Chapter 7
Dividend Decisions
Department of Accounting and Finance
College of Business and Economics
Mekelle University
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Chapter Outline
Dividend theories
Dividend policy
Practical consideration in dividend decisions
Alternatives to cash dividends
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Introduction
Dividend decisions refer to the decision to pay out
earnings versus retaining and reinvesting them.
Dividend payout ratio is the amount of dividends
paid relative to the company’s earnings.
Paying large dividends means simultaneously
deciding to retain little profits. Greater reliance on
external financing.
Paying small dividends corresponds to high profit
retention and less need for externally generated
equity funds.
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Dividend Theories
 As a firm’s investment opportunities increase, the
dividend payout ratio should decrease.
Dividend policy appears to be important.
If dividends influence stock price, this influence is
based on investors’ desire to minimize and defer
taxes.
Management should avoid surprising investors
when it comes to the firm’s dividends decision.
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Cont…
Do investors prefer high or low payouts?
Does Dividend Policy Affect Stock Price?
 There are three theories:
• Dividend Irrelevance theory
• Bird-in-the-Hand theory
• Tax Preference theory
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Cont…
Dividend Irrelevance Theory
• There is no relationship between dividend policy
and stock value- One dividend policy is as good as
another.
• According to Modigliani and Miller, investment and
borrowing decisions will not be altered by the
amount of any dividend payment.
• Investors are concerned only with total returns—they
are indifferent whether these returns come from
capital gains or dividend income.
• Theory is based on unrealistic assumptions (no taxes
or brokerage costs), hence may not be true. Needs
empirical test.
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Cont…
Bird-in-the-Hand Theory
• High dividends increase stock value.
• Preference for a high payout (current income).
• Investors think dividends are less risky than potential
future capital gains, hence they like dividends.
• Dividends are more certain than capital gains.
• If so, investors would value high payout firms more,
i.e., a high payout would result in a high P0.
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Cont…
Tax Preference Theory
• Low dividends increase stock price.
• Retained earnings lead to long-term capital gains,
which are taxed at lower rates than dividends.
• Capital gains taxes are also deferred.
• Stocks that allow tax deferral (low dividends-high
capital gains) will possibly sell at a premium.
• This could cause investors to prefer firms with low
payouts, i.e., a high payout results in a low P0.
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Cont…
Implications of 3 Theories for Managers
Theory
Implication
Irrelevance
Any payout OK
Bird in the hand
Set high payout
Tax preference
Set low payout
But which, if any, is correct?
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Cont…
Possible Stock Price Effects
Stock Price ($)
Bird-in-Hand
40
Irrelevance
30
20
Tax Preference
10
0
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50%
100%
Payout
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Cont…
Possible Cost of Equity Effects
Cost of equity (%)
Tax Preference
20
15
Irrelevance
10
Bird-in-Hand
0
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50%
100%
Payout
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Cont…
Which theory is most correct?
• Empirical testing has not been able to determine
which theory is correct.
• Thus, managers use judgment when setting policy.
• Analysis is used, but it must be applied with
judgment.
• both evidence and logic suggest that investors
prefer firms that follow a stable, predictable
dividend policy (regardless of the payout level)
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Dividend Policy
Dividend policy is defined as the choice between
financing investments with retained earnings or
paying out cash (i.e. dividends) and issuing new
shares of stock.
It includes these elements:
 High or low payouts?
 Stable or irregular dividends?
 How frequent?
 Do we announce the policy?
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Cont…
Alternative Dividend Policies
• Constant Dividend Payout Ratio
– Percentage of earnings paid out in dividends is held
constant.
• Stable Dollar Dividend Per Share
– Policy maintains a relatively stable dollar dividend over
time. The most common of the dividend policies.
• Small, Regular Dividend Plus a year-end Extra
(Hybrid dividend policy)
– Pays a small, regular dollar dividend plus a year-end extra
dividend in prosperous years.
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Cont…
Extensions of Dividend Policy
The “information content” or “signaling” hypothesis
• Managers hate to cut dividends, so won’t raise
dividends unless they think raise is sustainable. So,
investors regard dividend increases as signals of
management’s optimistic view about future earnings.
• Therefore, a stock price increase at time of a dividend
increase could reflect higher expectations for future
dividends themselves, not to a change in the dividend
payout policy.
• Dividends are important as a communication tool
about future earnings.
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Cont…
The “clientele effect”
• Different groups of investors, or clienteles, prefer
different dividend policies. Firms draw a certain
clientele given their stated dividend policy.
• The dividend clientele effect states that high-tax
bracket investors (like individuals) prefer low
dividend payouts and low tax bracket investors (like
corporations and pension funds) prefer high
dividend payouts.
• Clientele effects impede changing dividend policy.
Taxes & brokerage costs hurt investors who have to
switch companies.
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Cont…
The “residual dividend model”
• The retained earnings are needed for capital budget.
