Unit -V Dividend Policy

Lecture Agenda
Learning Objectives Important Terms Mechanics of Dividend Payments Cash Dividend Payments M&Ms Dividend Irrelevance Theorem The Bird in the Hand Argument Dividend Policy in Practice Relaxing the M&M Assumptions Stock Dividends and Stock Splits Share Repurchases Summary and Conclusions
Concept Review Questions
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Learning Objectives
You should understand the following: The mechanics of dividend payments and why they are different from interest payments The difference between a stock split and a stock dividend Under what assumptions a dividend payment is irrelevant and what a homemade dividend is Why dividend payments generally reflect the business risk of the firm How transactions costs, taxes and information problems give value to corporate dividend policies How stock dividends and stock splits differ How a share repurchase program can substitute for a dividend payout policy.
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Important Chapter Terms

Agency theory Bird in the hand argument Cash cow Declaration date Dividend reinvestment plans Dividend yield Equity market capitalization Ex-dividend date Ex Free cash flow Holder of record Homemade dividends Income stripping Odd lots Residual theory of dividends Special dividend Split shares Stock dividend Stock split Tax clienteles

Dividend Policy

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What is Dividend Policy?

Dividend Policy

Dividend Policy
What is It?

Dividend Policy refers to the explicit or implicit decision of the Board of Directors regarding the amount of residual earnings (past or present) that should be distributed to the shareholders of the corporation.
This decision is considered a financing decision because the profits of the corporation are an important source of financing available to the firm.

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Types of Dividends
Dividend Policy

Types of Dividends

Dividends are a permanent distribution of residual earnings/property of the corporation to its owners. Dividends can be in the form of:
Cash Additional Shares of Stock (stock dividend) Property

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. dividend.

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Dividends and Corporate Financing

Dividend Policy

Dividends a Financing Decision

In the absence of dividends, corporate earnings accrue to the benefit of shareholders as retained earnings and are automatically reinvested in the firm. When a cash dividend is declared, those funds leave the firm permanently and irreversibly. Distribution of earnings as dividends may starve the company of funds required for growth and expansion, and this may cause the firm to seek additional external capital.

Retained Earnings Corporate Profits After Tax Dividends

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Dividends versus Interest Obligations

Interest Interest is a payment to lenders for the use of their funds for a given period of time Timely payment of the required amount of interest is a legal obligation Failure to pay interest (and fulfill other contractual commitments under the bond indenture or loan contract) 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 firms assets in the case of dissolution or in the case of bankruptcy Dividends 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)

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The Mechanics of Dividend Payments

Dividend Policy

Dividend Payments
Mechanics of Cash Dividend Payments

Declaration Date Holder of Record Date Ex-dividend Date ExPayment Date

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Dividend Payments
Mechanics of Cash Dividend Payments
Declaration Date
this is the date on which the Board of Directors meet and declare the dividend. In their resolution the Board will set the date of record, the date of payment and the amount of the record, dividend for each share class. when CARRIED, this resolution makes the dividend a current liability for the firm.

Date of Record
is the date on which the shareholders register is closed after the trading day and all those who are listed will receive the dividend.

Ex dividend Date
is the date that the value of the firms common shares will reflect the dividend payment (ie. fall in value) ex means without. At the start of trading on the ex-dividend date, the share price will normally open for trading exat the previous days close, less the value of the dividend per share. This reflects the fact that purchasers of the stock on the ex-dividend date and beyond WILL NOT receive the exdeclared dividend.

Date of Payment
is the date the cheques for the dividend are mailed out to the shareholders.
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Dividend Declaration Time Line

2 business days prior to the Date of Record

Declaration Date

Date of Record

Date of Payment

The Board Meets and passes the motion to create the dividend

Ex Dividend Date is determined by the Date of Record. The market value of the shares drops by the value of the dividend per share on market openingcompared to the previous days close.
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Trade Settlement and the Ex Dividend Date

Changes in the Settlement Cycle In June 1995 the settlement cycle for all non-money-market Canadian and non-moneyU.S. securities was reduced from five business days (T + 5) to three business days (T + 3). The rationale for the change stems from the 1987 stock market crash when it was realized that a securities market failure could result in a credit market failure. The gridlock created in 1990 by the bankruptcy of Drexel Burnham Lambert, a large U.S. broker, increased the need to minimize the risks involved in the clearing and settlement of securities. The shortened settlement cycle requires that the payment of funds and the delivery of securities take place on the third business day after the trade date. This will reduce credit, market and liquidity risks by decreasing postposttrade settlement exposure. Ex Dividend Date The date is not chosen by the board of directors, rather it is determined as a result of the exchanges settlement practices and is a function of the date of record.

