Chapter

14

DIVIDEND POLICY

Understand cash payout procedures, their tax treatment, and the

role of dividend reinvestment plans.

Describe the residual theory of dividends and the key arguments

with regard to dividend irrelevance and relevance.

Discuss the key factors involved in establishing a dividend policy.

Review and evaluate the three basic types of dividend policies.

Evaluate stock dividends from accounting, shareholder, and company

points of view.

Explain stock splits and the firms motivation for undertaking them

Retain the cash to fund new investments,

Use the cash to pay off some of its debt, and/or

Distribute the cash back to the firms

shareholders either as a cash dividend or as
stock repurchases.

Return =

P1 - Po + D1
Po

P1 - Po
+
Po
Capital Gain

D1
Po
Dividend Yield
4

Finance profitable capital investments?

OR
Pay dividends to stockholders?

If we retain earnings for profitable investments, dividend

yield will be zero, but the stock price will increase,
resulting in a higher capital gain.

Return =

P1 - Po
Po

D1
Po
6

If we pay dividends, stockholders receive an

immediate cash reward for investing, but the capital
gain will decrease, since this cash is not invested in the
firm.

Return =

P1 - Po
Po

D1
Po
7

 How

much of the firms earnings should be

distributed to shareholders as dividends,
and

How

much should be retained for capital

investment?

The term payout policy refers to the decisions that a

firm makes regarding whether to distribute cash to
shareholders, how much cash to distribute, and the
means by which cash should be distributed.

Many companies pay a regular cash dividend.

Public companies often pay quarterly.
Sometimes firms will pay an extra cash dividend.

Companies will often declare stock dividends.

No cash leaves the firm.
The firm increases the number of shares outstanding.

Some companies declare a dividend in kind.

Ex: Wrigleys Gum sends a box of chewing gum.

10

A dividend is a redistribution from earnings.

Most companies maintain a dividend policy whereby they pay

a regular dividend on a quarterly basis.

Some companies pay an extra dividend to reward

shareholders if theyve had a particularly good year. Many
companies pay dividends according to a preset payout ratio,
which measures the proportion of dividends to earnings.

11

Dividend growth tends to lag behind earnings growth for most

corporations.

Since dividend policy is one of the factors that drives an

investors decision to purchase a stock, most companies
announce their dividend policy and telegraph any expected
changes in policy to the public.

Therefore, it can be seen that many companies use their

dividend policy to provide information not otherwise
available to investors.

12

At quarterly or semiannual meetings, a firms board of

directors decides whether and in what amount to pay cash
dividends.

If the firm has already established a precedent of paying

dividends, the decision facing the board is usually whether to
maintain or increase the dividend, and that decision is based
primarily on the firms recent performance and its ability to
generate cash flow in the future.

Boards rarely cut dividends unless they believe that the firms
ability to generate cash is in serious jeopardy.

13

The board of directors declares the dividend on the

announcement/declaration date, determines the amount of the
dividend, and decides on the payment date
The date of record (dividends) is set by the firms directors, the
date on which all persons whose names are recorded as
stockholders receive a declared dividend at a specified future
time.
A stock is ex dividend for a period, beginning 2 business days
prior to the date of record, during which a stock is sold without
the right to receive the current dividend.
The payment date is set by the firms directors, the actual date
on which the firm mails the dividend payment to the holders of
record.

14

15

On June 24, 2010, the board of directors of Best Buy announced

that the firms next quarterly cash dividend would be $0.15 per
share, payable October 26 to shareholders of record on October
5. At the time, Best Buy had 420,000,000 shares of common
stock outstanding. Before the dividend was declared, the key
accounts of the firm were as follows (dollar values quoted in
thousands):
Cash: $1,826,000
Dividends payable: $0
Retained earnings: $5,797,000

16

When the dividend was announced by the directors, $63

million of the retained earnings ($0.15 per share 420
million shares) was transferred to the dividends payable
account. The key accounts thus became:
Cash: $1,826,000
Dividends payable: $63,000
Retained earnings: $5,734,000

17

When Best Buy actually paid the dividend on October

26, this produced the following balances in the key
accounts of the firm:
Cash: $1,763,000
Dividends payable: $0
Retained earnings: $5,734,000

The net effect of declaring and paying the dividend was

to reduce the firms total assets (and stockholders
equity) by $63 million.
18

19

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
Dividends matter the value of the stock is based
on the present value of expected future dividends

20

Merton Miller and Franco Modigliani (MM) developed

a theory that shows that in perfect financial markets
(certainty, no taxes, no transactions costs or other
market imperfections), the value of a firm is unaffected
by the distribution of dividends.

