Chapter 113

3
Dividend Policy Decision

C13 - 1
 Dividend

Dividend refers to that portion of a firm’s earnings which are paid

out to the shareholders.

Net Income – alternative

1) 100% net income can be declared as dividend
2) 100% net income can be lets as retained earnings
3) Some part of net income can be declared as dividend and some
let as retained earnings.

C13 - 2
 Cash Dividend Payment Procedures
Board of Directors Meeting:
Dividend decision- whether to declare dividend and what amount to
pay cash dividends to stockholders is decided by the board of directors
of a corporation. Usually dividend decision is derived from the
financial position, future growth expectation as well as recent trend in
dividend declaration.
Amount of Dividend:
What amount or percentage of net income will be declared as dividend
and payment period is a key decision of the board meeting.
Relevant Date:
If the directors of the firm declare a dividend, they also typically issue
a statement indicating the dividend decision, the record date and the
payment date.
C13 - 3
 Cash Dividend Payment Procedures, cont.
Record Date:
All persons whose names are recorded as stockholders on the date of
record, receive a declared dividend at a specified future time. These
stockholders are often referred to as holders of record.
Ex dividend Date:
Period, beginning 4 business days prior to the date of record, during
which a stock is sold without the right to receive the current dividend.
This 4 days remain for updation or transfer of ownership. Ignoring
general market fluctuations, the stock’s price is expected to drop by the
amount of the declared dividend on the ex dividend date.
Payment Date:
The actual date on which the firm mails the dividend payment to the
holders of the record.
C13 - 4
 Dividend Reinvestment Plans
Plans that enables stockholders to use dividends received on the
firm’s stock to acquire additional shares- even fractional shares- at
little or no transaction cost.

Two approaches for dividend reinvestment-

(1) Shareholders can buy share from secondary market, equal

amount that they received as dividend and they take brokerage
house for purchasing the share from stock market and brokerage
house will get some commission.
Actually, when large number of group of shareholders are doing
this type of business, then the firm can treat it as reinvestment of
dividend.
C13 - 5
 Dividend Reinvestment Plans, cont.
2. Shareholders can buy share directly from the firm, without
going through a broker. From its point of view, the firm can
issue new shares to participants more economically, avoiding
the under pricing and flotation costs.

The existence of a DRIP may enhance the market appeal of a

firm’s shares.

C13 - 6
 The Relevance of Dividend Policy
The relevance of dividend policy was established through numerous
theories and research. But to a finance manager, capital budgeting and
capital structure decisions are far more important than dividend
decision. In other words, good investment and financing decision
should not be sacrificed for a dividend policy.

Before establishing the relevance or importance of dividend policy,

some key question have to be resolved:

• Does dividend policy matter?

• What effect does dividend policy have on share price?
• Is there a model that can be used to evaluate alternative dividend
policies in view of share value?
C13 - 7
 The Residual Theory of Dividends
Residual dividend policy (Residual Theory of Dividends), is a theory
that suggest that the dividend paid by the firm should be the amount
left
over after all acceptable investment opportunities have been
undertaken.
Using this approach the firm would treat the dividend decision in three
steps, as follows:

Step 1: Determine optimal level of capital expenditures

Step 2: Determine the optimal capital structure. Optimal capital

structure- the capital structure where the weighted average cost of
capital will be lower. Its basically the estimation of the total amount of
equity financing needed to support the expenditures estimated in step 1.
C13 - 8
 The Residual Theory of Dividends, cont.
Step 3: Determine the source of equity financing- retained earnings or
new common stock. As because, cost of retained earnings is less
compare to the cost of new common stock, so firm should use retained
earnings to meet the equity requirement determined in step 2.
If retained earnings are inadequate to meet this need, firm should raise
equity by selling new common stock.
If the available retained earnings are in excess of this need, distribute
the surplus amount – the residual- as dividend.

