Dividend

Dividend Policy
Policy
 Dividend
 The term ‘dividend’ refer to that part of
divisible profits among its shareholders.
 In other words, dividend is that portion of
company’s profit which is distributed
among its shareholders as a percentage
of par value of share or at a fixed rate per
share according to the decision of its
board of directors
 Interest VS Dividend
Interest is a payment to lenders
for a given period of time
Timely payment of the required
amount of interest is a legal
obligation
Failure to pay interest 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
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, and residual claim on
assets on dissolution and on
profits after all other claims have
been fully satisfied)
 Dividends Process
 Declaration Date – Board declares the dividend and
it becomes a liability of the firm
 Ex-dividend Date
 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 are determined
and they will receive the dividend payment
 Date of Payment – checks are mailed / electronic
payment made
Dividends Process

3 4
Types of dividend
 Dividends are a permanent distribution of residual
earnings/property of the corporation to its owners.
 Dividends can be in the form of:
 Cash
 Scrip Dividend/Bonus/ (stock dividend)
 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.
 Types of Dividends
Regular Dividend
 The dividend that is normally expected to
be paid by the firm.
Extra dividend
 A nonrecurring dividend paid to
shareholders in addition to the regular
dividend. It is brought about by special
circumstances.
 Cash Dividend

 Payment of cash by the firm to its

shareholders. These are the most
common and are usually paid four
times a year.
 Stock Dividends
and Stock Splits
Stock Dividend -- A payment of additional
shares of stock to shareholders. Often used
in place of or in addition to a cash dividend.
Small-percentage stock dividends
 Assume a company with 400,000 shares of $5 par
common stock outstanding pays a 5% stock dividend.
The pre-dividend market value is $40.

How does this impact the shareholders’ equity accounts?

 Small-Percentage
Stock Dividends
Before 5% Stock Dividend
Common stock
($5 par; 400,000 shares)
shares $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000
After 5% Stock Dividend
Common stock
($5 par; 420,000 shares)
shares $ 2,100,000
Additional paid-in capital 1,700,000
Retained earnings 6,200,000
Total shareholders’ equity $10,000,000
 Stock Dividends,
EPS, and Total Earnings
After a small-percentage stock dividend, what
happens to EPS and total earnings of
individual investors?
 Assume that investor SP owns 10,000 shares and the
firm earned $2.50 per share.
 Total earnings = $2.50 x 10,000 = $25,000.
 After the 5% dividend, investor SP owns 10,500 shares
and the same proportionate earnings of $25,000.
 EPS is then reduced to $2.38 per share because of the
stock dividend ($25,000 / 10,500 shares = $2.38 EPS).
EPS
Stock Dividends and Stock Splits
Large-percentage stock dividends

 The material effect on the market price per share

causes the transaction to be accounted for differently.
Reclassification is limited to the par value of additional
shares rather than pre-stock-dividend value of
additional shares.
 Assume a company with 400,000 shares of $5 par
common stock outstanding pays a 100% stock
dividend. The pre-stock-dividend market value per
share is $40. How does this impact the shareholders’
equity accounts?
 B/S Changes for the Large-
Percentage Stock Dividend

 $2 million ($5 x 400,000 new

shares) transferred (on paper)
“out of” retained earnings.
 $2 million transferred “into”
common stock account.
 Large-Percentage
Stock Dividends
Before 100% Stock Dividend
Common stock
($5 par; 400,000 shares)
shares $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000
After 100% Stock Dividend
Common stock
($5 par; 800,000 shares)
shares $ 4,000,000
Additional paid-in capital 1,000,000
Retained earnings 5,000,000
Total shareholders’ equity $10,000,000
 Stock Dividends
and Stock Splits
Stock Split -- An increase in the number of
shares outstanding by reducing the par value
of the stock.
 Similar economic consequences as a 100% stock
dividend.
 Primarily used to move the stock into a more
popular trading range and increase share demand.
 Assume a company with 400,000 shares of $5 par
common stock splits 2-for-1. How does this impact
the shareholders’ equity accounts?
 Stock Splits
Before 2-for-1 Stock Split
Common stock
($5 par; 400,000 shares)
shares $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000
After 2-for-1 Stock Split
Common stock
($2.50 par; 800,000 shares)
shares $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000
 Value to Investors of Stock
Dividends or Stock Splits

