MBA 656: ADVANCED FINANCIAL MANAGEMENT

DIVIDEND POLICYDIVIDEND POLICY

What are Dividends?What are Dividends? Dividends are corporate distributions to its shareholders

proportionate to the number of shares held by the latter. Dividends may be in the form of cash dividends, bonus issue (stock dividends), and property dividends.

A dividend is a distribution of corporate income to its shareholders on a pro rata basis. Potential buyers and sellers of a corporation’s shares are keenly interested in a company’s dividends policies and practices. Dividends are distributed out of accumulated earnings of the corporation except of a liquidating dividend which represents a return to the shareholders of their investment.

Types of DividendsTypes of Dividends

Type Form of Payment

Cash Dividends Cash

Stock Dividends

Shares of stock

Property Dividends

Non-cash assets

Scrip / Liability Dividends

Notes or other evidence corporate indebtedness

Relevant DatesRelevant Dates Date of Declaration Date when the board of directors (BOD) formally approves

and announces the dividend. Reduction in RE is recognized in the accounts.

Date of Record Set by the BOD, the date on which all persons whose names

are recorded as stockholders will receive a declared dividend at a specified future time. No entry made on this date.

Date of Payment Set by the BOD, the actual date on which the payment of

dividend is made. Entry is made on this date to record the settlement of dividend.

Dividend Payment TimelineDividend Payment Timeline

Entries made:Entries made:

Assuming there are 50,000 outstanding shares as of date of record:

Tax Treatment of DividendsTax Treatment of Dividends

Dividend Reinvestment Plans (DRIPs)Dividend Reinvestment Plans (DRIPs) Enable stockholders to use dividends received on

the firm’s stock to acquire additional shares, even fractional shares, at little or no transaction cost.

With DRIPs, plan participants typically can acquire shares at about 5% below the prevailing market price.

From its point of view, the firm can issue new shares to participants more economically.

Is it relevant to have a Dividend Policy?

Residual Theory of DividendsResidual Theory of Dividends

A school of thought that suggests that the dividend paid by a frim should be viewed as a residual -- the amount left over after all acceptable investment opportunities have been undertaken.

Suggests that the required return of investors is not influenced by the firm’s dividend policy – a premise that in turn implies that dividend policy is irrelevant.

Three Steps in Making a Dividend Decision:Three Steps in Making a Dividend Decision:

STEP 1: Determine the optimal level of capital expenditures, which would be the level generated by the point of intersection of the investment opportunities schedule (IOS) and weighted marginal cost of capital (WMCC) (as discussed in ‘The Cost of Capital’)

STEP 2: Estimate the total amount of equity financing needed to support the expenditures generated in Step 1using the optimal capital structure proportions (as discussed in ‘Leverage & Capital Structure’)

STEP 3: Because the cost of retained earnings is less than the cost of new common stock, use retained earnings to meet the equity requirement determined in Step2. If retained earnings are inadequate to meet this need, sell common stock. If the available retained earnings are in excess of this need, distribute the residual as dividends.

Sample analysis:Sample analysis:

Dividend Irrelevance TheoryDividend Irrelevance TheoryBy Merton H Miller and Franco Modigliani

Suggests that in a perfect world, the firm’s value is determined solely by the earning power and risk of its assets (investments) and that the manner in which it splits its earnings stream between dividends and internally retained (and reinvested) funds does not affect this value.

Dividend Relevance TheoryDividend Relevance TheoryBy Myron J. Gordon and John Lintner

There is a direct relationship between a firm’s dividend policy and its market value.

“A bird in the hand is worth two in the bush”

What is a Dividend Policy?What is a Dividend Policy?

The firm’s plan of action to beFollowed whenever a dividenddecision is made.

Factors Affecting Dividend PolicyFactors Affecting Dividend Policy

Legal ConstraintsContractual Constraints Internal Constraints Growth ProspectsOwner ConsiderationsMarket Considerations

Types of Dividend PoliciesTypes of Dividend Policies

Constant-Payout-Ratio Dividend Policy

Regular Dividend Policy

Low-Regular-and-Extra Dividend Policy

Constant-Payout-Ratio Dividend PolicyConstant-Payout-Ratio Dividend Policy• A dividend policy based on the payment of a

certain percentage of earnings to owners in each dividend period

• Dividend payout ratio – indicates the percentage of each dollar earned that is distributed to the owners in the form of cash. It is calculated by dividing the firm’s cash dividend per share by its earnings per share (EPS)

Regular Dividend PolicyRegular Dividend Policy

A dividend policy which is based on the payment of a fixed-rate dividend in each period. This policy provides the owners with generally positive information, thereby minimizing their uncertainty. Often, firms that use this policy increase the regular dividend once a proven increase in earnings has occurred. Under this policy, dividends are almost never increased.

• Often a regular dividend policy is built around a target dividend-payout ratio.

• Target Dividend-Payout ratio is a dividend policy under which the firm attempts to payout a certain percentage of earnings as a stated dollar dividend and adjusts that dividend toward a target payout as proven earnings increases occurs.

