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Dividend Policy

 Cash dividends—payments made to


stockholders.
 Dividend policy—decisions about when and how
much of earnings should be paid as dividends.
 Earnings that are paid out as dividends cannot
be used by the firm to invest in projects with
positive net present values—that is, to increase
the value of the firm.
 The dividend policy that maximizes the value of
the firm is said to be the optimal dividend policy.
Dividend Policy & Stock Value
 Optimal dividend policy—the dividend policy that
maximizes the value of the firm.
 Dividend Policy and Stock Value—researchers
argue whether there exists an optimal dividend
policy.
 Dividend irrelevance theory—a firm’s dividend policy does
not affect the value of a firm
 Dividend relevance theory—the dividend policy is an
important factor in the determination of a firm’s value.
Investors and Dividend Policy

Investors’ reactions to changes in dividend policies


can be summarized as follows:
 Information content, or signaling

 Clientele effect

 Free cash flow hypothesis


Dividend Policy & Signaling Theory
 Perhaps managers change dividends (increase or
decrease) only when it is necessary:
 Decreases occur only when the firm is facing financial
difficulty
 Increases occur only when it is expected that the firm
can continue to pay higher dividends long into the future
 If true, then changes in a firm’s dividend policy might
provide information to investors, who react accordingly:
 Good news—that is, a dividend increase—should cause
the stock price to increase
 Bad news—that is, a dividend decrease—should cause
the stock price to decrease
Dividend Policy & the Clientele Effect
 Investors might choose a particular stock due
to the firm’s dividend policy—that is, some
investors prefer dividends and others do not.
 If such a clientele effect does exist, then we
would expect that a firm’s stock price will
change when its dividend policy (payment) is
changed.
Dividend Policy & the Free Cash
Flow Hypothesis
 If investors want managers to maximize the value of the
firm, then dividends should be paid only when the firm
has no investment opportunities with positive net present
values.
 Only free cash flows should be paid as dividends—a firm
should pay dividends only when it has funds that are not
needed to invest in positive NPV projects
 If this theory is correct, then we might expect:
 A firm’s stock price to increase when dividends are
decreased so as to invest in positive NPV projects
 A firm’s stock price to decrease when dividends are
increased because not as many positive NPV projects
exist as in previous years.
Dividend Policy in Practice
Types of dividend payments:
 Residual dividend policy—dividends are paid only if earnings
are greater than what is needed to finance the equity portion of
the firm’s optimal capital budget for the year.
 Stable, predictable dividends—requires the firm to pay a
dividend that is the same every year or is constant for some
period and then is increased at particular intervals—that is,
dividend payments are fairly predictable.
 Constant payout ratio—pay the same percentage of earnings
as dividends each year (dividend payout ratio = DPS/EPS).
 Low regular dividend plus extras—requires a firm to pay some
minimum dollar dividend each year and then to pay an extra
dividend when the firm’s performance is above normal.
Dividend Policy in Practice
Year 1 Year 2 Year 3 Year 4
Net income $500,000 $300,000 $800,000 $150,000
Capital Budget $300,000 $350,000 $200,000 $140,000
# shares 250,000 250,000 250,000 250,000
P/O ratio 60.0% 60.0% 60.0% 60.0%
Low regular dividend $0.75 $0.75 $0.75 $0.75
Extra: % above $400,00040.0% 40.0% 40.0% 40.0%

Dividend Policy
Residual $0.80 $ - $2.40 $0.04
Stable $1.00 $1.00 $1.00 $1.00
Constant P/O $1.20 $0.72 $1.92 $0.36
Low regular $0.91 $0.75 $1.39 $0.75
Dividend Policy in Practice
Dividend payment procedures:
 Dividends are generally paid quarterly.
 The following dates are important when
establishing a dividend policy:
 Declaration date—the date the board of directors
states that a dividend will be paid to stockholders.
 Holder-of-record date—the date the firm “opens” its
ownership books to determine who will receive
dividends.
 Ex-dividend date—two working days before the
holder-of-record date (ex dividend means without
dividend).
 Payment date—the date the firm mails the dividend
checks
Dividend Policy in Practice
Dividend reinvestment plans (DRIPS)—permit
stock-holders to have dividend payments
automatically reinvested in the firm’s stock.
 Buy additional shares of a firm’s stock on a pro

rata basis using the cash dividend paid by the


firm.
 “Old-stock” DRIPS
 “New-stock” DRIPS
 Often there are little or no brokerage fees
involved with DRIPS.
Dividend Policies Around the World
 Great variation exists in dividend policies of firms in
different parts of the world.
 In most parts of the world, dividend policies are based
on local tax laws. For example, in countries where the
tax on capital gains is less than the tax on dividends,
firms tend to retain greater amounts of earnings than
in countries where the tax on dividends is relatively
small.
 In countries where stockholders’ rights are not well
protected, companies tend to pay greater amounts of
earnings as dividends—investors have a ”bird-in-hand”
attitude.
Factors Influencing Dividend Policy