 Effect on investor total wealth

 Effect on investor psyche
 Effect on cash dividends
 More popular trading range
 Informational content
 Stock Dividends
and Stock Splits
Reverse Stock Split -- A stock split in which the
number of shares outstanding is decreased.
 Used to move the stock into a more popular trading
range and increase share demand.
 Usually signals negative information to the market
upon its announcement (consistent with empirical
evidence).
 Assume a company with 400,000 shares of $5 par
common stock splits 1-for-4. How does this impact
the shareholders’ equity accounts?
 Reverse Stock Splits
Before 1-for-4 Stock Split
Common stock
($5 par; 400,000 shares)
shares $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000
After 1-for-4 Stock Split
Common stock
($20 par; 100,000 shares)
shares $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000
 Stock Repurchase
Stock Repurchase -- The repurchase (buyback)
of stock by the issuing firm, either in the open
(secondary) market or by self-tender offer.
Reasons for stock repurchase:
 Available for management stock-option plans
 “Go private” by repurchasing all shares from
outside stockholders
 To permanently retire the shares
 Methods of Repurchase
 Buy shares in the open market through
a broker.
 Buy a large block by negotiating the
purchase with a large block holder,
usually an institution.  (targeted stock
repurchase)
 Tender offer:  offer to pay a specific
price to all current stockholders.
 Repurchasing as
Part of Dividend Policy
Assume:
 Earnings after taxes $ 800,000
 Number of common
shares outstanding  400,000
 Earnings per share $ 2
 Current market price
per share $ 31
 Expected dividend per share $ 1
 Expected total dividends
to be paid out $ 400,000
 Repurchasing as
Part of Dividend Policy
If dividend is paid, shareholders receive:
 Expected dividend per share $ 1
 Market price per share $ 30
 Total value $ 31
If shares repurchased, shareholders receive :
 Dividend per share $ 0
 Market price per share* $ 31
 Total value $ 31
* Shares repurchased = $400,000 / $31 = 12,903
Original P/E ratio = $30/$2
$30 = 15
“New” EPS = $800,000 / 387,097 = $2.07
“New” market price = $2.07 x 15 = $31
Observed Dividend Policy
 Observed dividend policies show distinct national patterns
 Dividend Policies have pronounced industry patterns and these
are the same
 Within industries dividend payout tends to be directly related to
size and asset intensity, but is inversely related to growth rate
 Almost all firms maintain constant nominal dividend Payments
per share for long period of time
 The stock market reacts positively to dividend initiations and
increases, and has a strong negative reaction to dividend
decrease or eliminations
Observed Dividend Policy conti….
 Dividend changes clearly convey information about
management’s expectations regarding the firm’s current and
future earnings
 Taxes clearly influence dividend payouts, but the net effect is
ambiguous and taxes neither cause nor prevent companies from
initiation dividend payments
 In spite of intensive research, it is unclear exactly how dividend
payments affect the required return on firms' common stock
 Changes in transactions costs or in the technical efficiency
markets seem to have very little impact on dividend payouts
 Ownership structure matters
Three schools of thought on dividends
 If
 Dividends do not matter, and dividend policy does not
affect value.
 If
 Dividends are bad, and increasing dividends will reduce
value
 If
 Dividends are good, and increasing dividends will
increase value
 Dividends are irrelevant…
 The Miller-Modigliani Hypothesis: Dividends do not affect value
 Basis:
 If a firm's investment policy does not change, the value of the firm
cannot change with dividend policy. If we ignore personal taxes,
investors have to be indifferent to receiving either dividends or
capital gains.
 Underlying Assumptions:
 (a) There are no tax differences between dividends and capital gains.
 (b) If companies pay too much in cash, they can issue new stock,
with no flotation costs or signaling consequences, to replace this
cash.
 (c) If companies pay too little in dividends, they do not use the
excess cash for bad projects or acquisitions.
 Dividend Irrelevance Theory
 Miller and Modigliani showed algebraically that dividend
policy didn’t matter:
 Fixed Investment Policy.
 They showed that as long as the firm was realizing the
returns expected by the market, it didn’t matter
whether that return came back to the shareholder as
dividends now, or reinvested.
 They would see it in dividend or price appreciation.
 The shareholder can create their own dividend by
selling the stock when cash is needed.
 Dividends are bad…
 Individuals in upper income tax brackets might prefer
lower dividend payouts, 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, thereby lowering flotation
costs

