Issues in Dividend Policy

Dividend Policy

Dividend policy determines how much of a

company's earnings will be paid to shareholders and
how much will be retained.

A dividend, therefore, is an important element of

shareholders' returns. High dividends, however, imply
low retained earnings which are an important source
of funds for a company. Management must decide,
therefore, what proportion of earnings to pay out as
dividends and what proportion to retain.
 Different Types of Dividends
1. Many companies pay a regular cash dividend.
Public companies often pay quarterly.
Sometimes firms will throw in an extra cash dividend.
The extreme case would be a liquidating dividend.
2. Often companies will declare stock dividends.
No cash leaves the firm.
The firm increases the number of shares outstanding.
3. Some companies declare a dividend in kind.
Wrigley’s Gum sends around a box of chewing gum.
Dundee Crematoria offers shareholders discounted
cremations.
Procedure for Cash Dividend Payment
25 Oct. 1 Nov. 2 Nov. 6 Nov. 7 Dec.
…
Cum- Ex- Record Payment
Declaration
dividend dividend Date Date
Date
Date Date
Declaration Date: The board of directors declares a payment
of dividends.
Cum-Dividend Date: The last day that the buyer of a stock is
entitled to the dividend.
Ex-Dividend Date: The first day that the seller of a stock is
entitled to the dividend.
Record Date: The corporation prepares a list of all individuals
believed to be stockholders as of 6 November.
Procedure for Cash Dividend Payment
25 Oct. 1 Nov. 2 Nov. 6 Nov. 7 Dec.
…
Cum- Ex- Record Payment
Declaration
dividend dividend Date Date
Date
Date Date

Dates for Microsoft’s Special Dividend 2004

Price Behavior around the Ex-Dividend Date

• In a perfect world, the stock price will fall by the

amount of the dividend on the ex-dividend date.
-t …
-2 -1 0 +1 +2
…
$P

$P - div
The price drops Ex-
by the amount of dividend
the cash Date
Taxes complicate things a bit. Empirically, the
dividend price drop is less than the dividend and occurs
within the first few minutes of the ex-date.
Dividend Theories
Dividend theories discuss is there any relationship
between the dividend policy and the value of the
company. Optimal dividend policy for a firm strikes
that balance between current dividends and future
growth which maximizes the price of the stock.

Does dividend policy matter?

What effect does dividend policy have on share
price?
Dividend Theories
There are three theories of dividend policy:
 Residual Theory
 MM Irrelevance Theory
 Relevance Theory or The “Bird-in-hand”
Theory
 Dividend Signaling Theory
 Dividend Clientele Effect.
Residual Theory & its motives (Arguments
against Dividend Relevancy)
 The essence of the residual theory of dividend policy is that the
firm will only pay dividends from residual earnings, that is, from
earnings left over after all suitable (positive NPV) investment
opportunities have been financed.
 A high retentions policy reduces the need to raise fresh capital
(debt or equity), thus saving on associated issue and flotation
costs.
 A fresh equity issue may dilute existing ownership control; this
may be avoided if retentions are consistently high.
 A high retentions policy may enable a company to finance a more
rapid and higher rate of growth.
 When the effective rate of tax on dividend income is higher than
the tax on capital gains, some shareholders, because of their
personal tax positions, may prefer a high retention/low payout
policy.
 MM Irrelevance Theory
It has been argued that dividend policy has no effect on either
the price of a firm’s stock or its cost of capital i.e. dividend
policy is irrelevance. The theory of dividend irrelevancy was
perhaps most elegantly argued by its chief proponents, Franco
Modigliani and Merton H. Miller (usually referred to as M&M)
in their seminal paper in 1961.
MM based on some assumptions. They are:
 There are no personal or corporate tax
 There are no stock flotation or transaction cost
 Financial leverage has no effect on the cost of capital
 Investors and managers have the same information about the firm’s
future prospects
 Distribution of income between dividends and retained earnings
has no effect on the firm’s cost of equity.
 MM Irrelevance Theory (contd.)
 If dividends do affect value, it is only because of its informational
content, which signals management’s earnings expectations.
In practice, changes in a firm’s dividend policy can be observed to have an effect on its
share price- an increase in dividends producing a increase in share price and a reduction in
dividends producing a decrease in share price.
However, M&M suggested that the change in share price following a change in dividend
payment, is due to the informational content of the dividend payment, rather than the
dividend payment itself.
 The dividend clientele effect is a feature of M&M’s dividend irrelevancy theory. Usually,
Firms attracts shareholders based on their preference for the payment and stability of
dividends. Since shareholders knowingly invest based on their expectation, the value of
the firm is unaffected by dividend policy.
Investors who prefer income to capital growth will be attracted to companies with high
dividend payout policies and vice versa.
For example, many charities, pension funds and retired senior citizen
 In contrast, other groups of investors who (perhaps for taxation reasons,) may prefer
capital growth to income, will be attracted to firms with high earnings retention and low
dividend payout policies.
Relevance Theory or The “Bird-in-hand” Theory
 The essence of the bird-in-the-hand theory of dividend policy
(advanced by John Lintner in 1962 and Myron Gordon in 1963) is
that shareholders are risk-averse and prefer to receive dividend
payments rather than future capital gains.
 Myron Gordon and John Linter criticized the MM irrelevance
theory, and specifically the fifth assumption of MM irrelevance
theory.
 Current dividend payments reduce investor uncertainty, resulting in
reduction of discount rates in firm earnings which, increases value of
firm’s stocks.