• Dividends paid only if profits are not completely
used for investment purposes—only when there are
“residual earnings” after the financing of new
investments.
• Pay out any leftover earnings (the residual) as
dividends only if more earnings are available than
are needed to support the optimal capital budget.
• This policy minimizes flotation and equity signaling
costs, hence minimizes the WACC.
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Cont…
Using the Residual Model to Calculate Dividends
Paid
Net
Dividends = income–
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[( )( )]
Target
equity
ratio
Total
capital
budget
.
18
Cont…
Illustration
Given:
• Capital budget: $800,000.
• Target structure: 40% debt, 60% equity (want to
maintain).
• Forecasted net income: $600,000.
Instruction:
• How much of the $600,000 should we pay out as
dividends?
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Cont…
Solution:
Of the $800,000 capital budget, 0.6($800,000) =
$480,000 must be equity to keep at target capital
structure. [0.4($800,000) = $320,000 will be debt.]
With $600,000 of net income, the residual is
$600,000 – $480,000 = $120,000 = dividends paid.
Payout ratio = $120,000/$600,000
= 0.20 = 20%.
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Cont…
Question:
How would a drop in NI to $400,000 affect the
dividend? A rise to $800,000?
NI = $400,000: Need $480,000 of equity, so
should retain the whole $400,000.
= Dividends = 0.
NI = $800,000: Need $480,000 of equity,
Dividends = $800,000 – $480,000 = $320,000.
= Payout = $320,000/$800,000 = 40%.
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Cont…
How would a change in investment opportunities
affect dividend under the residual policy?
• Fewer good investments would lead to smaller
capital budget, hence to a higher dividend payout.
• More good investments would lead to a lower
dividend payout.
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Cont…
Advantages and Disadvantages of the Residual
Dividend Policy
• Advantages:
Minimizes new stock issues and
flotation costs.
• Disadvantages: Results in variable dividends, sends
conflicting signals, increases risk, and doesn’t appeal
to any specific clientele.
• Conclusion: Consider residual policy to help set
their long-run target payout ratios, but not as a
guide to the payout in any one year.
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Cont…
Setting Dividend Policy
Forecast capital needs over a planning horizon,
often 5 years.
Set a target capital structure.
Estimate annual equity needs.
Set target payout based on the residual model.
Generally, some dividend growth rate emerges.
Maintain target growth rate if possible, varying
capital structure somewhat if necessary.
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Cont…
Dividend Payment Procedures
• Dates that are important with regard to dividend payment:
• Declaration date: It is the date on which dividend is formally
declared by the board of directors.
• Date of record: Investors who own stock on this date receive
the dividend. However, this date was pushed forward some
days to ex-dividend date.
• Ex-dividend date: This is some days before the date of record
and any investor who buys shares on or after the ex-dividend
date is not entitled to dividend.
• Payment date: This is the date on which dividend checks are
mailed to the investors.
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Practical considerations important to dividend policy
• Legal Rules (e.g., Insolvency Rule and Undue Retention of
Earnings Rule )
• Liquidity Position
• Funding needs of the firm
• Ability to borrow
• Earnings predictability
• Control issues (stockholder or managerial control motives)
• Investment opportunities
• Inflation (as replacement costs of assets are higher in
inflationary periods, more retention of earnings may be
required)
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Alternatives to Cash Dividends
(1) Stock (Scrip) Dividends
– Occurs when stock shares, rather than cash, are
distributed to the stockholders.
– Stock dividends increase the number of shares
outstanding.
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Cont…
Advantages of scrip dividends:
(a) They can preserve a company’s cash position.
(b) Investors may be able to obtain tax advantages if
dividends are in the form of shares.
(c) Investors do not incur the transaction costs of
buying more shares.
(d) A small scrip dividend issue will not dilute the
share price significantly.
(e) A share issue will decrease the company’s
gearing, and may therefore enhance its borrowing
capacity.
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Cont…
Disadvantages of scrip dividends:
(a) It affects in future years, because the number of
shares in issue has increased, the total cash dividend
will increase, assuming the dividend per share is
maintained or increased.
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Cont…
(2) Stock Split
– A stock spilt occurs where, for example, each
ordinary share of $1 is spilt into two shares of 50c
each, thus creating cheaper shares with greater
marketability.
– There is possibly an added psychological
advantage, in that investors may expect a
company which splits its shares in this way to be
planning for substantial earnings growth and
dividend growth in the future. As a consequence,
the market price of shares may benefit.
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Cont…
For example, if one existing share of $1 has a
market value of $6, and is then split into two
shares of 50c each, the market value of the new
shares might settle at, say, $3.10 instead of the
expected $3, in anticipation of strong future
growth in earnings and dividends.
 The difference between a stock split and a scrip issue is
that a scrip issue converts equity reserves into share
capital, whereas a stock split leaves reserves unaffected.