 Dividend restrictions – debt contracts might limit the

percentage of income that can be paid out as dividends
Dividends are good not for these reasons
 The bird in the hand fallacy: Dividends
are better than capital gains because
dividends are certain and capital gains
are not.

 The Excess Cash Argument: The excess

cash that a firm has in any period should
be paid out as dividends in that period.
Dividends are good possibly for these reasons
 The Clientele Effect: There are stockholders who like
dividends, either because they value the regular cash
payments or do not face a tax disadvantage. If these are
the stockholders in your firm, paying more in dividends
will increase value.
 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,
there might be a transfer of wealth from the bondholders
to the stockholders.
 Tax Preference Theory
 There are three ways in which taxes affect
the dividend preferences of shareholders.
 For individual investors tax rates differ
for capital gains and dividends.
 Taxes on capital gains are not due until
the stock is sold.
 If the stock is held until the shareholder
expires, no tax is due at all.
Dividends Theories

 Theory of Irrelevance
 Bird In Hand theory
 Tax preference theory
Information Content Hypothesis
 Signaling:
 The theories thus far have assumed that
investors and managers have the same
information set.
 When it comes to prospect for the company,
managers may have better information than
investors.
 Therefore unexpected changes in dividends may
transmit information to the market that it didn’t
know before.
Information Content Hypothesis
 Signaling - continued
 Managers don’t cut dividends unless the
firm is in financial distress.
 It is therefore believed that firms do not
increase dividends beyond analyst's
expectations unless managers anticipate
stronger earnings than expectations.
 Unexpected changes in dividends pass on
information to the market.
Dividends Policies
 Stable dividend Policy
 Constant
 Constant Growth
 Fixed Payment
 Passive residual policy
 Dividend Stability
Stability -- maintaining the position of the firm’s
dividend payments in relation to a trend line.
4 50% of earnings Earnings per share
Dollars Per Share

paid out as dividends

3

2
Dividends
1 per share

Time
 Dividend Stability
Dividends begin at 50% of earnings, but are stable and
increase only when supported by growth in earnings.

4 50% dividend-payout Earnings per share

Dollars Per Share

rate with stability

3

1 Dividends per share

Time
 Dividend Policy in Practice
 Residual Dividend Policy: Investors prefer
to have the firm retain and reinvest
earnings if they can earn a higher risk
adjusted return than the investor can.
 Residual Dividend Policy suggests that
dividends should be that part of
earnings which cannot be invested at a
rate at least equal to the WACC.
 Dividend Policy Classes
 Residual Dividend Policy Steps:
1 Determine the optimal capital budget.
2 Determine the retained earnings that can be
used to finance the capital budget.
3 Use retained earnings to supply as much of
the equity investment in the capital budget as
necessary.
4 Pay dividends only if there are left-over
earnings.
 Dividend Policy Classes
 Stable, Predictable Dividend Policy: Due
to the possibility of a negative signal to
investors, many CFOs have set the
policy of never reducing their dividends.
 Dividends are only increased if
management is certain future
earnings will support such a high
dividend.
Any Question??????