Dividend Policy

What is It?

Dividend Policy refers to the explicit or implicit decision of the Board of Directors regarding the amount of residual earnings (past or present) that should be distributed to the shareholders of the corporation.
This decision is considered a finacing decision because the profits of the corporation are an important source of financing available to the firm.
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Types of Dividends
Dividends are a permanent distribution of residual earnings/property of the corporation to its owners. Dividends can be in the form of:
Cash Additional Shares of Stock (stock dividend) Property

If a firm is dissolved, at the end of the process, a final dividend of any residual amount is made to the shareholders this is known as a liquidating dividend.

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Payment Policies
1. Residual Dividend Payment
Earnings not used to finance capital investment are available for dividend payment
Same Rs.-dividend each quarter Constant % of earnings

2. Constant Cash Dividend

3. Constant payout ratio (%)

Dividends a Financing Decision

In the absence of dividends, corporate earnings accrue to the benefit of shareholders as retained earnings and are automatically reinvested in the firm. When a cash dividend is declared, those funds leave the firm permanently and irreversibly. Distribution of earnings as dividends may starve the company of funds required for growth and expansion, and this may cause the firm to seek additional external capital. Retained Earnings Corporate Profits After Tax Dividends

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Dividends versus Interest Obligations

Interest Interest is a payment to lenders for the use of their funds for a given period of time Timely payment of the required amount of interest is a legal obligation Failure to pay interest (and fulfill other contractual commitments under the bond indenture or loan contract) is an act of bankruptcy and the lender has recourse through the courts to seek remedies Secured lenders (bondholders) have the first claim on the firms assets in the case of dissolution or in the case of bankruptcy Dividends A dividend is a discretionary payment made to shareholders The decision to distribute dividends is solely the responsibility of the board of directors Shareholders are residual claimants of the firm (they have the last, and residual claim on assets on dissolution and on profits after all other claims have been fully satisfied)
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Dividend Payments
Mechanics of Cash Dividend Payments

Declaration Date Holder of Record Date Ex-dividend Date Payment Date

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Dividend Payments
Mechanics of Cash Dividend Payments

Declaration Date this is the date on which the Board of Directors meet and declare the dividend. In their resolution the Board will set the date of record, the date of payment and the amount of the dividend for each share class. when CARRIED, this resolution makes the dividend a current liability for the firm.

Date of Record is the date on which the shareholders register is closed after the trading day and all those who are listed will receive the 22 - 7 dividend. CHAPTER 22 Dividend Policy

Ex dividend Date is the date that the value of the firms common shares will reflect the dividend payment (ie. fall in value) ex means without. At the start of trading on the ex-dividend date, the share price will normally open for trading at the previous days close, less the value of the dividend per share. This reflects the fact that purchasers of the stock on the ex-dividend date and beyond WILL NOT receive the declared dividend.

Date of Payment is the date the cheques for the dividend are mailed out to the shareholders.

Empirical evidence on dividends

Dividends tend to lag earnings
Dividends are changed to reflect long-term shifts in earnings

Dividends are sticky Dividends are less volatile than earnings Dividend policy tends to follow the life cycle of the firm with mature firms returning more to owners

How does dividend policy affect stock price?

Constant growth stock valuation model:

D1 P0 rg
An increase in dividends increases D1 but also decreases g

Dividends are irrelevant

The Miller-Modigliani Hypothesis: Dividends do not affect value Basis: If a firm's investment policy (and hence cash flows) does not change, the value of the firm cannot change with dividend policy. If we ignore personal taxes, investors have to be indifferent to receiving either dividends or capital gains.

Dividends are irrelevant

Underlying Assumptions: (a) There are no tax differences between dividends and capital gains. (b) If companies pay too much in cash, they can issue new stock, with no flotation costs or signaling consequences, to replace this cash. (c) If companies pay too little in dividends, they do not use the excess cash for bad projects or acquisitions.

M&Ms Dividend Irrelevance Theorem

Residual Theory of Dividends

The Residual Theory of Dividends suggests that logically, each year, management should:
Identify free cash flow generated in the previous period Identify investment projects that have positive NPVs Invest in all positive NPV projects
If free cash flow is insufficient, then raise external capital in this case no dividend is paid If free cash flow exceeds investment requirements, the residual amount is distributed in the form of cash dividends.

M&Ms Dividend Irrelevance Theorem

Residual Theory of Dividends - Implication

The implication of the Residual Theory of Dividends are: Investment decisions are independent of the firms dividend policy No firm would pass on a positive NPV project because of the lack of funds, because, by definition the incremental cost of those funds is less than the IRR of the project, so the value of the firm is maximized only if the project is undertaken. If the firm cant make good use of free cash flow (ie. It has no projects with IRRs > cost of capital) then those funds should be distributed back to shareholders in the form of dividends for them to invest on their own. The firm should operate where Marginal Cost equals Marginal Revenue

M&Ms Dividend Irrelevance Theorem

Homemade Dividends

Shareholders can buy or sell shares in an underlying company to create their own cash flow pattern.
They dont need management declare a cash dividend, they can create their own.
Conclusion: under the assumptions of M&Ms model, the investor is indifferent to the firms dividend policy.