They argue that value is driven only by the future

earnings and risk of its investments.

Retaining earnings or paying them in dividends does

not affect this value.
21

Consider a firm that can either pay out dividends of RM10,000 per
year for each of the next two years or can pay RM9000 end of this
year, reinvest the other RM1000 into the firm and then pay
RM11,120 next year. Investors require a 12% return.

Market Value with constant dividend :

PV = 10,000 / (1.12) + (10,000) / 1.122 = RM16,900.51

Market Value with reinvestment:

PV = 9000 / (1.12) + 11,120 / (1.12)2 = RM16,900.51

If the company will earn the required return, then it doesnt matter
when it pays the dividends

22

XYZ Inc. is a RM42 stock about to pay a RM2 cash dividend.

An investor owns 80 shares and prefers a RM3 dividend.
The investors homemade dividend strategy:
Sell 2 shares ex-dividend
homemade dividends
Cash from dividend
RM160
Cash from selling stock
RM 80
Total Cash
RM240
Value of Stock Holdings
RM40 78 =
RM3120

RM3 dividend
RM240
0
RM240
RM39 x 80 =
RM3120
23

R
M
4
2
,R
R
M
3
6
0

8
s
h
a
r
e

s
h
a
r
e
R
M
3
9
R
,M
M
3
6
0

8
s
h
a
r
e

R
M
2
4
0
s
h
a
r
e
R
M
4
0
3,6078shareshareR
M
160R
M
80

In the above example, the investor began with a total

wealth of RM3,360:

After a RM3 dividend, his total wealth is still RM3,360:

After a RM2 dividend and sale of 2 ex-dividend shares, his

total wealth is still RM3,360:

24

The clientele effect is the argument that different payout policies

attract different types of investors but still do not change the
value of the firm.
Tax-exempt investors may invest more heavily in firms that pay
dividends because they are not affected by the typically higher tax rates
on dividends.
Investors who would have to pay higher taxes on dividends may prefer
to invest in firms that retain more earnings rather than paying dividends.
If a firm changes its payout policy, the value of the firm will not change
what will change is the type of investor who holds the firms shares.

25

Some investors prefer low dividend payouts and will

buy stock in those companies that offer low dividend
payouts

Some investors prefer high dividend payouts and will

buy stock in those companies that offer high dividend
payouts

26

Clienteles for various dividend payout policies are likely to

form in the following way:

Group
High Tax Bracket Individuals
Low Tax Bracket Individuals
Tax-Free Institutions
Corporations

Dividend Preference
Zero-to-Low payout
Low-to-Medium payout
Medium payout
High payout

Once the clienteles have been satisfied, a corporation is unlikely to

create value by changing its dividend policy.
27

What do you think will happen if a firm changes its

policy from a high payout to a low payout?

What do you think will happen if a firm changes its

policy from a low payout to a high payout?

If this is the case, does dividend POLICY matter?

28

Dividend reinvestment plans (DRIPs) are plans that enable

stockholders to use dividends received on the firms stock to
acquire additional shareseven fractional sharesat little or no
transaction cost.
Some companies even allow investors to make their initial purchases of
the firms stock directly from the company without going through a
broker.
With DRIPs, plan participants typically can acquire shares at about 5
percent below the prevailing market price.

29

The financial literature has reported numerous theories and

empirical findings concerning payout policy.
Although this research provides some interesting insights
about payout policy, capital budgeting and capital structure
decisions are generally considered far more important than
payout decisions.
In other words, firms should not sacrifice good investment and
financing decisions for a payout policy of questionable
importance.
The most important question about payout policy is this: Does
payout policy have a significant effect on the value of a firm?

30

The residual theory of dividends is a school of thought that

suggests that the dividend paid by a firm should be viewed as a
residualthe amount left over after all acceptable investment
opportunities have been undertaken.

31

Using the residual theory of dividends, the firm would treat the
dividend decision in three steps, as follows:
Determine its optimal level of capital expenditures, which would be the
level that exploits all of a firms positive NPV projects.
Using the optimal capital structure proportions, estimate the total
amount of equity financing needed to support the expenditures
generated in Step 1.
Because the cost of retained earnings, rr, is less than the cost of new
common stock, rn, use retained earnings to meet the equity requirement
determined in Step 2. If retained earnings are inadequate to meet this
need, sell new common stock. If the available retained earnings are in
excess of this need, distribute the surplus amountthe residualas
dividends.

