INTRODUCTION TO

CORPORATE FINANC –
Dividend Policy

Prepared by
 CHAPTER 22
Dividend Policy
 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 financing decision
because the profits of the corporation are an
important source of financing available to the firm.
 Definition:
Dividend Policy means that decision of the
management through which it is determined
how much of net profits are to be distributed as
dividend among the shareholders and how
much to be retained in the business.

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 Significance :
Determination of dividend policy of the firm is
one of the important financial decisions of the
management. Three main decisions are taken
in the financial management. These are:
i) Investment Decisions
ii) Financing Decision
iii) Dividend Decisions

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Factors Determining Dividend Policy

1. Financial Needs of the Company

2. Stability of Dividends
3. Legal Requirements
4. Liquidity
5. Growth Prospects
6. Availability of Funds
7. Earnings Stability

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8. Control
9. Taxes
10. Investment Opportuni9ties
11. Effects on Earnings Per Share
12. Age of Company
13. Inflation

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 Kinds of Dividend:
 Cash Dividend
 Stock Dividend or Bonus Shares
 Interim Dividend
 Extra Dividend
 Property Dividend
 Scrip Dividend
 Bond Dividend
 Composite Dividend

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 Types of Dividend Policy:

 Steady Dividends at the Present Level Policy

 Steady Dividends at a Lower Level Policy
 Steady Dividends at Higher Level Policy
 Dividends Fluctuating with Earnings Policy
 Low Regular Dividends Plus Extra Dividend
 Policy of Eliminating the Dividend Entirely

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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.
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 firm’s 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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THE MECHANICS OF
DIVIDEND PAYMENTS
Dividend Policy
 Trade Settlement and the Ex Dividend
Date
Changes in the Settlement Cycle
 In June 1995 the settlement cycle for all non-money-market Canadian and U.S.
securities was reduced from five business days (T + 5) to three business days (T + 3).
 The rationale for the change stems from the 1987 stock market crash when it was
realized that a securities market failure could result in a credit market failure. The
gridlock created in 1990 by the bankruptcy of Drexel Burnham Lambert, a large U.S.
broker, increased the need to minimize the risks involved in the clearing and
settlement of securities.
 The shortened settlement cycle requires that the payment of funds and the delivery
of securities take place on the third business day after the trade date. This will
reduce credit, market and liquidity risks by decreasing post-trade settlement
exposure.

Ex Dividend Date
 The date is not chosen by the board of directors, rather it is determined as a result of
the exchanges settlement practices and is a function of the date of record.

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 DIVIDEND DECISION AND
THE BOARD OF DIRECTORS
Dividend Policy
 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 BOD’s right
to make the dividend decision because:
 Board members are jointly and severally liable for any damages
they may cause
 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)

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 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 (less than 100 shares)

 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 firm’s 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
 shareholder’s wealth (theoretically) is unaffected

Effect on the Company

 conserves cash
 serves to lower the market value of firm’s 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

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

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 Dividend Payments
Stock Splits

 Although there is no theoretical proof, there is some who

believe that an optimal price range exists for a company’s
common shares.
 It is generally felt that there is greater demand for shares of
companies that are traded in the $40 - $80 dollar range.
 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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 Cash Dividend Payments
The Macro Perspective

 :
 Aggregate after-tax profits run at approximately 6% of GDP
but are highly variable
 Aggregate dividends are relatively stable when compared to
after-tax profits.
 They are sustained in the face of drops in profit during recessions
 They are held reasonably constant in the face of peaks in aggregate
profits.

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 Cash Dividend Payments
The Macro Perspective

 Aggregate Dividend payouts further illustrates the

effects of relatively stable dividend payouts in the
face of profit volatility:
 The normal aggregate dividend payout rate is about
40% of after-tax profit
 When profits drop and dividends are held constant,
payout rates rise to 100%

()

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MODIGLIANI AND MILLER’S
DIVIDEND IRRELEVANCE
THEOREM
M&M, Dividends and Firm Value
Modigliani and Miller’s Dividend Irrelevance
Theorem

The value of M&M’s Dividend Irrelevance

argument is that in the end, it shows where
value can be created with dividend policy and
why.

