dividend policy, irrelevance of dividend, relevance of dividend, factors effecting the dividend policy, stock split, stock reverse, stock dividend, treasury stock, stable and fixed dividend policies

1. Chapter 18
Dividend Policy
By Muhammad Shafiq
forshaf@gmail.com
http://www.slideshare.net/forshaf

2. Dividend Policy
• Passive Versus Active Dividend Policies
• Factors Influencing Dividend Policy
• Dividend Stability
• Stock Dividends and Stock Splits
• Stock Repurchase
• Administrative Considerations

3. Dividends as a Passive
Residual
• 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.
Can the payment of cash dividends affect
shareholder wealth?
If so, what dividend-payout ratio will maximize
shareholder wealth?

4. Irrelevance of Dividends
• 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.
A. Current dividends versus retention of
earnings

5. Irrelevance of Dividends
• 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.
B. Conservation of value

6. Relevance of 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.
A. Preference for dividends

7. Relevance of Dividends
• 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 dividend-yielding stocks
should sell at a discount to generate a higher
before-tax rate of return.
• Certain institutional investors pay no tax.
B. Taxes on the investor

8. Relevance of Dividends
• Corporations can typically exclude 70% of dividend income
from taxation. Thus, corporations generally prefer to receive
dividends rather than capital gains.
• The result is clienteles of investors with different dividend
preferences. In equilibrium, there will be the proper
distribution of firms with differing dividend policies to exactly
meet the needs of investors.
• Thus, dividend-payout decisions are irrelevant.
B. Taxes on the investor (continued)

9. Other Dividend Issues
• Flotation costs
• Transaction costs and divisibility of securities
• Institutional restrictions
• Financial signaling

10. Empirical Testing of
Dividend Policy
Tax Effect
• Dividends are taxed more heavily than capital gains, so
before-tax returns should be higher for high-dividend-paying
firms.
• Empirical results are mixed -- recently the evidence is largely
consistent with dividend neutrality.
Financial Signaling
• Expect that increases (decreases) in dividends lead to
positive (negative) excess stock returns.
• Empirical results are consistent with these expectations.

11. 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.

12. 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.

13. Factors Influencing Dividend
Policy
• Capital Impairment Rule -- many states prohibit the
payment of dividends if these dividends impair “capital”
(usually either par value of common stock or par plus
additional paid-in capital).
• Incorporation in some states (notably Delaware) allows a
firm to use the “fair value,” rather than “book value,” of its
assets when judging whether a dividend impairs “capital.”
Legal Rules

14. Factors Influencing Dividend
Policy
•Insolvency Rule -- some states prohibit the payment of
cash dividends if the company is insolvent under
either a “fair market valuation” or “equitable” sense.
•Undue Retention of Earnings Rule -- prohibits the
undue retention of earnings in excess of the present
and future investment needs of the firm.
Legal Rules

15. Factors Influencing Dividend
Policy
• Funding Needs of the Firm
• Liquidity
• Ability to Borrow
• Restrictions in Debt Contracts
• Control
Other Issues to Consider

16. Dividend Stability
Stability -- maintaining the position of the firm’s
dividend payments in relation to a trend line.
DollarsPerShare
3
4
2
1
Earnings per share
Dividends
per share
Time
50% of earnings
paid out as dividends

17. Dividend Stability
Dividends begin at 50% of earnings, but are stable and
increase only when supported by growth in earnings.
DollarsPerShare
3
4
2
1
Earnings per share
Dividends per share
Time
50% dividend-payout
rate with stability

18. 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.”

19. Types of Dividends
Extra dividend
• A nonrecurring dividend paid to shareholders in
addition to the regular dividend. It is brought
about by special circumstances.
Regular Dividend
 The dividend that is normally expected to be
paid by the firm.

20. Stock Dividends and
Stock Splits
Small-percentage stock dividends
• 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?
Stock Dividend -- A payment of additional shares
of stock to shareholders. Often used in place of
or in addition to a cash dividend.

21. B/S Changes for the Small-
Percentage 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.

22. Small-Percentage Stock
Dividends
Before 5% Stock Dividend
Common stock
($5 par; 400,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000
After 5% Stock Dividend
Common stock
($5 par; 420,000 shares) $ 2,100,000
Additional paid-in capital 1,700,000
Retained earnings 6,200,000
Total shareholders’ equity $10,000,000

23. Stock Dividends,
EPS, and Total Earnings
•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).
After a small-percentage stock dividend, what
happens to EPS and total earnings of individual
investors?

24. Stock Dividends and
Stock Splits
• Typically 20% or greater of previously outstanding common stock.
• The material effect on the market price per share causes the
transaction to be accounted for differently. Reclassification is
limited to the par value of additional shares rather than pre-
stock-dividend value of additional shares.
• Assume a company with 400,000 shares of $5 par common stock
outstanding pays a 100% stock dividend. The pre-stock-dividend
market value per share is $40. How does this impact the
shareholders’ equity accounts?
Large-percentage stock dividends

25. B/S Changes for the Large-
Percentage Stock Dividend
• $2 million ($5 x 400,000 new shares)
transferred (on paper) “out of” retained
earnings.
• $2 million transferred “into” common stock
account.

