UNIT FOUR
DIVIDEND
POLICY
DECISION
UNIT FOUR
CHAPTER ONE
DIVIDEND POLICY
Lesson 31
Chapter-10
Dividend Policy
Unit 4
Dividend Policy decision
After studying this lesson, you should be able to:
Understand the term ‘Dividend’.
Explain the factors affecting the dividend policy.
Explain the different forms of dividend.
Understand the factors affecting a firm's dividend and retained earnings
policy.
Explain important terms related to ‘Dividend’.
Explain the ‘Walter’s model’ related to ‘dividend ‘relevance school’.
We have already discussed some of the major financial decisions that a firm takes. One
of the other major decision areas in financial management relates to dividend policy.
The dividend policy decision involves the choice between distributing the profits
belonging to the shareholders and their retention by the firm. Before we start the
discussion for the day, I would like to ask you a simple question:
What do you understand by the term dividend?
Let me take a simple example to start with! After the guests go home, are you glad to
see some leftovers in the kitchen (specially when most of left over is cake). If so, you
will be able to answer my question immediately.
Yes! Dividends are a kind of left over cake for the shareholders.
How do we define dividends?
Dividend is the distribution of value to shareholders
Can you think of any factors that influence dividends?
Before discussing the dividend policies, we should discuss the factors involved in
formulating dividend policy.
1. Legal constraints:
Most states prohibits companies from paying out as cash dividends any portion of
the firm’s legal capital, which is measured by the par value of common stock.
Other states define legal capital to include not only the par value of the common
stock, but also any-paid in –capital in excess of par. These capital impairment
restrictions are generally established to provide a sufficient equity base to protect
creditor’s claims. Lets take an example to clarify the differing definitions of
capital:
Lets take the financial highlight of the company as follows:
Common stock at par
1,00,000
Paid-in capital in excess of par
2,00,000
Retained earnings
1,40,000
Total stockholders equity
4,40,000
In states where the firm’s legal capital is defined as the par value of the common
stock, the firm could pay out Rs 3,40,000 (2,00,000+1,40,000) in cash dividends
without impairing its capital. In other states where the firm’s legal capital includes
all paid-in capital, the firm could pay out only 1,40,000 in cash dividends.
An earnings requirement limiting the amount of dividends to the sum of the firm’s
present and past earnings is sometimes imposed. If I put in another words I can say
that the firm cannot 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
dividends than its current earnings.
2.Contractual constraints:
Often, the firm’s ability to pay cash dividends is constrained by restrictive provisions
in a loan agreement. Generally, these constraints prohibit the payment of cash
dividends until a certain level of earnings have been achieved, or they may limit
dividends to a certain amount or a percentage of earnings. Constraints on dividends
help to protect creditors from losses due to the firm’s insolvency. The violation of a
contractual constraint is generally grounds for a demand of immediate payment by
the funds supplier.
3.Internal constraints:
The firm’s ability to pay cash dividends is generally constrained by the
amount of excess cash available rather than the level of retained earnings against
which to charge them. Although it is possible for a firm to borrow funds to pay
dividends, lenders are generally reluctant to make such loans because they
produce no tangible or operating benefits that will help the firm repay the loan.
Although the firm may have high earnings, its ability to pay dividends may be
constrained by a low level of liquid assets. (Cash and marketable securities)
We will take the previous example to explain this point. In our example, the firm
can pay Rs1, 40,000 in dividends. Suppose that the firm has total liquid assets of
50,000 (20,000 cash +marketable securities worth Rs 30,000) and Rs 35,000 of
this is needed for operations, the maximum cash dividend the firm can pay is
15,000 (Rs 50,000- Rs35, 000)
4. Growth prospects:
The firm’s financial requirements are directly related to the anticipated degree of
asset expansion. If the firm is in a growth stage, it may need all its funds to
finance capital expenditures. Firms exhibiting little or no growth may never need
replace or renew assets. A growth firm is likely to have to depend heavily on
internal financing through retained earnings, as dividends
5. Owner considerations:
You know that in establishing a dividend policy, the firm’s primary concern
should be to maximise shareholder’s wealth. One such consideration is then tax
status of a firm’s owners. Suppose that if a firm has a large percentage of wealthy
stockholders who are in a high tax bracket, it may decide to pay out a lower
percentage of its earnings to allow the owners to delay the payments of taxes
until they sell the stock. Of course, when the stock is sold, the proceeds are in
excess of the original purchase price, the capital gain will be taxed, possible at a
more favorable rate than the one applied to ordinary income. Lower-income
shareholders, however who need dividend income will prefer a higher payout of
earnings.