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 M&M’s Dividend Irrelevance Theorem
M&M, Dividends, and Firm Value

Start with the single-period DDM:

D1 P
P0  1
(1Ke )

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 M&M’s Dividend Irrelevance Theorem
M&M, Dividends, and Firm Value

 Multiply by the number of shares outstanding

(m) to convert the single stock price model to a
model to value the whole firm:

m 1
(D P1)
[ 22-] 0
mP V0
(1Ke)

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 M&M’s Dividend Irrelevance Theorem
Assumptions

 No Taxes
 Perfect capital markets
 large number of individual buyers and sellers
 costless information
 no transaction costs
 All firms maximize value
 There is no debt

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 M&M’s Dividend Irrelevance Theorem
M&M, Dividends, and Firm Value

 Without debt, sources and uses of funds identity (sources =

uses) can be expressed as:

X 1  nP1  I1  mD1
 Where:
 X represents cash flow from operations
 I represents investment
 X–I is free cash flow
 mD1 is dividend to current shareholders at time 1

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 M&M’s 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.
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 M&M’s Dividend Irrelevance Theorem
Residual Theory of Dividends - Implication

The implication of the Residual Theory of Dividends are:

Investment decisions are independent of the firm’s 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 can’t 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 as seen in Figure 22 – 4 on the following slide:

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 M&M’s Dividend Irrelevance Theorem
Homemade Dividends

 Shareholders can buy or sell shares in an

underlying company to create their own cash
flow pattern.
 They don’t need management declare a cash
dividend, they can create their own.

Conclusion: under the assumptions of M&M’s model,

the investor is indifferent to the firm’s dividend
policy.

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The “Bird-in-the-Hand” Argument
M&M’s Assumptions Relaxed

 Risk is a real world factor.

 Firm’s that reinvest free cash flow, put that
money at risk – there is no certainty of
investment outcome – those forfeit dividends
that are reinvested…could be lost!
 Remember the two-stage DDM?

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The “Bird-in-the-Hand” Argument
M&M’s Assumptions Relaxed

 Remember the two-stage DDM?


ROEBVPS
InvROEK
 1
P  ( 2 e)
Ke 
(1K
)
e K
e

 The first term is the present value of existing opportunities

(PVEO)
 The second term is the present value of growth opportunities
(PVGO)
 These forecast returns face risks of new market entrants to
compete for the excess profits forecast in emerging
opportunities making PVGO extremely vulnerable.

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The “Bird-in-the-Hand” Argument
M&M’s Assumptions Relaxed

 Myron Gordon suggests that dividends are more stable than

capital gains and are therefore more highly valued by
investors.

 This implies that investors perceive non-dividend paying

firms to be riskier and apply a higher discount rate to value
them causing the share price to fall.

 The difference between the M&M and Gordon arguments

are illustrated in Figure 22 - 5 on the following slide:
 M&M argue that dividends and capital gains are perfect
substitutes

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DIVIDEND POLICY IN
PRACTICE
Dividend Policy
 Dividend Policy in Practice

 Firms smooth their dividends

 Firms tend to hold dividends constant, even in the
face of increasing after-tax profit
 Firms are very reluctant to cut dividends

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 Dividend Policy in Practice
Lintner’s Work on Dividend Adjustment

Implications
 The speed of dividend adjustment is only about 30
percent
 Firms are very reluctant to fully adjust
 Firms do not follow a policy of paying a constant
proportion of earnings out as dividends

Dividend policy in practice does not follow M&M’s

irrelevance arguments because the real world does
not match the assumptions used.

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 Relaxing the M&M Assumptions
Welcome to the Real World!

Transactions Costs
 Underwriting costs are very high, providing a strong
incentive for firms to finance growth out of free cash
flow
 Facing these high underwriting costs firms:
 With high growth rates have little incentive to pay
dividends
 With volatile earnings conserve cash from year to year
to finance projects and therefore pay very conservative
dividends

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 Relaxing the M&M Assumptions
Welcome to the Real World!

Dividends and Signalling

 Under conditions of information asymmetry, shareholders and
the investing public watch for management signals (actions)
about what management knows.
 Management is therefore very cautious about dividend
changes…they don’t want to create high expectations (this is
the reason for extra or special dividends) that will lead to
disappointment, and they don’t want to have investors over
react to negative earnings surprises (the sticky dividend
phenomenon)

(The Signalling Model is explained in Figure 22 – 6 found on the next slide.)

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 Relaxing the M&M Assumptions
Welcome to the Real World!