According to this approach, there will be no dividend declaration, if

firm’s equity needs exceeds the amount of retained earnings. This view
of dividend suggest that the required return of investors, Ks, is not
influenced by the firm’s dividend policy – that the dividend policy is
irrelevant.
C13 - 9
 Dividend Irrelevance Theory
Dividend irrelevance theory was developed by Merton H. Miller and
Franco Modigliani (M and M). They argue that the firm’s value is
determined solely by the earning power and risk of its assets
(investments). M and M’s theory suggest that in the perfect world
(certainty, no taxes, no transactions cost, and no other market
imperfections), the value of the firm is unaffected by the distribution
of dividends.

But our world is not perfect (there is uncertainties, taxes, transactions

cost and some market is imperfect), studies have shown that, the
increase in dividend result in increased share price, and decrease in
dividend result in decreased share price.

C13 - 10
 Dividend Irrelevance Theory, cont.
In response, M and M argue that these effect are attributable not to the
dividend itself but rather to-
• The informational content of dividend, and
• Clientele effect.
Informational Content: Information provided by the dividend of a firm
with respect to future earnings. Investors view a change in dividends, up
or down as a signal about future earnings. An increase in dividends is
viewed as a positive signal, and investors bid up the share price and a
decrease in dividends is a negative signal that cause a decreased in share
price.
Clientele Effect: A firm attracts share holders whose preferences for
the payment and stability of dividends correspond to the payment
pattern and stability of the firm itself.
C13 - 11
 Dividend Irrelevance Theory, cont.
In summary, dividend irrelevance argue that, all else being equal, an
investors’ required return- and therefore the value of the firm- is
unaffected by dividend policy for three reasons:

(1) The firm’s value is determined solely by the earning power and
the risk of its assets.
(2) If dividend do affect value, they so solely because of their
informational content.
(3) A clientele effect exists that causes a firm’s shareholders to
receive the dividends they expect.

The proponents of dividend irrelevance conclude that because

dividends are irrelevant to a firm’s value, the firm does not need to
have a dividend policy.
C13 - 12
 Dividend Relevance Theory
The theory, advanced by M. J. Gordon and J. Lintner, who suggest
that there is, in fact, a direct relationship between the firm’s dividend
policy and its market value.

Fundamental of this theory is their Bird-in-hand argument, in support

of dividend relevance theory, that investors see current dividends as
less risky than future dividends or capital gains. “A bird in the hand is
worth two in the bush.”

Gordon and Lintner argue that current dividend payments reduce

investors uncertainty, causing investors to discount the firm’s earnings
at a lower rate (Ks) and to place a higher value on the firm’s stock.

Conversely, if dividends are reduced or are not paid, investor

uncertainty will increase, raising the required return (Ks) and
lowering the stock’s value.
C13 - 13
 Dividend Relevance Theory, cont.
But, they fails to provide conclusive evidence in support of dividend
relevance arguments.

In practice, the action of both financial managers and stockholders

tend to support that belief that dividend policy does affect stock
value. That means, dividends are relevant- each firm must develop a
dividend policy that fulfils the goals of its owners and maximizes
their wealth as reflected in the firm’s share price.

C13 - 14
 Factors Affecting Dividend Policy
Before discussing the types of dividend policies, we will discuss the
factors that are considered in establishing a dividend policy.

Legal Constraints:
An earnings requirement limiting the amount of dividends is
sometimes imposed. With this restriction, the firm can not pay more
in cash dividends than the sum of its most recent and past retained
earnings. However, the firm is not prohibited from paying more in
dividend than its current earnings.

Contractual Constraints:
Often the firm’s ability to pay cash dividends is constrained by
restrictive provision in a loan agreement. Constraints on dividends
help to protect creditors from losses due to the firm’s insolvency.
C13 - 15
 Factors Affecting Dividend Policy, cont.
Internal Constraints:
The firm’s ability to pay cash dividends is generally constrained by
the amount of liquid assets (cash and marketable securities) available.
Although it is possible for a firm to borrow funds to pay dividends.

Growth Prospects:
The financial requirements are directly related to how much it expects
to grow and what assets it will need to acquire. A large, mature firm
has adequate access to new capital, whereas a growing firm may not
have sufficient funds available. A growing firm like to have to depend
on internal financing, so it is likely to pay out less amount of income
as dividend. On the other hand, a more established firm is in batter
position to pay out large amount of income as dividend.
C13 - 16
 Factors Affecting Dividend Policy, cont.
Owner Considerations:
Before establishing the dividend policy, the firm must consider some
subject which are related to its majority of shareholders.

