Chapter 1 (B) Dividends and Dividend Policy

Chapter 1
A Review of Dividends and Dividend Policy
 What are dividends?

 Distributions of earnings or profits to
shareholders.
 Dividends can be: cash dividend or stock
dividend.
 Cash dividends can take the form of :Regular,
Extra, Special, or Liquidating dividends (not
distribution of profits)
 Stock repurchases are sometimes used in lieu
of cash dividend
By A.S.@AAUSC,20017 1
 Dividends can be stated as: DPS, Payout Ratio,

and Dividend Yield.
Dividends policy involves resolving:
1) How much to pay or what percent of earnings to
pay?
2) How should earnings be distributed?
 Cash dividends, stock repurchases or both
3) How stable should it be?
 a balanced approach that considers the interest of
shareholders and that of the firm is the best
• Terms and procedures to dividend payments

1. Declaration of dividend
2. Holder of record date/date of record
3. Ex-dividend date
4. Payment date
e.g.
Jan 10 17 19 30
Declaration Ex-div. Date of Payment

Record Date
 Does Dividend Policy Matter?

 It is a very controversial issue.
 There is disagreement about the preference of investors:
Dividend or Capital Gain.
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 Increasing dividend slows future growth of a firm from
reinvestment of profits; whereas increasing dividend
increases stock price, decline in a firm’s growth rate
decreases it and vice versa. Is not conflicting outcome?
 Thus, an optimal dividend policy has to strike a balance
between current dividends and future growth so as to
maximize the stock price.
Dividend Theories
 There are three theories regarding the preference of
investors (to dividends or capital gain):
1. Dividend Irrelevance Theory
 Merton Miller and Franco Modigliani (M&M) say
dividend policy has no effect on firm value because
o The value of the firm depends only on the income
produced by its assets, instead of how this income is
split between dividends and retained earnings.
 Further, M&M argued that dividend policy of a firm is
irrelevant as shareholders can construct their own
dividend policy –Homemade dividend.
 This theory ignores the impact of taxes and transaction
costs.
2. Bird-in-the-Hand Theory
 Investors are more certain about current income,
dividends, than future income, capital gain.
 Therefore, high payout ratio maximizes stock price
than low payout ratio, according to Gordon and
Lintner.
 M&M called it “bird-in-the-hand fallacy” arguing
that the riskiness of the firm to shareholders
emanate from the riskiness of operating cash
flows from the firm’s assets instead of how these
cash flows are distributed.
3. Tax Preference Theory

 Investors might prefer a low dividend payout to a
high payout because of tax advantage.
 This will be true when:
 the long-term capital gains are taxed at lower rate
than the dividend income,
 Capital gains costs less tax money than dividends
received today due to time value of money,
 Holding a stock until one dies may help eliminate
taxes altogether.
 Other dividend policy issues that have to

be considered:
(1) The information content, or signaling,
hypothesis
• The theory that says investors regard
dividend changes as signals of
management’s earnings forecasts and hence
influence stock price.
• That is higher-than-expected increase in
dividend increases stock price and vice versa
(2) The clientele effect

• It is a tendency of a firm to attract a set of
investors who like its dividend policy.
• Different groups, or clienteles, of stockholders
prefer different dividend payout policy.
• Since a give dividend policy will have its own
group of client, it can be interpreted that a
firm can change its dividend policy when it
desires to do so.
• This view is challenged because it ignores:

(a) brokerage costs,
(b) the likelihood that stockholders who are
selling have to pay capital gain taxes, and
(c) a possible shortage of investors who like the
firm’s newly adopted dividend policy may put
existing stockholders at risk.
• M&M argued that the existence of clientele effect
doesn’t necessarily imply that one dividend policy
is better than any other.
Establishing the Dividend Policy in Practice

 In practice, maximizing stock price requires
striking a balance between internal needs for
funds and the desires of stockholders.
 When setting the dividend payout ratio of a firm,
we have to recognize that:
o the overriding objective is maximizing
shareholder wealth, and
o management should bring more value to
shareholders by reinvesting earnings than
shareholders would have done by themselves.
• Note that a single dividend policy does not suit all

firms- one size does not fit all:
– mature industries have few opportunities for
growth and hence pay more dividends
– growing industries may generate little or no excess
cash but have many good investment opportunities
and hence pay less in dividends
• The optimal payout ratio is a function of four factors:
(1) investors’ preference for dividends versus capital
gains,
(2) the firm’s investment opportunities,
(3) its target capital structure, and
(4) the availability and cost of external capital.
The Residual Dividend Model

o A model that supports paying dividend out of
leftover earnings after financing the firm’s
investment projects.
o The four steps followed in residual model:
1. Determine the optimal capital budget;
2. Determine the amount of equity needed to finance
that budget, given its capital structure;
3. Use retained earnings to meet equity requirements
to the extent possible; and
4. Pay dividends only if more earnings are available
than are needed to support the optimal capital
budget.
• Note that the residual dividend model ignores

the preference of shareholders for dividends
• For a firm that strictly follows this model, dividends
paid in a given year can be expressed as follows:
Dividends= Net Income – Retained earnings
required to help finance new investments
= Net Income – [(Target Equity Ratio) (Total
Capital Budget) ]
Illustration on Residual Dividend Model

