Chapter one

dividend and dividend policy

 DIVIDEND DECISIONS

 Dividends refer to that portion of a firm’s net earnings which

are paid out to the shareholders.
 If a distribution is made from sources other than current or
accumulated retained earnings, the term distribution rather than
dividend is used. a distribution from capital as a
liquidating dividend.
 Since dividends are distributed out of the profits, alternative
to the payment of dividends is the retention of the
earnings/profits.
 The retained earnings constitute an easily accessible
important source of financing the investment requirement of
the firm.
Cont.
 The amount and timing of the dividend is decided by
the board of directors, who also determine whether it is
paid out of current earnings or the past earnings kept as
reserve.
 Forms of Dividend
 Scrip Dividends: Profits do not necessarily mean adequate cash to
enable payment of cash dividends. In case the company does not
have a comfortable cash position, it may issue promissory notes
payable in a few months.
 Bonus Shares or Stock Dividends: Instead of paying dividends out of
accumulated reserves, the latter may be capitalized by issue of bonus shares to
the shareholders.
 Property Dividends: This form of dividend is unusual and may be in the
form of inventory or securities instead of cash payment.
 Extra/special dividends:the “extra” part may or may not be repeated in the
future. A special dividend is similar, but the name usually indicates that this
dividend is viewed as a truly unusual or one-time event and won’t be
repeated.
 liquidating dividend: usually means that some or all of the business has been
liquidated, that is, sold off. However it is labeled, a cash dividend payment
reduces corporate cash and retained earnings, except in the case of a
liquidating dividend (which may reduce paid-in capital).
 Procedures of Cash Dividend Payment

 The amount of the dividend is expressed as dollars per share (dividend per
share), as a percentage of the market price (dividend yield), or as a
percentage of earnings per share (dividend payout).
 Declaration date: The date on which the board of directors passes a
resolution to pay a dividend. Board declares the dividend, and it becomes
a liability of the firm.
 Ex-dividend date: This date is two business days before the date of
record (discussed next). If you buy the stock before this date, then you are
entitled to the dividend. If you buy on this date or after, then the previous
owner will get the dividend.
 Date of record: The date by which a holder must be on record to be
designated to receive a dividend. Based on its records, the corporation
prepares a list of all individuals believed to be stockholders. These are the
holders of record.
 Date of payment: The date on which the dividend checks are mailed.
Does Dividend Policy Matter

 Dividend policy is an integral part of the firm’s financing

decision. The dividend-payout ratio determines the amount of
earnings that can be retained in the firm as a source of financing.
A major aspects of the dividend policy of the firm is to determine
the appropriate allocation of profits between dividend payments
and additions to the firm’s retained earnings.
DIVIDEND DECISIONS
 There is, thus a type of inverse
relationship between retained earnings
and cash dividends i.e. larger retentions,
lesser dividends and vice versa
 Dividends decision is a major corporate
decision in the sense that the firm has to
chose between distributing the profits to
the shareholders and ploughing them
back into the business and the choice
depends on the effect of the decision on
the firm’s value.
DIVIDEND DECISIONS
 Profitable companies regularly face 3
questions:
1. How much of its free cash flow should it
pass on to shareholders?
2. Should dividends be paid as cash
dividend or by repurchasing stock?
3. Should it maintain a stable, consistent
payment policy or should it let the
payment vary as conditions change
The important aspect of dividend policy is to determine
the amount of earnings to be distributed to shareholders
and the amount to be retained in the firm.
Retained earnings are the most significant internal
sources of financing the growth of the firm. On the other
hand, dividends may be considered desirable from the
shareholders’ point of view as they tend to increase their
current return. Dividends, however, constitute the use of
the firm’s funds
PAY-OUT RATIO

 It refers to the percentage of net income to be paid

out as cash dividend.
 It should be based in large part on investors
preferences for dividends vs capital gains i.e. do
investors prefer
a. To have the firm distribute income as cash
dividends
b. To have it either repurchase stock or else plough the
earnings back into the business, both of which
should result in capital gains
PAY-OUT RATIO