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Dividend Decision and the Board of Directors

Dividend Policy

Dividend Policy
Dividends, Shareholders and the Board of Directors

There is no legal obligation for firms to pay dividends to common shareholders Shareholders cannot force a Board of Directors to declare a dividend, and courts will not interfere with the BODs right to make the dividend decision because:
Board members are jointly and severally liable for any damages they may cause Board members are constrained by legal rules affecting dividends including:
Not paying dividends out of capital Not paying dividends when that decision could cause the firm to become insolvent Not paying dividends in contravention of contractual commitments (such as debt covenant agreements)
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Dividend Payments
Dividend Policy

Dividend Payments
Dividend Reinvestment Plans (DRIPs)

Involve shareholders deciding to use the cash dividend proceeds to buy more shares of the firm
DRIPs will buy as many shares as the cash dividend allows with the residual deposited as cash Leads to shareholders owning odd lots (less than 100 shares)

Firms are able to raise additional common stock capital continuously at no cost and fosters an onongoing relationship with shareholders.

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Dividend Payments
Stock Dividends

Stock dividends simply amount to distribution of additional shares to existing shareholders They represent nothing more than recapitalization of earnings of the company. (that is, the amount of the stock dividend is transferred from the R/E account to the common share account. Because of the capital impairment rule stock dividends reduce the firms ability to pay dividends in the future.
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Dividend Payments
Stock Dividends

Implications
reduction in the R/E account reduced capacity to pay future dividends proportionate share ownership remains unchanged shareholders wealth (theoretically) is unaffected

Effect on the Company

conserves cash serves to lower the market value of firms stock modestly promotes wider distribution of shares to the extent that current owners divest themselves of shares...because they have more adjusts the capital accounts dilutes EPS

Effect on Shareholders
proportion of ownership remains unchanged total value of holdings remains unchanged if former DPS is maintained, this really represents an increased dividend payout

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Dividend Payments
Stock Dividend Example
ABC Company Equity Accounts as at February xx, 20x9 $5,000,000 20,000,000 $25,000,000

Common stock (215,000) Retained earnings Net Worth

The company, on March 1, 20x9 declares a 10 percent stock dividend when the current market price for the stock is $40.00 per share. This stock dividend will increase the number of shares outstanding by 10 percent. This will mean issuing 21,500 shares. The value of the shares is: $40.00 (21,500) = $860,000 This stock dividend will result in $860,000 being transferred from the retained earnings account to the common stock account:

next page...
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Dividend Payments
Stock Dividend Example
After the stock dividend:

ABC Company Equity Accounts as at March 1, 20x9 Common stock (236,500) Retained earnings Net worth $5,860,000 19,140,000 $25,000,000

The market price of the stock will be affected by the stock dividend: New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36 The individual shareholders wealth will remain unchanged.

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Dividend Payments
Stock Splits

Although there is no theoretical proof, there is some who believe that an optimal price range exists for a companys common shares. It is generally felt that there is greater demand for shares of companies that are traded in the $40 - $80 dollar range. The purpose of a stock split is to decrease share price. The result is:
increase in the number of share outstanding theoretically, no change in shareholder wealth

Reasons for use:

better share price trading range psychological appeal (signalling affect)
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Dividend Payments
Stock Split Example
The Board of Directors of XYZ Company is considering using a stock split to put its shares into a better trading range. They are confident that the firms stock price will continue to rise given the firms outstanding financial performance. Currently, the companys shares are trading for $150 and the companys shareholders equity accounts are as follows:
Commons shares (100,000 outstanding) Retained earnings Net Worth $1,500,000 15,000,000 $16,500,000

A 2 for 1 Stock Split:

New Share Price = P0[1/(2/1)] = $150[1/(2/1)] = $150[.5] = $75.00

The firms equity accounts:

Commons shares (200,000 outstanding) Retained earnings Net Worth
Dividend Policy

$1,500,000 15,000,000 $16,500,000

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Dividend Payments
Further Stock Split Examples
A 4 for 3 Stock Split:
New Share Price = P0[1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50

The firms equity accounts:

Commons shares (133,333 outstanding) Retained earnings Net Worth $1,500,000 15,000,000 $16,500,000

A 3 for 4 Reverse Stock Split:

New Share Price = P0[1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00

The firms equity accounts:

