Dividend Policy

What is It?

• Dividend Policy refers to the explicit or implicit decision of the Board of Directors regarding the amount of residual earnings (past or present) that should be distributed to the shareholders of the corporation.
– This decision is considered a finacing decision because the profits of the corporation are an important source of financing available to the firm.
CHAPTER 22 – Dividend Policy 22 - 1

Types of Dividends
• Dividends are a permanent distribution of residual earnings/property of the corporation to its owners. • Dividends can be in the form of:
– Cash – Additional Shares of Stock (stock dividend) – Property

• If a firm is dissolved, at the end of the process, a final dividend of any residual amount is made to the shareholders – this is known as a liquidating dividend.

CHAPTER 22 – Dividend Policy

22 - 2

Payment Policies
1. Residual Dividend Payment
• Earnings not used to finance capital investment are available for dividend payment
Same Rs.-dividend each quarter Constant % of earnings

2. Constant Cash Dividend
• •

3. Constant payout ratio (%)

– When a cash dividend is declared. Retained Earnings Corporate Profits After Tax Dividends CHAPTER 22 – Dividend Policy 22 . those funds leave the firm permanently and irreversibly. – Distribution of earnings as dividends may starve the company of funds required for growth and expansion. corporate earnings accrue to the benefit of shareholders as retained earnings and are automatically reinvested in the firm.4 . and this may cause the firm to seek additional external capital.Dividends a Financing Decision – In the absence of dividends.

5 . and residual claim on assets on dissolution and on profits after all other claims have been fully satisfied) CHAPTER 22 – Dividend Policy 22 .Dividends versus Interest Obligations Interest • Interest is a payment to lenders for the use of their funds for a given period of time • Timely payment of the required amount of interest is a legal obligation • Failure to pay interest (and fulfill other contractual commitments under the bond indenture or loan contract) is an act of bankruptcy and the lender has recourse through the courts to seek remedies • Secured lenders (bondholders) have the first claim on the firm’s assets in the case of dissolution or in the case of bankruptcy Dividends • A dividend is a discretionary payment made to shareholders • The decision to distribute dividends is solely the responsibility of the board of directors • Shareholders are residual claimants of the firm (they have the last.

Dividend Payments Mechanics of Cash Dividend Payments • • • • Declaration Date Holder of Record Date Ex-dividend Date Payment Date CHAPTER 22 – Dividend Policy 22 .6 .

the date of payment and the amount of the dividend for each share class. Date of Record – is the date on which the shareholders register is closed after the trading day and all those who are listed will receive the 22 . this resolution makes the dividend a current liability for the firm. In their resolution the Board will set the date of record.7 dividend.Dividend Payments Mechanics of Cash Dividend Payments Declaration Date – this is the date on which the Board of Directors meet and declare the dividend. CHAPTER 22 – Dividend Policy . – when CARRIED.

fall in value) – ‘ex’ means without. Date of Payment – is the date the cheques for the dividend are mailed out to the shareholders.Ex dividend Date – is the date that the value of the firm’s common shares will reflect the dividend payment (ie. less the value of the dividend per share. . – At the start of trading on the ex-dividend date. This reflects the fact that purchasers of the stock on the ex-dividend date and beyond WILL NOT receive the declared dividend. the share price will normally open for trading at the previous days close.

Empirical evidence on dividends • Dividends tend to lag earnings – Dividends are changed to reflect long-term shifts in earnings • Dividends are sticky • Dividends are less volatile than earnings • Dividend policy tends to follow the life cycle of the firm with mature firms returning more to owners .

How does dividend policy affect stock price? • Constant growth stock valuation model: D1 P0  rg • An increase in dividends increases D1 but also decreases g .

Dividends are irrelevant… • The Miller-Modigliani Hypothesis: Dividends do not affect value • Basis: – If a firm's investment policy (and hence cash flows) does not change. . investors have to be indifferent to receiving either dividends or capital gains. If we ignore personal taxes. the value of the firm cannot change with dividend policy.

