Financial Management 2

1
Dividend Policy

Dividend Policy

This module covers discussions on dividends, kinds of dividends, advantages

and advantages of paying dividends to shareholders, dividend policy, its
kinds and the different theories on dividend policy. This also includes stock
repurchase and stock split.
After studying the module, the students should be able to:
1. Define dividends and enumerate the types of dividends.
2. Understand the pros and cons of paying dividends to shareholders.
3. Understand dividend policy and the different theories relative to it.
4. Enumerate and explain the different types of dividend policy and the
factors affecting them.
5. Understand the meaning of stock repurchase and stock split.

Introduction
In corporate financial management, dividend policy has been an important
issue or topic as dividend payment is a major cash outlay for many
companies. Corporations are usually uncertain between paying dividends or
not. If they will not pay dividends, the profits earned will be reinvested in the
business.
Corporations who are willing to declare and pay dividends do not have a
static formula in determining the dividends payout ratio. How much of the
earnings will be given out as dividends? Or will the earnings be kept by the
company and added to the funds to be reinvested?

Dividend and Relevant Terminologies Defined

We will define the terms (although we have learned these already in some
accounting subjects) that we will be using and reading most often in this
module for us to understand easily and clearly the topics and subtopics
involved.
Dividend
This is part of the net income or earnings of a corporation which are
distributed by the company to its shareholders (investors or owners of
corporations). This is the main driver for shareholders to invest or buy
equities of a firm. Investors dreamt of receiving maximum returns on their
investment thus maximizing their wealth.

Course Module
 Financial Management 2
2
Dividend Policy

Dividend policy
This is the proposal or scheme that is made by top management of a
company to explain or justify the rationale relative to the firm’s dividend
payments to shareholders. It is a set of guidelines a company uses to help
them decide of whether to pay dividends or not, of how much or what
proportion of the earnings will be paid to the shareholders. There are some
observations that investors are not after the company’s dividend policy
because if they are in need or they want cash, they can sell portions of their
portfolio of equities.

Retained Earnings
Retained earnings pertains accumulated net income or earnings of a
corporation that is retained by the company as at the end of a particular
reporting period. It can also refer to a percentage or portion of the net
earnings of a corporation not paid out as dividends but held to be reinvested
in the business.

Dividend Payout Ratio

Dividend payout ratio reveals the portion of the current net earnings the firm
will pay its shareholders in the form of dividend and what portion the
company is reinvesting in the business for future growth, pay off obligations,
or add to cash reserves. This is computed by dividing dividend per share by
the earnings per share.

Advantages and Disadvantages in Paying Dividends

Shareholders have the right to receive the return of their investments but to
receive dividend and how much depend on the dividend policy, which
include the dividend declaration, set forth by the board of directors of a
company.
Below are some pros and cons of paying out dividends:
Advantages:
1. Cash dividends help in establishing the prices of equity.
2. It attract investors particularly those who wants returns in the form of
dividends.
3. Increase or higher cash dividend increases equity share price.
4. It can help reduce agency cost that might arise from management and
shareholders’ conflict due to “excess cash”.

Disadvantages:
1. It can decrease internal sources of financing and management might rely
on costly external financing.
2. Shareholders will pay tax for dividends received.
3. Once declared, dividends cannot be reduced without affecting the equity
share price.
 Financial Management 2
3
Dividend Policy

Schools of Thought on Dividend Policy

At the center of the different theories on dividend policy are two contrasting
schools of thought.
1. School of Dividend Irrelevance
The main proposition in this school of thought is that to the investors,
payment of dividends is irrelevant for they can sell portions of their
investments in equity if they are in need of cash. For the firm, paying
dividends or not is irrelevant in determining the price of shares of stock
so with the market value of the firm and the even the weighted average
cost of capital.
This idea was proposed by Franco Modigliani and Merton Miller (1958,
1961). Aside from the Modigliani and Miller Approach, the residual
theory of dividends also supports this school of dividend irrelevance.
2. School of Dividend Relevance
The argument in this school of thought is that if the firm pays dividends,
its stock prices will be higher so with its market values and the weighted
average cost of capital will be lower. Researchers who favored the ideals
of this school of thought include Gordon (1963), Lintner (1962) and
Walter (1963).