Commons shares (75,000 outstanding) Retained earnings Net Worth $1,500,000 15,000,000 $16,500,000

Clearly the Board can use stock splits and reverse stock splits to place the firms stock in a particular trading range.
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Dividend Payments
Stock Split Effects

shareholders wealth should remain unaffected:

Original Holdings: (100 shares @ $150/share) = $15,000 After a 4 for 1 split: (400 shares @ $37.50/share) = $15,000

the above will hold true if there is no psychological appeal to the stock split. There is some evidence that the share price of companies which split stock is more bouyant because of a positive signal being transferred to the market by this action.
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Stock Dividends versus Stock Splits

Stock Dividends
lowers stock price slightly little psychological appeal recapitalization of earnings no change in proportional ownership odd lots created theoretically, no value to the investor -

Stock Splits
large drop in stock price much stronger potential signalling effect no recapitalization same odd lots rare same

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Cash Dividend Payments

The Macro Perspective

Figure -1 illustrates:
Aggregate after-tax profits run at approximately 6% of GDP but afterare highly variable Aggregate dividends are relatively stable when compared to afterafter-tax profits.
They are sustained in the face of drops in profit during recessions They are held reasonably constant in the face of peaks in aggregate profits.

(See Figure - 1 on the following slide)

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Cash Dividend Payments

The Macro Perspective - Question

Why are dividends smoothed and not matched to profits?

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Cash Dividend Payments

The Micro Perspective

The companies chosen here illustrate the dramatic differences between companies:
Some pay no dividends Some pay consistent cash dividends representing substantial yields on current shares prices
The highest yields are found in the case of Income Trusts and large stable blue-chip financials and utilities blue-

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Cash Dividend Payments

Dividend Yields

Table

S&P/TSX

Index Dividend Yield

3 % %
3.42 0 3.07 0.53 0 5.16

Average %
4.29 0 3.31 0 0 5.88 7.34

%
2.52 0 2.85 0.54 0 4.52

%
1.41 0 3.37 0 0 5.35

%
1.07 0 3.17 0 0 5.59

%
3.15 0 2.9 0 0 4.06

%
3.99 0 3.48 0 0 4.92

%
4.08 0 3.28 0 0 5.73

%
4.44 0 3.57 0 0 4.51 7.09 3.31 0.00 3.27 0.13 0.00 5.19 7.22

CE Celesti a In . CI C C tt C rp ration Kinross old Corporation Trans lta Corporation Yello Pa es In ome nd

4.69 0 3.67 0.23 0 6.22

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Modigliani and Millers Dividend Irrelevance Theorem

M&M, Dividends and Firm Value

Modigliani and Millers Dividend Irrelevance Theorem

The value of M&Ms Dividend Irrelevance argument is that in the end, it shows where value can be created with dividend policy and why.

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M&Ms Dividend Irrelevance Theorem

M&M, Dividends, and Firm Value

Start with the single-period DDM: single-

[ -1]

D1  P 1 P0 ! (1  Ke )

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M&Ms Dividend Irrelevance Theorem

M&M, Dividends, and Firm Value

Multiply by the number of shares outstanding (m) to convert the single stock price model to a model to value the whole firm:

[ -2]

m( 1  1 ) ! V0 ! (1  e )

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M&Ms Dividend Irrelevance Theorem

Assumptions

No Taxes Perfect capital markets

large number of individual buyers and sellers costless information no transaction costs

All firms maximize value There is no debt

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M&Ms Dividend Irrelevance Theorem

M&M, Dividends, and Firm Value

Without debt, sources and uses of funds identity (sources = uses) can be expressed as:

[ -3]

X 1  nP1 ! I1  mD1
represents cash flow from operations represents investment is free cash flow is dividend to current shareholders at time 1
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Where:
    X I XI mD1

M&Ms Dividend Irrelevance Theorem

M&M, Dividends, and Firm Value

Solving for dividends paid out (mD1 ): (mD

mD1 ! X 1  nP1  I1

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M&Ms Dividend Irrelevance Theorem

M&M, Dividends, and Firm Value

If a firm pays out dividends that exceeds its free cash flow (X I), then it must issue new common shares to pay for these dividends. Substituting into Equation 2 we get:

[ -4]

X1  I1  [(m  n) P ! 1 ! (1  K )

The value of the firm is the value of the next periods free cash flow (X1 I1) plus the next periods equity market (X value
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M&Ms Dividend Irrelevance Theorem

