Revise Lecture 30
Dividend Policies & Decisions
1. Nature of dividend decisions?
2. Why investors want dividends?
3. Three main factors affecting dividends?
4. Constraints in paying dividends?
Factors Affecting Dividend Decision
Nature of Dividend Decisions
A firm’s dividend policies have the effect of
dividing the firm’s after tax profit into two
categories:
1. Funds to finance long-term growth
2. Funds to be distributed to shareholders
Factors Affecting Dividend Decision
Why Investors Want Dividends
Most investors expect two forms of return from
the purchase of common share:
1. Capital Gains
2. Dividends
Factors Affecting Dividend Decision
A number of factors may be analyzed to help
explain the investor’s expectation of dividends
over capital gains. Perhaps the three major
factors are:
1. Reduction of uncertainty
2. Indication of strength
3. Need for current income
Constraints on Paying Dividends
While most firms recognize the investor’s
demand for dividends, several factors may
restrict the firm’s ability to declare and pay
dividends. These are:
1. Insufficient cash
2. Contractual restrictions
3. Legal restrictions
• Alternative Forms Of Dividends
Alternative Forms Of Dividends
In addition to the declaration of cash dividends,
the firm has other options for distributing
profits to shareholders.
These options are the;
1. Stock dividend
2. Stock split
3. Stock repurchase
Alternative Forms Of Dividends
Stock Dividend
A stock dividend occurs when the board of
directors authorizes a distribution of common
stock to existing shareholders.
This has the effect of increasing the number of
outstanding shares of the firm’s stock.
Alternative Forms Of Dividends
Stock Dividend
For Example:
If a shareholder owns 100 shares of common
stock at a time when the firm distributes a 5 %
stock dividend, the shareholder receives 5
additional shares.
Alternative Forms Of Dividends
There are several aspects of a stock dividend;
1.
2.
3.
4.
5.
Conserves cash
Indicate higher future profits
Raises future dividends for investors
Has high psychological value
Retain proportional ownership for
shareholders
Stock Dividend
Conserves Cash
The stock dividend allows the firm to declare a
dividend without using up cash that may be
needed for operations or expansion.
Rather than seek additional external financing,
the firm can retain funds that would otherwise
be distributed to shareholders.
Stock Dividend
Indicate higher future profits
Normally a stock dividend is an indication of
higher future profits. If the profits do not rise,
the firm would experience a dilution of earnings
as a result of the additional shares outstanding.
Since a dilution of earnings is not desirable,
stock dividend are usually declared only by
board of directors who expect rises in earnings
to offset the additional outstanding shares.
Stock Dividend
Raises future dividends for investors
If the regular cash dividend is continued after an
extra stock dividend is declared, the shareholders
receive an increase in future cash dividends.
For example, a firm may declare a Rs1 regular
dividend and a 5% extra stock dividend. A
shareholder with 100 shares receives Rs100 and 5
additional shares. If the firm continues its Rs1
dividend, this investor would receive Rs105, an
increase of Rs5, in the next period.
Stock Dividend
Has high psychological value
Because of the positive aspects of stock
dividends, the dividend declaration is usually
received positively by the market. This tends to
encourage investment in the stock, thus
supporting or raising its market price.
Instead of experiencing a drop in value after a
stock dividend, the price may actually rise.
Stock Dividend
Retains proportional ownership for shareholders
The stock dividend differs from an issue of new
common stock. If the existing shareholders do
not have the funds to purchase new stock, their
proportion of the ownership in the firm will
decline as new investors purchase shares.
This is avoided by a stock dividend that is, in
effect, nothing more than a recapitalization of
the firm.
Stock Splits
• A stock split is a change in the number of
outstanding shares of stock achieved through
a proportional reduction or increase in the par
value of the stock. Only the par value and
number of outstanding shares are effected.
The amounts in the common stock
contributed capital and retained earnings
accounts do not change.
Stock Splits
• Just as the accounting values in the equity
accounts do not change, the market price of
the stock will normally adjust immediately to
reflect a stock split.
Stock Splits
Several reasons may be offered for the splitting
of a firm’s common stock as follows;
1. Reduction of market price of stock
2. Indication of growth
3. Reverse split
Stock Splits
1. Reduction of market price of stock
The major goal of most stock splits is to reduce
the per-share price of a firm’s common stock.
A lower price per share makes the stock more
affordable in round lots (100 shares) to more
investors.
Stock Splits
2. Indication of growth
The firm’s management may use the stock split
to inform the market that continued high
growth is forecast. The stock of high growth
companies would soon sell for several hundred
dollars per share if it were not split periodically.
Stock Splits
3. Reverse Split
An indication of trouble. Instead of increasing
the number of outstanding shares of stock, the
firm may want to reduce the number. This can
be accomplished through a reverse split, which
is reduction of outstanding shares.
The declaration of a reverse split is an indication
that the firm does not have such prospects.
Repurchase of Stock
A repurchase of stock occurs when a firm buys
back outstanding shares of its own common
stock. Firms repurchase stock for three major
reasons;
1. For stock options
2. For acquisitions
3. For retiring the stock
Repurchase of Stock
1. For stock option
A stock option is the right to purchase a
specified number of shares of common stock
during a stated period and at a stipulated price.
Stock options are frequently given to senior
officers of a company as an incentive to work to
raise the value of the firm.
Repurchase of Stock
2. For Acquisitions
When a firm is seeking control of another firm, it
may be willing to offer its own common stock
for the stock of other firm.
In this exchange of stock situation, the firm can
repurchase stock to make the acquisition. This
allows the takeover without increasing the
number of outstanding shares and avoids a
dilution of earnings.
Repurchase of Stock
3. For retiring the stock
Thus increasing earnings per share. When a firm
retires a portion of its stock, the retirement
increases the firm’s earnings per share.
The repurchase of stock for the purpose of
retiring it is treated as a form of cash dividend
by the internal revenue service.
Repurchase of Stock
• The firm could have distributed dividends with
the excess cash.
• Instead, it chose to reduce the number of
shares outstanding so that future dividends
could be increased. With this motive, the
repurchase decision can be treated similarly to
a dividend decision.