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SHARING FIRM WEALTH: DIVIDENDS and

DIVIDEND POLICIES

Dividend policy has no effect on either the price


of a firms stock or its cost of capital.

DIVIDEND POLICY

This involves the decision to pay out earnings or


to retain them for reinvestment in the firm.

Thus, the shareholder is indifferent to a choice


between dividends today or a claim on future
earnings.

A dividend is a distribution of earnings to


shareholders, generally paid in the form of cash
or stock.

The portion of after-tax earnings not paid out as


dividends is called retained earnings.

MM argue that the only important determinants


of a companys market value are the expected
level and risk of its cash flows or the income
produced by its assets, not on how this income
is split between dividends and retained earnings.

In a world of perfect capital markets, dividend


policy does not affect shareholder wealth.

Dividend payout ratio is the percentage of


earnings paid to shareholders in cash.

For example,

ADVANTAGES OF PAYING DIVIDENDS

Cash dividends can underscore good results


and provide support to the equity share price.

Dividends may attract institutional investors who


prefer some return in the form of dividends.

Equity share price usually increases with the


announcement of a new or increased dividend.

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.

Dividends absorb excess cash flow and may


reduce agency costs that arise from conflicts
between management and shareholders.

As such, the dividend is irrelevant to investors,


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

DISADVANTAGES OF PAYING DIVIDENDS

Dividends are taxed to recipients.

Dividends can reduce internal sources of


financing.

Once established, dividend cuts are hard to


make without adversely affecting a firms equity
share price.

DIVIDEND POLICY THEORIES

There is considerable controversy regarding


whether or not management can use dividends
to influence the market value of the firm.

2 Schools of thought:

Proportion of earnings paid out in


dividends is irrelevant

Proportion of earnings paid out in


dividends is relevant

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 his or her
expectations.

DIVIDEND POLICY THEORIES

2. Dividend policy relevance theory

In a world with market imperfections such as


taxes, flotation costs, and transaction costs, a
companys dividend policy affect its market
value.

There are several arguments for the dividend


relevance viewpoint.

DIVIDEND POLICY THEORIES

a. Bird-in-hand theory

Dividends may resolve uncertainty in the minds


of investors and may lower their required rate of
return on equity.

Because of the high variability of stock prices,


dividends represent a more reliable form of
return than capital gains.
The greater the certainty associated with
dividends may also lead investors to place a
higher value on dividends than on an equivalent
amount of uncertain and riskier capital gains.

Three theories of dividend policy


a. Dividend policy irrelevance theory
b. Dividend policy relevance theory
c.

Residual theory of Dividends policy

1. Dividend policy irrelevance theory

Proponents are Merton Miller and Franco


Modigliani (MM)

b. Information content effect

Dividend payments and dividend policy


statements may impart information to investors

about managements future expectations for the


firm.

The market reacts to dividend action which may


favorably or unfavorably depending on the
inferences and conclusions drawn by investors.

E.g. A company announcing an unexpected


increase in dividend can expect the stock prices
to rise.

Reasons for change in dividend policy should be


communicated to investors to avoid confusion
and misinterpretation.

Illustration:
Magnum, Inc. has an optimal capital structure of 40%
debt and 60% equity. Total earnings available to ordinary
shareholders for the coming year are expected to be
P1,500,000. The firms marginal cost of capital is 14%.
Magnum has the following investment opportunities
schedule. Compute for the amount of dividends to be
paid by the firm if dividends are treated as residual.

c. Clientele effect

Stocks attract particular groups based on


dividend yield and the resulting tax effects
should.

This implies that investors are attracted to firms


whose dividend policies meet their particular
needs.

1. Restrictions on dividend payment

Investors seeking to minimize their taxes or do


not need cash income may prefer firms that pay
no or low dividends.