M&M, Dividends, and Firm Value

The firm value is determined as the present value of the free cash flows to the equity holders:
V lue h s nothin to do with dividends

[ -5]

X t  It ! (1  K ) t t !1
E

The dividend is equal to the free cash flow each period, and dividends are therefore a residual after the firm has taken care of all of its investment requirements this is the Residual Theory of Dividends
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M&Ms Dividend Irrelevance Theorem

Residual Theory of Dividends

The Residual Theory of Dividends suggests that logically, each year, management should:
Identify free cash flow generated in the previous period Identify investment projects that have positive NPVs Invest in all positive NPV projects
If free cash flow is insufficient, then raise external capital in this case no dividend is paid If free cash flow exceeds investment requirements, the residual amount is distributed in the form of cash dividends.
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M&Ms Dividend Irrelevance Theorem

Residual Theory of Dividends - Implication

The implication of the Residual Theory of Dividends are:

Investment decisions are independent of the firms dividend policy
No firm would pass on a positive NPV project because of the lack of funds, because, by definition the incremental cost of those funds is less than the IRR of the project, so the value of the firm is maximized only if the project is undertaken. If the firm cant make good use of free cash flow (ie. It has no (ie. projects with IRRs > cost of capital) then those funds should be distributed back to shareholders in the form of dividends for them to invest on their own. The firm should operate where Marginal Cost equals Marginal Revenue as seen in Figure 4 on the following slide:
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M&Ms Dividend Irrelevance Theorem

Internal Funds, Investment, and Dividends
- 4 F GURE OP MAL NVESTMENT

Rate of Return IOS

MC=MR

WACC

Internal Funds Available

$11,976 Million $177,607 Million

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M&Ms Dividend Irrelevance Theorem

Homemade Dividends

Shareholders can buy or sell shares in an underlying company to create their own cash flow pattern.
They dont need management declare a cash dividend, they can create their own. Conclusion: under the assumptions of M&Ms model, the investor is indifferent to the firms dividend policy.

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The Bird-in-the-Hand Argument Bird-in-theDividend Policy

The Bird-in-the-Hand Argument Bird-in-theM&Ms Assumptions Relaxed

Risk is a real world factor. Firms that reinvest free cash flow, put that money at risk there is no certainty of investment outcome those forfeit dividends that are reinvestedcould be lost! Remember the two-stage DDM? two-

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The Bird-in-the-Hand Argument Bird-in-theM&Ms Assumptions Relaxed

Remember the two-stage DDM? twoROE1 v B PS Inv OE 2  K e ) P!  ( Ke Ke (1  K e )

[ -6]

The first term is the present value of existing opportunities (PVEO) The second term is the present value of growth opportunities (PVGO) These forecast returns face risks of new market entrants to compete for the excess profits forecast in emerging opportunities making PVGO extremely vulnerable.
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The Bird-in-the-Hand Argument Bird-in-theM&Ms Assumptions Relaxed

Myron Gordon suggests that dividends are more stable than capital gains and are therefore more highly valued by investors. This implies that investors perceive non-dividend paying nonfirms to be riskier and apply a higher discount rate to value them causing the share price to fall. The difference between the M&M and Gordon arguments are illustrated in Figure - 5 on the following slide:
M&M argue that dividends and capital gains are perfect substitutes
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The Bird-in-the-Hand Argument Bird-in-theM&M versus Gordons Bird in the Hand Theory
- 5 F GURE OPTIMAL INVESTMENT

D1 P0

Gordon M&M

P  P0 1 P0

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The Bird-in-the-Hand Argument Bird-in-theM&M versus Gordons Bird in the Hand Theory

Conclusions:
Firms cannot change underlying operational characteristics by changing the dividend The dividend should reflect the firms operations through the residual value of dividends

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Dividend Policy in Practice

Dividend Policy

Dividend Policy in Practice

Firms smooth their dividends
Firms tend to hold dividends constant, even in the face of increasing after-tax profit after Firms are very reluctant to cut dividends

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Dividend Policy in Practice

Lintners Work on Dividend Adjustment

John Lintner suggested a partial adjustment model to explain the smoothing of dividend behaviour illustrating that firms slowly change dividends as they move toward a new target level:

[ -7]
t

! (

* t

t-1

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Dividend Policy in Practice

Lintners Work on Dividend Adjustment

The target dividend Dt* Lintner suggested is a function of the firms optimal payout rate of the firms underlying earnings (Et) leading to the following equation: (E
[ -8]

Dt ! a  (1  b) Dt-1  cE1

The coefficient on lagged dividends was estimated at 0.70 indicating an adjustment speed (b) coefficent of (b 0.30. The coefficient on current earnings (c) was estimated at (c 0.15
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Dividend Policy in Practice

Lintners Work on Dividend Adjustment

Implications
The speed of dividend adjustment is only about 30 percent Firms are very reluctant to fully adjust Firms do not follow a policy of paying a constant proportion of earnings out as dividends Dividend policy in practice does not follow M&Ms irrelevance arguments because the real world does not match the assumptions used.
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Relaxing the M&M Assumptions

Welcome to the Real World!

