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Dividends > Dividend Policy
Dividend Policy
• Accounting Considerations
• Investor Preferences
• Stock Dividends vs. Cash Dividends
• Signaling
• Impact of Dividend Policy on Clientele
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Dividends > Dividend Policy
Accounting Considerations
• Cash dividends are payments taken directly from the firm's income. This is
formally accounted for by marking the amount down as a liability for the firm. The
amount is transferred into a separate dividends payable account and this is
debited on payment day.
• Accounting for stock dividends is essentially a transfer from retained earnings to
paid-in capital.
• Unlike cash dividends, stock dividends do not come out of the firm's income, so
the firm is able to both maintain their cash and offer dividends. The firm's net
assets remain the same, as does the wealth of the investor.
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Dividends > Dividend Policy
Investor Preferences
• Elements of dividend policy include: paying a dividend vs reinvestment in
company, high vs low payout, stable vs irregular dividends, and frequency of
payment.
• Some are of the opinion that the future gains are more risky than the current
dividends, so investors prefer dividend payments over capital gains. Others
contend that dividend policy is ultimately irrelevant, since investors are indifferent
between selling stock and receiving dividends.
• Assuming dividend relevance, coming up with a dividend policy is challenging for
the firms because different investors have different views on present cash
dividends and future capital gains.
Stock Market
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• Importance of the content and the stability of a dividend policy are subject to
much academic debate.
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Dividends > Dividend Policy
Stock Dividends vs. Cash Dividends
• Cash dividends provide steady payments of cash that can be used to reinvest in a
company, if the shareholder desires.
• Holders of stock dividends can sell their stock for (hopefully) high capital gains in
the future, or they can sell it off immediately to get cash, much like a cash
dividend. This flexibility is seen by some as a benefit of stock dividend.
• Cash dividends are immediately taxable as income, while stock dividends are only
taxed when they are actually sold by the shareholder.
• If an investor is interested in long-term capital gains, he or she will likely prefer
stock dividends. If an investor needs a regular source of income, cash dividends
Income from Dividends
will provide liquidity.
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• Firms can choose to issue stock dividends if they would like to direct their
earnings toward the development of the firm but would still like to appease
stockholders with some form of payment.
• Established firms with little more room to grow do not have pressing needs for all
their cash earnings, so they are more likely to give cash dividends.
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Dividends > Dividend Policy
Signaling
• Signaling is the idea that one agent conveys some information about itself to
another party through an action. It took root in the idea of asymmetric information;
in this case, managers know more than investors, so investors will find "signals" in
the managers' actions to get clues about the firm.
• For instance, when managers lack confidence in the firm's ability to generate cash
flows in the future they may keep dividends constant, or possibly even reduce the
amount of dividends paid out. Investors will notice this and choose to sell their
share of the firm.
• Investors can use this knowledge about signal to inform their decision to buy or
sell the firm's stock, bidding the price up in the case of a positive dividend
A company's dividend decision may signal what
management believes is the future prospects of
the firm and its stock price.
surprise, or selling it down when dividends do not meet expectations.
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• Firms are aware of this signaling effect, so they will try not to send a negative
signal that sends their stock price down.
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Dividends > Dividend Policy
Impact of Dividend Policy on Clientele
• The clientele effect is the idea that the type of investors attracted to a particular
kind of security will affect the price of the security when policies or circumstances
change.
• Current clientele might choose to sell their stock if a firm changes their dividend
policy and deviates considerably from the investor's preferences. Changes in
policy can also lead to new clientele, whose preferences align with the firm's new
dividend policy.
• In equilibrium, the changes in clientele sets will not lead to any change in stock
price.
Clientele Type Example
• The real world implication of the clientele effect lies in the importance of dividend
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policy stability, rather than the content of the policy itself.
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Appendix
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Dividends
Key terms
• capital gains Profit that results from a disposition of a capital asset, such as stock, bond, or real estate due to arbitrage.