 Recall the constant growth stock valuation model

 Po= D1/Ks – g If the company increases the pay-out ratio this
raises D1 which would cause the stock price to rise.
 If D1 is raised, then less funds will be available for growth
therefore g will decline, thus the stock price also declines.
Therefore dividends policy have two opposing effects.
 Optimal dividend policy is that policy which strikes a balance
between current dividends and future growth and maximizes the
firm’s stock price.
DIVIDEND THEORIES
 DIVIDEND IRRELEVANCE THEORY
 This is the theory that a firm’s policy has no effect in
either its value or its cost of capital
 MM argued that a firm’s value is determined only by
its basic earnings power and its business risk
 They argued that the value of the firm depends only
on its income produced by its assets not on how this
income is split between dividends and retained
earnings
DIVIDEND IRRELEVANCE THEORY
 MM noted that any shareholder can in theory
construct his/her own dividend policy.
 If a firm does not pay dividends a shareholder
who wants a 5% dividend can create it by selling
5% of his/her stock or
 If a company pays a higher dividend than an
investor desires , the investor can use the
unwanted dividends to buy additional shares of
the company’s stock.
 Therefore investors could buy and sell shares,
they can create their own dividend policy without
incurring cost, the firm’s policy would therfore be
irrelevant
DIVIDEND IRRELEVANCE THEORY
 Note: investors who want additional dividends must incur brokerage costs to sell
shares and investors who do not want dividends must first pay taxes on unwanted
dividends and incur brokerage costs to purchase shares with after-tax dividends.
Since taxes and brokerage costs certainly exist, dividend policy may well be
relevant
BIRD-IN-HAND THEORY
 Gordon & Lintner argued that cost
of equity (Ks) decreases as the
dividend pay-out is increased
because investors are less certain of
receiving the capital gains that are
supposed to result from retaining
earnings than they are receiving
from dividend payments
BIRD-IN-HAND THEORY
 They argued that investors value a
dollar or shilling of expected
dividends more highly than
dollar/shilling of expected capital
gains because the dividend yield
component ,D1/P0 is less risky than
the g component in the total
expected return equation.
 Ks= D1/Po + g
BIRD-IN-HAND THEORY
 It is based on the logic that what is
available at present is preferable to what
may be available in the future.
 Basing his model on this argument,
Gordon and Linter argue that the future is
uncertain and the more distant the future
is, the more uncertain it is likely to be.
 Therefore, investors would be inclined to
pay a higher price for shares on which
current dividends are paid
TAX PREFERENCE THEORY
 There are two tax related reasons for thinking
that investors might prefer a low dividend pay-out
to high pay-out:
 Long-term capital gains are generally taxed
at lower rate, whereas dividend income is taxed
at effective rates (marginal rates), therefore
wealthy investors (who own most of the stock and
receive most of the dividends) might prefer to
have companies retain and plough back earnings
into the business
 Taxes are not paid on the gain until a stock
is sold. Due to time value effects the amount of
taxes paid in the future has a lower effective cost
than the amount paid today
TAX PREFERENCE THEORY
 Because of these tax advantages,
investors may prefer to have
companies retain most of their
earnings.
 Therefore investors would be willing
to pay more for low pay-out
companies than for otherwise
similar high pay-out companies
INFROMATION
CONTENT/SIGNALING THEORY

 The theory states that investors regard

dividend changes as signals of
management’s earnings forecasts
 It has been observed that an increase in
dividends is often accompanied by an
increase in the price of the stock, while a
reduction in dividends generally leads to a
stock price decline
 It means therefore that investors prefer
dividends to capital gains
INFROMATION
CONTENT/SIGNALING THEORY

