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Dividend Policy

Introduction
Dividend policy refers to the choice of a firm to distribute its net earnings to
shareholders, or to invest them in the business. The choice would obviously
depend on the effect of the decision on the value of the firm. In other words, the
relationship between the dividends and the value should be the decision criterion.

Types of dividend policy:


Most companies view a dividend policy as an integral part of the corporate strategy.
Management must decide on the dividend amount, timing, and various other factors
that influence dividend payments. There are three types of dividend policies: a stable
dividend policy, a constant dividend policy, and a residual dividend policy.
Stable Dividend Policy
Stable dividend policy is the easiest and most commonly used. The goal of the policy
is steady and predictable dividend payouts each year, which is what most
investors seek. Whether earnings are up or down, investors receive a dividend. The
goal is to align the dividend policy with the long-term growth of the company rather
than with quarterly earnings volatility. This approach gives the shareholder more
certainty concerning the amount and timing of the dividend.

Constant Dividend Policy


The primary drawback of the stable dividend policy is that investors may not see a
dividend increase in boom years. Under the constant dividend policy, a company
pays a percentage of its earnings as dividends every year. In this way, investors
experience the full volatility of company earnings. If earnings are up, investors get a
larger dividend; if earnings are down, investors may not receive a dividend. The
primary drawback to the method is the volatility of earnings and dividends. It is
difficult to plan financially when dividend income is highly volatile.

Residual Dividend Policy:


Residual dividend policy is also highly volatile, but some investors see it as the only
acceptable dividend policy. With a residual dividend policy, the company pays out
what dividends remain after the company has paid for capital expenditures and
working capital. This approach is volatile, but it makes the most sense in terms of
business operations. Investors do not want to invest in a company that justifies its
increased debt with the need to pay dividends.

Payment Procedures :
Dividend normally are paid semi-annually or quarterly, and, when conditions permit, the
dividend is increased. For example, on October 17, 2006, the board of directors of Eastman
Kodak declared a $0.25 semi-annually common stock dividend. Either in the year, Kodak's
board indicated that it anticipated the annual dividend to be $0.50,which was the same as
the dividend paid in 2005. Kodak's stockholders were not raised when the $O.25semiannual
dividend was announced , but they would have been shocked if the dividend had been
eliminated because Kodak has paid a dividend since 1l2002.When Kodak declared the semi-
annual dividend , it issued the following statement:
1. Declaration Date
The board of directors of the company announces that a specified amount of dividend will be
paid to the stockholders. It is paid to the stockholders who will be on the record on the
company's record at some particular future date. The date on which directors meet and
announce dividend is called declaration date. Generally, the dividend is announced as a
percentage on the par value of the stock. However, in some cases, it can be the absolute amount
as $ 2 dividend per share.
2. Date Of Record
Along with the dividend announcement, the board of directors also specifies a date of record.
For example, if the board of directors meets on June10, 2010, and declares a 10 % cash
dividend to the stockholders of record on September 15; the July 10 is called declaration date
and the September 15 is called date of record. The company prepares a list of stockholders
from the stock transfer book at the close of business on the date of record. All the stockholders
of the record date are entitled to receive dividend as declared by the board. The new
stockholders would receive dividend if the shareholders' name is recorded in the shareholders'
registered on or before the date of record. But, if the company were notified of the transfer
after the date of record, the old owner of the stock would receive the dividends.
3. Ex-dividend Date
There can be delay of several days from the time a transfer takes place to the time the firm is
informed of the transfer. Therefore, shares transferred on, say September 12, would not
generally recorded on the company's book. In normal practice, the buyer and seller of the
stocks have four business days to settle the transactions prior to the date of record. For
example, if the date of record is September 15, the transaction must take place before
September 11 to entitle the new holder to receive dividend. Thus, the date when the right to
the dividend leaves the stock for new owner is called ex-dividend date. In our example if stock
is bought on or after September 11, the new shareholder is not entitled to receive dividend. As
a result of this, we normally expect that stock price will decline exactly by the amount of
dividend per share on the ex-dividend date.
4. Payment Date
At the time of dividend announcement, the board of directors also specifies the date on which
the payment of dividend is actually made and it is called the payment date. On this date the
company actually pays the dividend to all the stockholders of the date of record.