Dividends are bad

Individuals in upper income tax brackets might prefer lower dividend payouts, with the immediate tax consequences, in favor of higher capital gains Additionally,
Flotation costs low payouts can decrease the amount of capital that needs to be raised, thereby lowering flotation costs
Dividend restrictions debt contracts might limit the percentage of income that can be paid out as dividends

Dividends are good. for these reasons

The bird in the hand fallacy: Dividends are better than capital gains because dividends are certain and capital gains are not. The Excess Cash Argument: The excess cash that a firm has in any period should be paid out as dividends in that period.

The bird in the hand fallacy

Argument: Dividends now are more certain than capital gains later. Hence dividends are more valuable than capital gains. Counter: The appropriate comparison should be between dividends today and price appreciation today.

The excess cash hypothesis

Argument: The firm has (temporary) excess cash on its hands this year, no investment projects this year and wants to give the money back to stockholders. Counter: If this is a one-time phenomenon, the firm has to consider future financing needs.
Consider the cost of issuing new stock If it initiates dividends, it may need to raise capital through a stock issue just to pay dividends in the future.

Dividends are good.possibly for these reasons

The Clientele Effect: There are stockholders who like dividends, either because they value the regular cash payments or do not face a tax disadvantage. If these are the stockholders in your firm, paying more in dividends will increase value. Dividends as Signals: Dividend changes act as signals to financial markets about the future sustainable earnings of the firm Wealth Transfer: By returning more cash to stockholders, there might be a transfer of wealth from the bondholders to the stockholders.

A clientele based explanation

Basis: Investors may form clienteles based upon their tax brackets. Investors in high tax brackets may invest in stocks which do not pay dividends and those in low tax brackets may invest in dividend paying stocks. A study found that (a) Older investors were more likely to hold high dividend stocks and (b) Poorer investors tended to hold high dividend stocks

Dividends as signals
Dividend increases Stock prices increase significantly around dividend increase announcements. Management is signaling to the market that earnings will be sustainable at a higher level thus allowing the company to maintain a higher dividend level The opposite is true for dividend decreases Signals are most effective for smaller firms

Dividend Policy
Dividends, Shareholders and the Board of Directors

There is no legal obligation for firms to pay dividends to common shareholders Shareholders cannot force a Board of Directors to declare a dividend, and courts will not interfere with the BODs right to make the dividend decision because: Board members are jointly and severally liable for any damages they may cause

Dividend Policy
Board members are constrained by legal rules affecting dividends including: Not paying dividends out of capital Not paying dividends when that decision could cause the firm to become insolvent Not paying dividends in contravention of contractual commitments (such as debt covenant agreements)

Dividend Payments
Dividend Reinvestment Plans (DRIPs)

Involve shareholders deciding to use the cash dividend proceeds to buy more shares of the firm
DRIPs will buy as many shares as the cash dividend allows with the residual deposited as cash Leads to shareholders owning odd lots

Firms are able to raise additional common stock capital continuously at no cost and fosters an on-going relationship with shareholders.

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Dividend Payments
Stock Dividends

Stock dividends simply amount to distribution of additional shares to existing shareholders They represent nothing more than recapitalization of earnings of the company. (that is, the amount of the stock dividend is transferred from the R/E account to the common share account.

Because of the capital impairment rule stock dividends reduce the firms ability to pay dividends in the future.

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Dividend Payments
Stock Dividends Implications reduction in the R/E account reduced capacity to pay future dividends proportionate share ownership remains unchanged shareholders wealth (theoretically) is unaffected Effect on the Company conserves cash serves to lower the market value of firms stock modestly promotes wider distribution of shares to the extent that current owners divest themselves of shares...because they have more adjusts the capital accounts dilutes EPS
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Dividend Payments
Effect on Shareholders proportion of ownership remains unchanged total value of holdings remains unchanged if former DPS is maintained, this really represents an increased dividend payout

Dividend Payments
Stock Splits

Although there is no theoretical proof, there is some who believe that an optimal price range exists for a companys common shares. The purpose of a stock split is to decrease share price. The result is: increase in the number of share outstanding theoretically, no change in shareholder wealth Reasons for use: better share price trading range psychological appeal (signalling affect)
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Factors Influencing Dividend Policy

Legal Rules
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).

Factors Influencing Dividend Policy

Legal Rules
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.

Factors Influencing Dividend Policy

Other Issues to Consider
Funding Needs of the Firm Liquidity Ability to Borrow Restrictions in Debt Contracts (protective covenants) Control

Dividend Reinvestment Plans

Dividend Reinvestment Plan (DRIP) -- An optional plan allowing shareholders to automatically reinvest dividend payments in additional shares of the companys stock.

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.

Capital Structure Impact

Paying Dividends will
Reduce Assets (cash) Reduce Equity
Increases the relative amount of debt Higher debt ratios are seen as positive signals that management is trying to concentrate expected profits onto less equity. This should raise stock prices, lowering the cost of equity and the WACC.

Corporate Governance & Dividends

Executive Compensation
Fixed Pay (no equity link)
Underinvestment & Perk-taking problems Issuing dividends increases the probability a firm will need to issue new stock
Imposes market discipline on management to reduce these agency costs and maximize shareholder wealth

Stock Options (equity link)

Excessive risk-taking problem not alleviated by dividend policy
In fact, management is less likely to pay dividends or issue new stock since such actions would lower stock prices which reduces the value of stock options.