(1) Tax Status: If a firm has a large percentage of wealthy

stockholders who are in high tax bracket, it may decide to pay
out a lower percentage of its earnings.

(2) Owner’s Investment Opportunities: A firm should not retain

funds for investment in projects yielding lower returns than the
owners could obtain from external investments of equal risk.

(3) Potential Dilution of Ownership: If a firm pays out a high

percentage of earnings, new capital will have to be raised with
common stock. The result of a new stock issue may be dilution
of both control and earnings for the existing owners. The firm
can minimize the possibility of such dilution by paying low
dividend.
C13 - 17
 Factors Affecting Dividend Policy, cont.

Market Consideration:
Shareholders often view a dividend payment as a signal of the firm’s
future success. A stable and continuous dividend is a positive signal,
conveying the firm’s good health. Shareholders are likely to interpret
a passed dividend payment due to loss or to very low earnings as
negative signal. The non payment of dividend creates uncertainty
about future, which is likely to result in lower stock value.

C13 - 18
 Types of Dividend Policies
The firm’s dividend policy must be formulated with two basic
objectives in mind: providing for sufficient financing and maximizing
the wealth of the firm’s owners.

Constant-Payout-Ratio Dividend Policy:

The dividend payout ratio indicates the percentage of each dollar
earned that is distributed to the owners in the form of cash. It is
calculated by dividing the firm’s cash dividend per share by its earnings
per share
With a constant-payout-ratio dividend policy, the firm establishes that a
certain percentage of earnings is paid to owners in each dividend
period.
Although some firm use a constant-payout-ratio dividend policy, it is
not recommended.
C13 - 19
 Types of Dividend Policies, cont.
Regular Dividend Policy:
The regular dividend policy is based on the payment of a fixed dollar
dividend in each period. This policy provides the owners with
generally positive information thereby minimize their uncertainties.
Under this policy dividends are almost never decreased.

Low-Regular-and-Extra Dividend Policy:

Under this dividend policy, a firm is paying a low regular dividend,
supplemented by an additional dividend when earnings are higher than
normal in given period. By giving the low regular dividend the firm
gives investors a stable income necessary to build confidence in the
firm, and the extra dividend permits them to share in earnings from an
especially good period. The extra dividend should not be regular
event, otherwise, it becomes meaningless.
C13 - 20
 Other Forms of Dividends
Dividend can be paid in the forms other than cash:

Stock Dividend
Stock Repurchases

Stock Dividend (Bonus Share):

The payment of dividend to the existing shareholders in the form of
stock. Often firm pay stock dividends as a replacement for or a
supplement to cash dividend.

Firm find the stock dividend a way to give owners something

without having to use cash. Generally, when a firm needs to preserve
cash to finance rapid growth, a stock dividend is used.

C13 - 21
 Other Forms of Dividends, cont.
Stock Repurchase:
The repurchase by the firm of outstanding common stock in the market
place. Stock repurchase enhance shareholders value by;
(1) Reducing the number of share outstanding and thereby raising
earnings per share,
(2) Sending a positive signal to investors in the market place that
management believes that the stock is under valued, and
(3) Providing a temporary floor for the stock price, which may have
been decline.
Right Share:
Existing shareholders will get priority to purchase share at the time of
issuing of new common stock. This right is known as “Pre-emptive
Right”. Existing shareholders can exercise that right or not. If
shareholders don’t want to buy, then right will go to general investors.
C13 - 22
 Other Forms of Dividends, cont.
Stock Splits:
A stock split is a method commonly used to lower the market price of
a firm’s stock by increasing the number of shares belonging to each
shareholder. A stock split has no effect on firms capital structure.

The reason for stock split is that, the firm believes that its stock is
priced too high and that lowering the market price will enhance
trading activity. For example: 2-for-1 split, two new shares are
exchanged for each old share.

Sometimes a Reverse Stock Split can also happen.

For example: 1-for-3 split, one new share is exchanged for three old
shares. Reverse stock splits are initiated to raise the market price of a
firm’s stock when it is selling at too low price.
C13 - 23