Dividends are irrelevant… • Underlying Assumptions: – (a) There are no tax differences between dividends and capital gains. they can issue new stock. they do not use the excess cash for bad projects or acquisitions. – (b) If companies pay too much in cash. – (c) If companies pay too little in dividends. . to replace this cash. with no flotation costs or signaling consequences.

each year. then raise external capital – in this case no dividend is paid • If free cash flow exceeds investment requirements.M&M’s Dividend Irrelevance Theorem Residual Theory of Dividends The Residual Theory of Dividends suggests that logically. the residual amount is distributed in the form of cash dividends. . management should: – Identify free cash flow generated in the previous period – Identify investment projects that have positive NPVs – Invest in all positive NPV projects • If free cash flow is insufficient.

so the value of the firm is maximized only if the project is undertaken.M&M’s Dividend Irrelevance Theorem Residual Theory of Dividends .Implication The implication of the Residual Theory of Dividends are: Investment decisions are independent of the firm’s dividend policy • No firm would pass on a positive NPV project because of the lack of funds. • The firm should operate where Marginal Cost equals Marginal Revenue . It has no projects with IRRs > cost of capital) then those funds should be distributed back to shareholders in the form of dividends for them to invest on their own. because. by definition the incremental cost of those funds is less than the IRR of the project. • If the firm can’t make good use of free cash flow (ie.

they can create their own. the investor is indifferent to the firm’s dividend policy.M&M’s Dividend Irrelevance Theorem Homemade Dividends • Shareholders can buy or sell shares in an underlying company to create their own cash flow pattern. – They don’t need management declare a cash dividend. Conclusion: under the assumptions of M&M’s model. .

Dividends are bad… • Individuals in upper income tax brackets might prefer lower dividend payouts. thereby lowering flotation costs – Dividend restrictions – debt contracts might limit the percentage of income that can be paid out as dividends . with the immediate tax consequences. in favor of higher capital gains • Additionally. – Flotation costs – low payouts can decrease the amount of capital that needs to be raised.

Dividends are good…. . • The Excess Cash Argument: The excess cash that a firm has in any period should be paid out as dividends in that period. for these reasons • The bird in the hand fallacy: Dividends are better than capital gains because dividends are certain and capital gains are not.

Hence dividends are more valuable than capital gains. .The bird in the hand fallacy • Argument: Dividends now are more certain than capital gains later. • Counter: The appropriate comparison should be between dividends today and price appreciation today.

no investment projects this year and wants to give the money back to stockholders. – Consider the cost of issuing new stock – If it initiates dividends.The excess cash hypothesis • Argument: The firm has (temporary) excess cash on its hands this year. the firm has to consider future financing needs. it may need to raise capital through a stock issue just to pay dividends in the future. . • Counter: If this is a one-time phenomenon.

If these are the stockholders in your firm. there might be a transfer of wealth from the bondholders to the stockholders. either because they value the regular cash payments or do not face a tax disadvantage. • Dividends as Signals: Dividend changes act as signals to financial markets about the future sustainable earnings of the firm • Wealth Transfer: By returning more cash to stockholders. . paying more in dividends will increase value.Dividends are good….possibly for these reasons • The Clientele Effect: There are stockholders who like dividends.

Investors in high tax brackets may invest in stocks which do not pay dividends and those in low tax brackets may invest in dividend paying stocks.A clientele based explanation • Basis: Investors may form clienteles based upon their tax brackets. • A study found that – (a) Older investors were more likely to hold high dividend stocks and – (b) Poorer investors tended to hold high dividend stocks .

Dividends as signals • Dividend increases – Stock prices increase significantly around dividend increase announcements. – Management is signaling to the market that earnings will be sustainable at a higher level thus allowing the company to maintain a higher dividend level • The opposite is true for dividend decreases • Signals are most effective for smaller firms .

Dividend Policy Dividends. and courts will not interfere with the BOD’s right to make the dividend decision because: – Board members are jointly and severally liable for any damages they may cause . Shareholders and the Board of Directors • There is no legal obligation for firms to pay dividends to common shareholders • Shareholders cannot force a Board of Directors to declare a dividend.