Thus,‘’A bird in the hand is worth two in the bush’’

Dividend Signaling Theory

• Empirical evidence suggests large changes in dividends do affect

stock price.
• Investors view these changes as a signal of managerial
expectation of future earnings in the future, in the same direction.
• Investors view:
a) Increasing dividends as positive signal- bid up share price
b) Decreasing dividends as negative signal- reduce share
price
 Dividends and Investment Policy
• Firms should never forgo positive NPV projects to
increase a dividend (or to pay a dividend for the first
time).
• Recall that one of the assumptions underlying the
dividend-irrelevance arguments was “The investment
policy of the firm is set ahead of time and is not
altered by changes in dividend policy.”
• A final note:
-Dividends are relevant
-Dividend policy is irrelevant
Irrelevancy and irrelevancy of Stock Dividends:
Example
Egton plc has 2 million shares currently outstanding at £15 per share. The company
declares a 50% stock dividend
A 50% stock dividend will increase the number of shares by 50%:
2 million×1.5 = 3 million shares
The value of the firm prior to the stock dividend =2m times £15= £30m

After the stock dividend the value of the firm will remain at £30m – there has been
no change in the asset base or the expected earnings
This implies a price per share following the stock dividend of
£30m/ 3m shares = £10 per share

This assumes there is no information released or implied associated with the stock
dividend
 Types of Dividend Policies
Constant Payout Ratio Policy:
• Uses a constant dividend payout ratio
• A certain percentage of earnings (EPS) is paid to owners in
each dividend period
• Problem: dividends maybe low or nonexistent if the firm’s
earnings drop or suffers loss
• Assuming the firm maintains a payout ratio of 40% of its
earnings:
Types of Dividend Policies (Cont.)
Regular Dividend Policy:
• Payment of a fixed dollar dividend in each period
• Firm’s only increase the dividend once a sustainable
increase in earnings is achieved
• Dividends are almost never decreased
 Repurchase of Stock
• Instead of declaring cash dividends, firms can rid
itself of excess cash through buying shares of their
own stock.
• Recently share repurchase has become an important
way of distributing earnings to shareholders.
• When tax avoidance is important, share repurchase is
a potentially useful adjunct to dividend policy.
Share Repurchases or Dividend Payments?
(Irrelevancy Proposition)
Consider a firm that wishes to distribute $100,000 to its shareholders
(Number of shares 100,000).

Assets Liabilities & Equity

A.Original balance sheet
Cash $150,000 Debt 0
Otherassets 850,000 Equity 1,000,000
Value of Firm 1,000,000 Value of Firm 1,000,000
Shares outstanding = 100,000
Price per share= $1,000,000 /100,000 = $10
Share Repurchases or Dividend
Payments?(2)
If they distribute the $100,000 as cash dividend, the balance
sheet will look like this:
Assets Liabilitie s & Equity
B. After $1 per share cash dividend
Cash $50,000 Debt 0
Other assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstandin g = 100,000
Price per share = $900,000/1 00,000 = $9
Share Repurchases or Dividend
Payments?(3)
If they distribute the $100,000 through a stock repurchase, the
balance sheet will look like this:
Assets Liabilities & Equity
C. After stock repurchase
Cash $50,000 Debt 0
Other assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding = 90,000
Price per share = $900,000 / 90,000 = $10

Dividend or higher share price preferred?

 Re-purchase
•hypotheses
Information effect
• Management believe that the share price is too low
(positive signal)
• Company has run out of investment opportunities
(negative signal)
• Earnings increases are transitory (negative signal, given
the level of earnings
• Leverage effect
• Share re-purchases financed by debt will increase gearing
and this tends to have a positive impact on share prices,
but not necessarily so!
• With a contraction of the equity the Debt/Equity ratio will
increase even if the repurchases are financed internally