32

Dividend relevance theory is the theory, advanced by Gordon

and Lintner, that there is a direct relationship between a firms
dividend policy and its market value.

The bird-in-the-hand argument is the belief, in support of

dividend relevance theory, that investors see current dividends
as less risky than future dividends or capital gains.

33

Studies have shown that large changes in dividends do

affect share price.
Informational content is the information provided by the
dividends of a firm with respect to future earnings, which
causes owners to bid up or down the price of the firms
stock.
The agency cost theory says that a firm that commits to
paying dividends is reassuring shareholders that managers
will not waste their money.

34

Dividend policy represents the firms plan of action to

be followed whenever it makes a dividend decision.
First consider five factors in establishing a dividend
policy:
1.
2.
3.
4.
5.

legal constraints
contractual constraints
the firms growth prospects
owner considerations
market considerations

35

Legal Constraint
Contractual Constraints
Ex: by the restrictive provisions in loan agreements and bond
indentures
Internal Constraints
constrained by the amount of available cash
Although it is possible to borrow to pay dividends, lenders are
usually reluctant to grant them
Growth Prospects
growing firms use most of their internally generated funds to
support operations or finance expansion
Owners Considerations
a high percentage of earnings, new equity capital will have to be
raised with common stock.(i.e. dilution of ownership)
36

Why might a low payout be

desirable?
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
37

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 dont have to worry about
differential treatment between dividends and capital gains
38

Asymmetric information managers have more

information about the health of the company than
investors

Changes in dividends convey information

Dividend increases
Management believes it can be sustained
Expectation of higher future dividends, increasing present value
Signal of a healthy, growing firm
Dividend decreases
Management believes it can no longer sustain the current level
of dividends
Expectation of lower dividends indefinitely; decreasing present
value
Signal of a firm that is having financial difficulties
39

A firms dividend payout ratio indicates the

percentage of each dollar earned that a firm
distributes to the owners in the form of cash. It is
calculated by dividing the firms cash dividend per
share by its earnings per share.
A constant-payout-ratio dividend policy is a
dividend policy based on the payment of a certain
percentage of earnings to owners in each dividend
period.

40

41

Regular dividend policy is a dividend policy based

on the payment of a fixed-dollar dividend in each
period.
A regular dividend policy is often build around a
target dividend-payout ratio, which is a dividend
policy under which the firm attempts to pay out a
certain percentage of earnings as a stated dollar
dividend and adjusts that dividend toward a target
payout as proven earnings increases occur.

42

43

A low-regular-and-extra dividend policy is a

dividend policy based on paying a low regular
dividend, supplemented by an additional (extra)
dividend when earnings are higher than normal in a
given period.

An extra dividend is an additional dividend

optionally paid by the firm when earnings are higher
than normal in a given period.

44

A stock dividend is the payment, to existing owners, of a

dividend in the form of stock.
In a stock dividend, investors simply receive additional shares in
proportion to the shares they already own.
No cash is distributed, and no real value is transferred from the firm to
investors.
Instead, because the number of outstanding shares increases, the stock
price declines roughly in line with the amount of the stock dividend.
In an accounting sense, the payment of a stock dividend is a shifting of
funds between stockholders equity accounts rather than an outflow of
funds.

45

The current stockholders equity on the balance sheet of

Garrison Corporation, a distributor of prefabricated
cabinets, is as shown in the following accounts.
Preferred stock
Common stock (100,000 shares @ $4 par)
Paid-in capital in excess of par
Retained earnings
Total stockholders equity

$300,000
400,000
600,000
700,000
$2,000,000

46

Garrison declares a 10% stock dividend when the

market price of its stock is $15 per share. The resulting
account balances are as follows:
Preferred stock
Common stock (110,000 shares @ $4 par)
Paid-in capital in excess of par
Retained earnings
Total stockholders equity

$300,000
440,000
710,000
550,000
$2,000,000

47

Ms. X owned 10,000 shares of Garrison Corporations stock.

The companys most recent earnings were $220,000, and earnings are
not expected to change in the near future.
Before the stock dividend, Ms. X owned 10% of the firms stock, which
was selling for $15 per share.
Because Ms. X owned 10,000 shares, her earnings were $22,000
($2.20 per share 10,000 shares).
After receiving the 10% stock dividend, Ms. X has 11,000 shares, which
again is 10% of the ownership (11,000 shares 110,000 shares).
The market price of the stock can be expected to drop to $13.64 per
share [$15 (1.00 1.10)], which means that the market value of Ms.
Xs holdings is $150,000 (11,000 shares $13.64 per share).
The future earnings per share drops to $2.

