finance management fin420 chp 12

Dividend Policy Chapter 12

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A firm’s primary goal is to maximize the owners’

wealth i.e. by maximizing the share price. One

way management influences the share price is

through its dividend policies.

Learning objectives

After learning this chapter, you should be able to:

1. Understand the meaning of dividend.

2. Identify the important dates in dividend payment.

3. Know how a company makes dividend payments.

4. Understand the different types of dividend.

5. Compute the impact of dividend payment on company’s financial

statement.

6. Know the restrictions imposed on dividend payment.

Dividend Policy

GOAL

Chapter 12 Dividend Policy

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12.0 INTRODUCTION

Dividend policy is an important subject in corporate finance. A company would always

want to give as much as possible back to its shareholders by paying dividend. Or it can

invest the money for its shareholders, instead of paying it out. Therefore, the heart of the

dividend policy question is should the firm pay out money to its shareholders or should the

company take the money and invest it for its shareholders?

In this chapter we will focus on dividend policy, discussing a number of practical

considerations which influence a company’s board of directors decision in determining

dividend payment and how the dividends are paid.

• What is Dividend?

The term dividend usually refers to the total returns paid annually as

expected by shareholders. Besides expecting the prices of common stock to

appreciate, shareholders also expect to receive dividends regularly.

A firm’s dividend policy established guidelines to determine the amount of its

earnings to be paid out to shareholders as dividends. The critical question is a

choice of dividend policy affects its share price and hence values. This is

important for us to study and understand as almost all firms pay dividend, and

as a practice management will:

1. Pay part of earnings per share as dividend (dividend payout ratio) to

shareholder. This will result in cash drain from the firm and

shareholders will receive cash as return on their investment.

2. Reinvest part of earnings per share (retention rate) in the company.

Instead of paying dividends, the firm can retain and reinvest part of

EPS for other uses of cash that includes capital expenditures and

retiring existing debt. This will promote future growth and represent

lower cost of internal funds to support financing requirements.

How much of its earnings should the firm pay out as dividends to its

shareholders? The challenge is to come up with optimal dividend


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policy that strikes a balance between current dividend to satisfy the

investors demand and future growth that maximizes price of the stock.

Can dividend policy affect share price and hence the firm’s value? Similar the

study of capital structure, there are conflicting points of view about dividend

policy. In a perfect capital market environment, the dividend policy and capital

structure would not matter, as the cash flows will not change the firm’s value.

However, in practice, firms normally behave as though both matters. This is

because imperfections exist in the capital market operations due to such

matters as tax, information asymmetries, and transaction costs. These

provide the basis for the importance of dividend policy in practice.

The majority of managers believe that dividend policy is important even tests

of dividend policy have not found conclusively that dividends affect stock

price. However, it does show significant average stock price reactions to

dividend changes. These are the issues that we are going to deal with in this

chapter by presenting the conflicting views and try to justify why dividend

policy does matters to the shareholders and firms alike.

12.1 DIVIDEND POLICY PRACTICE It is important for the firm to establish a policy that will maximize shareholder wealth. This

can be achieved by employing a passive policy, distribute excess funds to shareholders, and

stabilize the absolute amount of dividends if necessary. The payout greater than excess

funds should occur only in an environment that has a net preference for dividends. Due to

institutional restrictions or signaling effects, there is a positive value associated with a

modest dividend. Dividends more than the passive policy do not appear to lead to share

price improvement because of taxes and flotation costs. Empirical testing showed:

1. Dividends are taxed more heavily than capital gains, so before-tax returns should be

higher for high-dividend-paying firms.

2. Evidence is largely consistent with dividend neutrality.

3. Expectation of increase (decreases) in dividend lead to positive (negative) excess

stock returns. Empirical results are consistent with these expectations.


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Regardless of the firm’s long-term dividend policy, most firms choose one of the following

alternative dividend payment patterns:

1. Constant dividend payout. In this policy, the firm pays the same percentage of

earnings as dividend to shareholders every year. With stable dividend payout ratio,

the Ringgit dividend per share naturally fluctuates every year as profits vary from

year to year.

2. Stable dollar dividend. This is the most popular policy that maintains a relatively

stable Ringgit dividend over time. Dividend does not change quickly until the

management is convinced that higher dividend cannot be maintained or current

dividend cannot be supported in the future.

