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FINANCIAL MANAGEMENT II
CHAPTER 1DIVIDEND POLICY AND THEORY
 Chapter Outline
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 Introduction
 Dividends- classification
 Factors influencing dividend payments
 Establishing dividend policy
 ResidualDividend approach
 Dividend stability

 A Compromise
 Characteristics of a Corporation
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Separate Legal Existence

Limited Liability of Stockholders
Transferable Ownership Rights
Ability to Acquire Capital
Continuous Life
Government Regulations
Additional Taxes
Corporate Management
 CORPORATE CAPITAL

 Owners’ equity in a corporation is

identified as stockholders’ equity,
shareholders’ equity, or corporate capital.
 The stockholders’ equity section of a
corporation’s balance sheet consists of:
1 paid-in (contributed) capital and
2 retained earnings (earned capital).
 CORPORATE CAPITAL

 When a corporation has only one class of stock, it

is identified as common stock.
 A printed or engraved form known as a stock
certificate serves as proof of stock ownership.
 The amount of stock that a corporation is
authorized to sell is indicated in its charter.
 The total amount of authorized stock at the time
of incorporation usually anticipates both initial
and subsequent capital needs of a company.
 Stockholders’ Equity: Sources of Paid-In Capital
Classes of Stock
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 Common Stock
 when there is only one class of stock it is “common stock”
 Preferred Stock
 nonparticipating vs. participating
 most preferred stock is nonparticipating
 cumulative vs. non-cumulative
 cumulative preferred stock has the right to receive regular dividends
that have been passed (are in arrears) before any common stock
dividends are paid
 COMMON STOCK
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 If a corporation has only one type of stock, it is

called “common stock”
 Gives its owner the right to:
 Vote at stockholder meetings
 Share in earnings distributions
 Purchase additional shares in proportion to the owner’s
present holding if more shares are issued
 Called the “preemptive right”
 Share in the assets if the corporation liquidates
 PREFERRED STOCK
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 Type of stock that gives its owners certain rights

and privileges superior to those of common
stockholders
 Example: The right to receive dividends before
common stockholders
 Dividends are stated as a dollar amount or a percent of par
value
 Does not give the same rights as common stock
 Example: Preferred stockholders do not have the right
to vote
 PARTICIPATING PREFERRED
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STOCK
 Gives owners the right to share with common stock
owners in dividends in excess of a stated dividend
rate
 Rare to find anymore
 Nonparticipating preferred stock limits the
preferred stock owners to the stated dividend rate
 DIVIDENDS
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 The term dividend usually refers to a cash distribution of

earnings.
 If a distribution is made from sources other than current
or accumulated retained earnings, the term distribution
rather than dividend is used.
 However, it is acceptable to refer to a distribution from
earnings as a dividend and a distribution from capital as a
liquidating dividend.
 DIVIDENDS

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 A dividend is distribution by a corporation to its

stockholders on a pro rata (equal) basis.
 A cash dividend is a pro rata distribution of cash
to stockholders.
 For a cash dividend to occur, a corporation must
have:
1 retained earnings,
2 adequate cash, and
3 declared dividends.
 Introduction(Cont’ed)
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 Dividends are returns given to shareholders out of profits

earned by a company.
 Payment of dividends not only depends upon profitability,
but also the recommendation of Board of Directors.
 Shareholders approve the dividend as recommended by
the Board of Directors.
 Dividend rate can be reduced by shareholders, but cannot
be increased.
 How Do Firms Distribute Cash to their
Shareholders?
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 Cash distributions can take two basic forms:

1. Cash dividend

2. Share repurchase
 How Do Firms Distribute Cash to their
Shareholders? (cont.)
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 The impact on the balance sheet will be as follows:

 On the Assets side, cash will be reduced due to cash

dividend or share repurchase.

 On the Equity side, there will be a corresponding

decrease.
 How Do Firms Distribute Cash to their
Shareholders? (cont.)
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 With cash dividend, cash is paid directly to the

shareholders.

 With a share repurchase, a company uses cash to

buy back its own shares from the market place,
thereby reducing the number of outstanding shares.
 Dividends – Classification
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 The most common type of dividend is in the form of cash.

 When public companies pay dividends, they usually pay
regular cash dividends in a year.
 Sometimes firms will pay a regular cash dividend and
an extra cash dividend.
 Paying a cash dividend reduces corporate cash and
retained earnings – except in the case of a liquidating
dividend (where paid-in capital may be reduced).
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 Many companies pay a regular cash dividend.

