Chapter 9

Dividend Policy

1
 Chapter Outline

• Dividend Decision
• Dividend Irrelevancy Theory
– Modigliani and Miller (MM) Hypothesis
• Dividend Residual Theory
• Relevance of Dividend
– “Birds in the Hand” Theory
– Clientele Effect
• Dividend Signalling
• Stock Repurchase
• Scrip Dividend or Scrip Issue

2
 Dividend Decision

What is dividend?
• A payment which a company pays to its shareholders. It is not an
expenses but it is a liability declared as dividend payable.
• It is a distribution of assets among the shareholders from the
company’s profits or net earnings.
• It determines what funds flow to investors and what is retained by
the firm for investment. The dividends pays may be treated as a
signal to investors. A company needs to take account of different
clienteles of shareholders in dividend decision.
• If it is distributed out of capital, it is known as liquidating dividend
• Dividend is expressed as:
 Dollar per share (dividend per share)
 Percentage of the market price (dividend yield)
 Percentage of earnings per share (dividend pay out)
3
 The Importance of Dividend Policy
The relationship between dividend decision and financing
decision:
• It is a strategy in regard to the amount they would pay to
their shareholders as dividend.
• Determines what portion of earnings will be paid out to the
shareholders and what will be retained in the business.
• The firm has three options to decide what to do with the
profits:
– Retain all the profits within the firm
– Distribute all the profits in the form of dividends to their
shareholders
– Retain some of the profits in the firm and distribute the remainder
as dividend
• Mostly, firms adopt the third option in formulating their
dividend policy 4
Trade-off between dividend and retained earnings
There seems to be an inverse relationship between retained earnings and
dividends.

dividend Retained External funding

earnings lead to higher
cost

• The decision to pay a large dividend would mean little amount for retained earning for
funding the growth. The firm will therefore place a greater reliance on external funding for
its investments.

Internal funding
dividend Retained but shareholders
earnings unhappy

• The decision to pay a small dividend would lead to higher profit retention and in turn
reduce the need for externally generated funds to finance the firm’s investments. But it
will make the shareholders unhappy especially to those rely on dividend as their current
income.
5
 Types of Dividends
1. Regular cash dividend.
– It’s paid out of a firm’s profits to the ordinary shareholders. It
can be stated as dividends per share or dividend yield.
– Reduces cash and retained earnings of the firm
2. Stock dividends or Scrip Issue.
– New issues of shares to existing shareholders as dividend for
free. Popularly known as bonus issue shares or scrip
dividend. Increases the number of shares outstanding and
reduces the value of each share
3. Stock Split
– Increase the number of shares outstanding.
– Stock split occurs for example when each OS of RM1.00 each
is split into two shares of RM0.50 each, thus creating cheaper
shares with greater marketability. (Investors may expect a company
which splits its shares is planning for substantial earnings growth and dividend growth in
the future.)
– Stock price will drop after stock split 6
 The Dividend Payment Process
• Dates describing the general chronology of a dividend payment:
– Declaration date – the day the board of directors announces its
intention to pay a dividend at AGM. The board will also
announce a date of record and a payment date.
– In-dividend date (Cum-dividend date) – the last day before the
ex-dividend date. On this day, the buyers will receive the
dividend whereas the seller will lose their right to the dividend
– Ex-dividend date – the day on which all shares bought and sold
no longer come attached with the right to be paid the most
recently declared dividend.
– Date of record – the dividend is payable to shareholders whose
names appear in the register of members as on the record date.
– Payment date – day when the company actually mails out the
cheques to the shareholders listed on the register of members
on the record date

Chapter 12 7
 Procedure for Cash Dividend Payment

15 Jan.
27 Jan. 28 Jan. 30 Jan 16 Feb.

Declaration Cum- Ex- Payment

Record Date
Date dividend dividend Date
Date Date

Declaration Date: The Board of Directors declares a payment of dividends

Cum Dividend Date: One trading day before the ex-dividend date is
entitled dividend for both existing shareholders and buyers.
Ex-Dividend Date: Trade on or after ex dividend date is not entitled
dividend for buyers. Sellers or existing shareholders will receive.
Record Date: The corporation prepares a list of all shareholders as per register
of members
Payment date: the cheques are mailed to the shareholders.
Chapter 9 - Dividend Policy 8
 Theories of Dividend Policy
• Dividend Irrelevancy Theory
– Modigliani and Miller (MM) Hypothesis
• Dividend Residual Theory
• Relevance of Dividend
– “Birds in the Hand” Theory
– Clientele Effect

9
 Dividend Irrelevancy Theory

1. To show that the dividend policy does not matter.

2. Since investors do not need dividends, they will not
pay higher prices for firms with higher dividend
payouts.
3. In other words, dividend policy will have no impact
on the value of the firm because investors can
create whatever income stream they prefer by
using homemade dividends.