3. Small regular dividend plus year-end extra payment. A firm with this policy tends

to pay small regular dividend plus extra dividend at end of year if earnings permit.

This is to avoid the suggestion of permanent dividend. However, it defeats the

purpose if extra dividends recurring and expected by the investors.

• Dividends as a Passive Residual

The passive dividend policy recognized that issuing new shares involves high

floatation costs. Firms with investment opportunities that require capital would

prefer to use internal funds rather than issue new stock. It calls for the firm to

accept all investments with positive net present values and use retained

earnings to finance investments when possible. If retained earnings left over

after making investments, pay a dividend with the residual. If there are no

residual funds, it pays no dividend.

To illustrate, consider a firm that finances 40% of its investments with debt

with the remaining with common equity. Presently, earnings of RM2 millions

are available for new investment or to pay dividends. Therefore, maximum

investments without changing its capital structure equals to:

Maximum investments = Equity / Equity ratio

= 2,000,000 / 0.6

= 3,333,333.33


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The maximum investment or total financing that the company can made is

RM3,333,333 that consists of RM2,000,000 of available funds, and

RM1,333,333 of new debt. If the company requires only RM2 millions in total

financing, therefore:

Equity requirements = 2,000,000 (0.60) = 1,500,000

Debt requirements = 2,000,000 (0.40) = 1,000,000

The firm only needs RM1.5 millions in equity and therefore, RM500,000

dividends can be paid out to stockholders as the firm has residual after the

equity requirements. However, If the company requires RM4 millions in total

financing:

Equity requirements = 4,000,000 (0.60) = 2,400,000

Debt requirements = 4,000,000 (0.40) = 1,600,000

With RM4 million financing requirements, the firm will pay no dividend as

there are no residual earnings available. In addition, the firm must issue

RM400,000 worth of new equity to meet the equity requirements since there

are only RM2 million available internally.

12.2 FACTORS INFLUENCING DIVIDEND POLICY Many considerations may influence the firm’s decision in setting the appropriate dividend

policy. Other general considerations that are relevant are:

1. Legal restrictions on dividend payment:

a. 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). State laws Designed to prevent excessive

payments of dividends. Often prohibit dividends to exceed legally defined

“surplus” retained earnings.

b. There may be legal restrictions on dividends called for in bond indentures,

loan agreements, and preferred stock agreements. In addition, state laws


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have restrictions on dividends if company is not financially sound. These

restrictions are designed to minimize the firm’s agency costs.

2. Insolvency rule. Some states prohibit the payment of cash dividends if the company

is insolvent under either a “fair market valuation” or “equitable” sense.

3. Undue retention of earnings rule. It prohibits the undue retention of earnings more

than the present and future investment needs of the firm.

4. Funding needs of the firm. Higher financing needs of the firm may restrict its ability

to distribute dividends to shareholders, and vice versa.

5. Liquidity Position. The firm must have sufficient cash to pay the dividend

6. Ability to borrow or sources of financing. Small firms may not be able to easily

raise money in the capital markets so they will have low dividends

7. Earning after tax (EAT) – dividends are paid out of a firm’s earning after tax. If the

net income after tax is high, dividend may be high. If the net income after tax is less,

an investor may get less dividend. However, a firm may pay a certain percentage out

of their EAT as dividends and the remainder will be retained and used for

reinvestment as an internal capital source.

8. Ownership control. Earnings will be retained to reduce the firm’s dependencies on

the external equity issues as it will dilute the ownership control of the firm.

9. Firm’s life cyclen - how much dividend is to be paid also depends on the life cycle

of the firm. During the early stage, the firm may face substantial capital needs to

support growth. Therefore, the proportion of dividends paid will be small. If the firm

is already at the maturity stage where there is stable finance, the firm may use all the

profits that are obtained and distribute them to the shareholders.


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• Industry Differences in Dividend Policy

Payout ratios vary systematically across industries. Investment opportunities

are comparable within an industry, but vary across industries. Behavioral

principle suggests using payout ratios similar to those of other firms in the

industry. Firm specific information must be taken into account.

1. Preference for paying common dividends. Smaller and younger

firms normally do not pay cash dividends. Sufficiently mature firms

begin paying cash dividends due to its stability.

2. Stability of dividends. Dividends are more stable from year to year

than are earnings. They follow the trend in cash flow more closely.