Dividend policy theory:

The relevant theory:

The value of firm is affected by its dividend policy the optimal dividend policy is the
one that maximizes the firm's value. The relevant theories are

1. The dividend valuation model


2. The Gordon growth model

The irrelevancy theory:

The theory that a firm's dividend policy has no effect on either its value or its cost of capital.
The irrelevant dividend policy is

Modigliani and Miller’s dividend

The dividend valuation model

This states that the value of a company’s shares is sustained by the expectation of
future dividends. Shareholders acquire shares by paying the current share price and
they would not pay that amount if they did not think that the present value of future
inflows (ie dividends) matched the current share price. The formula for the dividend
valuation model provided in the formula sheet is:

P0 = D0 (1+ g)/(re – g)

Where:

P0 = the ex-div share price at time 0 (i.e. the current ex div share price)
D0 = the time 0 dividend (i.e. the dividend that has either just been paid or which is
about to be paid)
re = the rate of return of equity (i.e. the cost of equity)
g = the future annual dividend growth rate.

The Gordon growth model

This model examines the cause of dividend growth. Assuming that a company makes neither
a dramatic trading breakthrough (which would unexpectedly boost growth) nor suffers from
a dreadful error or misfortune (which would unexpectedly harm growth), then growth arises
from doing more of the same, such as expanding from four factories to five by investing in
more non-current assets. Apart from raising more outside capital, expansion can only
happen if some earnings are retained. If all earnings were distributed as dividend the
company has no additional capital to invest, can acquire no more assets and cannot make
higher profits.It can be relatively easily shown that both earnings growth and dividend
growth is given by:

g = br

where b is the proportion of earnings retained and R is the rate that profits are earned on
new investment. Therefore, (1 – b) will be the proportion of earnings paid as a dividend.
Note that the higher b is, the higher is the growth rate: more earnings retained allows more
investment to that will then produce higher profits and allow higher dividends. So, if
earnings at time 1 are E1, the dividend will be E1(1 – b) so the dividend growth formula can
become:

P0 = D1 /(re – g) = E1 (1 – b)/(re – br)

Modigliani and Miller’s dividend irrelevancy theory

This theory states that dividend patterns have no effect on share values. Broadly it suggests
that if a dividend is cut now then the extra retained earnings reinvested will allow futures
earnings and hence future dividends to grow. Dividend receipts by investors are lower now
but this is precisely offset by the increased present value of future dividends. However, this
equilibrium is reached only if the amounts retained are reinvested at the cost of equity.

Example 1: earnings are all paid as dividend


Current position: Earnings = $0.8 per share (all paid out as dividend); R E =20%, the price per
share. would be

P0 = 0.8/0.2 = $4 (the PV of constant dividends received in perpetuity).

Example 2: earnings are reinvested at the cost of equity


So, what would happen if, from Time 1 onwards, half the earnings were paid out as dividend
and half retained AND re = R = 0.2 (meaning that the return required by investors is the
return earned on new investment)?

P0 = E1 (1 – b)/(re – bR)

P0 = 0.8(1 – 0.5)/(0.2 – 0.5 x 0.2) = $4

So, no change in the share value, and so the dividends are irrelevant.

Example 3: earnings are reinvested at more than the cost of equity


For example, the company has made a technological breakthrough and invests the retained
earnings to make use of the enhanced opportunities. As you might be able to predict, this
piece of good fortune must increase the share price.

re = 0.2 (as before) and R = 0.3

P0 = 0.8(1 – 0.5)/(0.2 – 0.5 x 0.3) = $8

In this case, the share price rises because the extra earnings retained have been invested in
a particularly valuable way.
Example 3: earnings are reinvested at less than the cost of equity
For example, the company invests the retained earnings in a way that turns out to be poor.
It has messed up. As you might be able to predict, this piece of bad luck or carelessness
must decrease the share price.

re = 0.2 (as before) and R = 0.1

P0 = 0.8(1 – 0.5)/(0.2 – 0.5 x 0.1) = $2.67

Dividend reinvestment plan (DRIP):

A plan that enables a stockholder to automatically reinvest dividends received


back into the stock of the paying firm. Most large companies offer dividend
reinvestment plans (DRIPs).