Theories of Dividend Irrelevance

1. Modigliani and Miller (M&M)Theory
Dividend policy is irrelevant as it has no effect on the equity share price
and the even on the cost of capital. This is what the proponents,
Modigliani and Miller, proposed and agreed upon. This is a continuation
to their paper in 1958; they argued that the capital structure of a
company is irrelevant in determining its future business prospects.
Modigliani and Miller also believed that capital gains and dividends are
both the same as returns in the perception of the investors; therefore, the
value of the company depends on the firm’s earnings or income as a
result of their investment policies not on how the income will be
allocated to dividends and retained earnings. This theory also explained
that shareholders or investors can produce cash inflow from their shares
depending on their needs even if their shares pay dividends or not. If the
investors do not need money, he can reinvest his dividends in shares. If
his shares are no-dividend paying, then he can sell portions of his
investment, if he needs cash.
Again, let us review the M&M assumptions or pinpointed conditions that
will make their hypothesis valid: the capital markets are perfect, there
are no taxes or transaction costs involved, if there are taxes, then the tax
rates for capital gains and dividends have no difference, the company has
a fixed investment policy, and there is no uncertainty as to the company’s
Course Module
Financial Management 2
4
Dividend Policy

future projects. But as the critics of the theory discloses, in the real
world, it is not possible for an economy to have the absence of taxes and
transaction costs.
2. The Residual Theory
This theory holds that a company pays dividends to its shareholders after
it has allotted or keeps cash for all their available and attractive
investment opportunities. Dividend policy, in this case, is highly
influenced by the prospective investment opportunities and the
availability of cash to finance them.
Under this theory, the company cannot miss out desirable investment
projects to distribute dividends to shareholders. Shareholders or
investors, on the other hand, do not care if the firm pays dividends or not.
Their concern is the possibility of higher cash flows in the future that
might result to capital appreciation of their shares and eventually higher
dividends payments.
Illustrative Case 1
RST has an optimal capital structure of 45% debt and 55% equity. For
the year, the EBIT has a balance of P2,000,000 , 75% of which are allotted
for the ordinary equity shareholders. The company’s cost of capital is
15%. It has also the following prospective investments :
Project Proposal Expected Investment Expected IRR(%)
1 P 1,200,000 20%
2 P 500,000 18%
3 P 350,000 13%
4 P 450,000 16%

What projects will constitute the firm’s optimal capital budget?

If dividends are treated as residual, how much dividends should be paid
out to shareholders?

Solutions:
The projects that will constitute the optimal capital budget are Projects
1,2 and 4 since they IRR is greater than the cost of capital of 15%. These
projects need capital requirement of P 2,150,000. P 1,182,500 of this
capital requirement will come from equity.

The amount of dividends that should be paid out to equity shareholders

is P 317,500 [(P2,000,000 x 75%) – P1,182,500].
 Financial Management 2
5
Dividend Policy

Theories of Dividend Relevance

1. The Gordon/Lintner (Bird-in-the-Hand) theory
Gordon, in 1963, stated in his stock valuation model that dividends the
firms will pay, the anticipated annual growth rate of dividends and the
firm’s current stock price determine the value of the company’s cost of
equity financing.
For the equity investors, the dividend yield is a significant measure of the
returns of their investment than the future growth rate of the net
earnings and the firm’s capital gains.
The assumptions underlying this theory are: the firm has no debt in its
capital structure, retained earnings are used to finance investment
projects since there is no external financing, there is a constant cost of
capital, and the presence of constant returns that disregards the
decreasing marginal efficiency of the investment.

2. The Walter Model

In 1963, Walter proposed a model that suggests that dividend policy is

significant in establishing a firm’s value. This model also presumes that
when dividends are paid to shareholders, these are reinvested for higher
returns.
Another possible condition is when the firm does not pay dividends to
shareholders. The earnings are investment in some profitable ventures to
earn returns. The firm’s rate of return must be equal to its cost of capital.
This model also suggests that the relationship between the rate of return
and cost of capital is important in establishing the dividend policy. It
further states the following:
D = dividend payout ratio
If rate of return is greater than the cost of capital, the firm should have
zero dividend payment and should make investments (D=O).
If rate of return is lesser than the cost of capital, the firm should have
100% dividend payment and there should be no investment out of
retained earnings (D=E)).
If rate of return is equal to the cost of capital, the firm is indifferent
between dividends and investments.

Assumptions of Walter’s model include the following: the firm has an infinite
life, cost of capital and rate of return on investment are constant, and there is
no external financing involved.