3. Regular decisions. Review dividend policy at least annually, and at

about the same time each year.

4. Regular payments. Quarterly payments most common. Annual, semi-

annual and monthly payments are less common.

5. Reluctance to cut dividends. Beyond regularity of dividends, firms

dislike to cut dividends. Dividend cut is interpreted as a negative

signal such as earnings prospects have worsened. Adversely affect a

firm’s share price.

6. Extra or special dividends. Paid in addition to regular-scheduled

dividends. Paid during periods of temporarily high earnings. Generally,

occur at the end of the fiscal year. Firm has substantial excess cash.

12.3 PROCEDURAL ASPECTS OF DIVIDEND POLICY Dividend payment follows several procedures set forth to answer several questions such as

(1) how frequently are the dividend payment to be made, and (2) who is entitled to the

dividends as shares are traded in the market continuously. Essential important dates are:

1. Declaration Date (DD). It is the date that the board of directors announces the

amount and date of the next dividend.


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2. Record Date (RD). The date set by the board of directors when a dividend is

declared, on which an investor must be a shareholder of record to be entitled to the

upcoming dividend.

3. Ex-dividend Date (ED). The first date on which a stock purchaser is no longer

entitled to the recently declared dividend. The buyer and seller of the shares have

several days to settle (pay for the shares or deliver the shares). The brokerage

industry has a rule that new shareholders are entitled to dividends only if they

purchase the stock at least two business days before the record date.

4. Payment Date (PD). The date when the corporation actually pays the declared

dividend and shareholders receive the dividends.

To illustrate, assume that the board of directors of Premier Goods Co. announced a dividend

of RM0.30 per share on March 1(Monday), 1999, payable to shareholders of record as of

March 19 (Friday), 1999. The dividend would be paid on March 25 (Thursday), 1999. What is

the ex-dividend date? What happens to the stock price on this day?

DD ED RD PD 1/3 17/3 19/3 25/3 Price = RM(P + 0.30) Price = RM(P) The ex-dividend date is two business days before the record date that is on Wednesday

March 17, 1999. Investors who purchased the shares on March 17, 1999 onwards are not

entitled to receive the upcoming dividends. Suppose Premier’s stock closed at RM20 on

Tuesday, March 16, 1999., the stock would open ex-dividend at about RM19.70 (=20–0.30).

12.4 TYPES OF DIVIDEND BEING DISTRIBUTED Firms do not always pay dividends in cash that will reduce the cash position and retained

earnings of the firm. Frequently firms pay stock dividend that increases the number of shares

each shareholder owns with each share has a proportionately smaller claim. Another method

of indirect dividend that achieves similar financial effect to stock dividend is stock split. The

only difference is in term of technical in rearranging the firm’s capital accounts on its balance

sheet. Neither method affects the net worth of the company or the proportional ownership

interest of any of the shareholders.


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12.4.1 Cash Dividend

It is a normal practice for the firm to distribute part of its earnings to

shareholders inform of cash dividend, quarterly or annually depending ob the

company’s policy. The cash dividend will be distributed directly to the

shareholders based on stated dividend per share as agreed and declared by

the company’s board of directors. This in fact represent the transfer of wealth

from the company to the shareholders with no significant impact on the

shareholders’ wealth.

To illustrate, assume that Azlina owns 10,000 shares of a company with

400,000 shares of RM5 par common stock outstanding. The company had

generate earnings after tax RM2 million during the period and decided to pay

RM2.50 dividend per share. This represent a 50% dividend payout ratio. The

pre-dividend market value is RM40. How does this affect the shareholders’

equity accounts?

Given the above decisions, “Total shareholder’s’ equity” increases to

RM10.60 million as shown in the following table before and after cash

dividend of RM1 per share.

Before cash dividend RM

(Mill) After cash dividend RM

(Mill)

Common stock

(RM5 par; 400,000 shares)

Additional paid-in capital

Retained earnings

2.00

1.00

7.00

Common stock



Retained earnings

2.00

1.00

6.00

Total shareholders’ equity 10.00 Total shareholders’ equity 9.00

The decisions involve the following transactions:

1. Amount of cash dividend paid to shareholders= RM1 million (=400,000

x RM2.50)

2. Value transferred “out of” retained earnings = RM1 million


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What is the effect of cash dividend on the market share price, Azlina’s total

earnings and wealth?

