Financial Management For Decision Makers

Second Canadian Edition

SECOND CANADIAN EDITION

PETER ATRILL PAUL HURLEY

FINANCIAL MANAGEMENT
FOR DECISION MAKERS

Chapter 11-1 © 2012 Pearson Canada Inc.

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 Chapter 11
Developing a Dividend Policy

LEARNING OUTCOMES

1 Describe the nature of dividends and the way in which

they are paid.
2 Explain why (in a world of perfect and efficient
markets) dividends should have no effect on
shareholder wealth.
3 Discuss the factors that influence dividend policy in
practice.
4 Discuss the alternatives to cash dividends that may be
Chapter 11-2 © 2012 Pearson Canada Inc.
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 The Payment of Dividends

• A dividend represents a return by a business to

its shareholders.

• Dividends can be paid in

– Cash
– Assets (rare)
– Additional shares (stock dividend)

Chapter 11-3 © 2012 Pearson Canada Inc.

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 The Payment of Dividends

Legal limits on the amounts that can be

distributed in the form of dividend payments to
shareholders.

The Board of Directors cannot legally declare a

dividend that causes retained earnings to
become negative

Chapter 11-4 © 2012 Pearson Canada Inc.

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 The Payment of Dividends

Activity 11-1

Why does the law impose limits on the amount

of cash that can be distributed as dividends?

Chapter 11-5 © 2012 Pearson Canada Inc.

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 The Payment of Dividends

Activity 11-1 solution

• If there were no legal limits, it would be possible for
shareholders to approve massive dividend payments
from the business and so leave the lenders and
creditors in an exposed financial position.
• The law tries to protect lenders and creditors by
preventing excessive withdrawals of shareholder
capital.
• One way in which this can be done is through placing
restrictions on dividend payments.
Chapter 11-6 © 2012 Pearson Canada Inc.

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 The Payment of Dividends

Activity 11-2

Bio-tech Ltd. started trading three years ago.

Net income (loss) was $200,000 for 2008,
$(150,000) for 2009, and $30,000 for 2010.
Bio-tech has never paid a dividend and wants to
know the maximum dividend it can declare in
early January 2011.

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 The Payment of Dividends

Activity 11-2 Solution

Under normal circumstances, the directors of Bio-

tech would be able to declare a maximum
dividend of $80,000.

Chapter 11-8 © 2012 Pearson Canada Inc.

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 Dividend Payment Dates

• Record date
• Ex-Dividend date
• Cum Dividend date
• Transaction date
• Settlement date

NB
Chapter 11-9 © 2012 Pearson Canada Inc.

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 Dividend Payment Dates

Record date
• A date set by the business
• All shareholders “of record” on that date will
receive the declared dividend
• The term record means the register of
shareholders maintained by the company

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 Dividend Payment Dates

Ex-dividend date
• Two business days before the record date.
• An investor who buys shares on or after the ex-
dividend date will not receive the current
dividend.

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 Dividend Payment Dates

Cum Dividend date

• One business day before the ex-dividend date
(or three busi­ness days before the record date)
is the last cum dividend date for the current
dividend.
• An investor who buys before the ex-dividend
date will receive the current dividend.
• All dates other than the ex-dividend period

Chapter 11-12 © 2012 Pearson Canada Inc.

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 Dividend Payment Dates

Transacting date
• The date the investor actually buys or sells
shares

Settlement date
• The date the investor must pay for the shares
he has purchased if he is a buyer
• The date that money is placed in the investor’s
account if he is a seller
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 Dividend Payment Dates

Activity 11.3
Page 423

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 Dividend Policy in Practice

The extent to which the profits generated

during a particular period (and available for
distribution) cover the dividend payment can be
expressed in the dividend cover ratio:

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 Dividend Policy and Shareholder Wealth

2 major schools of thought

The traditional
• school argues that investors prefer dividends
now because the amounts are more certain.
• “a bird in the hand is worth two in the bush”
• Future dividends are uncertain and therefore
must be devalued

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 Dividend Policy and Shareholder
Wealth
The Modernist theory of dividends
• The modernists (MM) argue that, given perfect
and efficient markets, the pattern of dividends
has no effect on shareholder wealth.
• Lower dividends paid to the shareholders will
be offset by a higher share price
• The modernist view ignores tax treatment of
dividends and of capital gains
• If the investor needs cash he can sell shares
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 The Importance of Dividends

The pattern of dividends is seen by investors

and corporate managers to be important.
It seems that there are three possible reasons
to explain this phenomenon. These are:

1. The clientele effect

2. The information signalling effect
3. The need to reduce agency costs
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 Reasons for the Importance of Dividends

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 Reasons for the Importance of
Dividends
The Clientele Effect
• Business with particular dividend policies will
attract particular investors
• Companies should clearly indicate their
dividend policy
• If a company suddenly changes its dividend
policy its investors will be unhappy and may sell
shares
• Share price may decline
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 Reasons for the Importance of
Dividends
The information signalling effect
• Changes in dividend policy may be interpreted
by investors as a signal of future prospects of
the company
• An increase in dividends may be interpreted as
a good omen about the future

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 Reasons for the Importance of
Dividends
The need to reduce agency costs
• Managers are agents of the business
• Shareholders and others may fear that
managers may spend cash on themselves if it is
left in the company
• Shareholders will desire that any excess cash be
paid out in the form of dividends

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 Factors Determining the Level of Dividends

• Investment Opportunities
– More investment opportunities = lower dividends

• Residual Theory of Dividends

• Legal Requirements
– No greeter than retained earnings
– Cannot cause retained earnings to be negative

• Chapter
Loan Covenants
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 Factors Determining the Level of
Dividends (Continued)
• Profit Stability
– Greater stability of profit leads to higher dividends

• Control
– Low dividends mean existing shareholders control
cannot be dilutes

• Threat of Takeover
– Low dividend policy may make the company more
vulnerable to takeovers
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 Factors Determining the Level of
Dividends (Continued)
• Market Expectations
– If the company does not pay out the amount
anticipated by the market the share price may fall

• Inside Information
– Executives may know information they are not
permitted to disclose which may influence the
level of dividends

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Factors Influencing the Level of Dividends

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 Level of Dividends

Dividend smoothing
• The pattern of dividends paid out is more
important than the level of dividends
• Managers perceive dividends as being important
for investors.

Managers prefer a smooth increase in dividends

and are reluctant to cut dividends.

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 Dividend Cover Ratio

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 Dividend Cover Ratio

Activity 11.4
Page 425

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 Alternatives to Cash Dividends

Stock dividends
• are a bookkeeping transaction, but the market
may see them as a sign of managers’ confidence
in the future, and respond positively.
• In theory there is no increase in investor wealth
• Stock dividends are taxable

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 Alternatives to Cash Dividends

Share repurchases
• involve repurchasing and then cancelling
shares.
• Shares are purchased on the open market
• Tend to support the share price
• Viewed positively by shareholders if the
company has excess cash on hand

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