3. The Clientele Effect Hypothesis

The tax on dividends and capital gains tax might influence the
shareholders preference for dividends against capital gains. Most of the
equity investors are often interested in the after-tax returns. Investors
who fall under the low tax brackets relying on regular steady income will
Course Module
 Financial Management 2
6
Dividend Policy

be much interested in investing in firms that pay high and unchanging

dividends so with the institutional investors who have significant
periodic cash flows. Investors on the high tax brackets, on the other hand,
consider investing in companies that keep or retain most of their income
to be reinvested for possible capital gains. Some of the clienteles are also
uninterested between dividends and capital gains.

Factors Affecting Dividend Policy

Dividends are the portion of the net earnings of a firm that is distributed and
paid to shareholders in return for their equity investment. Allocating the net
income of a company into dividends and retained earnings is not an easy
process. A lot of factors affect dividend payout and here are some of the most
significant and influential.
1. Legal requirements. There are certain conditions under the law on how
dividends will be distributed.
 Net income rule. This means that if the company earns profit
during the current year, it pays dividends, and if it incurs losses
then it will not.
 Capital impairment rule. Dividend payments should not be made
out of capital as it will affect the firm’s equity base which should
be sufficiently kept to protect the creditors’ claim.
 Insolvency rule. According to this rule, if the company’s total
assets are less than its total obligations, it can pay dividends
simply because it is considered financially bankrupt.
2. Company’s liquidity status. Paying dividends affects the liquidity position
especially when what are involved are cash dividends. Not all earnings
are in the form of cash and shortage of cash will prevent the paying of
dividends unless the firm will borrow cash or will pay stock dividends.
3. Repayment of debts. A firm usually has some forms of debt financing in
order to meet its investment needs. Retaining its earnings to pay debts at
maturity will reduce the amount for dividend distribution to
shareholders. Out of the company’s earnings (cash) the firm should pay
first its long-term obligations and what remains will be the source of
dividend payouts.
4. Expected rate of return. The company may prefer to retain the earnings
for reinvestment rather than paying dividends particularly if it has a
reasonably higher expected rate of return on a new and possibly
profitable investment.
5. Stable earnings. A company with a comparatively higher stable earnings
will more likely to pay higher dividends than one with fluctuating income.
 Financial Management 2
7
Dividend Policy

6. Fear of weakening management control. A firm may not sell additional

ordinary equity shares when additional funding arises due to fear of
dilution in management control. This will result to keeping more of the
earnings than distributing them as dividends.
7. Easy access to capital market. If a firm can easily penetrate the capital
market for raising additional funds, retained earnings is not so much a
concern so its dividend payment ability is high.
8. State of the Shareholders’ individual tax. Shareholders in the higher
personal tax bracket prefer capital gain that dividend because tax on
dividend is higher that capital gains tax.

Types of Dividend Policy

The basic types of dividend policy are as follows:
1. Regular dividend policy
2. Stable dividend policy
3. Irregular dividend policy
4. No dividend policy

Regular Dividend Policy

With this type of policy, the investors received dividends at a common or
standard rate. This is favorable to investors who want to have regular
income. This mode of dividend payment can be retained if the company has
regular earnings.
Some advantages of this policy are:
 It creates and increases shareholders’ confidence.
 It contributes to steady market values of shares.
 It helps in preserving the goodwill of the firm.
 It provides regular income to shareholders

Stable Dividend Policy

The payment of dividends under this type is characterized by a certain sum

of money paid to the shareholders from period to period. This is of three
types:
a) Constant dividend per share. The firm (usually those with stable
earnings) created a reserve account which will be used to pay fixed
amount of dividend in the period or year that the earnings of the
company are not sufficient.
b) Constant dividend payout ratio. A fixed percentage of earnings are set
as dividend payment every year. The amount of dividend payments varies
in direct proportion to the income of the company. Many firms preferred
this policy because this relates to their ability to pay dividends.

Course Module
 Financial Management 2
8
Dividend Policy

Illustrative Case 2
LMN Corporation earned P 5,000,000 in 2015 and paid P 2.00 per share on
1,500,000 outstanding equity shares. In 2016, the corporation registered a
lower earnings of P 4,000,000.

Compute for the total dividends paid in 2015; the dividend payout ratio; the
amount of dividends paid in 2016, and the dividend per share in 2016.

Solutions:
2015 total dividends paid = 1,500,000 shares x P 2 per share = P 3,000,000
Dividend Payout ratio = P3,000,000/P5,000,000 = 60%
2016 amount of dividends = 60% x P4,000,000 = P 2,400,000
Dividends per share (2016) = P 2,400,000 / 1,500,000 shares = P1.60

c) Regular dividends plus extra dividend. This means the payment of a

constant low dividend per share and extra dividend in the year when the
firm registers high income.
This policy has the same advantages with the regular dividend policy.