1. Market price per share =RM37.50 (=RM40 – RM2.50)

2. Azlina’s total earnings are RM25,000 (=RM2.50 x 10,000) before stock

dividend.

3. Total wealth after cash dividend = RM400,000 (=Total earnings +

Total market value of shares owned (=10,0000 x RM37.50))

Therefore, Azlina’s total wealth does not changed at RM400,000 (=10,000 x

RM40) before the cash dividend.

12.4.2 Stock Dividends and Stock Split

A stock dividend is more expensive administratively than cash dividend, but

there are several rational adopting stock dividends or split:

1. Optimal Price Range (RM10 – RM30). Some managers believe stock

price should not be too high and will split the stock or reduce the

dividend to reduce the price. Used to move the stock into a more

popular trading range, increase share demand and broaden the

ownership of the firm’s shares.

2. Information. Stock splits and dividends are seen as a signal that the

company is growing. However, it represents a negative signal if the

firm decided to issue stock dividend because of financial difficulty.

3. Cash Dividend Substitute. Companies who want to conserve cash

or do not have cash available to pay a regular dividend may issue a

stock dividend instead.


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• Stock dividends

A stock dividend proportionately increases the number of shares each

shareholder owns. A 10% stock dividend Increases total number of

shares outstanding by 10% and Increases each shareholder holding

by 10%. If a shareholder own 100 shares before the stock dividend,

she owns 110 shares after the stock dividend is paid. The fair market

value of these new shares is transferred from retained earnings to

paid in capital. Capital contributed more than par value. Total common

stockholder’s equity remains unchanged. Typically, a stock dividend

less than 20% of previously outstanding common stock as more than

25% are considered a stock split.

To illustrate, assume a company with 400,000 shares of RM5 par

common stock outstanding pays a 5% stock dividend. The pre-

dividend market value is RM40. How does this affect the shareholders’

equity accounts?

Given the above decisions, “Total shareholder’s’ equity” remains

unchanged at RM10 million as shown in the following table before 5%

stock dividend and after the 5% stock dividend.

Before 5% Stock Dividend RM

(Mill) After 5% Stock Dividend RM

(Mill)

Common stock



Retained earnings

2.00

1.00

7.00

Common stock



Retained earnings

2.00

1.70

6.20


The transfer of accounts is as follows:

1. Number of new shares issued = 400,000 shares (0.05) =

20,000 shares

2. Value transferred “into” common stock = 20,000 shares (RM5)

= RM100,000


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3. Value “into” additional paid-in-capital = 20,000 shares (RM40 –

RM5) = RM700,000

What is the effect of stock dividends on total earnings, earnings per

share (EPS) and the share price? To illustrate, assume that Azlina

owns 10,000 shares and the earned RM2.50 per share:

1. Azlina’s total earnings are RM25,000 (=RM2.50 x 10,000)

before stock dividend.

2. After the 5% dividend, she owns 10,500 shares (=10,000 x

1.05) and the same proportionate earnings of RM25,000.

3. Therefore, EPS is reduced to RM2.38 per share (=RM25,000 /

10,500) because of the stock dividend.

4. The share price will also decline proportionately to RM38.10

(=RM40 / 1.05).

If the stock dividend is 20% or greater of previously outstanding

common stock, the material effect on the market price per share

causes the transaction to be accounted for differently. Reclassification

is limited to the par value of additional shares rather than pre-stock-

dividend value of additional shares.

To illustrate, assume a company with 400,000 shares of RM5 par

common stock outstanding pays a 100% stock dividend. The pre-

stock-dividend market value per share is RM40. How does this affect

the shareholders’ equity accounts?

Given the above decisions, “Total shareholder’s’ equity” remains

unchanged at RM10 million as shown in the following table before

100% stock dividend and after the 100% stock dividend.


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Before 100% Stock Dividend RM (Mill)

After 100% Stock Dividend RM (Mill)

Common stock



Retained earnings

2.00

1.00

7.00

Common stock



Retained earnings

4.00

1.00

5.20


1. Number of new shares issued = 400,000 shares (1) = 400,000

shares

2. Value transferred “out of” retained earnings = 400,000

shares(RM5) = RM2,000,000

3. Value transferred “into” common stock = 400,000 shares

(RM5) = RM2,000,000

As for the above example, Azlina’s total earnings will remains

constant. However:

1. EPS will decline by more than 50% to RM1.25 [=RM25,000 /

((1 + 1)10,000].

