dividend and dividend policy

7/28/2019 Dividend and Dividend Policy

1/9

Dividend And Dividend Policy

The term dividendusually refers to cash paid out of earnings. If a payment is made from

sources other than current or accumulated retained earnings, the term distribution, rather

than dividend, is used. However, it is acceptable to refer to a distribution from earnings as a

dividend and a distribution from capital as a liquidating dividend. More generally, any direct

payment by the corporation to the shareholders may be considered a dividend or a part of

dividend policy.

Dividends come in several different forms. The basic types of cash dividends are:

1. Regular cash dividends

2. Extra dividends

3. Special dividends

4. Liquidating dividends

we also discuss dividends paid in stock instead of cash, and we also consider another

alternative to cash dividends, stock repurchase.

Cash Dividends:

The most common type of dividend is a cash dividend. Commonly, public companies

pay regular cash dividends four times a year. As the name suggests, these are cash

payments made directly to shareholders, and they are made in the regular course of business.

In other words, management sees nothing unusual about the dividend and no reason why it

wont be continued.

Sometimes firms will pay a regular cash dividend and an extra cash dividend. By calling part

of the payment extramanagement is indicating that the extra part may or may not be

repeated in the future. A special dividendis similar, but the name usually indicates that this

dividend is viewed as a truly unusual or one-time event and wont be repeated. Finally, the


2/9

payment of a liquidating dividendusually means that some or all of the business has been

liquidated, that is, sold off.

Payment Procedure:

The mechanics of a cash dividend payment can be illustrated by the example in Figure

and the following description:

1-Declaration date:

On January 15, the board of directors passes a resolution to pay a dividend of $1 per share on

February 16 to all holders of record as of January 30.

2-Ex-dividend date:

To make sure that dividend checks go to the right people, brokerage firms and stock

exchanges establish an ex-dividend date. This date is two business days before the date of

record (discussed next). If you buy the stock before this date, then you are entitled to the

dividend. If you buy on this date or after, then the previous owner will get the dividend.

In Figure, Wednesday, January 28, is the ex-dividend date. Before this date, he stock is said

to trade with dividend or cum dividend. Afterwards, the stocktrades ex dividend. The

ex-dividend date convention removes any ambiguity about who is entitled to the dividend.

Because the dividend is valuable, the stock price will be affected when the stock goes ex.

We examine this effect in a moment.

3-Date of record:

Based on its records, the corporation prepares a list on January 30 of all individuals believed

to be stockholders. These are the holders of record, and January 30 is the date of record (or

record date). The word believedis important here. If you buy the stock just before this date,

the corporations records may not reflect that fact because of mailing or other delays. Without

some modification, some of the dividend checks will get mailed to the wrong people. This is

the reason for the ex-dividend day convention.


3/9

4-Date of payment:

The dividend checks are mailed on February 16.

Example of Procedure for Dividend Payment

Dividend Policy:

Its the decision to payout earnings versus retaining and reinvesting them.. Includes these

elements.

1. High or low payout?

2. Stable or irregular dividends?

3. How frequent?

4. Do we announce the policy?

Dividend policy of the company depends upon their shareholders whether they want high

payout or low payout. It also depends upon the market condition, If the market is easily

understandable and more stable it will be helpful in setting an efficient dividend policy for

the company. Dividend policy can be set by the company by looking at their growth potential

in the future, If they are setting high payouts they should check their growth potential

whether they will able to maintain these high payouts to their shareholders in futures or not.


4/9

Do investors prefer high or low payouts? There are three theories:

1-Dividend Irrelevance Theory

Much like their work on the capital-structure irrelevance proposition, Modigliani and Miller

also theorized that, with no taxes or bankruptcy costs, dividend policy is also irrelevant. This

is known as the "dividend-irrelevance theory", indicating that there is no effect from

dividends on a company's capital structure or stock price.