6. Market Considerations:
The risk-return concept also applies to the firm’s dividend policy. A firm where
the dividends fluctuate from period to period will be viewed as risky, and
investors will require a high rate of return, which will increase the firm’s cost of
capital. So, the firm’s dividend policy also depends on the market’s probable
response to certain types of policies. Shareholders are believed to value a fixed or
increasing level of dividends as opposed to a fluctuating pattern of dividends.
Putting in other words, I can say that the market consideration is a kind of
information content of the dividends. It’s a kind of signal for the firm to decide
its final policy. A stable and continuous dividend is a positive signal that conveys
to the owners that the firm is in good in health. On the other side, if the firm
skips in paying dividend due to any reason, the shareholders are likely to
interpret this as a negative signal.
Now that you are clear with factors that play an important role in deciding the
dividend policy, one question might be particularly coming in your mind “ what is
the form in which dividends are paid?” or How do the firms pay dividends?”
Before discussing various dividend policies I will tell you the different ways of
paying dividends.
Cash dividend:
It takes various forms
1. Regular cash dividend – cash payments made directly to stockholders, usually
each quarter
2. Extra cash dividend – indication that the “extra” amount may not be repeated in
the future
3. Special cash dividend – similar to extra dividend, but definitely won’t be repeated
4. Liquidating dividend – some or all of the business has been sold
Stock Dividends:
1. Pay additional shares of stock instead of cash.
2. Increases the number of outstanding shares.
3. Small stock dividend
a. Less than 20 to 25%
b. If you own 100 shares and the company declared a 10% stock dividend, you
would receive an additional 10 shares
4. Large stock dividend – more than 20 to 25%
Some important dates in paying dividends
1.
Declaration Date – Board declares the dividend and it becomes a liability of the
company.
2.
Ex-dividend Date
a. Occurs two business days before date of record
b. If you buy stock on or after this date, you will not receive the dividend
c. Stock price generally drops by about the amount of the dividend
3. Date of Record – Holders of record are determined and they will receive the
dividend payment
4.
Date of Payment – checks are mailed
These dates will be better understood with a practical example.
Example:
For every share you hold. Suppose you hold a share worth Rs 10.
Dates:
|_____________|______________|___________|____
1/15
Declaration
Date
1/26
Ex-dividend
Date
1/30
2/15
Record
Payment
Date
Date
Are you eligible for the dividend?
Yes. If you hold the share prior to the ex-dividend date you will receive the dividend.
Should the price of your share be affected after you have received the dividend?
The stock price will fall by the amount of the dividend on the ex-date (Time 0). If you get
dividend of Re 1 per share and the stock price is Rs 10 per price of your share on ex-date
will be Rs 9 per share (10-1)
I hope that that you are clear with the basics of dividends. As you know that the main
objective of every firm is to maximise shareholders wealth and so is for paying
dividends.
Can you tell me the important components of shareholders return?
Dividends (Payout). Ok. Anything else that comes to your mind. What if the firm does not
pay dividend? Yes, it is the capital gains from the investment of that retained money
(Retained earnings). You know that either decision will affect the value of the firm.
Therefore the most crucial issues for a firm in paying dividends contribute the following
elements:
1. High or low payout?
2. How frequent?
3. Do we announce the policy?
4. Amount in near future & long term
5. Stable or irregular dividends?
I hope you agree that the most important aspect of dividend policy is to determine the
amount of earnings to be distributed to shareholders and the amount to be retained in
the firm with an objective to maximise shareholder’s return.
