Chapter 3

Dividends and Dividend Policy

19-1
 Introduction
• The financial manager must take careful
decisions on how the profit should be
distributed among shareholders.
• It is very important and crucial part of the
business concern, because these decisions are
directly related with the value of the business
concern and shareholder’s wealth.
 Meaning of Dividend
• Dividend refers to the business
concerns net profits distributed
among the shareholders.
• It may also be termed as the part of
the profit of a business concern, which
is distributed among its shareholders.
 TYPES OF DIVIDEND/FORM OF DIVIDEND

 Dividend may be distributed among

the shareholders in the form of cash
or stock.
 Hence, dividends are classified into:
A. Cash dividend
B. Stock dividend
C. Bond dividend
D. Property dividend
Procedure for Cash Dividend Payment
25 Oct. 1 Nov. 2 Nov. 6 Nov. 7 Dec.
…

Declaration Cum- Ex- Record Payment

Date dividend dividend Date Date
Date Date
Declaration Date: The Board of Directors declares
a payment of dividends.
Cum-Dividend Date: The last day that the buyer of a
stock is entitled to the dividend.
Ex-Dividend Date: The first day that the seller of a
stock is entitled to the dividend.
Record Date: The corporation prepares a list of all
individuals believed to be stockholders as of 6
November.
 TYPES OF DIVIDEND POLICY
 Regular dividend policy - Dividend payable at the
usual rate is called as regular dividend policy. This
type of policy is suitable to the small investors,
retired persons and others.
 Stable dividend policy - means payment of
certain minimum amount of dividend regularly.
 Irregular dividend policy – when facing
constraints of earnings and unsuccessful business
operation
 No dividend policy - Sometimes the company
may follow no dividend policy because of its
unfavourable working capital position of the
amount required for future growth of the
concerns.
 FACTORS DETERMINING
DIVIDEND POLICY
• Profitable Position of the Firm
• Uncertainty of Future Income
• Legal Constrains
• Liquidity Position
• Sources of Finance
• Growth Rate of the Firm
• Tax Policy
• Capital Market Conditions (Perfect or imperfect)
 Does Dividend Policy Matter?
 Dividends matter – the value of the stock is
based on the present value of expected
future dividends
 Dividend policy may not matter
Dividend policy is the decision to pay dividends
versus retaining funds to reinvest in the firm
In theory, if the firm reinvests capital now, it
will grow and can pay higher dividends in the
future

17-8
 Dividend Decision Theories
• Dividend decision consists of two
important concepts which are based on
the relationship between dividend
decision and value of the firm.
• There are two theories
– Irrelevance of Dividend
– Relevance of Dividend (Bird-in-the-
Hand Theory)
 Irrelevance of Dividend
Theory
• According to professors Soloman,
Modigliani and Miller, dividend policy has
no effect on the share price of the
company.
• There is no relation between the dividend
rate and value of the firm. Dividend
decision is irrelevant of the value of the
firm.
• Modigliani and Miller contributed a major
approach to prove the irrelevance dividend
concept.
 MM Assumptions
 MM approach is based on the following
important assumptions:
1. Perfect capital market.
2. Investors are rational.
3. There are no tax.
4. The firm has fixed investment policy.
5. No risk or uncertainty.
 Criticisms of MM approach
 MM approach consists of certain criticisms also. The following are the major criticisms of MM
approach.

 MM approach assumes that tax does not exist. It is not applicable in

the practical life of the firm.
 MM approach assumes that, there is no risk and uncertain of the
investment. It is also not applicable in present day business life.
 MM approach does not consider floatation cost and transaction cost. It
leads to affect the value of the firm.
 MM approach considers only single decrement rate, it does not exist in
real practice.
 MM approach assumes that, investor behaves rationally. But we
cannot give assurance that all the investors will behave rationally.
 RELEVANCE OF DIVIDEND
• According to this concept, dividend
policy is considered to affect the value
of the firm.
• Relevance of dividend concept is
supported by two eminent persons like
Walter and Gordon.
 Walter’s Model

• Prof. James E. Walter argues that the

dividend policy almost always affects the
value of the firm.
• Walter model is based in the relationship
between the following important factors:
– Rate of return I
– Cost of capital (k)
 Walter’s Model(Contd…)
• According to the Walter’s model, if r > k,
the firm is able to earn more than what the
shareholders could by reinvesting, if the
earnings are paid to them.
• The implication of r > k is that the
shareholders can earn a higher return by
investing elsewhere.
• If the firm has r = k, it is a matter of
indifferent whether earnings are retained or
distributed.
 Assumptions of Walter’s
Model
Walters model is based on the following important
assumptions:
1. The firm uses only internal finance.
2. The firm does not use debt or equity finance.
3. The firm has constant return and cost of capital.
4. The firm has 100 recent payout.
5. The firm has constant EPS and dividend.
6. The firm has a very long life.
 Gordon’s Model
 Myron Gorden suggest one of the popular model which
assume that dividend policy of a firm affects its value, and it
is based on the following important assumptions:

