DIVIDEND POLICY

Introduction
• When a firm generates cash from operations,
what can the firm do with the cash?

1. Use the cash to fund new investments,

2. Use the cash to pay off some of its debt, and/or
3. Distribute the cash back to the firm’s
shareholders either as a cash dividend or as
stock repurchases.
 Introduction (cont.)
• This chapter provides answers to three questions regarding a
firm’s dividend policy:
1. What are the pros and cons of the methods the
firm can use to distribute cash?
2. Why should the firm’s shareholders care about
the firm’s dividend policy given that they can
generate cash when they need it by selling some
of their shares?
3. What cash distribution policies do most firms
use in practice?
 DIVIDEND POLICY
Factors to be considered for deciding a dividend policy:
External factors – the external factors that the finance
manager is required to take into consideration before
formulating the dividend policy of the company are:
1.Investment opportunities – The formulation of the
dividend policy depends upon the investment
opportunities available to the company. The company
will like to retain the profits to be invested in the
projects whose investment opportunities involve a
higher rate of return than the cost of capital of the
company.
 DIVIDEND POLICY – External factors
– 2.Phase of the trade cycles – The dividend policy of the
company depends upon the phase of the trade cycle that
the company is in.
– In the phase of boom and prosperity the company will like
to retain more profits which can be used by it during the
times of depression. Further by retaining the profits the
company will like to take benefits of the investment
opportunities prevailing during the time of boom.
– Thus the company does not like to distribute huge
amounts of profits by way of dividends in the time of
boom though its earning capacity permits it to do so. the
company likes to withhold the dividend payments
– During times of depression to retain profits in the business
to preserve its liquidity position. It is also necessary that
the company declares high dividends to increase the
marketability of its shares.
DIVIDEND POLICY – External factors
3.Tax policy – The dividend can be paid by the company
only out of the profit after tax, thus the tax policy of
the government affects the dividend policy of the
company. For the shareholder dividend received is
taxable income, this increases the tax liability of the
individual.
• 4.Legal restrictions – The Company has to formulate
its dividend policy within the legal framework of the
Companies Act
• 5.The restrictions imposed by the lending institutions
– The lending banks and financial institutions impose
certain restrictions on the company preventing the
payment of dividend entirely, or limiting the amount of
dividend, or disallowing the payment of dividend if
certain conditions are not fulfilled by the company so
long as it still owns loans to them.
 DIVIDEND POLICY – Internal factors
• 1. Liquidity position – Before formulating the dividend
policy consideration should be given to the present
liquidity position and future liquidity commitments of the
company.
• 2. Attitude of the management – The dividend policy
depends upon the attitude of the management. If the
management is aggressive it may decide to pay more
dividends but if the management is conservative it will like
to retain more profits in the business to take care of
contingencies.
• 3. Age of the company – A young and growing concern
likes to retain maximum profits in the business in order to
grow further and to expand whereas an old and
established concern has reached the saturation point and
will follow a high dividend policy.
 DIVIDEND POLICY – Internal factors
• 4. Composition of shareholding – If the company is a
private limited company having less number of
shareholders it will like to retain more profits and restrict
the payment of dividends so as to reduce the tax liability of
the individual shareholders. But if the company is a public
limited company tax bracket of the individual shareholders
does not have a significant impact on the dividend policy of
the company.

• 5. Nature of business / earnings – A company having stable

earnings may be able to formulate long term dividend
policy and may even follow a high dividend policy if the
earnings permit. But a company having unstable earnings
may retain its profits during boom to ensure the dividend
policy is not affected by cyclical variations.
 DIVIDEND POLICY – Internal factors

• 6. Customs and traditions – The customs and traditions of

the company also affect the dividend policy of the company
e.g. a company having a stable dividend policy for 20 years
will maintain the same in the 21st year despite adverse
profitability or liquidity situations.

• 7. Growth rate of company – A rapidly growing company

will retain a majority of its profits in order to take care of its
expansion needs.
 16.1 How Do Firms
Distribute Cash to their
Shareholders?

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How Do Firms Distribute Cash to their
Shareholders?
• With cash dividend, cash is paid directly to the
shareholders. The shareholders can not increase the
rate of dividend recommended by the board of
directors.
• The board of directors can also declare an interim
dividend. This is the dividend declared between two
annual general meetings.
• With a share repurchase, a company uses cash to buy
back its own shares from the market place, thereby
reducing the number of outstanding shares.
 Cash Dividends
• A firm’s dividend policy determines how much
cash it will distribute to its shareholders and
when these distributions will be made.
• Dividends are generally described in terms of
dividend payout ratio, which indicates the
amount of dividends paid relative to the
company’s earnings.
 Dividend Payment Procedures
• Generally, companies pay dividends on a
quarterly basis. There are several dates that
are important with regard to dividend
payment:
• (a) Announcement date: It is the date on
which dividend is formally declared by the
board of directors.
• (b) Date of record: Investors who own stock on
this date receive the dividend. However, this
date was pushed forward two days to ex-
dividend date.
 Dividend Payment Procedures (cont.)

(c) Ex-dividend date: This is two days before the

date of record, and any investor who buys
shares after the ex-dividend date is not
entitled to dividend.
(d) Payment date: This is the date on which
dividend cheques are mailed to the investors.
 Dividend Payment Procedures (cont.)
Date Explanation Calendar Date
Announcement Date Dividend is declared. March 15
Ex-Dividend Date Shares begin trading May 17
ex-dividend.
Record Date Dividend will be paid to May 19
shareholders who own
the stock on this date.