Agency Theory
 Investors are wary of senior management so they seek to put
controls in place.
 There is a fear that managers may waste corporate resources by
over-investing in low or poor NPV projects.
 Gordon Donaldson argued this is the reason for the pecking
order managements tend to use when raising capital
 Shareholders would prefer to receive a dividend and then have
management file a prospectus, justifying investment in projects and
the need to raise the capital that was just distributed as a dividend.
 Shareholders are prepared to pay those additional underwriting
costs as an agency cost incurred to monitor and assess management.

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 Repurchased Shares

 called treasury stock (U.S.)

 non-voting (U.S.)
 may not receive dividends (U.S.)
 if not retired, can be resold (U.S.)
 unlike the U.S., repurchases in Canada do not
involve shares that can be placed into treasury
stock - they are canceled

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 Effects of A Share Repurchase

 EPS should increase following the repurchase if

earnings after-tax remains the same
 a higher market price per outstanding share of
common stock should result
 stockholders not selling their shares back to the
firm will enjoy a capital gain if the repurchase
increases the stock price.

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Advantages of Share Repurchases

 signal positive information about the firm’s future cash flows

 used to effect a large-scale change in the firm’s capital structure
 increase investor’s return without creating an expectation of
higher future cash dividends
 reduce future cash dividend requirements or increase cash
dividends per share on the remaining shares, without creating
a continuing incremental cash drain
 capital gains treated more favourably than cash dividends for
tax purposes.

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 Borrowing to Pay Dividends
An Example

 The foregoing example illustrates:

 it is possible for a firm with ‘borrowing capacity’ to borrow funds
to pay cash dividends.
 this is not possible if the lenders insist on restrictive covenants that
limit or prevent this from occurring.
 the cash for the dividend must be present in the cash account.
 payment of dividends reduces both the cash account on the asset
side of the balance sheet as well as the retained earnings account
on the ‘claims’ side of the balance sheet.
 in the absence of restrictions, it is possible to transfer wealth from
the bondholders to the stockholders. (Bondholders in this example
may have thought their firm would have only a 25% debt ratio….after the
dividend the debt ratio rose to 33% and the equity cusion dropped from
75% to 66%.)

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Factors that affect Dividend Policy

 Company projects low growth, has excess funds,

may = large dividends (PG & E)
 Management expects high growth, high need for
cash; may = high retained earnings and low or
no dividends (high tech firms)
 Stockholders’ preferences
Capital gains vs ordinary income

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Factors that affect dividend policy
 Restrictions on dividend payments
Bond indenture agreements
Lack of retained earnings
 Availability of cash

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Dividend determination methods

 Dividend Rate. Most companies use a fixed

dollar amount per share. This amount is
determined by the Board of Directors
 Dividends tend to stay the same or increase
slightly each year; shows stability, positive
future
 Decreases in dividends can severely impact
the stock price

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 Leading Dividend Theories

 Clientele Dividend Theory

 Some investors, such as elderly people on fixed
incomes, tend to prefer to receive dividend
income.
 Others, such as young investors often prefer
growth, and tend to like their income in the form
of capital gains rather than as dividend income.

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 Alternatives to Cash Dividends
 Stock Dividends
 Existing shareholders receive additional shares of
stock instead of cash dividends
 Stock dividends represent a distribution of stock of less
than 25% of total shares outstanding
 Done usually if the firm wants to conserve cash
 The number of shares is expressed as a percentage of
current stock holdings.

e.g. if there is a 10% stock dividend, you

would receive one additional share for
every 10 that you currently own.
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Alternatives to Cash Dividends

 Stock Splits
 If total shares will increase by more than 25%, the
company will usually declare a stock split.
 Expressed as a ratio to original shares.

e.g. a 2-1 split means that each investor

will end up with twice as many shares as
they had prior to the split.
Link to Reuters
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 Stock Repurchases

 A firm buys back its own stock on the open

market
 A very common occurrence recently
 By reducing the number of shares outstanding,
earnings per share are increased
 Rather than payout a dividend, which would
have immediate tax consequences for the investor,
a stock repurchase increases the share price
 Stock repurchase reverses the impact of dilution
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 Stock Repurchase Effect
 Serves as a perfect replacement for a dividend
payment to shareholders
 Example: stock worth $60 per share pays $4
dividend. Shareholder has a Stock worth $60
and must pay tax on the $4 dividend
 If dividend money used to repurchase stock
instead, shareholder ends up with stock worth
$64 with no immediate recognition of income

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