Dividend Policy – Board members are constrained by legal rules affecting dividends including: • Not paying dividends out of capital • Not paying dividends when that decision could cause the firm to become insolvent • Not paying dividends in contravention of contractual commitments (such as debt covenant agreements) .

Dividend Payments Dividend Reinvestment Plans (DRIPs) • Involve shareholders deciding to use the cash dividend proceeds to buy more shares of the firm – DRIPs will buy as many shares as the cash dividend allows with the residual deposited as cash – Leads to shareholders owning odd lots • Firms are able to raise additional common stock capital continuously at no cost and fosters an on-going relationship with shareholders. CHAPTER 22 – Dividend Policy 22 .25 .

CHAPTER 22 – Dividend Policy 22 .26 . • Because of the capital impairment rule stock dividends reduce the firm’s ability to pay dividends in the future. (that is. the amount of the stock dividend is transferred from the R/E account to the common share account.Dividend Payments Stock Dividends • Stock dividends simply amount to distribution of additional shares to existing shareholders • They represent nothing more than recapitalization of earnings of the company.

.27 ..because they have more – adjusts the capital accounts – dilutes EPS CHAPTER 22 – Dividend Policy 22 .Dividend Payments Stock Dividends Implications – reduction in the R/E account – reduced capacity to pay future dividends – proportionate share ownership remains unchanged – shareholder’s wealth (theoretically) is unaffected Effect on the Company – conserves cash – serves to lower the market value of firm’s stock modestly – promotes wider distribution of shares to the extent that current owners divest themselves of shares.

this really represents an increased dividend payout .Dividend Payments Effect on Shareholders – proportion of ownership remains unchanged – total value of holdings remains unchanged – if former DPS is maintained.

no change in shareholder wealth • Reasons for use: – better share price trading range – psychological appeal (signalling affect) CHAPTER 22 – Dividend Policy 22 . • The result is: – increase in the number of share outstanding – theoretically.Dividend Payments Stock Splits • Although there is no theoretical proof.29 . there is some who believe that an optimal price range exists for a company’s common shares. • The purpose of a stock split is to decrease share price.

.Factors Influencing Dividend Policy Legal Rules • Capital Impairment Rule -.many states prohibit the payment of dividends if these dividends impair “capital” (usually either par value of common stock or par plus additional paid-in capital).

prohibits the undue retention of earnings in excess of the present and future investment needs of the firm.some states prohibit the payment of cash dividends if the company is insolvent under either a “fair market valuation” or “equitable” sense.Factors Influencing Dividend Policy Legal Rules • Insolvency Rule -. • Undue Retention of Earnings Rule -. .

Factors Influencing Dividend Policy Other Issues to Consider • • • • Funding Needs of the Firm Liquidity Ability to Borrow Restrictions in Debt Contracts (protective covenants) • Control .

. The plan essentially reduces the effective dividend-payout ratio. • The firm can issue new stock..Dividend Reinvestment Plans Dividend Reinvestment Plan (DRIP) -. • The firm can use existing stock. A trustee (e. • Some plans offer discounts and eliminate brokerage costs for current shareholders.g. This method raises “new” funds for the firm. a bank) purchases the stock on the open market and credits current shareholders with the new shares.An optional plan allowing shareholders to automatically reinvest dividend payments in additional shares of the company’s stock.

lowering the cost of equity and the WACC. • This should raise stock prices. .Capital Structure Impact • Paying Dividends will – Reduce Assets (cash) – Reduce Equity • Increases the relative amount of debt • Higher debt ratios are seen as positive signals that management is trying to concentrate expected profits onto less equity.

management is less likely to pay dividends or issue new stock since such actions would lower stock prices which reduces the value of stock options. .Corporate Governance & Dividends • Executive Compensation – Fixed Pay (no equity link) • Underinvestment & Perk-taking problems • Issuing dividends increases the probability a firm will need to issue new stock – Imposes market discipline on management to reduce these agency costs and maximize shareholder wealth – Stock Options (equity link) • Excessive risk-taking problem not alleviated by dividend policy – In fact.

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