Lets try to analyse the above statement with the help of a practical example.
Before taking the example you should know that:
Growth rate is the product of ROE & Retention ratio
g = ROE * b
Now, let’s assume that there are two companies A & B. Both have ROE of 20% and the
worth of one share is Rs 10. Company A has a high payout policy of 80% and Company
B has a low payout policy of 20%. Now, we will see the consequence of both the policies
of companies A & B:
Year
Equity
Earnings @ 20%
Dividends Retained Earnings
1
100
20
16
4
2
104
20.8
16.64
4.16
3
108.16
21.63
17.31
4.32
4
112.48
22.5
18
4.5
5
116.98
23.4
18.72
4.68
10
142.33
28.47
22.77
5.69
15
173.17
34.63
27.71
6.92
20
210.68
42.14
33.71
8.43
1
10
20
4
16
2
116
23.2
4.64
18.56
3
134.56
26.91
5.38
21.53
4
156.09
31.22
6.24
24.98
5
181.07
36.21
7.24
28.97
10
380.30
76.06
15.21
60.85
Company A
(High payout)
Company B
(Low payout)
15
798.75
159.75
31.95
127.8
20
1677.65
335.53
67.11
268.42
You can examine from the above table that over a long period of time, Low payout is
overtaking high payout company. Company B retains much more (Rs 268.42) than
Company A (Rs 8.43). Company A’s dividends and equity investments are growing @
16 % per annum while that of Company A at 4% only.
Can we say that a higher payout policy means more current dividends & less retained
earnings, which may consequently result in slower growth and perhaps lower market
price/ share. On the other hand, low payout policy means less current dividends, more
retained earnings & higher capital gains and perhaps higher market price per share.
Capital gains are future earnings while dividends are current earnings.
I hope that you are clear with the distinction between low payout and high payout
companies, capital gains and dividends. You should note an important point that
dividends in most countries attract higher taxes. Therefore it is quite plausible that some
investor’s would prefer high-payout companies while others may prefer low-payout
companies.
How do we define dividend policy?
It’s the decision for the firm to pay out earnings versus retaining and reinvesting them
Now that you know that there exists a relationship between dividend policy and value
of the firm. Being an investor, what would you prefer high payouts or low payouts?
Yeah! You would prefer a high payout! Why? Because, you want to enjoy all the benefits
today and you don’t trust future. Ok! So you don’t want to take the risk. What about
others! I heard ‘low payout’ from someone. Why would you prefer low payout! Because
you want your firm to grow with new investment opportunities using your money since
you know that retained earnings are comparatively cheaper. See, it is very difficult
specify. We have different theories bases on differing opinions of the analysts; some
consider dividend decision to be irrelevant and some believe dividend decision to be an
active variable influencing the value of the firm.
Lets study these theories one by one.
Dividend Relevance: Walter’s Model
Prof. James E. Walter argues that the choice of dividend policies almost always affect the
value of the firm. His model is based on the following assumptions:
1. Internal financing: The firm finances all investment through retained earnings;
i.e. debt or new equity is not issued.
2. Constant return and cost of capital: the firm’s rate of return, r , and its cost of
capital, k , are constant.
3. 100% payout or retention: All earnings are either distributed as dividends or
reinvested internally immediately.
4.
Infinite time: the firm has infinite life
Valuation Formula: Based on the above assumptions, Walter put forward the following
formula:
P = DIV + (EPS-DIV) r/k
k
P = market price per share
DIV= dividend per share
EPS = earnings per share
DIV-EPS= retained earnings per share
r = firm’s average rate of return
k= firm’s cost o capital or capitalisation rate
The above equation is reveals that the market price per share is the sum of two
components:
a. The first component DIV is the present value of an infinite stream of dividends.
k
b. The second component (EPS-DIV) r/k is the present value of an infinite stream of
k
returns from retained earnings.
