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Dividend Policy

Dividend decision deals with the process and procedures that firms employ in the determination
of an appropriate dividend policy. Of major concern is how much of the firm’s earnings should
be distributed to the shareholders in the form of cash dividends or stock repurchases. Retained
earnings and dividends are alternative uses of available net income. In evaluating potential
dividend policies, managers must also consider its capital budgeting decisions and its capital
structure decisions. The interaction of these three decisions determines the value of the firm.

• Firms with a history of taking on good projects and the potential for more good projects in
the future can pay much less dividends than they have cash flows and hold on to surplus
cash, because stockholders trust them to invest the cash wisely.
• In contrast, stockholders in firms with history of poor project choice will be reluctant about
retention of cash, because of the fear that cash will be invested in poor projects.

I. Dividend payout ratios vary considerably across industries and even within an industry.
Dividend decisions are affected by a number of factors concerning: legality, bond
indenture provisions, tax aspects, liquidity considerations, borrowing capacity,
earnings prospects, growth requirements, the inflation outlook, shareholder
preferences, and dilution effects.

A. Most states impose three types of regulations on the payment of dividends by

firms that are chartered in that state. (1) The capital impairment restriction
stipulates that dividends cannot be paid out of capital. Capital is typically defined
as either the common stock account or that account together with other
contributed capital in excess of the par value of the common stock. (2) The net
earnings restriction stipulates that dividends must be paid only out of present and
past net earnings. (3) The insolvency restriction states that dividends cannot be
paid when a firm is insolvent, when the firm's liabilities exceed its assets. This is
to protect the creditors of the firm.

B. Restrictive covenants in bond indentures, loan agreements, lease contracts, and

preferred stock agreements may prohibit or limit dividend payments.

C. Typically capital gains are taxed at lower rates, which favor the retention of
earnings (and, hopefully, leading to future capital gains) over distributing cash
dividends. Another tax advantage of capital gains is that dividends are taxed in the
year they are received, but capital gains (and corresponding taxes) can be deferred
indefinitely. If the majority of shareholders are in the high marginal tax bracket,
they may favor a policy of high earnings retention over a policy of high dividend

D. In the US, the IRS code prohibits excessive accumulation of profits for the
purpose of protecting stockholders from paying taxes on the dividends that they

would otherwise receive. A tax is imposed on these excessive accumulations.

E. Payment of dividends requires liquidity, i.e., cash. Firms with substantial cash
flow and liquidity are more able to pay dividends.

F. Available investment opportunities together with the availability of capital may

dictate that earnings be retained in the business rather than paid out as dividends.

G. Firms are often reluctant to lower their dividend payments once they are
established. Firms with stable earnings are able to pay higher dividends without
risk of cutting them than are firms with unstable earnings.

H. Firms in rapid growth industries with a substantial need for capital must
frequently retain earnings for investment or face the higher cost of external equity

I. Inflation may decrease a firm's ability to pay high dividends because funds
generated by depreciation will not be adequate for the firm to maintain its
productive capability in the face of rising equipment costs. Also, inflation may
decrease a firm's liquidity because of the rising dollar investment in inventories
and accounts receivable for the same volume level of business.

J. For broadly-held firms, dividend policies attract investor groups with preferences
for those payout policies. Thus, the clientele effect theory of dividends suggests
that maintaining a steady policy will account for the preferences of a firm's
stockholders. In other words, high payout firms will attract investors desiring
high dividend yields while low payout firms will appeal to shareholders that
prefer earnings retention and greater price appreciation.

K. If payment of large dividends results in the need to raise external equity capital
and existing shareholders cannot maintain their proportionate share of ownership,
their control in the company may be diluted.

II. There are two schools of thought regarding the effect of dividend policy on a firm's
value. One school, led by Miller and Modigliani, argues that dividend policy is
irrelevant, that dividend policy does not affect firm value. The other school, led by
Gordon, Durand, and Lintner obviously disagrees.

A. Miller and Modigliani (MM) contend that the value of a firm is based on its
investment decisions. The payment of a particular dividend is only a mere
financing detail since a dividend policy can be offset by other forms of financing,
such as selling new shares of common stock.

1. The MM irrelevance of dividends argument is based on several

assumptions: no taxes; no transactions costs; no issuance costs on new

securities; a fixed or given investment policy.

2. When the issue of new common shares is used to finance a cash dividend,
the value of the old shares will be diluted and will fall by the amount of
the dividend received. Conversely, if stockholders forego a dividend, their
stock does not realize the drop that would have occurred if a dividend
were paid. The wealth of a shareholder (cash received from dividends
plus the value of shares owned) is not affected by dividend policy.

3. MM suggest that empirical evidence documenting the influence of

dividend policy on stock price may be due to the fact that dividends may
contain informational content regarding the firm’s future earnings
prospects. Thus changes in dividend payments represent a signal to
investors concerning the future earnings and cash flows of the company.