Transactions Costs
Underwriting costs are very high, providing a strong incentive for firms to finance growth out of free cash flow Facing these high underwriting costs firms:
With high growth rates have little incentive to pay dividends With volatile earnings conserve cash from year to year to finance projects and therefore pay very conservative dividends

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Relaxing the M&M Assumptions

Welcome to the Real World!

Dividends and Signalling

Under conditions of information asymmetry, shareholders and the investing public watch for management signals (actions) about what management knows. Management is therefore very cautious about dividend changesthey dont want to create high expectations (this is the reason for extra or special dividends) that will lead to disappointment, and they dont want to have investors over react to negative earnings surprises (the sticky dividend phenomenon)
(The Signalling Model is explained in Figure 6 found on the next slide.)

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Relaxing the M&M Assumptions

The Signalling Model
- 6 FIGURE

et et * dt * dt

Time

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Relaxing the M&M Assumptions

Welcome to the Real World!

Agency Theory
Investors are wary of senior management so they seek to put controls in place. There is a fear that managers may waste corporate resources by overover-investing in low or poor NPV projects. Gordon Donaldson argued this is the reason for the pecking order managements tend to use when raising capital
Shareholders would prefer to receive a dividend and then have management file a prospectus, justifying investment in projects and the need to raise the capital that was just distributed as a dividend. Shareholders are prepared to pay those additional underwriting costs as an agency cost incurred to monitor and assess management.

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Relaxing the M&M Assumptions

Welcome to the Real World!

Taxes and the Clientele Effect

Table -3 (on the following slide) illustrates that different classes of investors face different tax brackets Preference for dividends versus capital gains income depends on the province of residence and taxable income level leading to tax clienteles.
High income earners tend to prefer capital gains (there is an additional tax incentive for such individuals in that they can choose the timing of the sale of their investmentremember only realized capital gains are subject to tax Low income earners tend to prefer dividends

Conclusion firms should not change dividend policy drastically since it upsets the existing ownership base.
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Relaxing the M&M Assumptions

Taxes
le -3 Individ l te ( ) on Dividend
,
.52 12.45 3.63 12.63 0.00 10.65 5.95 14.37 0.00 12.02

nd C pit l
,
15.69 18.85 13.83 18.00 20.74 21.71 26.06 22.86 17.05 21.34

in
,
20.04 20.35 13.83 18.00 20.74 21.71 26.06 22.86 19.06 22.63

Income evel
itish Columbia Albe ta Onta io Quebe Nova otia i i en s Capital gains i i en s Capital gains Di i en s Capital gains Di i en s Capital gains Divi en s Capital gains

,
6.19 15.58 8.03 16.00 8.24 15.58 15.42 19.19 8.75 18.48

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Relaxing the M&M Assumptions

Repackaging Dividend-Paying Securities Dividend-

Tax clienteles help to explain the financial engineering whereby different parts of the return by the firm are stripped, repackaged and sold to different investors as illustrated in Figure 7. (See the following slide) Split shares are shares sold as the dividends and capital gains parts.

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Relaxing the M&M Assumptions

MYWs B Corporation Shares
- 7 FIGURE

$454 million

MYW
$330 million $143 million

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Share Repurchases
Simply another form of payout policy. An alternative to cash dividend where the objective is to increase the price per share rather than paying a dividend. Since there are rules against improper accumulation of funds, firms adopt a policy of large infrequent share repurchase programs.

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Share Repurchases
Dividend Policy

Share Repurchases
allowed under the OBCA and CBCA reasons for use:
Offsetting the exercise of executive stock options Leveraged recapitalizations Information or signalling effects Repurchase dissident shares Removing cash without generating expectations for future distributions Take the firm private.

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Disadvantages of Share Repurchases

they are usually done on an irregular basis, so a shareholder cannot depend on income from this source. if regular repurchases are made, there is a good chance that Revenue Canada will rule that the repurchases were simply a tax avoidance scheme (to avoid tax on dividends) and will assess tax there may be some agency problems - if managers have inside information, they are purchasing from shareholders at a price less than the intrinsic value of the shares.

