Finance Strategy & Policy

Dividend Policy

IQRA University
Raheel Bhagar
[email protected]
 Stock Returns:

Return = P1 - Po + D1
Po
 Stock Returns:

Return = P1 - Po + D1
Po

P1 - Po D1
= +
Po Po
 Stock Returns:

P1 - Po + D1
Return =
Po

P1 - Po D1
= +
Po Po

Capital Gain
 Stock Returns:

P1 - Po + D1
Return =
Po

P1 - Po D1
= +
Po Po

Capital Gain Dividend Yield

 Dilemma: Should the firm use
retained earnings for:

a) Financing profitable capital

investments?
b) Paying dividends to stockholders?
 P1 - Po D1
Return = +
Po Po

• If we retain earnings for profitable

investments,
 P1 - Po D1
Return = +
Po Po

• If we retain earnings for profitable

investments, dividend yield will be zero,
 P1 - Po D1
Return = +
Po Po

• If we retain earnings for profitable

investments, dividend yield will be zero,
but the stock price will increase, resulting
in a higher capital gain.
 P1 - Po D1
Return = +
Po Po

• If we pay dividends,
 P1 - Po D1
Return = +
Po Po

• If we pay dividends, stockholders receive

an immediate cash reward for investing,
 P1 - Po D1
Return = +
Po Po

• 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.
 So, dividend policy really
involves 2 decisions:

• How much of the firm’s earnings should

be distributed to shareholders as
dividends, and
• How much should be retained for
capital investment?
 Is Dividend Policy Important?

Three viewpoints:
1) Dividends are Irrelevant. If we
assume perfect markets (no taxes,
no transaction costs, etc.) dividends
do not matter. If we pay a dividend,
shareholders’ dividend yield rises,
but capital gains decrease.
 P1 - Po D1
Return = +
Po Po

• With perfect markets, investors are

concerned only with total returns,
and do not care whether returns
come in the form of capital gains or
dividend yields.
 P1 - Po D1
Return = +
Po Po

• With perfect markets, investors are concerned

only with total returns, and do not care
whether returns come in the form of capital
gains or dividend yields.
• Therefore, one dividend policy is as good as
another.
 2) High Dividends are Best
• Some investors may prefer a certain dividend now over a risky
expected capital gain in the future. This is know as Theory of Bird-in-
the-Hand
• Myron Gordon and John Lintner argued that long term returns
declines (or price increase) as the dividend payout is increased
because investors are less certain of receiving the capital gains than
they are of receiving dividend payments.

• MM disagreed. They argued that returns is independent of dividend

policy, which implies that investors are indifferent between dividends
and capital gains.

• MM called the Gordon-Lintner argument the bird-in-the hand fallacy.

 2) High Dividends are Best
• Some investors may prefer a certain
dividend now over a risky expected
capital gain in the future.

P1 - Po D1
Return = +
Po Po
 3) Low Dividends are Best
• Dividends are taxed immediately.
Capital gains are not taxed until the
stock is sold.
• Therefore, taxes on capital gains can be
deferred indefinitely.
• This is known as Tax Preference Theory
 Do Dividends Matter?
Other Considerations:
1) Residual Dividend Theory:
• The firm pays a dividend only if it has
retained earnings left after financing all
profitable investment opportunities.
• This would maximize capital gains for
stockholders and minimize flotation
costs of issuing new common stock.
 Do Dividends Matter?
2) Clientele Effects:
• Different investor clienteles prefer different
dividend payout levels.
• Some firms, such as utilities, pay out over
70% of their earnings as dividends. These
attract a clientele that prefers high
dividends.
• Growth-oriented firms which pay low (or no)
dividends attract a clientele that prefers
price appreciation to dividends.
 Do Dividends Matter?
3) Information Effects:
• Unexpected dividend increases usually
cause stock prices to rise, and
unexpected dividend decreases cause
stock prices to fall.
• Dividend changes convey information
to the market concerning the firm’s
future prospects.
 Do Dividends Matter?
4) Agency Costs:
• Paying dividends may reduce agency costs
between managers and shareholders.
• Paying dividends reduces retained
earnings and forces the firm to raise
external equity financing.
• Raising external equity subjects the firm to
scrutiny of regulators (SECP) and investors
and therefore helps monitor the
performance of managers.
 Do Dividends Matter?
5) Expectations Theory:
• Investors form expectations concerning the
amount of a firm’s upcoming dividend.
• Expectations are based on past dividends,
expected earnings, investment and
financing decisions, the economy, etc.
• The stock price will likely react if the actual
dividend is different from the expected
dividend.
 Dividend Policies
1) Constant Dividend Payout Ratio: if
directors declare a constant payout ratio
of, for example, 30%, then for every
Rupee of earnings available to
stockholders, 30 paisa would be paid out
as dividends.
• The ratio remains constant over time,
but the Rupee value of dividends
changes as earnings change.
 Dividend Policies
2) Stable Dollar Dividend Policy: the firm
tries to pay a fixed dollar dividend each
quarter.
• Firms and stockholders prefer stable
dividends. Decreasing the dividend sends
a negative signal!
 Dividend Policies
3) Small Regular Dividend plus Year-End
Extras
• The firm pays a stable quarterly dividend
and includes an extra year-end dividend
in prosperous years.
• By identifying the year-end dividend as
“extra,” directors hope to avoid signaling
that this is a permanent dividend.
 Jan.4 Jan.30 Feb.1 Mar. 11
Declare Ex-div. Record Payment
dividend date date date
Dividend Payments
1) Declaration Date: the board of
directors declares the dividend,
determines the amount of the dividend,
and decides on the payment date.
 Jan.4 Jan.30 Feb.1 Mar. 11