4. MM claim that the existence of clienteles of investors favoring a particular

firm's dividend policy should have no effect on share value. Some
investors may sell a company's stock after a dividend policy change, but
others will buy, and no net change in the stock's value should result.

B. A second school (Bird-in-the hand View) asserts that the MM argument is

reasonable, but that MM's restrictive assumptions would cause dividend policy to
be important if the assumptions were relaxed.

1. Risk-averse investors prefer cash dividends now over the promise of more
income later.

2. Brokerage costs make it expensive for stockholders to sell part of their

holdings to substitute for cash dividends.

3. Removal of the no tax assumption may make a difference. Shareholders

in the high marginal tax bracket may prefer low (or no) dividends,
preferring that the firm reinvest the earnings within the firm resulting in a
capital gain (from price appreciation) that is taxed a lower rate when the
stock is finally sold in the future.

4. High issuance costs make it expensive for a firm to sell external equity
(sell new shares of stock) to finance a cash dividend payment.

5. The payment of dividends can reduce agency costs between shareholders

and management. Paying cash dividends causes a firm to raise more
capital in external markets, which subject the firm to scrutiny by
regulators and potential investors. This serves as a monitoring function of
managerial performance.

III. A number of alternative dividend strategies are frequently used as the basis for a dividend
policy. The actual choice of a policy is influenced by the practical considerations above.

A. The passive residual policy integrates the dividend decision with the optimal
capital budget.

1. If the optimal capital budget can be financed with a package that does not
fully utilize available earnings, the earnings not required for retention are
paid out in dividends.
2. If the optimal capital budget fully uses the available earnings, no dividend
is paid.
3. Under this policy, dividends can fluctuate significantly from year to year
depending on the firm's investment opportunities.
4. In practice, the dividends can be smoothed by recognizing that it is
acceptable for the actual capital structure to vary around the target by
borrowing more in years with a high demand for funds and using more
equity in years with less demand for funds.
5. The residual theory suggests that "growth" firms will normally have lower
dividend payout ratios than non- growth firms.

B. Much evidence indicates that most firms and stockholders prefer reasonably
stable dividend policies.

1. Stable dividends are characterized by a reluctance to reduce the dollar

level of dividends from one period to the next.

2. Under a policy of stable dividends, increases in dividends tend to lag

behind increases in earnings to insure against a need to decrease them in
the future.

3. Stable dividends are desirable for a number of reasons.

a. Dividends are often interpreted as an indication of the firm's longer

run profit potential.

b. Many shareholders depend on dividends for their cash income


c. Stability of dividends may be taken as an indication of the

riskiness of the firm and affect the capitalization rate and cost of

d. Many financial institutions such as banks, pension funds, and

insurance companies are restricted in the types of common stock

that they can own. Some are restricted to firms that have a record
of continuous and stable dividends.

C. Some firms attempt to maintain a fairly constant payout ratio. If a firm's

earnings fluctuate substantially, a constant payout ratio causes dividends to
fluctuate also.

D. Some firms follow a policy of paying a small regular dividend plus year-end

1. Stockholders can depend on the regular payout.

2. The policy can accommodate changing earnings and investment


IV. Corporations generally pay dividends quarterly.

A. The board of directors holds quarterly or semi-annual meetings to decide the

amount of dividends to be paid. The declaration and payment procedure follows
the sequence given below:

1. Declaration date--the board of directors announces a dividend to be

payable to shareholders of record on the record date. (for example,
February 1)

2. Record date--the firm takes its list of shareholders from its stock transfer
books. (for example, February 15) These shareholders of record will
receive dividend checks mailed on the payment date.

3. Ex-dividend date--the major stock exchanges require two business days

prior to the record date. (for example, February 13) Persons buying the
stock on February 13 or later are buying the stock ex-dividend, meaning
without the dividend.

4. Payment date--the date the dividend checks are actually mailed. (for
example, March 1)

B. Many firms have dividend reinvestment plans.

Under these plans, shareholders can elect to have their cash dividends reinvested
automatically in additional shares. Some plans purchase existing shares on the
open market (through a trustee) and other plans purchase newly issued shares.
The latter plan raises new equity capital for the firm. Brokerage commissions are
not charged for these plans. Investors are still liable for income taxes on dividends
reinvested even though they received no cash.

V. Dividends are usually taken to mean cash dividends. Sometimes firms declare stock
dividends that result in the payment of additional shares of stock to common

A. Stock dividends are usually stated as a percent of shares outstanding.

B. Stock dividends increase the number of shares outstanding.

C. An accounting transaction transfers the pre-dividend market value of the dividend

from retained earnings to the capital accounts.

1. The par value of the new shares is credited to common stock.

2. Any additional value is credited to contributed capital in excess of par.

D. Because each shareholder's proportionate claim on the firm's net worth and
earnings is unchanged, the market price of each share of stock should decline in
proportion to the number of new shares issued.