48

The Shareholders Viewpoint

From a shareholders perspective, stock dividends
result in a dilution of shares owned.
For example, assume a stockholder owned 100 shares at
RM20/share (RM2,000 total) before a stock dividend.
If the firm declares a 10% stock dividend, the
shareholder will have 110 shares of stock. However,
the total value of her shares will still be RM2,000.
Therefore, the value of her share must have fallen to
RM18.18/share (RM2,000/110).

49

An investor has 120 shares. Does the value of the

investors shares change?
Shares outstanding: 1,000,000.
Net income = RM6,000,000.
P/E = 10.
25% stock dividend.

50

Before the 25% stock dividend:

EPS = 6,000,000/1,000,000 = RM6.
P/E = P/6 = 10, so P = RM60 per share.
Value = RM60 x 120 shares = RM7,200.
After the 25% stock dividend:
# shares = 1,000,000 x 1.25 = 1,250,000.
EPS = 6,000,000/1,250,000 = RM4.80.
P/E = P/4.80 = 10, so P = RM48 per share.
Investor now has 120 x 1.25 = 150 shares.
Value = RM48 x 150 shares = RM7,200.

51

The Companys Viewpoint

Disadvantages of stock dividends include:
The cost of issuing the new shares
Taxes and listing fees on the new shares
Other recording costs
Advantages of stock dividends include:
The company conserves needed cash
Signaling effect to the shareholders that the firm is retaining
cash because of lucrative investment opportunities

52

A stock split is a method commonly used to lower the

market price of a firms stock by increasing the number
of shares belonging to each shareholder.
Stock splits are often made prior to issuing additional stock
to enhance that stocks marketability and stimulate market
activity.

It is not unusual for a stock split to cause a slight increase in

the market value of the stock, attributable to its
informational content and to the fact that total dividends
paid commonly increases slightly after a split.

53

A stock split is a recapitalization that affects the number of

shares outstanding, par value, earnings per share, and market
price.
The rationale for a stock split is that it lowers the price of the
stock and makes it more attractive to individual investors.
Common explanation for split is to return price to a more
desirable trading range

A reverse stock split reduces the number of shares

outstanding and raises stock pricethe opposite of a stock
split.
The rationale for a reverse stock split is to add respectability to
the stock and convey the meaning that it isnt a junk stock.

54

55

A stock repurchase is the purchasing and retiring of

stock by the issuing corporation.

A repurchase is a partial liquidation since it decreases

the number of shares outstanding.

It may also be thought of as an alternative to cash

dividends.

56

Company buys back its own shares of stock

Tender offer company states a purchase price and a
desired number of shares
Open market buys stock in the open market

Instead of declaring cash dividends, firms can rid

themselves of excess cash through buying shares of their
own stock

Similar to a cash dividend in that it returns cash from the

firm to the stockholders
57

Stock repurchases send a positive signal that

management believes that the current price is low.
Tender offers send a more positive signal than open
market repurchases because the company is stating a
specific price.
The stock price often increases when repurchases are
announced
Repurchases increase leverage, and can be used to
move toward the optimal capital structure.

58

Alternative reasons for stock

repurchases:
To use the shares for another purpose
To alter the firms capital structure
To increase EPS and ROE resulting in a higher
market price
To reduce the chance of a hostile takeover

59

Consider a firm that wishes to distribute RM100,000 to its

shareholders.
Assets
A. Original balance sheet

Liabilities & Equity

Cash
0
RM150,000 Debt
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= RM1,000,000 /100,000 =RM10

60

If they distribute the RM100,000 as a cash dividend, the

balance sheet will look like this:
Assets

Liabilities & Equity

B. After RM1 per share cash dividend
Cash

RM50,000
Other Assets
850,000

Debt
Equity

900,000

Value of Firm

Value of Firm

900,000

900,000

Shares outstanding = 100,000

Price per share = RM900,000/ 100,000 = RM9
61

If they distribute the RM100,000 through a stock repurchase,

the balance sheet will look like this:
Assets
C. After stock repurchase
RM50,000
Cash
Other Assets 850,000
Value of Firm 900,000

Liabilities & Equity

Debt
Equity
Value of Firm

0
900,000
900,000

Shares outstanding = 90,000

Price per share = RM900,000 / 90,000 = RM10

62