• Challenger Corp. considers three possible
scenarios regarding its investment
opportunities : Poor, Average, and Good.
60% equity financing for all its new
investments with 12% cost of capital is
assumed.
• The summary of earnings, investments, and
resulting payout ratios are given on the next
slide.
Investment Opportunities
Poor Average Good
Capital budget 80 140 300
Net income (NI) 120 120 120
Required equity (0.6 × CB) 48 84 180
Div. paid (NI – Required Eq.) 72 36 -60
Div. payout ratio (Div./NI) 60% 30% 0%
What can be said about the impact of residual
dividend model on payout ratio?
What can you say if the above figures are
forecasted values for the coming three years?
Conclusion on Residual Dividend Model:

• Strict adherence to the residual dividend
model results in unstable dividend payout
ratio that will make investors unhappy.
• Therefore, firms should use the residual
policy to help set their long-run target payout
ratios, but not as a guide to set the payout in
any one year. This can be achieved by
following the forthcoming steps:
1. Estimate what the firm’s earnings and

investment opportunities are likely to be,
on average, over the next five or so
years.
2. Use this forecasted information to find
the residual model payout ratio and
amount of dividends during the
planning period.
3. Then, set a target payout ratio based
on the projected data.
A Compromise Dividend Policy

– A dividend policy that attempts to compromise different
goals and propagates that target capital structure and
payout ratios are long-term goals that may vary in the
short-run.
– This policy puts forward the following goals in the
order of importance:
1. Avoid cutting back on positive NPV projects to pay a
dividend.
2. Avoid dividend cuts.
3. Avoid the need to sell equity.
4. Maintain a target debt-equity ratio.
5. Maintain a target dividend payout ratio.
 Dividend Reinvestment Plans (DRIPs)

– Dividend reinvestment plan is a plan that enables a
stockholder to automatically reinvest dividends received
back into the stock of the paying firm.
– Two forms of DRIPs:
1. “Old Stock” plan:
• Involves buying back of stocks outstanding and distributing
them to participating shareholders on a pro rata basis
• It is executed through an investment bank at some cost-
service fees.
• It gives advantage of economics of scale for small investors
who are not interested in taking dividends.
2. “New Stock” plan:
– Involves issuing new shares of stock to participating
shareholders directly by the firm.
– Often issued at a discount since there is no intermediary
and no service fees to be incurred.
– It is a source of new paid-up capital.
• In both kinds of plans shareholders must pay dividend
tax.
The key lesson learned from DRIPs:
• A study of shareholders’ participation rate in DRIPs
makes it an important source of feedback to
management in understanding the preference of
shareholders and accordingly to adjust the firm’s payout
ratio.
 Factors that Influence Dividend Policy

(1) Constraints on dividend payments
• Bond Indenture
• Preferred stock restrictions
• Impairment of capital rule
• Availability of cash
(2) Investment opportunities
• Number of profitable investment opportunities
• Possibility of accelerating or delaying projects
(3) Availability and cost of alternative sources

of capital
• Cost of selling new stock
• Ability to substitute debt for equity
• The desire for control
(4) Effects of dividend policy on Ks in light of:
• stockholders’ desire for current versus future income,
• perceived riskiness of dividends versus capital gains
• the tax advantage of capital gains over dividends,
and
• the information content of dividends (signaling).
 Stock Dividends and Stock Splits

Both stock dividends and stock splits increase the
number of stocks outstanding.
Both are meant for increasing the liquidity of the
stock of a company by making it affordable to
buy for many and eventually increase the overall
market value of the firm.
Both provide management of a company with a
relatively low- cost way of signaling that the
firm’s future prospects look good.
1. Stock Dividends:
 Issuing new share of stocks to shareholders
in lieu of cash dividend.
 Causes some accounting costs.
 Useful to effect a gradual year after year
reduction in stock price per share.
2. Stock Split
 Involve replacing old stocks by a relatively large
number of new shares stock, e.g. two-for-one split
means issuing two new shares of stock for each
share of stock held by an investor.
 Does not cause accounting cost.
 Very effective to realize a significant reduction in
stock price per share after a sharp price run- up.
 Price Effects of Stock Split and Stock Dividends