Payment Date Dividends are May 27

distributed to the
shareholders of record
on the record date.
 Stock Repurchases (Stock Buyback)
• Stock repurchase is when a firm uses its cash
to repurchase some of its own stock. This
results in a reduction in the firm’s cash
balance as well as the number of shares of
stock outstanding.
• 3-types:
• 1. Open Market Repurchase - Here the firm
acquires the stock on the market, often buying
a relatively small number of shares everyday.
This will put upward pressure on share prices.
This is the most widely used method for stock
repurchase.
 Repurchase Their Shares?-3 types
• 2.Tender Offer - A company uses this method
when it wants to buy a relatively large number
of shares very quickly.
– The company makes a formal offer to buy a
specified number of shares at a stated price.
– The price is set above the market price to attract
sellers.
• Direct Purchase from a large investor
– Here the firm purchases the stock from one or
more major stockholders on a negotiated basis.
This method is not used frequently.
 Non-Cash Distributions: Stock Dividends and Stock
Splits
• A stock dividend is a pro-rata distribution of
additional shares of stock to the firm’s current
stockholders. These distributions are generally
defined in terms of a fraction paid per share.
– For example, a firm might pay a stock dividend of .20
shares of stock per share or 2 shares for every 10 held.
• Stock split is essentially a very large stock
dividend. For example, a 2-for-1 split would entail
receiving two new shares for every old share
currently held.
- With a 2-for-1 split, the number of shares
will double and the share price will drop in half.
16.2 Does Dividend
Policy Matter?

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 Does Dividend Policy Matter?
• Modigiliani and Miller suggest that without
taxes and transaction costs, cash dividends
and share repurchases are equivalent and the
timing of the distribution is unimportant.

• This is known as the Modigiliani and Miller

dividend irrelevancy proposition.
 The Irrelevance of the Distribution
Choice
• The distribution choice is irrelevant under the
following assumptions:
1. There are no taxes.
2. No transaction costs are incurred in either
buying or selling shares of stock.
3. The firm’s operating and investment policies are
fixed.
 The Irrelevance of the Distribution
Choice (cont.)
• The dividend irrelevancy proposition can be
illustrated in two ways:

1.Timing of dividend distributions does not affect

firm value.
2.In the absence of taxes and transaction costs, a
cash dividend is equivalent to a share repurchase.
 Individual Investor Wealth Effects –
Personal Taxes
• What are the tax rules with regard to
dividends and share repurchases?
1. 100% of cash dividends are taxable in the year in
which they are received.
2. When individuals sell shares, tax is assessed only
on the capital gain (i.e. price appreciation of
stock).
 Individual Wealth Effects –
Personal Taxes (cont.)
3. If an individual decides not to sell his or her
share back to the company making the stock
repurchase, they will not incur any taxes.
Why Dividend Policy is Important?
• Transactions are costly
– Since taxes are incurred when dividends are
received and transactions costs are incurred when
buying and selling shares, investors will prefer to
select companies whose dividend policy match up
with their own preferences. Because firms with
different dividends attract different dividend
clienteles, it is important that dividend policy
remain somewhat stable.
 Why Dividend Policy is Important?
(cont.)
• The Information Conveyed by Dividend and
Share Repurchase Announcement
– Investors and stock market are constantly trying to
decipher the information released by firms to
better understand what they imply about firm
values.
– Firms tend to increase their dividends when
dividends can be sustained in the future. In such
cases, dividend increase is clearly good news.
 Why Dividend Policy is Important?
(cont.)
• Share repurchases are also viewed very
favorably as it reveals that the firm has
generated more money than it currently
needs. Share repurchases may also reveal that
the equity is currently underpriced.
• The empirical evidence indicates that
dividends and share repurchases do in fact
convey favorable information to investors.
 Why Dividend Policy is Important?
(cont.)
• The Information Conveyed by Stock Dividends
and Stock Splits
– The announcement of stock dividends and stock
splits also tend to generate positive stock returns.
This increase is harder to explain as stock
dividends and stock splits do not affect firm’s cash
flows.
– Some researchers have suggested that firms have
a preferred trading range and stock splits help
bring stock prices to that trading range.
 Why Dividend Policy is Important?
(cont.)
• A second possibility is that stock splits and
stock dividends tend to attract attention.
Naturally, firm would like to attract attention
only when the prospects are favorable.

• Thus even though there is no direct effect on

cash flows, the market reacts favorably.
16.3 Cash Distribution
Policies in Practice

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 Cash Distribution Policies in Practice
1. Stable Payout- In a survey of CEOs, most
CEOs recognized the importance of
maintaining consistency and stability in
dividend policy.
2. Stock Repurchase decisions - are driven by
executive’s feeling that the stock is a good
investment relative to its true value and that
there are a lack of good investment
opportunities to invest in.
 Residual Dividend Policy
3. Residual dividend policy, the firm first
finances its investments using its own
earnings. Dividends are paid out of the
residual earnings that are not needed to
finance new investment opportunities.
• While this policy minimizes the cost of
financing, it can lead to unstable dividends for
shareholders.
Other Factors Playing a Role in How Much to
Distribute
i. Liquidity Position - Because dividend payments
and stock repurchases are made with cash, and not
with retained earnings, the firm must have cash
available for payouts to be made.
ii. Lack of Other Sources of Financing - Many small
or new companies may not have access to the capital
markets, and must depend upon internally generated funds
to fund their investment opportunities. As a result, the
dividend pay out ratio for such firms is generally lower.
iii. Earnings Predictability - A company’s payout ratio
depends to some extent on the predictability of a firm’s
profits over time. Firms with stable earnings will typically
pay out a larger portion of its earnings.