Debt contracts often limit dividend payments to


earning generated after the loan was granted. Also,
contracts often stipulate that no dividends can be paid
unless the current ratio, times-interest-earned ratio, and
other safety ratios exceed stated minimums.

a. Contractual constraints

This views that dividends are paid out of the


residual or leftover earnings remaining after
profitable investment opportunities are
exhausted.

b. Legal constraints

This is based on the fact the investors prefer to


have the firm reinvest earnings rather than pay
them out in dividends if the rate of return the firm
can earn on reinvested earnings exceed the rate
investors can themselves obtain on other
investments of comparable risk.

Liquidating dividends can be paid out of capital,


but they must be indicated as such, and they must not
reduce capital below the limits stated in debt contracts.

2. Residual theory

Under this concept, a firm should follow these


steps when deciding on its payout ratio:

a. Determine the optimal capital budget;

Dividend payments cannot exceed retained


earnings. This is designed to protect creditors.

c. Internal constraints
Cash dividends can be paid only with cash.
Thus, a shortage of cash in the bank can restrict
dividend payments. However, the ability to borrow can
offset this factor.
d. Penalty on improperly accumulated earnings

To prevent wealthy individuals from using


corporations to avoid personal taxes, the Tax
Code provides for this rule.

If the BIR can demonstrate that a firms dividend


payout ratio is being deliberately held down to
help shareholders avoid personal taxes, the firm
is subject to heavy penalties.

b. Determine the amount of capital needed to


finance the budget;
c.

FACTORS INFLUENCING DIVIDEND POLICY

Income-oriented investors and tax-exempt


organization may seek out firms that pay large
cash dividends.

2. Residual theory

Use retained earnings to supply the equity


component to the extent possible; and

d. Pay dividends only if more earnings are


available than are needed to support the optimal
capital budget.

2. Investment Opportunities

Fast growing companies usually reinvest most of


their earnings whereas more mature companies
often have higher dividend payout ratios.

The ability to accelerate or to postpone projects


will permit a firm to adhere more closely to its
target dividend policy.

3. Availability and cost of alternative sources of


capital
a. Dividend policy
New and/or small firms often have
limited access to capital markets and must rely heavily
on internal funds to finance profitable projects.
Consequently, they restrict their cash dividend
payments.
b. Cost of selling new stock
If a firm needs to finance a given level of
investment, it can obtain equity by retaining earnings or
by selling new ordinary equity shares. Thus, dividends
will be decreased.
c. Ability to substitute debt for equity
If the firm can adjust its debt ratio
without raising costs sharply, it can maintain a constant
peso dividend, even if earnings fluctuate, by using a
variable debt ratio.
d. Control
If management desires to maintain
control, it may limit stock sales and hence retained
earnings than it normally would.

TYPES OF DIVIDEND POLICY

2.Constant dividend payout ratio policy


This is one in which a firm pays out a constant
percentage of earnings as dividends. This will cause
dividends to be unstable and unpredictable, if earnings
fluctuate.

TYPES OF DIVIDENDS

A. Cash dividends
1. Regular cash dividends
2. Extra dividends
3. Special dividends
4. Liquidating dividends
Four critical dates:
a. Declaration date firm is legally
obligated to meet the dividend payment
once the dividend is declared.
b. Record date firm closes its stock
transfer books and make up a list of
shareholders who are eligible to receive
the declared dividend.
c.

Ex-dividend date date on which the


right to the most recently declared
dividend no longer goes along with the
sale of the stock. Shareholders
purchasing stock before this date will
receive the next dividend.

d. Payment date

1. Stable Dividend Policy

b. Stock Dividends

This is characterized by the tendency to keep a


stable peso amount of dividends per share from period
to period. Firms tend to establish a predetermined target
dividend payout ratio in which dividends are increased
only after management is convinced that future earnings
can support the higher dividend payment.

This is a proportional distribution by a


corporation of its own stock to its stockholder. A
corporation may choose to distribute stock dividends to:

TYPES OF DIVIDEND POLICY

a. Continue dividends but conserve cash


b. Reduce the market price of its stock on a per
share basis.