Declare Ex-div. Record Payment

dividend date date date

Dividend Payments
2) Ex-Dividend Date: To receive the dividend, you have to
buy the stock before the ex-dividend date. On this
date, the stock begins trading “ex-dividend” and the
stock price falls approximately by the amount of the
dividend.
 Jan.4 Jan.30 Feb.1 Mar. 11
Declare Ex-div. Record Payment
dividend date date date

Dividend Payments
3) Date of Record:
 Jan.4 Jan.30 Feb.1 Mar. 11
Declare Ex-div. Record Payment
dividend date date date

Dividend Payments
3) Date of Record: 2 days after the ex-dividend date, the
firm receives the list of stockholders eligible for the
dividend.
• Often, a bank trust department acts as registrar and
maintains this list for the firm.
 Jan.4 Jan.30 Feb.1 Mar. 11
Declare Ex-div. Record Payment
dividend date date date

Dividend Payments
4) Payment Date: date on which the firm
mails the dividend checks to the
shareholders of record.
 Stock Dividends and Stock Splits
• Stock dividend: payment of additional shares of
stock to common stockholders.
• Example: Citizens Bancorporation of Maryland
announces a 5% stock dividend to all
shareholders of record. For each 100 shares
held, shareholders receive another 5 shares.
• Does the shareholders’ wealth increase?
 Stock Dividends and Stock Splits
• Stock Split: the firm increases the number of
shares outstanding and reduces the price of
each share.
• Example: Joule, Inc. announces a 3-for-2 stock
split. For each 100 shares held, shareholders
receive another 50 shares.
• Does this increase shareholder wealth?
• Are a stock dividend and a stock split the
same?
 Stock Dividends and Stock Splits
• Stock Splits and Stock Dividends are
economically the same: the number of shares
outstanding increases and the price of each
share drops. The value of the firm does not
change.
• Example: A 3-for-2 stock split is the same as a
50% stock dividend. For each 100 shares held,
shareholders receive another 50 shares.
 Stock Dividends and Stock Splits
• Effects on Shareholder Wealth: these will cut
the company “pie” into more pieces but will
not create wealth. A 100% stock dividend (or
a 2-for-1 stock split) gives shareholders 2
half-sized pieces for each full-sized piece they
previously owned.
• For example, this would double the number
of shares, but would cause a $60 stock price
to fall to $30.
 Stock Dividends and Stock Splits
• Why bother?
• Proponents argue that these are used to
reduce high stock prices to a “more popular”
trading range (generally $15 to $70 per share).

• Opponents argue that most stocks are

purchased by institutional investors who have
millions of dollars to invest and are indifferent
to price levels. Plus, stock splits and stock
dividends are expensive!
 Stock Dividend Example
• shares outstanding: 1,000,000
• net income = $6,000,000;
• P/E = 10
• 25% stock dividend.
• An investor has 120 shares. Does the
value of the investor’s shares change?
Before the 25% stock dividend:
• EPS = 6,000,000/1,000,000 = $6
• P/E = P/6 = 10, so P = $60 per share.
• Value = $60 x 120 shares = $7,200
After the 25% stock dividend:
• # shares = 1,000,000 x 1.25 = 1,250,000.
• EPS = 6,000,000/1,250,000 = $4.80
• P/E = P/4.80 = 10, so P = $48 per share.
• Investor now has 120 x 1.25 = 150 shares.
• Value = $48 x 150 = $7,200
 Stock Dividends
In-class Problem

shares outstanding: 250,000

net income = $750,000;
stock price = $84
50% stock dividend.
What is the new stock price? Hint ()
 Hint:

stock price

( )
P/E = net income
# shares
Before the 50% stock dividend:
• EPS = 750,000 / 250,000 = $3
• P/E = 84 / 3 = 28.

After the 50% stock dividend:

• # shares = 250,000 x 1.50 = 375,000.
• EPS = 750,000 / 375,000 = $2
• P/E = P / 2 = 28, so P = $56 per share.

(a 50% stock dividend is equivalent to a

3-for-2 stock split)
 Stock Repurchases
• Stock Repurchases may be a good
substitute for cash dividends.
• If the firm has excess cash, why not
buy back common stock?
 Stock Repurchases
• Repurchases drive up the stock
price, producing capital gains for
shareholders.
• Repurchases increase leverage, and
can be used to move toward the
optimal capital structure.
• Repurchases signal positive
information to the market - which
increases stock price.
 Stock Repurchases
• Repurchases may be used to avoid a
hostile takeover.
Example: T. Boone Pickens attempted
raids on Phillips Petroleum and Unocal
in 1985. Both were unsuccessful
because the target firms undertook
stock repurchases.
 Stock Repurchases
Methods:
• Buy shares in the open market through a
broker.
• Buy a large block by negotiating the
purchase with a large block holder, usually
an institution (targeted stock repurchase).
• Tender offer: offer to pay a specific price to
all current stockholders.
 READINGS
KEY READINGS:
• Brigham, E. F., & Ehrhardt, M. C. (Latest Edition). Financial Management
Theory & Practice. (Chapter-18).

FURTHER READINGS:
• Khan, M., Y., Jain, P., K., Financial Management (3rd Ed.). (Chapter-04).
Horne, J. C., & Wachowicz, J. M. (11 Ed). Fundamentals of Financial
Management. (Chapter-18)
• A Survey of Management Views on Dividend Policy H. Kent Baker, Gail
Farrelly and Richard B. Edelman Page 78 of 78-84
http://www.jstor.org/stable/3665062 37.
• Fischer Black and MyronScholes(1974), "The effects of dividend yield and
dividend policy on common stock prices and returns" Journal of Financial
Economics, Volume 1, Issue 1, Pages 1-22.