Let’s apply the theoretical formula to a practical illustration to improve our
understanding. We will take three models, one of a growth firm, the other normal firm
and a declining firm. The financial data of all the three firms is given as follows:
Growth firm
Normal firm
Declining firm
R
20%
15%
10%
K
15%
15%
15%
EPS
Rs 4
Rs 4
Rs 4
DIV
Rs 4
Rs 4
Rs 4
Now, we have all the elements of the formula. Lets compute the share price for the
growth firm first.
We know that:
P = DIV + (EPS-DIV) r/k
k
= 4 +(4-4) 0.20/0.15
0.15
By solving the equation, we get the share price equal to Rs 26.67.In the same way, you
can get the share price of the other two firms also. i.e. the price of the share for Normal
firm is Rs 26.67 and declining firm also it is Rs 26.67.
You can see that the price is similar for all the three firms. Now, if you compute the new
share price for all the firms if I assume that the dividend is Rs 2 instead of Rs 4 other
things remaining the same. Could you get the these share price:
Growth firm: Rs 31.11
Normal firm: Rs 26.67
Declining firm: Rs 22.22
Could you note something peculiar here?
•
When the rate of return is greater than the cost of capital (r > k), the price per
share increases as the dividend payout ratio decreases.
•
When the rate of return is equal to the cost of capital (r=k), the price per share
does not vary with changes in dividend payout ratio.
•
When the rate of return is lesser than the cost of capital (r< k), the price per
share increases as the dividend payout ratio increases.
•
The optimum payout ratio for a growth firm (r > k) is nil.
•
The optimum payout ratio for a normal firm (r = k) is irrelevant
•
The optimum payout ratio for a declining firm (r< k) is 100%
Despite its popularity does the Walter’s model suffer from any limitation?
As you have seen that this model can be useful to show the effects of dividend policy on
all equity firms under different assumptions about the rate of return. However the
simplified nature of the model can lead to conclusions, which are not true in general,
though true for the model. Lets analyse the model critically on the following points:
1. No External Financing
Walter’s 's model of share valuation mixes dividend policy with investment policy of the
firm. The model assumes that retained earnings finance the investment opportunities of
the firm only and no external financing-debt or equity-is used for the purpose. When such
a situation exists, either the firm's investment or its dividend policy or both will be suboptimum. Lets take a diagrammatic representation to explain the point. We will take the
amount of earnings, investment and financing (in rupees) on the horizontal axis the rates
of return and the cost of capital on the vertical axis. It is assumed that the cost of capital,
k, remains constant regardless of the amount of new capital raised.
r=k
r<k
Return and costs (%)
R>k
K=ka =km
( Rs)
1
E
I*
2
E
r
Earning, investment and new financing
Figure A firm’s investment opportunities
You can see from the diagram that the firms average cost of capital ka is equal to the
marginal cost of capital, km. The rates of on investment opportunities available to the
firm are assumed to be decreasing. This implies that the most profitable investments will
be made first and the poorer investments made last. In the figure I* rupees of investment
occurs where r = k. I* is the optimum investment regardless whether the capital to
finance this investment is raised by selling shares, debentures, retaining earnings or
obtaining a loan. If the firm's earnings are E, then (I* - E,) amount should be raised
finance the investments. However, external financing is not included in Walter's model.
Thus, for this situation Walter's model would show that the owner's wealth is maximised
by retaining and investing firm's total earnings of E, and paying no dividends. Thus, the
wealth of the owners will be maximised only when this optimum investment is made.
2. Constant rate of return,
Walter's model is based on the assumption that r is constant. In fact, r decreases as more
and more investment is made. This reflects the assumption that the most profitable
investments are made and then the poorer investments are made. Thy firm should stop at
a point where r = k. In the figure above, the optimum point of investment occurs at I*
where r = k; if the firm's earnings areE2 it pay dividends equal to (E2 - l)*; on the other
hand, Walter's model indicates that, if the firm’s earnings are E2 they should be
distributed because r < k at E2. This is clearly an erroneous and will fail to optimise the
wealth of the owners.
3.