Chapter 9 - Dividend Policy 10

 Dividend Irrelevancy Theory
• Modigliani and Miller (MM 1961) hypothesized “ dividend policy
has no effect to the share price of the firm”
• It is because the firm may increase earnings through financing good
investment project and therefore increase value of the firm.
• The hypothesis is supported by the following assumptions:
– A perfect capital market exists in which all investors are rational
– All investors have homogeneous expectations on future profit and dividend and
complete information available to all investors
– The investment decisions are unaffected by dividend policy
– No taxes on dividends or capital gains.
– No transaction costs associated with converting share price appreciation into
cash when selling shares
– When high dividend paid leaving less retained earnings, firms can issue shares
without flotation cost to finance the project.
– When low dividend paid, high retained earnings is used to finance all positive
NPV project – managers acting bona fide and for good faith.

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 Dividend Irrelevancy Theory
• The dividend irrelevancy theory put forward by Modigliani &Miller (M&M)
argues that in a perfect capital market (no taxation, no transaction costs, no
market imperfections), existing shareholders will only be concerned about
increasing their wealth, but will be indifferent as to whether that increase
comes in the form of a dividend or through capital growth.

• As a result, a company can pay any level of dividend, with any funds
shortfall being met through a new equity issue, provided it is investing in all
available positive NPV projects.

• If they need cash, then any investor requiring a dividend could

"manufacture" their own by selling part of their shareholding.

• Equally, any shareholder wanting retentions when a dividend is paid can

buy more shares with the dividend received.

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 Dividend Irrelevancy Theory
• MM argument that after dividend paid, the market share price (MP)
of the firm will correspondingly drop equal to the value of dividend
paid because cash is used to pay dividend thus reducing asset
available.
• The share price of the firm before dividend must equal to share
price after dividend plus value of dividends (DPS). Therefore no
effect on share price
27 Jan. 28 Jan.

Cum-dividend Date Ex-dividend Date

MP: RM5.00 MP: RM4.80 + 0.20 = RM5.00

DPS : RM0.20

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 Price Behavior around the Ex-Dividend Date
• In a perfect world, the stock price will fall by the amount of
the dividend on the ex-dividend date.

-t …
-2 -1 0 +1 +2 …

RMP

RMP - div
The price drops by the Ex-dividend
amount of the cash Date
dividend RM0.20
Taxes complicate things a bit. Empirically, the price drop is
less than the dividend and occurs within the first few minutes
of the ex-date.
Chapter 9 - Dividend Policy 14
 Dividend Policy Irrelevance Theory
• Share price before or close to ex-date (cum dividend
date) usually increase because of the market forces
drive by the dividend gain and capital gain investors.
• When close to ex-date, dividend gain investor normally
will buy to enjoy dividend but capital gain investor will
sell to utilize the higher price of shares to benefit the
higher profit on disposal of shares
• However, after ex-date, normally the share price will
drop by the amount equal to the value of dividend paid

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 Dividend Policy Irrelevance Theory -
investors’ perspective
• From an investor's perspective, if a company's dividend is too small,
an investor could sell some shares to create capital gain to replicate
the cash flow he or she expected.
• As such, the dividend is irrelevant to investors, meaning investors
care little about a company's dividend policy since they can simulate
their own personalized income or homemade dividend
• The manner in which earnings are divided into dividends and RE
does not affect the value of the firm
• Investors are concerned only with total returns from investment
decisions because they are indifferent whether these returns from
dividend gain or capital gains.

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 Dividend Policy Irrelevance Theory –
homemade dividends
Example: Mr. A holds 1,000 unit shares. A firm declare RM0.20 DPS. If Mr. A
would like to have RM2,000 income , he can sell part of the shares to top-up
the dividend income . MP of shares on ex-date is RM4.80.

Desired income RM2,000

(-) Dividend income
(RM0.20 x 1,000 unit) 200
Income top-up from selling shares 1,800

Unit of shares sold = RM1,800 / RM4.80 = 375. Next year Mr. A has 625 unit of
shares to entitle for a dividend income. Mr. A is creating RM1,800 as
homemade as his own income stream.