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Methods of Share Repurchases

tender offer:
this is a formal offer to purchase a given number of shares at a given price over current market price. the purchase of shares through an investment dealer like any other investor this is not designed for large block purchases.

open market purchase:

private negotiation with major shareholders In any repurchase program, the securities commission requires disclosure of the event as well as all other material information through a prospectus.

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Repurchased Shares
called treasury stock (U.S.) non-voting (U.S.) nonmay not receive dividends (U.S.) if not retired, can be resold (U.S.) unlike the U.S., repurchases in Canada do not involve shares that can be placed into treasury stock - they are canceled

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Repurchase Example
Current EPS = [total earnings] / [# of shares] = $4.4 m / 1.1 m = $4.00 Current P/E ratio = $20 / $4 = 5X EPS after repurchase of 100,000 shares = $4.4 m / 1.0 = $4.40 Expected market price after repurchase: = [p/e][EPSnew] = [5][$4.40] = $.00 per share [p/e][EPS

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Effects of A Share Repurchase

EPS should increase following the repurchase if earnings after-tax remains the same after a higher market price per outstanding share of common stock should result stockholders not selling their shares back to the firm will enjoy a capital gain if the repurchase increases the stock price.

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Advantages of Share Repurchases

signal positive information about the firms future cash flows used to effect a large-scale change in the firms capital largestructure increase investors return without creating an expectation of higher future cash dividends reduce future cash dividend requirements or increase cash dividends per share on the remaining shares, without creating a continuing incremental cash drain capital gains treated more favourably than cash dividends for tax purposes.

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Disadvantages of Share Repurchases

signal negative information about the firms future growth and investment opportunities the provincial securities commission may raise questions about the intention share repurchase may not qualify the investor for a capital gain

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Borrowing to Pay Dividends

Signalling

Borrowing to Pay Dividends

Is this legal? is it possible to do? Yes
the firm must have the ability and capacity to borrow the firm must have sufficient retained earnings to allow it to pay the dividend the firm must have sufficient cash on hand to pay the cash dividend the firm must NOT have agreed to any limitations on the payment of dividends under the bond indenture. A possible answer is to signal to the market that the board is confident about the firms ability to sustain cash dividends into the future.
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Why?

Borrowing to Pay Dividends

An Example

Before Borrowing:
Assets: Cash 10 Fixed Assets 140 Total Assets $150 Liabilities: Long-term Debt 0 Common Stock 50 Retained Earnings 100 Total Claims $150 0% Debt

After Borrowingbefore cash dividend:

Assets: Cash 60 Fixed Assets 140 Total Assets $200 Liabilities: Long-term Debt 50 Common Stock 50 Retained Earnings 100 Total Claims
Dividend Policy

25% Debt

$200
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Borrowing to Pay Dividends

An Example

After Dividend Declarationbefore date of payment.

Assets: Cash 60 Fixed Assets 140 Liabilities: Current liabilities Long-term Debt Common Shares Retained earnings Total Claims 50 50 50 50 $200 50% Debt

Total Assets

$200

After Cash Dividend payment of $50

Assets: Cash 10 Fixed Assets 140 Total Assets $150 Liabilities: Long-term Debt Common Stock Retained earnings Total Claims Dividend Policy 50 50 50 $150

33% Debt

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Borrowing to Pay Dividends

An Example The foregoing example illustrates:
it is possible for a firm with borrowing capacity to borrow funds to pay cash dividends. this is not possible if the lenders insist on restrictive covenants that limit or prevent this from occurring. the cash for the dividend must be present in the cash account. payment of dividends reduces both the cash account on the asset side of the balance sheet as well as the retained earnings account on the claims side of the balance sheet. in the absence of restrictions, it is possible to transfer wealth from the bondholders to the stockholders. (Bondholders in this example
may have thought their firm would have only a 25% debt ratio.after the dividend the debt ratio rose to 33% and the equity cusion dropped from 75% to 66%.)

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Summary and Conclusions

In this chapter you have learned:
About the different types of dividends including, regular and special cash dividends, stock dividends, stock splits as well as share repurchases. M&Ms dividend irrelevance argument and the real world factors such as transactions costs, taxes, clientele effects and signalling tend to favour real-world dividend relevance real Tax motives and other reasons explain why firms might want to repurchase their shares.

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