,000 – 2,000,000)
Dividends = P 2,000,000.00

Example #2

Case 1
Consider a business with a capital budget of P8,000,000. The business follows a 60-40 debt-equity split
that they wish to maintain. The company makes a net income forecast of P5,000,000.
Establishing the Dividend Policy
Robelle Althea R. Galay

Dividends = Net income - (Target equity ratio x Total capital budget)

= P5,000,000.00 – (0.40 x P8,000,000.00)
= P5,000,000.00 – P3,200,000.00
Dividends = P 1,800,000.00

Payout Ratio = 36% (1.8M / 5M)

Case 2
Net income drops to P3,000,000.

Dividends = Net income - (Target equity ratio x Total capital budget)

= P3,000,000.00 - (0.40 x P8,000,000.00)
= P3,000,000.00 – P3,200,000.00
Dividends = -P200,000.00

In case of negative values, entire income is retained and no dividends will be paid and
the company would have to issue new common stock in order to maintain its target
capital structure. Payout ratio would also be zero.

Advantages
Reduces the occurrence of raising external funds
Reduces the issues of new stocks and flotation
costs
Disadvantages
Creates volatility in the dividend payments that
may be undesirable for some investors
The amount payable as dividend fluctuates
heavily

Due to unstable and unfluctuating dividends as an effect of varying investment opportunities (the higher
the investment opportunity, the lower residual income for dividend payout), firms should:

1. Estimate earnings and investment opportunities, on average, over the next five or so years
2. Use this forecasted information to find the average residual model amount of dividends, and the
payout ratio, during the planning period
3. Set a target payout policy based on the projected data

Setting the Target Payout Ratio: Low-Regular-Dividend-Plus-Extras Model / Flexible Dividend Policy
- The policy of announcing a low, regular dividend that can be maintained no matter what
and then, when times are good, paying a designated “extra” dividend.

Advantages Disadvantages
Eliminates uncertainty in investors’ mind about A company paying regular dividends may have
dividend payment less money to grow the business
Provides a source of regular source of income to This policy may give wrong impression to the
investors stockholders who may treat extra dividends as
part of regular dividends with the result that they
Establishing the Dividend Policy
Robelle Althea R. Galay

may react very strongly to omission of extra

dividends in future when earnings of the
company do not warrant distribution of extra
dividends, wherein the company may lose
confidence of stockholders and also its credit
standing in the market
Ensures more dividend payouts to shareholders
in periods of super normal profits

Payment Procedures

For example, ABC Company paid P50.00 per share per quarter (quarterly dividend) in 2022, or at an
annual rate of P200.00 (annual dividend). In late 2022, ABC Company’s Board of Directors met, reviewed
projections for the next year, and decided to keep the 2022 dividend at P200.00. The directors
announced the P200.00 rate, so stockholders could count on receiving it unless the company
experienced unanticipated operating problems. On November 8, 2022, the directors of ABC Company
met and declared the regular quarterly dividend of P50.00 per share, payable to holders of record at the
close of business on December 8, payment to be made on January 3, 2023.

1. Declaration Date
- For accounting purposes, the declared dividend becomes an actual liability on the
declaration date.
- In the example, declaration date is on November 08, 2022.

2. Holder-of-Record Date
- If the company lists the stockholder as an owner on this date, then the stockholder receives
the dividend.
- In the example, at the close of business on the holder-of-record date, December 8, the
company closes its stock transfer books and makes up a list of shareholders as of that date.
If ABC Company is notified of the sale before 5 p.m. on December 8, then the new owner
receives the dividend. However, if notification is received on or after December 9, the
previous owner receives the dividend check.

3. Ex-dividend Date
- The date on which the right to the current dividend no longer accompanies a stock (usually
two business days prior to the holder-of-record date)
- In the example, suppose Kalehla buys 100 shares of stock from MK on December 5. Will the
company be notified of the transfer in time to list Kalehla as the new owner and pay the
dividend to her? To avoid conflict, the securities industry has set up a convention under
which the right to the dividend remains with the stock until two business days prior to the
holder-of-record date; on the second day before that date, the right to the dividend no
longer goes with the shares. The date when the right to the dividend leaves the stock is
called the ex-dividend date.
Establishing the Dividend Policy
Robelle Althea R. Galay

Dividend goes with stock if it is bought on or before December 5

Ex-dividend date. Buyer does not receive the dividend December 6
Buyer does not receive the dividend December 7
Holder-of-record date; not normally of concern to stockholder December 8

Therefore, if Kalehla is to receive the dividend, she must buy the stock on or before
December 5. If she buys it on December 6 or later, MK will receive the dividend because he
will be the official holder of record. ABC Company’s dividend amounts to P50.00 per
quarter, so the ex-dividend date is important.

4. Payment Date
- The date on which a firm actually mails dividend checks.

Dividend Reinvestment Plan (DRIP)

- A plan that enables a stockholder to automatically reinvest dividends received back into the
stock of the paying firm.
- Instead of cash dividends, stock dividends are received
- For example, consider an investor that receives a cash dividend on his shares. The investor
fully participates in a DRIP and reinvests the cash dividends for additional shares. During the
next dividend payout, the investor will receive more cash dividends due to the additional
shares purchased through the DRIP.