1. The firm is an all equity firm.

2. The firm has no external finance.

3. Cost of capital and return are constant.

4. The firm has perpectual life.

5. There are no taxes.

6. Cost of capital is greater than growth rate

 Stock Dividends Vs. Stock Splits,
continued
• Both stock dividends and stock splits increase the
number of shares outstanding, so the “pie is
divided into smaller pieces”.
• Unless the stock dividend or split conveys
information, or is accompanied by another event
like higher dividends, the stock price falls so as to
keep each investor’s wealth unchanged.
 Low Payout Please
• Why might a low payout be desirable?
– High Level of income: Individuals in upper
income tax brackets might prefer lower
dividend payouts, given the immediate tax
liability, in favor of higher capital gains with the
deferred tax liability
– Flotation costs – low payouts can decrease the
amount of capital that needs to be raised,
thereby lowering flotation costs
– Dividend restrictions – debt contracts might
limit the percentage of income that can be paid
out as dividends

17-19
 High Payout Please
 Why might a high payout be desirable?
 Desire for current income
Individuals that need current income, i.e., retirees
Groups that are prohibited from spending
principal (trusts and endowments)
 Uncertainty resolution – no guarantee that the higher
future dividends will materialize
 Taxes
Dividend exclusion for corporations
Tax-exempt investors don’t have to worry about
differential treatment between dividends and
capital gains

17-20
 What’s the “information content,” or “signaling,”
hypothesis?

• Asymmetric information – managers have more information

about the health of the company than investors

• Managers hate to cut dividends, so won’t raise dividends

unless they think raise is sustainable. So, investors view
dividend increases as signals of management’s view of the
future.

• Therefore, a stock price increase at time of a dividend

increase could reflect higher expectations for future
dividends themselves, not to a change in the dividend payout
policy.
 What’s the “clientele effect”?

• Different groups of investors, or clienteles, prefer

different dividend policies.

• The dividend clientele effect states that high-tax bracket

investors (like individuals) prefer low dividend payouts
and low tax bracket investors (like corporations and
pension funds) prefer high dividend payouts. So
different groups desire different levels of dividends.

• Clientele effects impede changing dividend policy.

Taxes & brokerage costs hurt investors who have to
switch companies.
 Repurchase of Stock
• When the firm itself repurchases
(buyback) its own stock from the share
holders, either in the open (secondary)
market or by self-tender offer, we called
it Stock Repurchase.
• Instead of declaring cash dividends,
firms can rid itself of excess cash
through buying shares of their own
stock.
• Recently share repurchase has become
an important way of distributing
earnings to shareholders.
 Reasons for stock repurchase
• If there is no best investment option like investing on
its own stock.
• If there is excess free cash out of current investment
opportunity and dividend.
• To defend hostile takeover by other company.
• “Go private” by repurchasing all shares from outside
stockholders
• To permanently retire the shares.
• As an alternative to distributing cash as dividends.
• To make a large capital structure change.

19-24
 Methods of Repurchase
Open-market repurchase - A company repurchases its stock
through a brokerage on the secondary market. In this repurchase
style the companies not announce that it is going to repurchase.
Fixed-price self-tender offer - An offer by a firm to repurchase some
of its own shares, typically at a set price and at specified period of
time.
Dutch auction self-tender offer - A buyer (seller) seeks bids within a
specified price range, usually for a large block of stock or bonds.
Direct negotiation - In this method of repurchase the firm directly
discuss with some shareholders to repurchase their share.

19-25
 Stock Dividends and Stock Splits
Stock Dividend: A payment of additional or bonus shares of stock to existing
shareholders. Often used in place of or in addition to a cash dividend.
Firm issues new shares in lieu of paying a cash dividend. If 10%, get 10
shares for each 100 shares owned.

Stock split: Firm increases the number of shares outstanding, say 2:1.
Sends shareholders more shares.

 Both stock dividends and stock splits increase the number of shares
outstanding, so “the pie is divided into smaller pieces.”

 Unless the stock dividend or split conveys information, or is

accompanied by another event like higher dividends, the stock price falls
so as to keep each investor’s wealth unchanged.
19-26
 Stock dividend and stock split ...cont’d

Bonus shares and share splits:

• involve issuing new shares on a pro-rata
basis to the current shareholders
• do not change the firm’s assets,
earnings, risk assumed and investors’
percentage of ownership in the company
• increase the number of shares
outstanding
• reduce the value per share

19-27
 Why firms pay stock
dividend?
• To avoid double taxation
• Stock dividend is great means to pay
dividend under financial difficulty.
• Conservation of cash - for other
profitable investment
• Is bell or indication of higher future profit
• To increase future dividend
• To make the share price more attractive

19-28
 Reverse Splits
 When the share is over split it becomes undervalue and loss
respect from many investors.
 Undervalued shares are not as such traded in the market
because their price in the market is below the popular
trading range.
 Like stock split reverse split also not affect the equity of share
holders.
 Reasoning:
reduction in transaction costs
increase in share marketability (trading range)
regain respectability.

19-29
 The end of Chapter 3

Thank you!!

19-30