1. On average, the price of a company’s stock rises
shortly after it announces a stock split or dividend.
2. This price rise may be the result of signals of
favorable prospects for earnings and dividends, not a
desire for stock splits/dividends per se.
3. However, if there is no announcements of increase in
earnings and dividends in the next few months, stock
price will drop back to the earlier level.
4. Stock split and stock dividends will be advantageous
to investors buying in round lots (100 shares) as
they cause relatively lower commissions than small
investors dealing with low-priced stocks.
 Stock Repurchases
 Are means of buying back a firm’s own shares of
stock, thereby decreasing shares outstanding,
increasing EPS, and, often, increasing the stock
price.
 It allows to substitute capital gain for dividends.
 Stock repurchase may be made to:
1. Distribute a firm’s extra cash by buying back shares
outstanding in lieu of cash dividend
2. Quickly adjust a firm’s capital structure that is over
weighted with equity
Illustration on the effects of stock repurchases:

• Champ Corporation expects to earn Birr 6 million in
2006 and 60% of this amount, Birr 3.6 million, is
planned to be allocated for distribution to common
stockholders. The firm currently has 1.5 million
shares outstanding and the market price per share
is Birr 9.6. Champ has two alternatives:
– it can either use the Birr 3.6 million to repurchase 300,000
shares of its own through a tender offer at Birr 12 a share
or
– pay a cash dividend of Birr 2.4 a share.
How the repurchase option affects Champ’s EPS and

market price per share?
Analysis:
Current EPS=T. Earnings = Birr 6.0 million = Br 4/ share
N. of shares Out. 1.5 million
P/E ratio = Br 9.6/4 =2.4 times
EPS after repurchasing 300,000 shares= Br 6/1.2
=Br 5 per share
Expected market price after
repurchase=(P/E)(EPS)=(2.4)(5)= Br12 per share
• Note that investors would receive a before tax

income of Br 2.4 per share in either of the two
options.
– What is the implication of buying back the
shares above or below Birr 12?
Advantages of Repurchases:
1) Repurchase announcements viewed as a
positive signal.
2) Repurchase gives shareholders flexibility in their
decision (they can choose to sell or not to sell).
3) A repurchase help reduce the supply of stocks
and boost the price per share.
4) It is a very good means to distribute a
temporarily available cash flow and avoids the
negative signaling effect of future dividend cuts.
5. Repurchases when combined with dividend

approach gives a firm an edge, flexibility, in
adjusting or varying the total distribution of
earnings to shareholders without sending a
negative signal.
6. Repurchases can be used to produce large-

scale changes in capital structure.
Disadvantages of Repurchases:
1) Dividend payments might benefit stock prices
than capital gains because cash dividends are
generally considered to be dependable, but
repurchases are not.
2) Shareholders’ lack of information about the
intent of management and the firm’s future
prospect, if any, may result in suspicion and legal
battle between management and shareholders.
3) If the firm pays too high price for repurchased
stock, existing shareholders will be harmed.
Concluding remarks about repurchases:

• Combining repurchases with dividends is the
most effective way of distributing cash flows
to shareholders serving both the interest of
shareholder and the firm’s own need for
financing and quickly adjusting its capital
structure when needed.
End of Chapter 1
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Chapter 1 (B) Dividends and Dividend Policy

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Chapter 1 (B) Dividends and Dividend Policy

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Chapter 1

A Review of Dividends and Dividend Policy

 What are dividends?

 Dividends can be stated as: DPS, Payout Ratio,

• Terms and procedures to dividend payments

Declaration Ex-div. Date of Payment

 Does Dividend Policy Matter?

3. Tax Preference Theory

 Other dividend policy issues that have to

(2) The clientele effect

• This view is challenged because it ignores:

Establishing the Dividend Policy in Practice

• Note that a single dividend policy does not suit all

The Residual Dividend Model

• Note that the residual dividend model ignores

Illustration on Residual Dividend Model

Conclusion on Residual Dividend Model:

1. Estimate what the firm’s earnings and

A Compromise Dividend Policy

 Dividend Reinvestment Plans (DRIPs)

 Factors that Influence Dividend Policy

(3) Availability and cost of alternative sources

 Stock Dividends and Stock Splits

 Price Effects of Stock Split and Stock Dividends

Illustration on the effects of stock repurchases:

How the repurchase option affects Champ’s EPS and

• Note that investors would receive a before tax

5. Repurchases when combined with dividend

6. Repurchases can be used to produce large-

Concluding remarks about repurchases:

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