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Chapter 16

Dividend Policy

16-2 © 2002, 2012 Frank M. Werner and James A.F. Stoner

Dividend Policy

Introductory concepts – does it matter

how shareholders get their returns?

Dividend theories

Dividends in practice

How a dividend is paid


Dividend Policy



Dividend theories




How Shareholders Get Their

Returns

Dividend – a payment made by a

corporation directly to its stockholders

Dividends are one of two ways

shareholders get returns – the other is

stock price appreciation


Does it Matter How Shareholders

Get Their Returns?

The effect of raising the dividend

– Other things equal, increasing the dividend should

raise the firm’s stock price

– However, if a dividend increase leads investors to

raise their required rate of return or lower their

growth forecast, increasing the dividend could

lower the firm’s stock price

The critical question – does a dividend

paid today change investors’ forecasts of

future dividends or required rate of return?


Dividend Policy



Dividend theories




Theories That Argue for the

Payment of Dividends

Risk reduction theories

– Payment of a dividend resolves some uncertainty

about the amount and timing of returns

– Changes in dividends convey valuable

information about the company’s future

– Dividends increase investors’ liquidity




Market imperfection theories

– Dividends broaden the demand for the firm’s

stock since some institutional investors are

restricted to buying shares of dividend-paying

companies

– The tax code makes paying dividends attractive

to:

• corporate investors – 70% of dividends are tax free

• companies at risk for “improper accumulation”




Efficiency theory – dividends give

investors the freedom to reinvest their

returns in other companies, improving the

allocation of invested capital


Theories That Argue Against

the Payment of Dividends

Supply-demand theory – selling fewer

new shares avoids increasing the supply

and lowering their price

Market imperfection theories

– Not paying dividends avoids processing costs

– Not paying dividends avoids the flotation costs

of issuing additional shares

– Not paying dividends avoids exposing

shareholders to double taxation


Supply-Demand Theory


Theories That Argue Against

the Payment of Dividends

Control theory – not paying dividends

avoids dilution of ownership and control

Sustainable growth theory – not paying

dividends permits the firm to grow faster

before having to sell additional shares


A Theory That Concludes

Dividends are Irrelevant

Modigliani and Miller:

– Payment of a dividend merely reallocates

investors’ value from the company to the

investor

– “Homemade dividends” – an investor who is

unhappy with the dividend can:

• buy a few shares with the dividend money to return it

to the firm

• sell a few shares to take more money out of the firm


Theories That Argue for

Consistency

Clientele theory – Investors choose to invest in companies with

dividend policies they prefer

– Over time, a company’s investors will reflect its dividend policy, not vice versa

– Therefore: any dividend policy will do, just don’t change it

Market imperfection theories – It is difficult to home-make dividends when the

price of a share is very high

– The transactions cost for small share purchases or sales is proportionately high


A Theory That Argues Against

Setting a Dividend Policy

Residual theory

– Set retained earnings, not dividends

– The residual approach

• Determine the need for new financing

• Determine how much of this new financing should

come from equity

• Use retained earnings to the greatest extent possible

• Make the dividend whatever is left over from the

year’s earnings


Dividend Policy



Dividend theories




Dividends in Practice

Stability of payments

– Stable payout ratio

– Stable dollar dividend

– Stable dollar dividend plus a year-end bonus

payment

Company maturity – stage in life cycle

– Birth – low dividends due to limited cash

– Rapid growth – low dividends due to needs

– Maturity – high dividends to provide returns


Stable Payout Ratio


Stable Dollar Dividend


Dividends in Practice

Other practical considerations

– Availability of cash

– Alternative uses of cash

– Access to banks and financial markets

– Shareholder preferences

– Legal or charter restrictions


Dividend Policy



Dividend theories




Announcement of a Dividend


How a Dividend is Paid

Four dates

– Date of declaration – board of directors votes to

pay the dividend

– Date of record – company looks at its

shareholder list to determine who receives the

dividend

– Ex-dividend date – stock-exchange ensures that

those who purchase shares after this date do not

receive the dividend

– Payment date – dividend checks are mailed


A Dividend Timetable

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