Irregular Dividend Policy

The company does not pay regular dividends to its shareholders. Some
reasons are uncertain or erratic earnings of the company, lack of liquid
resources (cash), company’s option not to pay regular dividends, and
unpredictable status or condition of the business.

No Dividend Policy

The firm may apply this no dividend policy if they the need funds for an
expected growth of the firm or to meet some working capital requirements.

Dividend: Its Nature and Types

Distributions to the shareholders out the firm’s earnings are referred to as
dividends. A direct payment to shareholders made by the company is
dividend. If the payment to shareholders will be coming from the firm’s
capital, we can call it liquidating dividend.
Types of Dividends
A. Cash dividend. This is most common form of dividend. Payment of this
dividend will reduce the firm’s most liquid asset – cash and retained
earnings.
Payment of dividends depends on the decision of the company’s board of
directors. Declaration of dividends creates an obligation on the part of the
company. Cash dividend is usually expressed in the following ways: in
pesos per share, as a percentage of the market price or dividend yield, or
 Financial Management 2
9
Dividend Policy

as a percentage of the net earnings or dividend per share. Cash dividends

are usually paid annually but sometimes some corporations do it
quarterly or semi -annually. The board of directors sets the dividend
policy and declares the dividends and the financial manager does the
implementation and distribution to the shareholders.
There are four important dates to consider in the payment of dividends.
1. Declaration date. This is the day when the company’s board of
director’s meets, decides to pay dividends, and announces the details
of their decision.
2. Record date. The date in which the corporation closes its share
transfer books and prepare a list of shareholders who are the eligible
recipients of the dividend payment.
3. Ex-dividend date. This is the date when the new shareholders’ right
to receive such declared dividend was announced. The shares will sell
ex-dividend for four business days before the record date which
means the shareholders who purchases stocks before this date will
receive the next dividend.
4. Payment date. This is the date the company sets to distribute the
check payments to the shareholders of record. It is conventionally
fixed at two to four weeks after the record date.
B. Stock dividend. This is the issuance of the corporation of its own
ordinary equity shares to ordinary equity shareholders. Stock dividends
do not reduce the company’s cash or transfer its assets to the
shareholders. The shareholders receive the same proportion of shares, at
the end diluting the book value per share and they will be at the same
relative position after the stock dividend distribution.
Companies choose to distribute stock dividends for the following reasons:
 To continuously distribute dividends but keeping the company’s
cash which can be used in their expansion projects, inventory
purchases, pay liabilities, etc. Shareholders do not pay tax on
stock dividends as in their receipts of cash dividends.
 To cut down the market price of its stock on a per share basis. The
increased supply of shares of stock will cause the market price of
the share to go down and since it will become less expensive, more
investors will be attracted to buy.
C. Property dividend. Rather than making payment of dividends in cash or
in the form of stocks, the company may opt to distribute properties as
dividends. The property distributed will be recorded at its fair market
value. The difference between the book value and the fair market value of
the asset is often recognizing as gain or loss. Property as dividends may
change the taxable or the reported income of the firm.

Course Module
 Financial Management 2
10
Dividend Policy

D. Scrip dividend. In the absence of sufficient funds to pay or issue

dividends, the firm may issue a scrip dividend which is basically a
promissory note to pay the shareholders at a later date. These notes
payable can bear interest or not.

Stock Split
A Stock split is an increase in the number of outstanding shares of stock.
When corporations feel that the price of their stocks is high enough that
prospective investors are hesitant to buy, they may declare a stock split to
attract them. A stock split increases (at times doubled) the number of
outstanding shares at the same time reduce the par or stated value per share
(into half the original par). But bear in mind that the stock split will not
change the firm’s overall equity value.
Illustrative Case 3
RST Corporation has an outstanding ordinary equity of 100,000 shares, P10
par. The company declared a 2 to 1 stock split.
The 100,000 equity shares will become 200,000 shares and the par value per
share will now be P 5. The overall equity value of P 1,000,000 will remain the
same.