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(3) Stock Repurchases
-As an alternative to paying cash dividends, a firm
has the option of distributing cash to its shareholders
through the repurchase of its own shares.
-Repurchase or stock buyback is when a firm
repurchases its own stock, resulting in a reduction in
the number of shares outstanding.
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Cont…
Benefits of a stock repurchase scheme:
(a) Finding a use of surplus cash.
(b) Internal investment opportunity.
(c) Modifying (readjusting) capital structure.
(d) Repurchase of a company’s own shares allows
debt to be substituted for equity, so raising gearing.
(e) Increase in earning per share through a reduction
in the number of shares in issue.
(f) Elimination of minority ownership.
(g) “Going private” by repurchasing all shares from
outside stockholders
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Cont…
Drawbacks of a share repurchase scheme:
(a) It can be hard to arrive at a price that will be fair
both to the vendors and to any shareholders who are
not selling shares to the company.
(b) A repurchase of shares could be seen as an
admission that the company cannot make better use
of the funds than the shareholders.
(c) Some shareholders may suffer from being taxed
on a capital gain following the purchase of their
shares rather than receiving dividend income.
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Cont…
Repurchase Procedure
 Option 1: Shares could be bought in the open
market at the going market price.
 Option 2: A tender offer or a formal offer by the
company to buy a specified number of shares at a
predetermined and stated price. The tender price is
set above the current market price to attract sellers.
 Option 3: A negotiated purchase from one or more
major stockholders.
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Chapter end
‘’ questions
1. Discuss the theory of dividend irrelevance.
2. Do you agree that a firm may be extremely profitable and still be cash
poor? Why or why not?
3. Explain this statement: firms with abundant investment opportunities
often have relatively low dividend payout ratios.
4. How could ownership control constrain the growth of a firm?
5. Discuss how the concept of signaling is related to dividend policy.
6. Explain the impact that the issue of dividends may have on a company’s
share price.
7. Discuss the advantages and disadvantages of stock dividends, stock split
and stock repurchases.
8. What are the factors Influencing Dividend Policy in Ethiopia?
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Exercise 7.1
Suppose that a company has the following
position:
Net Profit
---------- $50 million
Number of shares before repurchase -- 10 million
Earnings per share
---------- $5
Price-Earnings ratio
---------- 20
The company plans to repurchase 2 million shares
of stock at the going market price. Ignore taxes.
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Cont…
 Required:
1. What effect does the repurchase have on the value of the
firm?
2. What effect will the repurchase have on the price per
share, earnings per share, and price-earnings ratio?
3. How would the value of the firm, price per share, earnings
per share, and price-earnings ratio be affected if the firm used
the cash for the repurchase to pay a dividend instead?
4. Which of the two methods of distributing cash is preferred
by the shareholders? Would your answer change if the
shareholders were subject to personal taxation?
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Exercise 7.2
ABC and XYZ both operate in Hong Kong. They
operate in similar markets and are generally
considered to be direct competitors. Both companies
have had similar earnings records and capital
structures over the past ten years.
The earnings and dividend record of the two
companies over the past six years is as follows:
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Cont…
ABC
XYZ
Year to 31
March
EPS
cents
DPS
cents
Average
share
price ($)
EPS
cents
DPS
cents
Average
share
price ($)
2006
230
60
2,100
240
96
2,200
2007
150
60
1,500
160
64
1,700
2008
100
60
1,000
90
36
1,400
2009
– 125
60
800
– 100
0
908
2010
100
60
1,000
90
36
1,250
2011
150
60
1,400
145
58
1,700
N.B EPS = Earnings per share and DPS = Dividends per share
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Cont…
ABC has had 25 million shares in issue for the past six
years. XYZ currently has 25 million shares in issue. At
the beginning of 2010 it had a 1 for 4 rights issue.
The EPS and DPS have been adjusted in the above
table.
The BOD Chairman of ABC is concerned that the
share price of XYZ is higher than his company,
despite the fact that ABC has recently earned more
per share than XYZ and frequently during the past six
years has paid a higher dividend.
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Cont…
Required:
• (a) Discuss:
(i) the apparent dividend policy followed by each
company over the past six years and comment on the
possible relationship of these policies to the
companies market values and current share prices;
and
(ii) Whether there is an optimal dividend policy for
ABC that might increase shareholder value.
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Cont…
• (b) Forecast earnings for ABC for the year to 31 March 2012
are $40 million. At present, it has excess cash of $2.5 million
and is considering a share repurchase in addition to
maintaining last year’s dividend. The Chairman thinks this will
have a number of benefits for the company, including a
positive effect on the share price.
 Advise the Chairman of ABC of
(i) how a share repurchase may be arranged;
(ii) the main reasons for a share repurchase;
(iii) the potential problems of such an action, compared with
a one-off extra dividend payment, and any possible effect on
the share price of ABC.
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• End of chapter Notes!
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