Low-Regular-and-Extra Dividend PolicyLow-Regular-and-Extra Dividend Policy

A dividend policy based on paying a low regular dividend, supplemented by an additional dividend when earnings are higher than normal in a given period.

An extra dividend optionally paid by the firm if earnings are higher than normal in a given period.

Stock DividendsStock Dividends A stock dividend is the payment, to existing

owners, of a dividend in the form of stock.

Accounting Aspects – the payment of a stock dividend is a shifting between stockholders’ equity accounts rather than an outflow of funds.

A small stock dividend is a stock dividend that represents less than 20 to 25% of the common stock

Other Forms of Dividends: Stock DividendsOther Forms of Dividends: Stock DividendsA stock dividend is paid in stock rather than in cash.

Many investors believe that stock dividends increase the value of their holdings.

In fact, from a market value standpoint, stock dividends function much like stock splits. The investor ends up owning more shares, but the value of their shares is less.

From a book value standpoint, funds are transferred from retained earnings to common stock and additional paid-in-capital.

The current stockholder’s equity on the balance sheet of Garrison Corporation, a distributor of prefabricated cabinets, is as shown in the following accounts.

Other Forms of Dividends: Stock Dividends (cont)Other Forms of Dividends: Stock Dividends (cont)Accounting Aspects

Other Forms of Dividends: Stock Dividends (cont)Other Forms of Dividends: Stock Dividends (cont)Accounting Aspects

If Garrison declares a 10% stock dividend and the

current market price of the stock is $15/share, $150,000

of retained earnings (10% x 100,000 shares x

$15/share) will be capitalized.

The $150,000 will be distributed between the common

stock (par) account and paid-in-capital in excess of par

account based on the par value of the common stock.

The resulting balances are as follows

Other Forms of Dividends: Stock Dividends (cont)Other Forms of Dividends: Stock Dividends (cont)Accounting Aspects

Because 10,000 new shares (10% x 100,000) have been issued at the current price of $15/share, $150,000 ($15/share x 10,000 shares) is shifted from retained earnings to the common stock and paid-in-capital accounts.

Other Forms of Dividends: Stock Dividends (cont)Other Forms of Dividends: Stock Dividends (cont)The Shareholder’s Viewpoint

– From a shareholder’s perspective, stock dividends result in a dilution of shares owned.

– For example, assume a stockholder owned 100 shares at $20/share ($2,000 total) before a stock dividend.

– If the firm declares a 10% stock dividend, the shareholder will have 110 shares of stock. However, the total value of her shares will still be $2,000.

– Therefore, the value of her share must have fallen to $18.18/share ($2,000/110).

Other Forms of Dividends: Stock Dividends (cont)Other Forms of Dividends: Stock Dividends (cont)The Company’s Viewpoint

– Disadvantages of stock dividends include:

• The cost of issuing the new shares

• Taxes and listing fees on the new shares

• Other recording costs

– Advantages of stock dividends include:

• The company conserves needed cash

• Signaling effect to the shareholders that the firm is retaining cash because of lucrative investment opportunities

Delphi Company, a forest products concern, had 200,000 shares of $2-par value common stock outstanding and declares a 2-for-1 split. The total before and after split impact on stockholders equity is:

Other Forms of Dividends:Stock SplitsOther Forms of Dividends:Stock SplitsA stock split is a recapitalization that affects the number of

shares outstanding, par value, earnings per share, and market price.

The rationale for a stock split is that it lowers the price of the stock and makes it more attractive to individual investors

Other Forms of Dividends:Stock Splits (cont.)Other Forms of Dividends:Stock Splits (cont.)

Research on both stock splits and stock dividends generally supports the theory that they do not affect the value of shares. They are often used, however, to send a signal to investors that good things are going to happen.

Other Forms of Dividends:Stock Splits (cont.)Other Forms of Dividends:Stock Splits (cont.)A reverse stock split reduces the number of shares outstanding

and raises stock price—the opposite of a stock split.The rationale for a reverse stock split is to add respectability to the

stock and convey the meaning that it isn’t a junk stock.

Other Forms of Dividends:Stock RepurchasesOther Forms of Dividends:Stock RepurchasesA stock repurchase is the purchasing and retiring of

stock by the issuing corporation.

A repurchase is a partial liquidation since it decreases the number of shares outstanding.

It may also be thought of as an alternative to cash dividends.

Other Forms of Dividends:Stock Repurchases (cont.)Other Forms of Dividends:Stock Repurchases (cont.)Alternative reasons for stock repurchases:

– To use the shares for another purpose

– To alter the firm’s capital structure

– To increase EPS and ROE resulting in a higher market price

– To reduce the chance of a hostile takeover

Other Forms of Dividends: Stock Repurchases Viewed as a Cash DividendOther Forms of Dividends: Stock Repurchases Viewed as a Cash DividendThe repurchase of stock results in a type of reverse dilution.

The net effect of the repurchase is similar to the payment of a cash dividend.

However, if the firm pays the dividend, the owner would have to pay tax on the income.

The gain on the increase in share price as a result of the repurchase, however, would not be taxed until sold.