 Public companies often pay quarterly.
 Sometimes firms will throw in an extra cash dividend.
 The extreme case would be a liquidating dividend.
 Often companies will declare stock dividends.
 No cash leaves the firm.
 The firm increases the number of shares outstanding.
 Some companies declare a dividend in kind.
 Dividends – Classification
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 Another type of dividend is paid out in shares of stock.

This dividend is referred to as a stock dividend.
 It is not a true dividend because no cash leaves the
firm. Rather, a stock dividend increases the number of
shares outstanding, thereby reducing the value of each
share.
 A stock dividend is commonly expressed as a ratio; for
example, with a 2 percent stock dividend a shareholder
receives 1 new share for every 50 currently owned.
 What is “dividend policy”?
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 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?
 Cash Dividends
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 A firm’s dividend policy determines how much

cash it will distribute to its shareholders and when
these distributions will be made.

 Dividends are generally described in terms of

dividend payout ratio, which indicates the amount
of dividends paid relative to the company’s
earnings.
 Dividend Policy : Significance
 Outflow of cash, pressure on liquidity of the company
 Opportunity cost of the funds distributed
 Dividend payment maximizes shareholders’ current
wealth while retention facilitates future wealth
generation.
 Dividend payment is a sign of goodwill, and a positive
impact on investors, and in turn the market price /
share.
 Retention leads to faster growth resulting in higher
21 profitability and increase in shareholders’ wealth.
 Factors Influencing Dividend Policy
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External Factors Internal Factors

 General state of  Desire of Shareholders
Economy  Financial needs of
 Capital Markets Company
 Legal Restrictions  Nature of Earnings
 Contractual  Desire of Control
Restrictions  Liquidity Position
 Taxation Policy
 External Factors – Dividend Policy
 General state of Economy – in cases of uncertainty, depression in
the economy, the management may like to retain the earnings and
build up reserves to absorb shocks in the future and preserve
liquidity.
 Capital Markets – if a firm has easy access to capital markets to
raise funds, it may follow liberal dividend policy and vice versa.
 Legal Restrictions – the management must comply to all legal
restrictions such as transfer to reserves etc.
 Contractual Restrictions – lending financial institutions may put
restrictions on dividend payments to protect their interests.
 Taxation Policy – consideration of corporate taxes and dividend
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distribution tax to be paid by the companies.
 Internal Factors – Dividend Policy
 Desire of Shareholders – the shareholders, being the owners of
the company influence the dividend payout. Their expectation for
dividend depicts companies strength, certainty and liquidity.
 Financial needs of Company – financial needs of the company
may directly conflict with shareholders’ desire. Company’s vision
for future growth and profitability may bypass the dividend
expectation.
 Nature of Earnings – a firm with a stable income can afford to
have higher dividend payout and vice versa.
 Desire of Control – higher dividend implies liquidity crunch that
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can be met by new equity issue. New equity dilutes management
Dividend Distribution Theories

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 Do investors prefer high or low payouts?
There are three theories:
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 Irrelevant: Investors do not care about payout.

(Miller and Modigliani).
 Relevance/Bird – in - hand: Investors prefer a high
payout (Gordon and Litner).
 Tax preference: Investors prefer a low payout in
order to get growth and capital gains . Better to call it
“Tax Avoidance Theory.”
 Dividend Irrelevance Theory
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 Investors are indifferent between dividends and

retention-generated capital gains. If they want cash,
they can sell stock. If they don’t want cash, they can
use dividends to buy stock.
 Miller - Modigliani support irrelevance, but their
theory is based on unrealistic assumptions (no taxes
or brokerage costs), and hence may not be true. Need
empirical test.
 Dividend Irrelevance Theory
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Homemade Dividends
 Shareholders through their actions can alter the
corporate dividend policy to suit their needs
 thus, corporation can’t do anything for the shareholders
that they can’t do for themselves
 The shareholder who receives a dividend that is greater than
desired can reinvest the excess
 The shareholder who receives a dividend that is smaller than
desired can sell extra shares of stock
 “Bird in the Hand” Theory
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 Gordon argued that a dividend-in-the-hand is worth more than the present value
of a future dividend.
 A Br 1 in dividend now is worth more than Br 2 in dividend later on.
 Investors think dividends are less risky than potential future capital gains, hence
they like dividendIf s.
Why might a high payout be desirable?
 Desire for current income
 Individuals in low tax brackets
 Uncertainty resolution – no guarantee that the higher future dividends will
materialize
 Taxes
 Dividend exclusion for corporations (dividends received by corporations are
tax exempt)
 Tax-exempt investors don’t have to worry about differential treatment
between dividends and capital gains (e.g., pension funds)
 Real World Factors Favoring a High Dividend
Policy
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 Desire for Current Income

