Financial

Management Chapter 18
Theory and
Practice
Tenth Edition
Dividend Policy
Eugene F. Brigham
Michael C. Ehrhardt
Instructor: Saad Rafi
Institute of Business Management
 What is “dividend policy”?
• It’s the decision to pay out earnings versus
retaining and reinvesting them.
• Do shareholder’s prefer current or deferred
income?
 Is Dividend Policy Important?

Three viewpoints:
1) Dividends are Irrelevant. If we
assume perfect markets (no taxes,
no transaction costs, etc.) dividends
do not matter. If we pay a dividend,
shareholders’ dividend yield rises,
but capital gains decrease.
 P1 - Po D1
Return = +
Po Po

• With perfect markets, investors are

concerned only with total returns,
and do not care whether returns
come in the form of capital gains or
dividend yields.
• Therefore, one dividend policy is as
good as another.
 2) High Dividends are Best
• Some investors may prefer a certain
dividend now over a risky expected
capital gain in the future.
 2) High Dividends are Best
• Some investors may prefer a certain
dividend now over a risky expected
capital gain in the future.

P1 - Po D1
Return = +
Po Po
 3) Low Dividends are Best
• Dividends are taxed immediately.
Capital gains are not taxed until the
stock is sold.
• Therefore, taxes on capital gains can be
deferred indefinitely.
 Residual dividend model
• Find the retained earnings needed for the capital
budget.
• Pay out any leftover earnings (the residual) as
dividends.
• This policy minimizes flotation and equity signaling
costs, hence minimizes the WACC.

Dividends= Net Income - (Target Equity Ratio*Total

Capital Budget)
Residual dividend model - Example
• Capital budget: $800,000.
• Target capital structure that the company wants to
maintain: 40% debt, 60% equity.
• Forecasted net income: $600,000.
• How much of the $600,000 should we pay out as
dividends?
– Dividend = NI – (Target Capital Ratio * Capital Budget)
– Dividend = 600,000 – (0.60*800,000) =
– Dividend = 600,000-480,000 = 120,000.
– Divided at NI 450,000 and 750,000
Residual dividend model - Example
• Of the $800,000 capital budget,
• Equity = 0.6($800,000) = $480,000
• Debt = 0.4($800,000) = $320,000
• With $600,000 of net income, the residual is
$600,000 - $480,000 = $120,000 = dividends
paid.
• Payout ratio = $120,000/$600,000
= 0.20 = 20%.
Residual dividend model - Example
How would a drop in NI to $400,000 affect the
dividend? A rise to $800,000?
• NI = $400,000
– Need $480,000 of equity, so should retain the whole
$400,000.
– Dividends = 0. Issue new shares
– Payout = 0
• NI = $800,000:
– Need $480,000 of equity
– Dividends = $800,000 - $480,000 = $320,000.
– Payout = $320,000/$800,000 = 40%.
 Do Dividends Matter?
Other Considerations:
1) Residual Dividend Theory:
• The firm pays a dividend only if it has
retained earnings left after financing all
profitable investment opportunities.
• This would maximize capital gains for
stockholders and minimize flotation
costs of issuing new common stock.
 Do Dividends Matter?
2) Clientele Effects:
• Different investor clienteles prefer different
dividend payout levels.
• Some firms, such as utilities, pay out over
70% of their earnings as dividends. These
attract a clientele that prefers high
dividends.
• Growth-oriented firms which pay low (or no)
dividends attract a clientele that prefers
price appreciation to dividends.
 Do Dividends Matter?
3) Information Effects:
• Unexpected dividend increases usually
cause stock prices to rise, and
unexpected dividend decreases cause
stock prices to fall.
• Dividend changes convey information
to the market concerning the firm’s
future prospects.
 Do Dividends Matter?
4) Agency Costs:
• Paying dividends may reduce agency costs
between managers and shareholders.
• Paying dividends reduces retained
earnings and forces the firm to raise
external equity financing.
• Raising external equity subjects the firm to
scrutiny of regulators (SEC) and investors
and therefore helps monitor the
performance of managers.
 Do Dividends Matter?
5) Expectations Theory:
• Investors form expectations concerning the
amount of a firm’s upcoming dividend.
• Expectations are based on past dividends,
expected earnings, investment and financing
decisions, the economy, etc.
• The stock price will likely react if the actual
dividend is different from the expected
dividend.
– Actual dividend is higher than expected dividend
then stock price will go up and vice versa.
 Dividend Payment Procedures

Mar 8 Mar 20 Mar 22 Apr 18

Declaration Ex-dividend date Record Date Payment Date

date

Share price falls

 Important Dates
• Declaration date
– The date on which the board of directors passes a resolution to
pay a dividend.
• Ex-dividend date
– The date two business days before the date of record,
establishing those individuals entitled to a dividend.
• Date of record
– The date by which a holder must be on record in order to be
designated to receive a dividend.
• Payment date
– The date the dividend checks are mailed.
 Dividend Payments
1.Stock Dividends – No of Shares will Increase
but the value of the investment remain same.
For Example: 20% stock dividend announced –
with every 10 share you will get 2 extra shares.
2.Stock Splits – 1 Share = 2 shares 1:2
Reverse Stock Split : 2 for 1 = 2 Shares = 1 Shares
3.Stock Repurchase
 Stock Dividend - Example
• LUX Products has 2 million shares currently
outstanding at a price of $15 per share. The company
declares a 50% stock dividend. How many shares will
be outstanding after the dividend is paid?
– 2 * .50 = 1 million
– 2 million + 1 million = 3 million shares
– Value before Stock Dividend: 2 Million * $ 15/share = $30
Million
– Price after Stock Dividend = Value of Stock / New No. of
Shares = 30 / 3 = $ 10/Share
– Value after Stock Dividend: 3 Million*$10/share = $30
Million
 Stock Dividend - Example Cont.
• After the stock dividend what is the new price
per share and what is the new value of the
firm?
– Price/share = $30 mil/3
= $10 per share
– Value of the firm = 3 million * $10
= $30 million
– The value of the firm before was 2 mil x $15 per
share, or $30 mil.
 Stock Splits - Example
• Amoeba Products has 2 million shares currently
outstanding at a price of $15 per share. The
company declares a 3 for 1 stock split. What is
the new amount of shares you will own?