26. Large-Percentage Stock
Dividends
Before 100% Stock Dividend
Common stock
($5 par; 400,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000
After 100% Stock Dividend
Common stock
($5 par; 800,000 shares) $ 4,000,000
Additional paid-in capital 1,000,000
Retained earnings 5,000,000
Total shareholders’ equity $10,000,000

27. Stock Dividends and
Stock Splits
• 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?
Stock Split -- An increase in the number of
shares outstanding by reducing the par value of
the stock.

28. Stock Splits
Before 2-for-1 Stock Split
Common stock
($5 par; 400,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000
After 2-for-1 Stock Split
Common stock
($2.50 par; 800,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000

29. 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

30. Stock Dividends and
Stock Splits
• Used to move the stock into a more popular trading range and
increase share demand.
• Usually signals negative information to the market upon its
announcement (consistent with empirical evidence).
• Assume a company with 400,000 shares of $5 par common
stock splits 1-for-4. How does this impact the shareholders’
equity accounts?
Reverse Stock Split -- A stock split in which the
number of shares outstanding is decreased.

31. Reverse Stock Splits
Before 1-for-4 Stock Split
Common stock
($5 par; 400,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000
After 1-for-4 Stock Split
Common stock
($20 par; 100,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000

32. Stock Repurchase
Reasons for stock repurchase:
• Available for management stock-option plans
• Available for the acquisition of other companies
• “Go private” by repurchasing all shares from outside
stockholders
• To permanently retire the shares
Stock Repurchase -- The repurchase (buyback) of
stock by the issuing firm, either in the open
(secondary) market or by self-tender offer.

33. Methods of Repurchase
• Fixed-price self-tender offer -- An offer by a firm to repurchase
some of its own shares, typically at a set price.
• Dutch auction self-tender offer -- A buyer (seller) seeks bids
within a specified price range, usually for a large block of stock
or bonds. After evaluating the range of bid prices received, the
buyer (seller) accepts the lowest price that will allow it to
acquire (dispose of) the entire block.
• Open-market purchase -- A company repurchases its stock
through a brokerage house on the secondary market.

34. Repurchasing as
Part of Dividend Policy
Assume:
• Earnings after taxes $ 800,000
• Number of common shares
outstanding  400,000
• Earnings per share $ 2
• Current market price
per share $ 31
• Expected dividend per share $ 1
• Expected total dividends to be
paid out $ 400,000

35. Repurchasing as
Part of Dividend Policy
If dividend is paid, shareholders receive:
• Expected dividend per share $ 1
• Market price per share $ 30
• Total value $ 31
If shares repurchased, shareholders receive:
• Dividend per share $ 0
• Market price per share* $ 31
• Total value $ 31
* Shares repurchased = $400,000 / $31 = 12,903
Original P/E ratio = $30/$2 = 15
“New” EPS = $800,000 / 387,097 = $2.07
“New” market price = $2.07 x 15 = $31

36. Summary of Repurchasing as
Part of Dividend Policy
• The capital gain arising from the repurchase (stock
rising from $30 to $31) exactly equals the dividend
($1) that would have otherwise been paid.
• This result holds in the absence of taxes and
transaction costs.
• To the taxable investor, capital gains (repurchases)
are favored to dividend income as the tax on the
capital gain is postponed until the actual sale of the
common shares.

37. Summary of Repurchasing as
Part of Dividend Policy
• Stock repurchases are most relevant for firms with
large amounts of excess cash that might otherwise
generate a significant taxable transaction to
investors.
• Firms must be careful not to make regularly
occurring repurchases or the IRS may consider the
capital gains as dividends for tax purposes.

38. Investment or Financing
Decision?
Financing Decision
• It possesses capital structure or dividend policy motivations.
• For example, a repurchase immediately changes the debt-
to-equity ratio (higher financial leverage).
Investing Decision
 Not really, as stock that is repurchased is held as
treasury stock and does not provide an expected return
like other investments.

39. Possible Signaling Effect
• Repurchases have a positive signaling effect.
• For example, if the stock is undervalued management may
tender for shares at a “premium.” This signals that the share
prices are undervalued.
• Dutch-auction self-tenders have less signaling power likely
due to a smaller tender premium.
• Open-market purchases have only a modest positive
signaling effect likely due to many programs being instituted
after significant share price declines.

40. Administrative Considerations:
Procedural Aspects
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.
May 8 May 29 May 31 June 15

41. Administrative Considerations:
Procedural Aspects
Ex-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.
May 8 May 29 May 31 June 15

42. Administrative Considerations:
Procedural Aspects
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.
May 8 May 29 May 31 June 15

43. Dividend Reinvestment
Plans
• The firm can use existing stock. A trustee (e.g., a bank)
purchases the stock on the open market and credits current
shareholders with the new shares.
• The firm can issue new stock. This method raises “new”
funds for the firm. The plan essentially reduces the effective
dividend-payout ratio.
• Some plans offer discounts and eliminate brokerage costs
for current shareholders.
Dividend Reinvestment Plan (DRIP) -- An optional plan
allowing shareholders to automatically reinvest dividend
payments in additional shares of the company’s stock.