 Resolution of Uncertainty
 Tax Arbitrage
 Agency Costs
 Desire for Current Income
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 The homemade dividend argument relies on no transactions

costs.
 To put this in perspective, mutual funds can repackage
securities for individuals at very low cost: they could buy low-
dividend stocks and with a controlled policy of realizing
gains, pay their investors at a specified rate.
 Resolution of Uncertainty
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 It would be erroneous to conclude that increased dividends

can make the firm less risky.
 A firm’s overall cash flows are not necessarily affected by
dividend policy—as long as capital spending and borrowing
are not changes.
 Thus, it is hard to see how the risks of the overall cash flows
can be changed with a change in dividend policy.
 Tax Arbitrage
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 Investors can create positions in high dividend-yield securities

that avoid tax liabilities.
 Thus, corporate managers need not view dividends as tax-
disadvantaged.
 Agency Costs
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 Agency Cost of Debt

 Firms in financial distress are reluctant to cut dividends.

To protect themselves, bondholders frequently create loan

agreements stating dividends can only be paid if the firm
has earns, cash flow and working capital above pre-
specified levels.
 Agency Costs of Equity
 Managers will find it easier to squander funds if they have

a low dividend payout.

Tax Preference (or Tax Avoidance) Theory
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 Why might a low payout be desirable?

 Individuals in upper income tax brackets might prefer lower
dividend payouts, with the immediate tax consequences, in
favor of higher capital gains
 What are the implications of the three
Theories for managers?
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Theory Implication
Irrelevance Any payout “OK”
Bird in the Hand Set high payout
Tax preference Set low payout

But which, if any, is correct?

Dividend Irrelevance, Bird-in-the-Hand, and Tax Preference
Dividend Theories: Possible Stock Price Effects
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Stock Price (Br )

Bird-in-Hand
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30 Irrelevance

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Tax preference
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0 50% 100% Payout

 Which theory is most correct?
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 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.
 Informational content (Signaling )Theory
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 Asymmetric information – managers have more information about