In other words, dividend policy will have no impact on the value of the firm
because investors can create whatever income stream they prefer by
using homemade dividends.
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 Conclusion

1. The change in dividend policy did not affect the value

of the stock
2. The value of the shareholders remain unchanged.
3. This proves that investors are indifferent to dividend
policy. (MM Theory)
4. All individuals have the same beliefs concerning future
investments, profits and dividends
5. The investment policy of the firm is set ahead of time,
and is not altered by changes in dividend policy. The
company is assumed to adopt the “Residual
Dividend” policy.

Chapter 9 - Dividend Policy 18

 Dividend Residual Theory
1. Dividends are paid only if profits are not completely used for
investment purposes.
2. It implies that the dividends should be the remaining amount of
after tax profits (the “residual” amount), after put aside money
to invest in all viable investments opportunities.
3. Therefore, the dividend policy should be:
i. Maintain the optimum debt ratio in financing future
investments.
ii. Accept an investment if NPV is positive
iii. Finance the equity portion of new investments first by
internally generated funds. If internally generated funds still
remain, pay dividends.

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 Dividend Policy Relevance Theory
Gordon (1962) and Lintner (1964)
• Taxation and transaction costs do impact on the dividend
policy of the firm that cause homemade dividend costly.
• Gordon (1962) and Lintner 1964) argued that investors
value current dividends more than future dividend or capital
gains when making decisions related to stocks.
• Investors prefer current dividend because less risky due to:
– Dividends are more predictable than capital gains
– Dividends are more certain than capital gains
• Less risky lead to lower discount rate will lead to higher
firm’s value
• Dividend Gordon growth model the firm’s value and growth
potential : High dividend will attract investors to buy so lead to high
firm’s value when investors perceived earnings is good.
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 Dividend Policy Relevance Theory
Gordon (1962) and Lintner (1964)
• The bird-in-the-hand may sound familiar as it is taken from an old
Malay proverb:
• "a bird in the hand is worth two in the bush.“
• In this theory "the bird in the hand' is referring to current
dividends and "the bush" is referring to future dividend and
capital gains.
• Investors appreciate “what is currently available (current dividend)
is preferable to what may or may not be available in the future
(future dividend and capital gains)”
– Current dividend resolves uncertainty and remove any chance of
risk in the future

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Dividend Relevance Policy and Investors
The Clientele Effect
• The clientele effect is the idea that the type of investors
attracted to a particular kind of securities will affect the
price of the security when policies change.
• High dividend payout may attract investors that:
– Need a regular cash income as source of fund to meet the their
living expenses
– Low income tax bracket
– Risk averse investor (low risk taker) such as the institutional
investor who prefer regular and stable dividend
– Those rely on fixed income like the retired pensioner, widow,
orphan
• Lead to increase in demand for the firm’s share and
positive effect on the firm’s value
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Dividend Relevance Policy and Investors
The Clientele Effect
• Some clientele would prefer a company that doesn't pay
dividends at all, but instead invests their retained
earnings to finance project with positive NPV.
• Investors believe the good growth potential and positive
NPV project will increase earnings and rise in share
price and apparently will create healthy capital gains.

• Low dividend payout may attract investors that:

– High income tax bracket
– Wealthy and sufficient earnings from their paid employment

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Dividend Relevance Policy and Investors
The Clientele Effect
• The existence of clientele effect implies that certain investors
buying shares because of the dividend policy employed.
Firms need to adopt a stable and consistent dividend policy.
• Those who prefer dividend gain over capital gain, there are
a subsets of clientele might prefer a stock that pays a high
dividend, while another subset might look for a balance
between dividend payout and reinvestment in the
company; low dividend.
• Any change in the dividend policy would influence the
clientele group that might force them to sell the shares that
eventually will result in a drop in the share price

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 Dividend Signalling
Information Content of Dividend
• When a management has the information about the firm’s
future prospect that the investors don’t have, that is called as
market imperfection; information asymmetry
• How do investors analyze firm’s profitability?
– Dividend payout policy is one of the indicator; changes in
dividend policy as source of information about the firm’s
profitability that can affect share price.
– Informational effect: Price of a firm’s stock will generally
rise when its current dividend is increased and fall when its
current dividend has been reduced or omitted.
– Signaling effect: High dividend signaling an optimistic view
(has many positive NPV project) while declining dividend
implies pessimistic view (no project, poor earnings)

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 Dividend Signalling
Information Content of Dividend
• A dividend increase is management’s signal to the market that
the firm is expected to do well. The rise in stock price following
dividend signal is called “Information content effect of the dividend”.
This theory of information content is also known as the
signaling hypothesis.
• Conversely, the market infers a decrease in cash flows from a
dividend reduction leading to fall in stock price. This raises an
interesting corporate strategies; Could management increase
dividends just to make the market think that cash flow will be higher
even the management knows that the cash flows will not rise?
• The equation below must hold if a firm is neither issuing nor
repurchasing stock. If it’s not paid out in dividends, it must be used
in some expenditures either involves a capital expenditure or stock
repurchases. Dividends and stock repurchases are perfect substitutes.