Plan the stockholder can automatically reinvest dividends they receive in the stock of the
paying corporation. There are two types of DRIPs (referred to as “drips" ):(I) plans that
involve only “old" stock that already is outstanding and traded in the financial markets and
(2) plans that involve newly issued stock. In either case, the stockholder must pay income
taxes on the amount of the dividends even though stock rather than cash is received.

FACTORS INFLUENCING DIVIDEND POLICY


In addition to management’s belief concerning which dividend theory is most Correct, a
number of other factors are considered when a particular dividend policy is chosen. The
factors firms take into account can be grouped into these five breed categories:

1. Constraints on dividend payments: The amount of dividends a arm can pay might be limited
due to (I) debt contract restrictions, which often stipulate that no dividends can be paid unless certain
financial measures exceed stated minimums; (2) the fact that dividend payments cannot exceed the
balance sheet item “retained earnings" (this is known as the impairment of capital role, which is
designed to protect creditors by prohibiting the company form distributing assets to stockholders
before debt holders are paid); (3) cash availability because cash dividends can be paid only with cash;
and(4) restrictions imposed by the Internal Revenue Service (IRS)on improperly accumulated
retained earnings. If the IRS can demonstrate that a firm's dividend payout ratio is being held down
deliberately to help its stockholders avoid personal taxes, the firm is subject to lax penalties. But this
factor generally is relevant only to privately owned firms.

2. Investment opportunities: Firm's that have large numbers of acceptable capital budgeting
projects generally have low dividend payout ratios and vice versa. But if a firm can accelerate or
postpone projects (flexibility) then it can adhere more closely to a target divided policy.
3. Alternative sources of capital: When a firm needs to finance a given level Of investment and
flotation costs are high the cost of external equity, rs making it better to set a law payout ratio and to
finance by retaining earnings rather than through sale of new common stock. Also, if the firms can
adjust its debt/assets ratio without raising capital sharply, it can maintain a stable dollar dividend,
even if earnings fluctuate, by using a variable debt /asset ratio.

4. Ownership dilution : If management is concerned about maintaining control it might be reluctant


to sale new stock; hence . the company might retain more earnings than it otherwise world more
earnings than otherwise would.

5. Effects of dividend policy on rs: The effects of dividend policy on rs might be considered in term
of four factor: (a) stockholder desire for current versus future income. (b) the perceived riskiness of
dividends versus capital gain, (c) the tax advantage of capital gains over most dividends and (d) the
information content of dividend. Because we discussed each of these factor earlier.

Stock Dividend and Stock Split


Stock Dividend:

A stock dividend is a dividend payment made in the form of additional shares rather
than a cash pay-out. Companies may decide to distribute this type of dividend to
shareholders of record if the company's availability of liquid cash is in short supply.
These distributions are generally acknowledged in the form of fractions paid per
existing share, such as if a company issued a stock dividend of 0.05 shares for each
single share held by existing shareholders.

Stock Split:

A stock split is a corporate action in which a company divides its existing shares into
multiple shares to boost the liquidity of the shares. Although the number of shares
outstanding increases by a specific multiple, the total dollar value of the shares
remains the same compared to pre-split amounts, because the split does not add any
real value. The most common split ratios are 2-for-1 or 3-for-1, which means that the
stockholder will have two or three shares, respectively, for every share held earlier.

Dividend signalling theory: Dividend signalling is a theory that suggests that a company
announcement of an increase in dividend pay-outs is an indication of positive future
prospects. The theory is directly tied to game theory; managers with good investment
potential are more likely to signal. While the concept of dividend signalling has been widely
contested, the theory is still a concept used today by some investors.
Because the dividend signalling theory has been treated skeptically by analysts and
investors, there has been regular testing of the theory. On the whole, studies indicate that
dividend signalling does occur. Increases in a company's dividend pay-out generally forecast
a positive future performance of the company's stock. Conversely, decreases in dividend pay
outs tend to accurately portend negative future performance by the company.