Corporate Finance (MAIB FIN 101) Aug 2022

Financial Leverage and

Capital Structure Policy

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Dividend Policy
Cash Dividends and Dividend Payment

The term dividend usually refers to cash paid out of earnings

If a payment is made from sources other than current or accumulated retained

earnings, the term distribution, rather than dividend, is used

It is acceptable to refer to a distribution from earnings as a divi- dend and a

distribution from capital as a liquidating dividend

The basic types of cash dividends are these:

1. Regular cash dividends.
2. Extra dividends.
3. Special dividends.
4. Liquidating dividends. Corporate Finance (MAIB FIN 101) Aug 2022 3
Dividend Policy
CASH DIVIDENDS
The most common type of dividend is a cash dividend. Commonly, public companies
pay regular cash dividends four times per year.

Sometimes firms will pay a regular cash dividend and an extra cash dividend
“Extra” part may or may not be repeated in the future

The payment of a liquidating dividend usually means that some or all of the business
has been liquidated

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Dividend Policy
STANDARD METHOD OF CASH DIVIDEND PAYMENT
The decision to pay a dividend rests in the hands of the board of directors of the
corporation
When a dividend has been declared, it becomes a debt of the firm and cannot easily
be rescinded

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Dividend Policy
Commonly, the amount of the cash dividend is expressed in terms of dollars per share
(dividends per share)
Also expressed as a percent- age of the market price (the dividend yield) or as a percentage of
net income or earnings per share (the dividend payout)
MORE ABOUT THE EX-DIVIDEND DATE

Price Behavior around the

Ex-Dividend Date for a $1
Cash Dividend

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Dividend Policy
Does Dividend Policy Matter?

Dividend policy is the time pattern of dividend payout.

In particular, should the firm pay out a large percentage of its earnings now or a small
(or even zero) percentage? This is the dividend policy question.

The theory that dividends do not matter

Shareholders adjust their holdings to changing dividend rates to keep returns constant

Homemade dividend policy

The tailored dividend policy created by individual investors who undo corporate
dividend policy by reinvesting dividends or selling shares of stock.

Corporate Finance (MAIB FIN 101) Aug 2022 7

Dividend Policy
Real-World Factors Favoring a Low Dividend Payout

1. Taxes – Tax rates for dividends and capital gains can be different
2. Flotation costs – Paying out more dividend and raising capital when needed, has
higher flotation costs
3. Dividend Restrictions- Bond covenants and legal limits

Real-World Factors Favoring a High Dividend Payout

4. Desire for current income
5. Tax and other benefits from high dividends
This can vary from corporate shareholders to individual shareholders and tax-
exempt investors

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Dividend Policy
More on Real-World Factors

Three different positions on dividends we have see so far

1. Based on the homemade dividend argument, dividend policy is irrelevant.
2. Because of tax effects for individual investors and new issue costs, a low-dividend
policy is best.
3. Because of the desire for current income and related factors, a high-dividend policy
is best.

There has been some consistency that stock prices rise when the current dividend is
unexpectedly increased, and they generally fall when the dividend is unexpectedly
decreased

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Dividend Policy
INFORMATION CONTENT OF DIVIDENDS
There has been some consistency that stock prices rise when the current dividend is
unexpectedly increased, and they generally fall when the dividend is unexpectedly
decreased

Information content effect : The market’s reaction to a change in corporate dividend

payout.

Clientele effect : The observable fact that stocks attract particular groups based on
dividend yield and the resulting tax effects.

Corporate Finance (MAIB FIN 101) Aug 2022 10

Dividend Policy
Stock Repurchases: An Alternative to Cash Dividends

Share repurchases are typically accomplished in one of three ways.

First, companies may purchase their own stock, through open market purchases. the
firm does not reveal itself as the buyer. The seller does not know whether the shares
were sold back to the firm or sold to another investor.

Second, the firm could institute a tender offer. Here, the firm announces to all of its
stockholders that it is willing to buy a fixed number of shares at a specific price.

Third firms may repurchase shares from specific individual stockholders. This
procedure has been called a targeted repurchase

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Dividend Policy
REAL-WORLD CONSIDERATIONS IN A REPURCHASE

TAX
Under some tax laww, a repurchase has a significant tax advantage over a cash
dividend.
A dividend is taxed, and a shareholder has no choice about whether or not to receive
the dividend. In a repurchase, a shareholder pays taxes only if
(1) the shareholder actually chooses to sell and
(2) the shareholder has a capital gain on the sale.

SHARE REPURCHASE AND EPS

A share repurchase reduces the number of outstanding shares, but it has no effect on
total earnings. As a result, EPS rises.

Corporate Finance (MAIB FIN 101) Aug 2022 12

Dividend Policy
DIVIDENDS AND DIVIDEND PAYERS

While we know dividends are large in the aggregate, we also know that the num- ber
of companies that pay dividends has declined

CORPORATIONS SMOOTH DIVIDENDS

(1)dividend growth lags earnings growth and
(2)dividend growth will tend to be much smoother than earnings growth.

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Dividend Policy
SUMMARY

1. Aggregate dividend and stock repurchases are massive, and they have increased steadily
in nominal and real terms over the years.
2. Dividends are heavily concentrated among a relatively small number of large, mature
firms.
3. Managers are very reluctant to cut dividends, normally doing so only due to firm-specific
problems.
4. Managers smooth dividends, raising them slowly and incrementally as earnings grow.
5. Stock prices react to unanticipated changes in dividends.

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Dividend Policy
Stock Dividends and Stock Splits

A stock dividend is not a true dividend because it is not paid in cash. The effect of a
stock dividend is to increase the number of shares that each owner hold

Stock Split : When a split is declared, each share is split up to create additional shares.
For example, in a three-for-one stock split, each old share is split into three new
shares.

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Dividend Policy
Popular Trading Range
Proponents of stock dividends and stock splits frequently argue that a security has a proper
trading range.
When the security is priced above this level, many investors do not have the funds to buy the
common trading unit of 100 shares, called a round lot. Although securities can be purchased
in odd-lot form (fewer than 100 shares), the commissions are greater.
Firms will split the stock to keep the price in this trading range.

REVERSE SPLITS
A stock split in which a firm’s number of shares outstanding is reduced
A less frequently encountered financial maneuver
Three Reasons
• transaction costs to shareholders may be less after the reverse split
• liquidity and marketability of a company’s stock might be improved when its price is
raised to the popular trading range
• stocks selling at prices below a certain level(MAIB
Corporate Finance areFINnot considered
101) Aug 2022 respectable 16