Cash Flow= Capital Expenditure + Dividends

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 Stock Repurchase
• Instead of declaring cash dividends, firms can rid
themselves of excess cash through buying shares of
their own stock.
• Recently, share repurchase has become an important
way of distributing earnings to shareholders due to:
– Flexibility for shareholders
– Keeps stock price higher
• Good for insiders who hold stock options
– As an investment of the firm (undervaluation)
– Tax benefits

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Stock Repurchase versus Dividend – I
Consider a firm that wishes to distribute $100,000 to its
shareholders.

Assets Liabilities & Equity

A.Original balance sheet
Cash $150,000 Debt 0
Other Assets 850,000 Equity 1,000,000
Value of Firm 1,000,000 Value of Firm 1,000,000
Shares outstanding = 100,000
Price per share= $1,000,000 /100,000 = $10

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No reproduction or distribution without the prior written consent of McGraw-Hill Education.
19-28
Stock Repurchase versus Dividend – II
If they distribute the $100,000 as a cash dividend, the balance
sheet will look like this:

Assets Liabilities & Equity

B. After $1per share cash dividend
Cash $50,000 Debt 0
Other Assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding = 100,000
Price per share = $900,000/100,000 = $9

Copyright © 2019 McGraw-Hill Education. All rights reserved.

No reproduction or distribution without the prior written consent of McGraw-Hill Education.
19-29
Stock Repurchase versus Dividend – III
If they distribute the $100,000 through a stock repurchase, the
balance sheet will look like this:

Assets Liabilities & Equity

C. After stock repurchase
Cash $50,000 Debt 0
Other Assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding= 90,000
Price pershare = $900,000 / 90,000 = $10

Copyright © 2019 McGraw-Hill Education. All rights reserved.

No reproduction or distribution without the prior written consent of McGraw-Hill Education.
19-30
 Stock Repurchase
BENEFITS
• Use for surplus cash which may
be a “dead asset”
• Increase in EPS through a
reduction in the number of shares
in issue
• Increase in gearing. Stock
repurchase may allows debt to be
substituted for equity, so raising
gearing
• Re-adjustment of the company’s
equity base to more appropriate
level, for a company whose
business is in decline
• Possibly preventing a takeover or
enabling a quoted company to
withdraw from the stock market
DRAWBACKS
• It can be hard to arrive at the price
that will be fair to any shareholders
who are not selling shares to the
company
• A stock repurchase can be seen as
an admission that the company
cannot make better use of the
funds to the shareholders
• Some shareholders may be
suffered from being taxed on a
capital gain following the purchase
of their shares rather than
receiving dividend income
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 Scrip Dividend or Scrip Issue
• Also known as a Stock dividends or Bonus Issue
• When the management would prefer to retain cash flow but
consider that they must pay certain amount of dividend, they might
offer equity shareholders the choice of a cash dividend or a scrip
dividend or a stock dividend.
• A scrip dividend is a dividend paid by new issues of additional
company shares to existing shareholders rather than by cash as
dividend for free.
• Increases the number of shares outstanding and reduces the value
of each share.

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 Scrip Dividend or Scrip Issue
BENEFITS DRAWBACKS
• It can preserve a company’s cash • Assuming that dividend per share
position if a substantial number of is maintained or increased, the
shareholders take up the share total cash paid as a dividend will
option increase.
• Investors may be able to obtain • Scrip dividend may be seen as
tax advantage if dividends are in negative signal by the market. The
the form of shares company is experiencing the cash
• Investors looking to expand their flow issues.
holding can do so without
incurring the transaction costs of
buying more shares
• A small scrip dividend issue will
not dilute the share price
significantly.
• A share issue will decrease the
company’s gearing, therefore
enhance its borrowing capacity. 33
Sources was adapted from:
• Ross, Westerfield, Jaffe, Rodziah, Shelia, (2016) Corporate Finance (2nd.
Ed), McGraw Hill.
• Rodziah Abd Samad, Shelia Christabel, Mohd. Nizal Haniff, (2013) Financial
Management for Beginners, (4th Edition) McGraw-Hill.
• ACCA F9 Financial Management Study Text 2016

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