MM's dividend-irrelevance theory says that investors can affect their return on a stock

regardless of the stock's dividend. For example, suppose, from an investor's perspective, that

a company's dividend is too big. That investor could then buy more stock with the dividend

that is over the investor's expectations. Likewise, if, from an investor's perspective, a

company's dividend is too small, an investor could sell some of the company's stock to

replicate the cash flow he or she expected. As such, the dividend is irrelevant to investors,

meaning investors care little about a company's dividend policy since they can simulate their

own.

2-Bird-in-the-Hand Theory:

The bird-in-the-hand theory, however, states that dividends are relevant. Remember that total

return (k) is equal to dividend yield plus capital gains. Myron Gordon and John Lintner

(Gordon/Litner) took this equation and assumed that k would decrease as a company's payout

increased. As such, as a company increases its payout ratio, investors become concerned that

the company's future capital gains will dissipate since the retained earnings that the company

reinvests into the business will be less.

Gordon and Lintner argued that investors value dividends more than capital gains when

making decisions related to stocks. The bird-in-the-hand may sound familiar as it is taken

from an old saying: "a bird in the hand is worth two in the bush." In this theory "the bird in


5/9

the hand' is referring to dividends and "the bush" is referring to capital gains.

3-Tax-Preference Theory

Taxes are important considerations for investors. Remember capital gains are taxed at a lower

rate than dividends. As such, investors may prefer capital gains to dividends. This is known

as the "tax Preference theory".

Additionally, capital gains are not paid until an investment is actually sold. Investors can

control when capital gains are realized, but, they can't control dividend payments, over which

the related company has control.

Capital gains are also not realized in an estate situation. For example, suppose an investor

purchased a stock in a company 50 years ago. The investor held the stock until his or her

death, when it is passed on to an heir. That heir does not have to pay taxes on that stock's

appreciation.

The Clientele Effect:

In our earlier discussion, we saw that some groups (wealthy individuals, for example) have an

incentive to pursue low-payout (or zero payout) stocks. Other groups (corporations, for

example) have an incentive to pursue high-payout stocks. Companies with high payouts will

thus attract one group, and low-payout companies will attract another. These different groups

are called clienteles, and what we have described is a clientele effect. The clientele effect

argument states that different groups of investors desire different levels of dividends. When a

firm chooses a particular dividend policy, the only effect is to attract a particular clientele. If

a firm changes its dividend policy, then it just attracts a different clientele. What we are left

with is a simple supply and demand argument. Suppose 40 percent of all investors prefer high

dividends, but only 20 percent of the firms pay high dividends. Here the high-dividend firms

will be in short supply; thus, their stock prices will rise. Consequently, low-dividend firms


6/9

will find it advantageous to switch policies until 40 percent of all firms have high payouts. At

this point, the dividend market is in equilibrium. Further changes in dividend policy are

pointless because all of the clienteles are satisfied. The dividend policy for any individual

firm is now irrelevant.

Dividend Policy in Practice:

1-Residual Dividend Policy:

Investors prefer to have the firm retain and reinvest earnings if they can earn a higher risk

adjusted return than the investor can. Residual Dividend Policy suggests that dividends

should be that part of earnings which cannot be invested at a rate at least equal to the WACC.

Residual Dividend Policy Steps:

1-Determine the optimal capital budget.

2-Determine the retained earnings that can be used to finance the capital budget.

3-Use retained earnings to supply as much of the equity investment in the capital budget as

necessary.

4-Pay dividends only if there are left-over earnings.

2-Stable, Predictable Dividend Policy:

Due to the possibility of a negative signal to investors, many CFOs have set the policy of

never reducing their dividends.Dividends are only increased if management is certain future

earnings will support such a high dividend. A variation of this policy is one in which

dividends exhibit a stable, predictable growth rate. In that instance the company has to set the

policy in such a way that the growth rate can be sustained for the foreseeable future.

Stable, Predictable Dividend Policy Steps:

1-Pay a predictable dividend every year.