the health of the company than investors.
 Changes in dividends convey information.
 Dividend increases
 Management believes higher dividend can be sustained
 Expectation of higher future dividends, increasing present value
 Signal of a healthy, growing firm
 Dividend decreases
 Management believes it can no longer sustain the current level
of dividends
 Expectation of lower dividends indefinitely; decreasing present
value
 Signal of a firm that is having financial difficulties
 Clientele Dividend Theory
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 Some investors prefer low dividend payouts and will buy stock in
those companies that offer low dividend payouts. Investors at higher
marginal tax rates prefer capital gains to dividends.
 Some investors prefer high dividend payouts and will buy stock in
those companies that offer high dividend payouts. Tax-free
foundations and retirees at lower marginal tax rates prefer cash
now and on a predictable basis.
 Each firm, therefore, attracts the type of investor that likes its
dividend policy.
 Investors will self-select into the stocks have their preferred payout
policy
 Managers should focus on capital budgeting decisions and ignore
investor preferences.
 Types of Dividend Policies:
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Constant-Payout-Ratio Policy
 With a constant-payout-ratio dividend policy, the firm
establishes that a specific percentage of earnings is paid to
shareholders each period.
 It is possible that a company could set a policy to payout a certain
percentage of earnings as dividends.
 A major shortcoming of this approach is that if the firm’s earnings
drop or are volatile, so too will be the dividend payments.
 As mentioned earlier, investors view volatile dividends as
negative and risky – which can lead to lower share prices.
 Constant Payout Ratio Policy Steps:
 Pay a constant proportion of earnings (if positive).
 Base optimal capital budget on residual retained earnings.
 Types of Dividend Policies:
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Constant growth dividend policy
 dividends increased at a constant rate each year.
 Types of Dividend Policies:
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Regular Dividend Policy
 A regular dividend policy is based on the payment of a fixed-
dollar dividend each period.
 It provides stockholders with positive information indicating that
the firm is doing well and it minimizes uncertainty.
 Generally, firms using this policy will increase the regular
dividend once earnings are proven to be reliable.
 Dividends are only increased if management is certain future
earnings will support such a high dividend.
 Regular Dividend Policy Steps:
 Pay a predictable dividend every year.
 Base optimal capital budget on residual retained earnings (after dividend).
 Types of Dividend Policies:
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Low-Regular-and-Extra Dividend Policy
 This policy is a hybrid of the last two policies. It is meant to keep
expectations low for dividends, and supplement those dividends
with bonuses in good years.
 Using this policy, firms pay a low regular dividend,
supplemented by additional dividends when earnings can support
it.
 When earnings are higher than normal, the firm will pay this
additional dividend, often called an extra dividend, without the
obligation to maintain it during subsequent periods.
 This type of policy is often used by firms whose sales and
earnings are susceptible to swings in the business cycle.
 The problem is the potential for negative signaling
 Types of Dividend Policies:
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Low-Regular-and-Extra Dividend Policy
 Low Regular Dividend Plus Extras Steps:
 Pay a predictable dividend every year.
 In years with good earnings pay a bonus dividend.
 Base optimal capital budget on residual of regular dividend
and compromising with bonus for capital budgeting
projects.
 Types of Dividend Policies:
Residual Dividend Policy
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 If a firm wishes to avoid new equity sales, then it has to rely on internally
generated equity to finance new, positive NPV projects.
 Dividends can only be paid out of what is left over. This left over is called
the residual, and such a dividend policy would be called residual dividend
policy.
 With a residual dividend policy, the firm’s objective is to meet its
investment needs and maintain its desired debt/equity ratio before paying
dividends.
 Residual Dividend Policy Steps:
 Determine the optimal capital budget.
 Determine the retained earnings that can be used to finance the
capital budget.
 Use retained earnings to supply as much of the equity investment in
the capital budget as necessary.
 Pay dividends only if there are left-over earnings.
 Types of Dividend Policies:
Residual Dividend Policy - Example
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 Given
 Need Br 5 million for new investments
 Target capital structure: D:E = 2:3
 Net Income = Br 4 million
 Finding dividend
 40% financed with debt (2 million)
 60% financed with equity (3 million)
 NI – Equity financing = Br 4M – Br 3M = Br 1 million,
paid out as dividends
 Types of Dividend Policies:
Residual Dividend Policy – Class Activity
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 Harar Corporation has a target equity ratio of 65%, and

its capital budget is Br 2 million. If Harar has net income
of Br 1.6 million and follows a residual dividend policy,
how much will its dividend be?
 Types of Dividend Policies:
Compromise Dividend Policy
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 Goals, ranked in order of importance

 Avoid cutting back on positive NPV projects to pay a
dividend
 Avoid dividend cuts
 Avoid the need to sell equity
 Maintain a target debt/equity ratio
 Maintain a target dividend payout ratio

 Companies want to accept positive NPV projects, while

avoiding negative signals.
 Cash Dividends
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 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. It is brought about by special circumstances.
 Liquidating dividend – some or all of the business has been sold
Dividend Payment Chronology
 Declaration Date – Board declares the dividend and it becomes a liability of
the firm.
 Ex-dividend Date
 To make sure that dividends checks go to the right people
 Occurs two business days before date of record
 If you buy stock on or after this date, you will not receive the dividend.
 Stock price generally drops by about the amount of the dividend
 Date of Record – Holders of record (shareholders according to the firm’s
records) are determined and they will receive the dividend payment
 Date of Payment – checks are mailed
 Dividend Payment Chronology
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Example: on Thursday January 15 ,2008, the board of

director of MM co. passes a resolution to pay a
dividend of $1 per share on February 16 to all holders
of a record date as of January 30.
 Price Behaviour Around Ex-dividend Date
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 Establishing Dividend Policy
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 Forecast capital needs over a planning horizon,

often 5 years.
 Set a target capital structure.
 Estimate annual equity needs.
 Set target payout based on the residual model.
 Generally, some dividend growth rate emerges.
Maintain target growth rate if possible, varying
capital structure somewhat if necessary.
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 The end