Stock Repurchase
Stock repurchase maybe regarded as an alternative to paying dividends for
it is another method of returning cash to shareholders/investors. The
company may ask the shareholders to tender their shares for repurchase.
Stock repurchase is also called buyback. Reacquired shares by the issuing
company are called treasury shares.
A stock repurchase can increase value for shareholders for some reasons:
1. Share repurchase can be used to change the capital structure of the
company without increase debt financing ;
2. Stock repurchase may lead to additional shares for mergers and
acquisitions, stock dividends and other stock option plans;
3. Share repurchase can increase the earnings per share and the market
price of stocks.
4. Capital gains taxes are lower than taxes on dividends.
Advantages of a Stock Repurchase
Capital gains taxes are lower than dividend tax rate. A shareholder can
choose stock repurchase, accept payment and pay the corresponding taxes
while with cash dividends, he has no choice but accept the payment and pay
taxes.
Minimizing repurchase programs or even stopping it will not be perceived
as a negative signal while reducing dividend payments are.
 Financial Management 2
11
Dividend Policy

When management announced the repurchase program it is perceived by

many as a positive informational signal, since management knows the firms
prospects better than anyone else and that the shares are worth the buyback.

Disadvantages of a Stock Repurchase

It will be unfavorable for shareholders who tender their shares for
repurchase if they do not know the full details of the and why of the
repurchase before they agree with it. This situation may lead to filing of a
lawsuit against the company.
A company may find itself paying more for the shares it repurchases and this
may result to dilution. Announcing a stock repurchase may send a negative
signal to the shareholders that the management does not know where to
spend the cash used in the repurchases.
The tax authorities (Bureau of Internal Revenue) may penalized the firm if it
will be proven that the repurchase was done to avoid dividend taxation.
Illustrative Case 4
RST Corporation has 30,000 shares outstanding. This year’s net income
amounted to P150, 000. The current stock price is P 50. The company
implements a 5% stock repurchase.
What is RST’s current EPS?
What is the price effect ratio?
How many outstanding shares are there for RST after the repurchase?
What is the new RST EPS?

Solutions:
RST’s current EPS = P150, 000 / 30,000 shares = P5
P/E ratio = P 50/ P5 = 10 times
RST’s new number of outstanding shares = 30,000 (1-.05) = 28,500 shares
RST’s EPS = P150, 000/28,500 shares = P5.26

References and Online Supplementaries

Book References

Brigham, Eugene, Houston, Joel (2012) fundamentals of Financial

Management, South-Western Cengage Learning, Ohio, USA.

Cabrera, Ma. Elenita Balatbat (2015) Financial Management, Principles and

Applications, Vol. 2. GIC Enterprises Co. Inc. Manila

Course Module
Financial Management 2
12
Dividend Policy

Horngren, Charles T., Harrizon Jr., Walter T, & Bamber, Linda S. Accounting.
Fifth Edition. Prentice Hall International Edition

Medina, Roberto G. (2016 reprint) Business Finance. Rex Book Store, Manila.

Supplementary Reading Materials

Lecture 9: Corporate Equity, Earnings and Dividends

www.econ.yale.edu/~shiller/course/252/Lect10Dividends.ppt
Lecture 10: Corporate Equity, Earnings and Dividends ... Dividends are
taxable as personal income,share repurchases are capital gains, lower rate.
Accessed: November 6, 2017

Dividends or Repurchases? - University of Illinois at Urbana ...

https://www.coursera.org/learn/corporate-finance.../lecture/.../dividends-
or-repurchase...
Jan 25, 2017 - Video created by University of Illinois at Urbana-Champaign
for the ... You will discuss the mechanics of dividends and share repurchases,
and ...
Accessed: November 6, 2017

Dividend and Payout Policy

https://ocw.mit.edu/courses/sloan-school-
of...ii.../lecture.../lec11apayoutpolicy.pdf
Dividend Policy (aka Payout Policy). Firms transfer funds to shareholders
through: cash dividends share repurchases. Payout Policy: How is money
being paid ...
Accessed: November 6, 2017

Supplementary Online Videos

2017: CFA Level 2: Corporate Finance - Dividends and Share ...
https://www.youtube.com/watch?v=trMIqcQqf2Q
Jan 29, 2017 - Uploaded by FinTree
This video covers the following key areas: -Dividend irrelevan. ... 2: Corporate
Finance - Dividends and Share ...

CFA Level I - Corporate Finance - Dividends and Share Repurchases ...

https://www.youtube.com/watch?v=nRrtfWuIuU4
Jun 20, 2014 - Uploaded by Quartic
This is a short video of our CFA Level I Corporate Finance: R39 -- Dividends
andShare Repurchases class ...