Constant opportunity Cost of Capital, k
A firm's cost of capital or discount rate, k, does not remain constant; it changes directly
with the risk. Thus, the present value of the firm’s income moves inversely with the cost
of capital. By assuming that the discount rate, k, is constant, Walter's model abstracts
from the effect of risk on the value of the firm.
I hope that you are clear as we are using examples and diagrammatic presentations very
frequently.
So by now you all are clear about the determinants of dividend, main terms in dividend &
also about the Walters model of dividend policy.
Let us now try some problems to make the concept clearer.
Example
The following information is available for ABC Ltd.
Earnings per share
: Rs. 4
Rate of return on investments
: 18 percent
Rate of return required by shareholders
: 15 percent
What will be the price per share as per the walter model if the payout ratio is 40 percent?
50 percent? 60 percent?
Solution.
According to the Walter model,
P = D + (E – D) r/k
------------------k
Given E = Rs4, r = 0,andk = 0.15, the value of P for the three different payout ratios is as
follow:
Payout ratio
40 percent
P
1.6 + (2.40) 0.18/0.15
--------------------------------
= Rs 29.87
0.15
50 percent
2.00 + (2.00) 0.18/0.15
-------------------------------0.15
= Rs29.33
60 percent
2.40 + (1.60) 0.18/0.15
---------------------------- = Rs28.80
0.15
Example
The following information is available for Annu Mallick Musicals.
Earnings par share
: Rs5.00
Rate of return required by shareholders
: 16 percent
Assuming that the Gorden valuation model holds, what rate of return should be earned on
investments to ensure that the the market price is Rs. 50 when the dividend payout is 40
percent?
Solution
According to the Gordon model
E1(1 – b)
Po = --------------K – br
Plugging in the various values given, we get
5.0(1- .06)
50 = -------------------0.16 – 0.6r
Solving this for r, we get
R = 0.20 = 20 percent
Hence, Annu Mallick Musicals must earn a rate of return of 20 percent on its
investments.
Example
The stocks of firms X and Y are considered to be equally risky. Investors expect the share
of firm X- the firm which does not plan to pay dividend to be worth Rs.180 next year.
From a share of firm Y, too, investors expect a payoff of Rs180 – Rs 15 by way of
dividends and Rs 165 by way of share price a year from now.
Dividends are taxed at 20 percent and capital gains at 10 percent. What will be the
current price of the shares of X and Y, if each of them offers an expected post-tax rate of
return of 15 percent. Assume that the radical position applies.
Solution
Px, the current price per share of X and Py, the current price per share of Y are calculated
below:
1. Next year’s price
2. Dividend
Firm X
Firm Y
Rs 180
Rs 165
-
Rs15
3. Total pre-tax payoff
Rs 180
Rs 180
4. current price
Px
Py
5. Capital gain
180-Px
165-Py
6. Tax on dividend at 20%
-
Rs.3
7. Post-tax dividend
0
Rs.12
8. Tax on capital gain at 10%
.10(180-Px)
.10(165-Py)
9. Post tax capital gains
.90(180-Px)
.90(165-Py)
10.Total post-tax return(7)+(9)
.90(180-Px)
12+.90(165-Py)
11. Post-tax rate of return (10)/(4)
.90(180-Px)
12+.90(165-Py)
-----------------
-------------------
Px
Since
0.90(180-Px)
----------------Px
= 0.15
Py
Px = Rs 154.29
Since
12+ 0.90(165 –Py)
------------------------ = 0.15
Py
Py = Rs152.85
In my next class we will discuss about other two important models of dividend policy i.e.
Gordon’s dividend policy
&
Modigliani-Miller (MM) dividend policy
IMPORTANT
Slide 1
Dividend
Dividend Policy
Policy
18-1
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 2
Dividend Policy
Passive Versus Active Dividend
Policies
‹ Factors Influencing Dividend Policy
‹ Dividend Stability
‹ Stock Dividends
‹
18-2
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 3
Dividends as a
Passive Residual
Can the payment of cash dividends affect
shareholder wealth?
If so, what dividenddividend-payout ratio will
maximize shareholder wealth?
‹
The firm uses earnings plus the additional
financing that the increased equity can support to
finance any expected positive-NPV projects.