The following factors should be considered


when developing a dividend policy:
 Constraints on dividend payments
 Investment opportunities
 Alternative sources of capital
 Ownership dilution
 Effects of dividend policy on the cost of equity,
rs
Constraints on Dividend Payments
The amount of dividends a firm pays might be
limited by:
 Restrictions in debt agreements that state the

maximum amount of dividends that can be paid in


any year
 The amount of retained earnings—represents the

maximum amount of dividends that can be paid


 The liquidity position of the firm—if cash is not

available, dividends cannot be paid


 Limits of the IRS on the amount of earnings a firm

can retain for non-specific reasons


Investment Opportunities

Firms that need great amounts of funds for


positive NPV investments—that is, high-
growth firms—usually pay relatively low
amounts of dividends when compared to
firms with few positive NPV investments.
Alternative Sources of Capital
 The higher the costs of issuing new
common stock, generally the lower the
relative amount of dividends paid by a
firm.
Ownership Dilution
 Companies that want to avoid the
dilution of ownership that occurs when
new stock is issued tend to retain
earnings to finance investments.
 Such companies might follow a residual
dividend policy.
Effects of Dividend Policy on rs

 Firms want to minimize its WACC


 Factors such as risk perception, information
content (signaling), and preference for
current returns versus future returns (that
is, dividend yield or capital gains) are
considered when the dividend policy is
established.
Stock Splits and Stock Dividends

 Some firms pay dividends in the form of stock

or change the number of shares of stock that


is outstanding through a stock split.

 Neither of these actions by themselves has

economic value in the sense that each does


nothing to change stockholders’ wealth.
Stock Splits
 An action taken by a firm to change the number of
outstanding shares of stock and the price per share.
 Many firms believe their stock has an optimal price
range within which their stock should trade.
 If the price of the stock exceeds the price range, then the firm
will execute a stock split.
 If the price of the stock is below the price range, then the firm
will execute a “reverse” stock split.
 When a “regular” stock split is initiated, generally the
price of the stock actually settles above “split price.”
 Information content
 Impact—increase the number of shares; lower the market
price per share
Stock Dividends
 Dividends paid in the form of stock rather than
cash.
 Like stock splits, a stock dividend does not
have specific economic value:
 increases the total number of shares of stock each
stockholder owns
 stock price per share decreases
 A firm might use a stock dividend to keep the
price of its stock within a particular range.
Balance Sheet Effects—Stock Splits
 The number of shares outstanding changes relative to the split,
which also changes the stated par value of the stock.
 Example: If a firm initiates 2-for-1 split, the equity portion of its
balance sheet before and after the split would be:
Before the Stock Split:
Common stock at par (50,000 shares outstanding, $2 par)
$100,000
Additional paid-in capital 200,000
Retained earnings 300,000
Total common stockholders’ equity $600,000
After the Stock Split:
Common stock at par (100,000 shares outstanding, $1 par)
$100,000
Additional paid-in capital 200,000
Retained earnings 300,000
Total common stockholders’ equity $600,000
Balance Sheet Effects—Stock
Dividend
 The firm must transfer capital from retained earnings
to the “Common stock” account and the “Additional
paid-in capital” account to reflect the fact that a
dividend was paid.
 The transfer from retained earnings is computed as
follows:

d = Numberof shares× Stockdividend


Fundstransferre  
 Marketprice

 × 


g   as a percent   of thestock
fromretainedearnings  outstandin  
Balance Sheet Effects—Stock
Dividend
Example: The firm pays a 10 percent stock dividend
and P0 = $20; outstanding shares = 50,000:

Numberof = Numberof shares × Stockdividend




   
Shares"Paid"  outstandin
g   as a percent 

= 50,000 x 0.10 = 5,000 shares

d = Numberof shares× Stockdividend


Fundstransferre  
 Marketprice
×



g   as a percent   of the stock
fromretainedearnings  outstandin    

= 50,000× 0.10 × $20 = $100,000


 
Balance Sheet Effects—Stock
Dividend
 Example: $100,000 is transferred from retained earnings; $10,000
= (5,000 shares) x $2 par is transferred into the Common stock
account and the remaining $90,000 is transferred into Additional
paid-in capital; the balance sheet effect is:
Before the Stock Dividend:
Common stock at par (50,000 shares outstanding, $2 par)
$100,000
Additional paid-in capital 200,000
Retained earnings 300,000
Total common stockholders’ equity $600,000
After the Stock Dividend:
Common stock at par (55,000 shares outstanding, $2 par)
$110,000
Additional paid-in capital 290,000
Retained earnings 200,000
Total common stockholders’ equity $600,000
Price Effects of Stock Splits and
Stock Dividends
 Both stock splits and stock dividends increase the
number of outstanding shares of stock and decrease
stock price.
 Splits and stock dividends create no economic value by
themselves.
 Studies have shown that the market price of the stock
affected by such actions might change
 If investors expect future earnings and cash dividends to increase
(decrease), then the price will increase (decrease) above the
relative price associated with the stock split or the stock dividend.
 If the future expectations do not pan out, however, the price of the
stock will eventually settle at a price that yields an economic
change in investors’ wealth approximately equal to zero.