• cash dividend a payment by the company to shareholders paid out in currency, usually via electronic funds transfer or a printed
paper check
• cash dividends Cash dividends are those paid out in currency, usually via electronic funds transfer or by paper check.
• clientele The body or class of people who frequent an establishment or purchase a service, especially when considered as
forming a more-or-less homogeneous group of clients in terms of values or habits.
• clientele effect The theory that changes in a firm's dividend policy will cause loss of some clientele who will choose to sell their
stock, and attract new clientele who will buy stock based on dividend preferences.
• declaration date the day the Board of Directors announces its intention to pay a dividend
• dividend A pro rata payment of money by a company to its shareholders, usually made periodically (e.g., quarterly or annually).
• dividend clientele Sets of investors who are attracted to certain types of dividend policy.
• dividend decision A decision made by the directors of a company. It relates to the amount and timing of any cash payments
made to the company's stockholders. The decision is an important one for the firm as it may influence its capital structure and
stock price. In addition, the decision may determine the amount of taxation that stockholders pay.
• dividend policy A firm's decisions on how to distribute (or not distribute) their earnings to their shareholders.
• information asymmetry In economics and contract theory, information asymmetry deals with the study of decisions in
transactions where one party has more or better information than the other.
• paid-in capital Capital contributed to a corporation by investors through purchase of stock from the corporation.
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Dividends
• retained earnings The portion of net income that is retained by the corporation rather than distributed to its owners as
dividends.
• signalling Action taken by one agent to indirectly convey information to another agent.
• stock dividends Stock or scrip dividends are those paid out in the form of additional stock shares of either the issuing
corporation or another corporation.
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Dividends
Stock Market
Different kinds of investors are active in stock market.
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Dividends
A company's dividend decision may signal what management believes is the future prospects of the firm and
its stock price.
A model developed by Merton Miller and Kevin Rock in 1985 suggests that dividend announcements convey information to investors regarding the firm's
future prospects. Many earlier studies had shown that stock prices tend to increase when an increase in dividends is announced and tend to decrease
when a decrease or omission is announced. Miller and Rock pointed out that this is likely due to the information content of dividends.
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Dividends
Income from Dividends
When choosing between cash or stock dividends, the trade-off is between liquidity in the short-term or income from capital gains in the long-term.
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Dividends
Clientele Type Example
Retirees are more likely to prefer high dividend payouts over capital gains since this provides them with cash income. Therefore, if a company
discontinued paying dividends, the clientele effect may cause retiree shareholders to sell the stock in favor of other income generating investments.
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Dividends
Which of the following influences how a dividend is reported on a
company's books?
A) Whether the dividend is paid using retained earnings or current year
income.
B) Whether the dividend is paid using cash or stock.
C) When the dividend is declared by the company.
D) All of these answers.
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Dividends
Which of the following influences how a dividend is reported on a
company's books?
A) Whether the dividend is paid using retained earnings or current year
income.
B) Whether the dividend is paid using cash or stock.
C) When the dividend is declared by the company.
D) All of these answers.
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Dividends
Which of the following is an element of a company's dividend
policy?
A) Whether dividends are paid out in cash or stock.
B) All of these answers.
C) Whether the company pays dividends at all.
D) How often the company pays dividends.
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Dividends
Which of the following is an element of a company's dividend
policy?
A) Whether dividends are paid out in cash or stock.
B) All of these answers.
C) Whether the company pays dividends at all.
D) How often the company pays dividends.
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Dividends
In which of the following situations would a shareholder prefer to
receive stock dividends as opposed to cash dividends?
A) The investor is looking to own shares in the company for a long period
of time.
B) Cash dividends and stock sales are both taxed using capital gain
rates.
C) The investor wants a regular stream of income from his investment.
D) All of these answers.
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Dividends
In which of the following situations would a shareholder prefer to
receive stock dividends as opposed to cash dividends?
A) The investor is looking to own shares in the company for a long period
of time.
B) Cash dividends and stock sales are both taxed using capital gain
rates.
C) The investor wants a regular stream of income from his investment.