‹
Any unused earnings are paid out in the form of
dividends. This describes a passive dividend
policy.
18-3
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 4
Irrelevance of Dividends
A. Current dividends versus retention
of earnings
‹
M&M contend that the effect of dividend
payments on shareholder wealth is
exactly offset by other means of
financing.
‹
The dividend plus the “new” stock price
after dilution exactly equals the stock
price prior to the dividend distribution.
18-4
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 5
Irrelevance of Dividends
B. Conservation of value
‹
M&M and the total-value principle ensures
that the sum of market value plus current
dividends of two firms identical in all
respects other than dividend-payout ratios
will be the same.
‹
Investors can “create” any dividend policy
they desire by selling shares when the
dividend payout is too low or buying shares
when the dividend payout is excessive.
18-5
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 6
Relevance of Dividends
A. Preference for dividends
‹
Uncertainty surrounding future company
profitability leads certain investors to
prefer the certainty of current dividends.
‹
Investors prefer “large” dividends.
‹
Investors do not like to manufacture
“homemade” dividends, but prefer the
company to distribute them directly.
18-6
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 7
Relevance of Dividends
B. Taxes on the investor
‹
Capital gains taxes are deferred until the
actual sale of stock. This creates a timing
option.
‹
Capital gains are preferred to dividends,
everything else equal. Thus, high dividendyielding stocks should sell at a discount to
generate a higher before-tax rate of return.
‹
Certain institutional investors pay no tax.
18-7
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 8
Empirical Testing
of Dividend Policy
Tax Effect
‹ Dividends
are taxed more heavily than capital gains,
so before-tax returns should be higher for highdividend-paying firms.
‹ Empirical results are mixed -- recently the evidence
is largely consistent with dividend neutrality.
Financial Signaling
‹ Expect
18-8
that increases (decreases) in dividends lead
to positive (negative) excess stock returns.
‹ Empirical results are consistent with these
expectations.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 9
Implications for
Corporate Policy
‹ Establish
a policy that will maximize
shareholder wealth.
‹ Distribute
excess funds to shareholders
and stabilize the absolute amount of
dividends if necessary (passive).
‹ Payouts
greater than excess funds
should occur only in an environment
that has a net preference for dividends.
18-9
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 10
Implications for
Corporate Policy
‹
There is a positive value associated
with a modest dividend. Could be due
to institutional restrictions or
signaling effects.
‹
Dividends in excess of the passive
policy does not appear to lead to
share price improvement because of
taxes and flotation costs.
18-10
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 11
Factors Influencing
Dividend Policy
Other Issues to Consider
‹ Funding
Needs of the Firm
‹ Liquidity
‹ Ability
to Borrow
‹ Restrictions
in Debt Contracts
‹ Control
18-11
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 12
Dividend Stability
Dollars Per Share
Stability -- maintaining the position of the firm’s
dividend payments in relation to a trend line.
18-12
4
50% of earnings
paid out as dividends
Earnings per share
3
2
Dividends
per share
1
Time
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 13
Dividend Stability
Dollars Per Share
Dividends begin at 50% of earnings, but are stable and
increase only when supported by growth in earnings.
18-13
4
50% dividend-payout
rate with stability
Earnings per share
3
2
Dividends per share
1
Time
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 14
Valuation of
Dividend Stability
‹
Information content -- management may be able to
affect the expectations of investors through the
informational content of dividends. A stable dividend
suggests that the company expects stable or
growing dividends in the future.
‹
Current income desires -- some investors who desire
a specific periodic income will prefer a company with
stable dividends to one with unstable dividends.
‹
Institutional considerations -- a stable dividend may
permit certain institutional investors to buy the
common stock as they meet the requirements to be
placed on the organizations “approved list.”
18-14
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 15
Types of Dividends
Regular Dividend
‹ The
dividend that is normally expected to
be paid by the firm.
Extra dividend
‹A
nonrecurring dividend paid to
shareholders in addition to the regular
dividend. It is brought about by special
circumstances.