Pre - stock dividend price

Post - stock dividend price =
1+ Percentage stock dividend rate

A 10% stock dividend would reduce the stock price by 9.09%.

E. Even though the theoretical value of a stock dividend is zero, firms declare them
for several reasons.

1. A stock dividend may broaden the ownership of the firm's shares since
many stockholders sell the stock from the dividend.

2. If the firm pays a cash dividend, a stock dividend results in an effective

increase in cash dividends provided that the level of the cash dividend is
not reduced.

3. The reduction in share price may broaden the appeal of the stock to
investors resulting in a real increase in market value.

VI. Stock splits are similar to stock dividends. They increase the number of shares and
reduce the price of each share.

VII. Some firms distribute funds to investors through repurchasing shares of the stock
rather than paying dividends.

• Stock may be repurchased by a tender offer, in the open market, or by negotiation

with larger holders.
• Repurchased stock is known as treasury stock.
• Stock repurchases reduce the number of shares outstanding and hence increase the
• Plans for a repurchase are usually announced so that investors know the reason
for the additional trading in the stock and can wait for the anticipated price
increase before selling their shares.
• Ignoring taxes, transactions costs, and other market imperfections it can be shown
that cash dividends and share repurchases are equivalent. Therefore, investors
should be indifferent between the two methods of cash distribution.
• From a tax perspective, share repurchases are preferred because capital gains
may be taxed at a lower rate than dividend income.
• Repurchases allow the stockholder to exercise his/her preference for current
income or longer term capital gains.
• The IRS will not permit a firm to regularly repurchase a stock as an alternative to
paying cash dividends because repurchases convert ordinary income to capital
gains which receive preferential tax treatment. Regular stock repurchases are
viewed as equivalent to cash dividends and taxed accordingly.
• Share repurchases, like cash dividend increases, can represent a signal that
management expects higher future earnings. The market often responds favorably
to such positive signals.
• Substituting discretionary stock repurchases for regular cash dividends provides
the firm flexibility of deferring stock buyback programs when competing uses for
the cash flow exist.


Stock repurchases are an alternative to dividends for transmitting cash to shareholders. Shares
repurchased by the issuing firm are called treasury stock. Share repurchases are commonly used
to restructure firm's capital structure. For example if a company wishes to raise its debt ratio,
it can issue debt and use the proceeds to purchase its shares.

Advantages to shareholders/firm management

• Dividends are fully taxed when received, repurchases result in capital gain on sale of shares
• Repurchases may be used to dispose of proceeds from sale of assets or divisions or
temporary increase in cash flows
• Repurchases can be used to increase debt ratio quickly
• Repurchases can be used to remove a large block of stock overhanging in the market

• Repurchase stock (treasury) may be used to finance acquisitions, stock option incentive
plans, etc.


• Repurchase is often viewed as an indicator that the firm is unable to locate good investments
- negative signal.
• If too high a price is paid in repurchase, it will be detrimental to the remaining shareholders

Note: Repurchases on regular basis do not appear feasible, occasional repurchases offer
significant advantages over cash dividends and to bring about changes in firm's capital structure.

Example: The Farah Company has released the following data:

• Earnings available to common shareholders $1,000,000

• # of common shares outstanding 400,000
• EPS ($1 million/ 400,000) $2.5
• Market price per share $50
• P/E 20


Pay Cash Dividends

• The firm is considering using $800,000 to pay cash dividends or repurchase shares. If
cash dividends are paid, the amount will be $ 2 per share ($800,000/400,000).

Repurchase Shares
• If the firm pays $52 per share to repurchase stock, it could repurchase about 15,385
shares (800,000/52).
• As a result of the repurchase outstanding shares reduce to 384,615 and EPS rise to
$2.60 ($1 million/384,615).
• If the stock still sold at 20 X earnings, its market price would rise to $52.

Result: In both cases stockholders receive $2 per share.

Practical Framework for Analyzing Dividend Policy

How much did the firm pay out? How much could it have afforded to pay out?

What it actually paid out: Dividends + Equity Repurchase

What it could have paid out: Net Income + Depreciation - Capex

- ∆WCR - Principal Repayments on Debt
+ New Debt Issue

Firms pays out too little Firm pays out too much
FCFE > Dividends FCFE < Dividends

Do you trust managers in the company What investment opportunities does the
with your cash? firm have?
Look at past project choice: Look at past project choice:
Compare: ROE to Cost of Equity Compare: ROE to Cost of Equity

Firm has history of Firm has history of Firm has good Firms has poor
good project choice poor project choice project projects
and good projects in
the future

Force managers to
Give managers the justify holding cash or Firm should cut Firm should deal with
flexibility to keep cash return cash to dividends and its investment
and set dividends stockholders reinvest more problem first and then
cut dividends