2. Share will also by 50% to RM20 [=RM40 / (1 + 1)].

Note that the factor of (1 + 1) in the above calculation represents

original number of shares plus growth in number of shares due to

stock dividend.. As such, a factor of + 1 is equivalent to a 100% stock

dividend.

• Stock Splits

A stock split alters the par value of the shares but there is no transfer

of balances between the equity accounts. The total number of shares

outstanding increases. In a 3-for-2 stock split, 3 new shares are

issued for every 2 pre-split shares outstanding. Thus, there is a 50%

increase in the number of shares outstanding.


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In term of rearranging the capital accounts, it has similar economic

consequences as a 100% stock dividend. Assume a company with

400,000 shares of RM5 par common stock splits 2-for-

How does this affect the shareholders’ equity accounts?

Before 2-For-1 Stock Split RM

(Mill) After 2-For-1 Stock Split RM

(Mill)

Common stock



Retained earnings

2.00

1.00

7.00

Common stock



Retained earnings

2.00

1.00

7.00


It involves the following changes:

1. Number of shares outstanding = 400,000 shares (2 / 1) =

800,000 shares

2. Value of par value per share = RM5 (1 / 2) = RM2.50

As shown, capital accounts value remains constant with changes in

par value per share and number of shares outstanding. What is the

effect on Azlina’s total earnings, EPS, and the share price?

1. Azlina now owns 20,000 shares (=10,000 x (2 / 1)) with EPS of

RM1.25 (=RM2.50 x (1 / 2)).

2. Her total earnings remains constant, but the share price is

reduced to RM20 (=RM40 (1 / 2)).


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• Reverse Stock Splits

The firm may also decide to issue a reverse stock split. To illustrate,

assume a company with 400,000 shares of RM5 par common stock

splits 1-for-4. How does this affect the shareholders’ equity accounts?

Before 1-For-4 Stock Split RM

(Mill) After 1-For-4 Stock Split RM

(Mill)

Common stock



Retained earnings

2.00

1.00

7.00

Common stock

(RM2.50 par; 100,000 shares)


Retained earnings

2.00

1.00

7.00


It involves the following changes:

1. Number of shares outstanding = 400,000 shares (1 / 4)

= 100,000 shares

2. Value of par value per share = RM5 (4 / 1) = RM20.00

Given the above reverse stock split:

1. Azlina now owns 2,500 shares (=10,000 x (1 / 4)) with EPS of

RM10 (=RM2.50 x (4 / 1)).

2. Her total earnings remain constant with share price of RM160

(=RM40 x (4 / 1)).

12.5 THE PROS AND CONS OF PAYING DIVIDEND Payment of dividends provides some positive aspects such as:

1. Cash dividend can signals good results and provides support to stock price.

2. Stock price usually increases with the announcement of a new of increased dividend.

3. Dividends may attract institutional investors who prefer steady dividends return. The

presence of institutional and individual investors may ease the firm in an effort to

raise future capital at lower cost because of wider market reach.


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4. Dividends absorb excess cash flow.

5. Dividend may reduce agency costs that arise from conflicts between management

and shareholders.

On the other hand, dividends also present some negative aspects such as:

1. Dividends are taxed as ordinary income for shareholders.

2. Dividends will reduce internal source of financing and have to rely on more expensive

external source of funds. Thus, the firm may force to forgo positive NPV projects due

to higher cost of capital.

3. Dividends cuts are hard to make once established without adversely affecting the

stock price.


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1. What are the factors affecting dividend policy? Give any four factors.

2. Selayang Baru has had a net income of RM13 million last year, and has had

2 million common shares outstanding. They declared a 12 percent stock

dividend. Calculate EPS before and after the stock dividend.

3. The stockholders’ equity portion of Midland Corporation is as follows:

Comon stock ( 2 million shares at RM10 par) RM20,000,000

Capital in excess of par 17,000,000

Retained Earnings 33,000,000

The current market value of Midland’s stock is RM20

Show what the Balance Sheet will look like if the company declares a 10%

stock dividend.


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finance management fin420 chp 12

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