2-Base optimal capital budget on residual retained earnings (after dividend).


7/9

3-Constant Payout Ratio Policy:

It is possible that a company could set a policy to payout a certain percentage of earnings as

dividends. The problem is that such a policy would not fit the needs of the firm's

stockholders, since it would cause a great deal of volatility in dividends paid (see clientele

effect spoken of earlier).

Constant Payout Ratio Policy Steps:

1-Pay a constant proportion of earnings (if positive).

2-Base optimal capital budget on residual retained earnings.

4-Low Regular Dividend Plus Extras:This policy is a hybrid of the last two policies. It is meant to keep expectations low for

dividends, and supplement those dividends with bonuses in good years. The problem is the

potential for negative signaling.

Low Regular Dividend Plus Extras Steps:

1-Pay a predictable dividend every year.

2-In years with good earnings pay a bonus dividend.

3-Base optimal capital budget on residual of regular dividend and compromising with bonus

for capital budgeting projects.

Stock Repurchases:

When a firm wants to pay cash to its shareholders, it normally pays a cash dividend. Another

way is to repurchase its own stock. In 2000, for example, 2,072 firms announced buyback

programs totalling almost $300 billion. In fact, net equity sales in the United States have

actually been negative in some recent years. This has occurred because corporations have

actually repurchased more stock than they have sold. Stock repurchasing has thus been a

major financial activity, and it appears that it will continue to be one.


8/9

Reasons for repurchases:

As an alternative to distributing cash as dividends. To dispose of one-time cash from an asset sale. To make a large capital structure change.

Advantages of Repurchasing:

Stockholders can tender or not. Helps avoid setting a high dividend that cannot be maintained. Repurchased stock can be used in take-over's or resold to raise cash as needed. Income received is capital gains rather than higher-taxed dividends. Stockholders may take as a positive signal--management thinks stock is undervalued.

Disadvantages of Repurchasing:

May be viewed as a negative signal (firm has poor investment opportunities). IRS could impose penalties if repurchases were primarily to avoid taxes on dividends. Selling stockholders may not be well informed, hence be treated unfairly. Firm may have to bid up price to complete purchase, thus paying too much for its own

stock.

Stock Dividends and Stock Splits:

Another type of dividend is paid out in shares of stock. This type of dividend is called a stock

dividend. A stock dividend is not a true dividend because it is not paid in cash. The effect of

a stock dividend is to increase the number of shares that each owner holds. Because there are

more shares outstanding, each is simply worth less. A stock dividend is commonly expressed

as a percentage; for example, a 20 percent stock dividend means that a shareholder receives

one new share for every five currently owned (a 20 percent increase). Because every

shareholder receives 20 percent more stock, the total number of shares outstanding rises by


9/9

20 percent. As we will see in a moment, the result is that each share of stock is worth about

20 percent less.

A stock splitis essentially the same thing as a stock dividend, except that a split is expressed

as a ratio instead of a percentage. When a split is declared, each share is split up to create

additional shares. For example, in a three-for-one stock split, each old share is split into three

new shares.

Stock splits and stock dividends have essentially the same impacts on the corporation and the

shareholder: they increase the number of shares outstanding and reduce the value per share.

The accounting treatment is not the same, however, and it depends on two things: (1) whether

the distribution is a stock split or a stock dividend and (2) the size of the stock dividend if it is

called a dividend. By convention, stock dividends of less than 20 to 25 percent are called

small stock dividends. The accounting procedure for such a dividend is discussed next. A

stock dividend greater than this value of 20 to 25 percent is called a large stock dividend.

Large stock dividends are not uncommon. For example, in 2000, Corning announced a 200

percent stock dividend, and, in 1999, biotechnology company Amgen announced a 100

percent stock dividend, to name a few. Except for some relatively minor accounting

differences, this has the same effect as a two-for-one stock split.

dividend and dividend policy

Documents