 MM argued that companies are reluctant

to reduce dividends and hence do not
raise unless they anticipate higher
earnings in the future.
 Thus MM argued that a higher than
expected dividend increase is a signal to
investors that the firm’s management
forecasts good future earnings
INFROMATION
CONTENT/SIGNALING THEORY
 Conversely, a dividend reduction or a smaller than
expected increase is a signal that the firm’s
management is forecasting poor earnings in the
future.
 According to MM, therefore investors reactions to
changes in dividend policy do not necessary mean
that investors prefer dividend to retained earnings.
 Rather, they argued the price changes following
dividends actions simply indicate that there is an
important information or signaling content in
dividend announcements.
CLIENTELE EFFECT
 This the tendency of a firm to attract a
set of investors who like its dividend
policy
 Different groups or clienteles of stock
holders prefer dividend payout policies
e.g.
 Retires, the poor and the old etc generally
prefer cash income, so they may want the
firm to payout a high percentage of
earnings.
CLIENTELE EFFECT
 On the other hand, investors in their peak
earnings years might prefer re-
investment, because they have less need
for current investment income and would
simply reinvest dividends received after
paying income taxes on these dividends
 Investors who want current investment
income should own shares in high
dividend payout firms and vice versa
DIVIDEND POLICIES
 STABLE DIVIDEND POLICY
 This is where the dividend growth
rate is predictable
 The shareholders can also be
certain that the current dividend will
not be reduced.
 It may not grow at a stable rate but
management will probably be able
to avoid reducing the dividend
DIVIDEND POLICIES
 RESIDUAL DIVIDEND MODEL
 Dividend paid is equal to net income minus the
amount of retained earnings necessary to finance
the firm’s optimal capital budget
1. The determines the optimal budget
2. 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
STOCK SPLIT
 This is an action taken by a firm to
increase the number of shares
outstanding e.g. doubling the
number of shares outstanding by
giving each stock holder two new
shares for each one formally held
STOCK DIVIDENDS
 This dividend paid in the form of additional
shares of stock rather than cash
 Effects:
1. The price of a stock rises shortly after a company
announces a stock split or stock dividend
2. The price increases are as a result of investors
taking split/dividends as signals of higher future
earnings
3. However if during the next few months it does
not announce an increase in earnings and
dividends , then stock price will go back to the
earlier level
FACTORS AFFECTING DIVIDEND
POLICY

 They may be grouped into four

broad categories:
1. Constraints on dividends
2. Investment opportunities
3. Availability and cost of alternative
sources of capital
4. Effects of dividend policy on cost of
capital
1. CONTRANTS
 BOND HOLDERS. Debt contracts often
limit dividend payments to earnings after
loan was granted
 PREFERRED STOCK RESTRICTIONS.
Common dividends cannot be paid if
company has not omitted its preferred
dividend
 IMPAIREMENT OF CAPITAL RULE.
Dividends payments cannot exceed the
balance sheet item retained earnings. It is
designed to protect creditors
2. INVESTMENT OPPORTUNITIES

1. Number of profitable investment

opportunities available
2. Possibility of accelerating or
delaying projects will permit a
firms to adhere more closely to
stable dividend policy
3. ALTERNATIVE SOURCES OF
CAPITAL
1. Cost of selling new stock. If the floatation are
high it is better to have a low payout ratio and
finance through retained earnings
2. Ability to substitute debt for equity. If a firm can
finance a given level of investment with either
debt or equity. Low flotation cost will permit a
more flexible dividend policy because equity can
either be raised by retained earnings or by selling
new stock
3. Control. If the management is concerned about
maintaining control, it may be reluctant to sell
new stock .
4. EFFECTS OF DIVIDEND POLICY
ON COST OF CAPITAL
 It may be considered in terms of four factors
1. Shareholders desire for current versus future
income
2. Perceived riskiness of dividends versus capital
gains
3. The tax advantage of capital gains over
dividends
4. The information content of dividends
 The important of each factor in terms of its effect
on cost of capital varies from firm to firm
depending on the make-up of its current and
possible future stockholders
 END