18-15
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 16
Stock Dividends
and Stock Splits
Stock Dividend -- A payment of additional
shares of stock to shareholders. Often used
in place of or in addition to a cash dividend.
SmallSmall-percentage stock dividends
‹
‹
18-16
Typically less than 25% of previously
outstanding common stock.
Assume a company with 400,000 shares of $5 par
common stock outstanding pays a 5% stock
dividend. The pre-dividend market value is $40.
How does this impact the shareholders’ equity
accounts?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 17
B/S Changes for the SmallPercentage Stock Dividend
‹
$800,000 ($5 x 20,000 new shares)
transferred (on paper) “out of” retained
earnings.
‹
$100,000 transferred “into” common stock
account.
‹
$700,000 ($800,000 - $100,000) transferred
“into” additional paid-in-capital.
‹
“Total shareholders’ equity” remains
unchanged at $10 million.
18-17
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 18
Stock Dividends,
EPS, and Total Earnings
After a smallsmall-percentage stock dividend, what
happens to EPS and total earnings of
individual investors?
‹
Assume that investor SP owns 10,000 shares and the
firm earned $2.50 per share.
‹
Total earnings = $2.50 x 10,000 = $25,000.
‹
After the 5% dividend, investor SP owns 10,500 shares
and the same proportionate earnings of $25,000.
‹
EPS is then reduced to $2.38 per share because of the
stock dividend ($25,000 / 10,500 shares = $2.38 EPS).
EPS
18-18
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 19
Stock Dividends
and Stock Splits
Stock Split -- An increase in the number of
shares outstanding by reducing the par value
of the stock.
‹
Similar economic consequences as a 100% stock
dividend.
‹
Primarily used to move the stock into a more
popular trading range and increase share demand.
‹
Assume a company with 400,000 shares of $5 par
common stock splits 2-for-1. How does this impact
the shareholders’ equity accounts?
18-19
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 20
Stock Splits
Before 22-forfor-1 Stock Split
Common stock
($5 par; 400,000 shares)
$ 2,000,000
shares
Additional paid1,000,000
paid-in capital
Retained earnings
7,000,000
Total shareholders’ equity
$10,000,000
After 22-forfor-1 Stock Split
Common stock
($2.50 par; 800,000 shares)
$ 2,000,000
shares
Additional paid1,000,000
paid-in capital
Retained earnings
7,000,000
Total shareholders’ equity
$10,000,000
18-20
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 21
Value to Investors of Stock
Dividends or Stock Splits
‹
Effect on investor total wealth
‹
Effect on investor psyche
‹
Effect on cash dividends
‹
More popular trading range
‹
Informational content
18-21
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 22
Investment or
Financing Decision?
Investing Decision
‹
Not really, as stock that is repurchased is held as
treasury stock and does not provide an expected
return like other investments.
Financing Decision
‹
It possesses capital structure or dividend policy
motivations.
‹
For example, a repurchase immediately changes
the debt-to-equity ratio (higher financial leverage).
18-22
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 23
Administrative Considerations:
Procedural Aspects
May 8
May 29
May 31
June 15
Record Date -- The date, set by the board of
directors when a dividend is declared, on which
an investor must be a shareholder of record to
be entitled to the upcoming dividend.
The board of directors met on May 8th to declare
a dividend payable to shareholders on June 15th
to the shareholders of record on May 31st.
18-23
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 24
Administrative Considerations:
Procedural Aspects
May 8
May 29 May 31
June 15
ExEx-dividend Date -- The first date on which a
stock purchaser is no longer entitled to the
recently declared dividend.
The buyer and seller of the shares have several days to
settle (pay for the shares or deliver the shares). The
brokerage industry has a rule that new shareholders are
entitled to dividends only if they purchase the stock at
least two business days prior to the record date.
18-24
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
Slide 25
Administrative Considerations:
Procedural Aspects
May 8
May 29
May 31
June 15
Declaration Date -- The date that the board of
directors announces the amount and date of the
next dividend.
Payment Date -- The date when the corporation
actually pays the declared dividend.
18-25
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________