D) All of these answers.
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Dividends
Which of the following is NOT something that can be assumed
about a stock based on a dividend announcement?
A) If the dividend amount unexpectedly falls, shareholders will tend to sell
their shares.
B) When a company's dividends steadily grown, this confirms the
financial strength of the company.
C) If the dividend amount is unexpectedly increased, shareholders will
bid the price up.
D) All of these answers.
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Dividends
Which of the following is NOT something that can be assumed
about a stock based on a dividend announcement?
A) If the dividend amount unexpectedly falls, shareholders will tend to sell
their shares.
B) When a company's dividends steadily grown, this confirms the
financial strength of the company.
C) If the dividend amount is unexpectedly increased, shareholders will
bid the price up.
D) All of these answers.
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Dividends
Which of the following statements regarding the clientele effect's
influence on stock price is true?
A) All of these answers.
B) Investors may keep shares that don't reflect their dividend preferences
due to reinvestment costs.
C) Investors lost due to a dividend policy shift are often offset by new
investors who like the shift.
D) The content of a company's dividend policy is not as important as
whether it is stable.
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Dividends
Which of the following statements regarding the clientele effect's
influence on stock price is true?
A) All of these answers.
B) Investors may keep shares that don't reflect their dividend preferences
due to reinvestment costs.
C) Investors lost due to a dividend policy shift are often offset by new
investors who like the shift.
D) The content of a company's dividend policy is not as important as
whether it is stable.
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Dividends
Attribution
• Wikipedia. "Signalling (economics)." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Signalling_(economics)
• Wikipedia. "information asymmetry." CC BY-SA 3.0 http://en.wikipedia.org/wiki/information%20asymmetry
• Boundless Learning. "Boundless." CC BY-SA 3.0 http://www.boundless.com//finance/definition/signalling
• Wikipedia. "dividend decision." CC BY-SA 3.0 http://en.wikipedia.org/wiki/dividend%20decision
• Wikipedia. "The Dividend Decision." CC BY-SA 3.0 http://en.wikipedia.org/wiki/The_Dividend_Decision#Information_signalling
• Wikipedia. "Clientele effect." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Clientele_effect
• Wiktionary. "clientele." CC BY-SA 3.0 http://en.wiktionary.org/wiki/clientele
• Boundless Learning. "Boundless." CC BY-SA 3.0 http://www.boundless.com//finance/definition/dividend-clientele
• Boundless Learning. "Boundless." CC BY-SA 3.0 http://www.boundless.com//finance/definition/clientele-effect
• Wikipedia. "Dividend." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Dividend
• Wikipedia. "Dividend policy." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Dividend_policy#Relevance_of_dividend_policy
• Wikipedia. "stock dividends." CC BY-SA 3.0 http://en.wikipedia.org/wiki/stock%20dividends
• Wikipedia. "cash dividends." CC BY-SA 3.0 http://en.wikipedia.org/wiki/cash%20dividends
• Wikipedia. "Cash dividend." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Cash_dividend#Forms_of_payment
• Wikipedia. "Statement of retained earnings." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Statement_of_retained_earnings
• Wikipedia. "Cash dividend." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Cash_dividend#Forms_of_payment
• Wiktionary. "retained earnings." CC BY-SA 3.0 http://en.wiktionary.org/wiki/retained+earnings
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Dividends
• Wikipedia. "paid-in capital." CC BY-SA 3.0 http://en.wikipedia.org/wiki/paid-in%20capital
• Wikipedia. "Dividend policy." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Dividend_policy#Relevance_of_dividend_policy
• Wikipedia. "Dividend policy." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Dividend_policy
• Wiktionary. "dividend." CC BY-SA 3.0 http://en.wiktionary.org/wiki/dividend
• Wikipedia. "capital gains." CC BY-SA 3.0 http://en.wikipedia.org/wiki/capital%20gains
• Wikipedia. "dividend policy." CC BY-SA 3.0 http://en.wikipedia.org/wiki/dividend%20policy
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