– Number of shares = 2 million x 3

= 6 million shares
Value of Firm before Split = 2*15=30 million
New Share Price = 30/6 = $5/share
Value of Firm after Split = 6*5= 30 million
 Stock Splits – Example Cont.
• After the stock split what is the new price per
share and what is the new value of the firm?
– Price per share = $15 / 3
= $5 per sh.
– Value of the firm = 6 million * $5
= $30 million
– The value of the firm before was 2 mil x $15 per
share, or $30 mil.
 Stock Repurchases
Reasons for repurchases:
• As an alternative to distributing cash as
dividends.
• To dispose of one-time cash from an asset
sale.
• To make a large capital structure change.
 Stock Repurchases - Example
• ABC Company has after-tax earnings of S5 million
and 2,500,000 shares of common stock outstanding.
Also suppose the stock trades at a P/E ratio of 10.
Then EPS and market price as follows:
– EPS = EAT/Number of shares
= $5,000,000/2,500,000
= $2.0
– Market Price = EPS * P/E
= $2.0 * 10
= $20.0
 Stock Repurchases - Example
• Now suppose ABC has $1 million that it can distribute
in dividends. If it does so, the dividend per share will be
– Dividends = $1,000,000/2,500,000
= $0.4 per share

• However, suppose the company uses the $1 million to

buy its own shares instead of paying a dividend. Then it
can purchase and retire:
$1,000,000/20 = 50,000 shares
 Stock Repurchases - Example
• After the repurchase , there will be 2,450,000 shares
left outstanding
– 2,500,000 – 50,000 = 2,450,000
• If earnings don’t change EPS will then be
– EPS = $5,000,000/2,450,000
= $2.04 per share
• Finally, if the P/E remains the same, the market price
of the remaining shares will be
– Market price = EPS * P/E
= 2.04 x 10 = $ 20.40
Stock Repurchases – Example No 2
• Lucky Company has after-tax earnings of PKR 10 million and
3,500,000 shares of common stock outstanding. Also suppose
the stock trades at a P/E ratio of 15. Calculate EPS and market
price before and after Stock Repurchase? Company has PRK
1,500,000 is available for stock repurchase.
– EPS = EAT/Number of shares
= $10,000,000/3,500,000
= $2.86
– Market Price = EPS * P/E
= $2.86 * 15
= $42.86
 Stock Repurchases - Example
• Now suppose LUCKY has PKR1.5 million that it can distribute
in dividends. If it does so, the dividend per share will be
– Dividends = PKR 1,500,000/3,500,000
= PKR 0.42 per share

• However, suppose the company uses the PKR1.5 million to

buy its own shares instead of paying a dividend. Then it can
purchase and retire:
$1,500,000/42.86 =35,000 shares
 Stock Repurchases - Example
• After the repurchase , there will be 3,465,000 shares
left outstanding
– 3,500,000 – 35,000 = 3,465,000
• If earnings don’t change EPS will then be
– EPS = PKR 10,000,000/3,465,000
= PKR 2.89 per share
• Finally, if the P/E remains the same, the market price
of the remaining shares will be
– Market price = EPS * P/E
= 2.89 x 15 = PKR 43.29
 Practice Problems
1) ABC Corporation has 1.3 million common shares outstanding and total earnings
of $2.4 million. The firm paid dividends totaling $550,000. The firm has no
preferred stock.
– What were the dividends per share paid by ABC? Ans: DPS= 0.42
– What was ABC’s dividend payout ratio? Ans: 22.92%
2) Price stock sells for $275 per share and you own 300 shares.
– What is the current market value of your investment?
• Value of Firm= 275*300=82,500
– What is the new price per share, new amount of shares you will own, and the
new market value of your investment if the firm declares a 3 for 1 stock split?
If the firm declares a 15% stock dividend?
– Case 1 = 3 for 1 stock split
• New Number of Shares = 300*3=900
• New Stock price = Value of Firm / New No of Shares = 82,500/900 = 91.66
– Case 2: 15% Stock Dividend
• New Number of Shares= 300*15% = 45+300= 345
• New Stock price = Value of Firm / New No of Shares = 82,500/345 = 239
 Practice Problems

3) Semi-Nowl Corporation has 1.1 million shares of

8% cumulative preferred stock outstanding with a
stated value of $100 per share. If dividends are not
paid for four years, what will be the amount of
arrearage?
4) Suppose you own 500 shares of FSU Inc. 12%
convertible preferred stock. If each preferred share
is convertible into 25 common shares, what is the
conversion value of your 5,000 preferred shares if
the common stock is trading at $30 per share?
 Practice Problems

5) KLM Company issued $3 million of 9.75% $80 par

preferred shares in 2001. Calculate the total
amount of dividends paid on this issue per year and
the annual amount of the dividends per share.