DIVIDEND

POLICY
Aman, Johanna Rose M.
Cueto, Kaye Marie L.
 Dividend

 A dividend is a distribution of a portion of a

company's earnings, decided by the board of
directors, paid to a class of its shareholders.
Dividends can be issued as cash payments,
as shares of stock, or other property.
 Dividend Policy

 It is the set of guidelines a company uses to

decide how much of its earnings it will pay
out to shareholders.
 It is an important subject in corporate finance
and dividends are a major cash outlay for
many corporations.
 Advantages of Dividend Policy

1. Cash dividends can underscore good results

and provide support to equity share price.
2. Dividends may attract institutional investors
who prefer some return in the form of
dividends.
3. Equity share price usually increases with the
announcement of a new or increased
dividend.
4. Dividends absorb excess cash flow and may
reduce agency costs that arise from conflicts
between management and shareholders.
 Disadvantages of Dividend Policy

1. Dividends are taxed to recipients.

2. Dividends can reduce internal sources of
financing.
3. Once established, dividends cuts are hard to
make without adversely affecting a firm’s
equity share price.
 Concepts of Dividend Policy
 Dividend policy involves the decision to pay
out earnings or to retain them for
reinvestment in the firm.
 The portion of after-tax earnings not paid out
as dividends is called retained earnings.
 A dividend payout ratio is the percentage of
earnings paid to shareholders in cash.
 Dividend policy affects the investor attitude
and the firm’s financial structure, flow of
funds, liquidity, growth rate, and cost of
capital.
 Dividend Policy Theories

1. The Dividend Policy Irrelevance Theory

2. The Dividend Policy Relevance Theory
3. The Residual Theory of Dividends Policy
 The Dividend Policy
Irrelevance Theory
 The dividend irrelevance theory is the theory
that investors do not need to concern
themselves with a company's dividend policy
since they have the option to sell a portion of
their portfolio of equities if they want cash.
 The Dividend Policy
Irrelevance Theory
 It indicates that a company’s declaration and
payment of dividends should have little to no
impact on stock price. If this theory holds
true, it would mean that dividends do not add
value to a company’s stock price.
 Illustrative Example
Consider a simple case of Burnham
Corporation. Burnham is an all-equity firm that existed
for 10 years. The current financial managers plan to
dissolve the firm in two years. The total cash flows the
firm will generate, including the proceeds from
liquidation, will be P10,000 in each of the next two
years.
At present time, dividends at each date are set
to the cash flow of P10,000. there are 100 shares
outstanding, so the dividend per share is P100.
Assuming a 10% required return, the value of a share
of stock today is:
 Solution

𝐷1 𝐷2
𝑃𝑜 = +
(1+𝑅)1 (1+𝑅)2

𝑃100 𝑃100
= +
1.10 1.102

= P173.55
 The Dividend Policy
Relevance Theory
 It states that in the world with market
imperfections such as taxes, floatation costs,
and transaction costs, a company’s dividend
policy affects its market value.
 Arguments for the Dividend Relevance
viewpoint:
1. Dividends may resolve uncertainty in the
minds of investor and may lower their
required return on equity. Because of the
high variability of stock prices, dividends
represent a more reliable form return than
capital gains. This is known as the “Bird-in-
hand” theory.
2. Dividend payments and dividend policy
statements may impart information to investors
about management’s future expectations for the
firm. This “Information content effect” which is the
reaction of the market to dividend action may
affect stock prices favorably or unfavorably
depending on the inferences and conclusions
drawn by investors.
3. The “Clientele effect” is the observable fact
that 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. Income-oriented investors and
tax-exempt organizations may seek out firms that
pay large cash dividends.
 Residual Theory of Dividends Policy

 It views that dividends are paid out of the

residual or leftover earnings remaining after
profitable investment opportunities are
exhausted. In practice, dividend policy is very
much influenced by investment opportunities
and by the availability of funds with which to
finance new investments.
Under the residual theory of dividends policy, a
firm should follow these steps when deciding on
its payout ratio:

1. Determine the optimal capital budget.

2. Determine the amount of capital needed to
finance the budget.
3. Use retained earnings to supply the equity
component to the extent possible; and
4. Pay dividends only if more earnings are
available than are needed to support the
optimal capital budget.
 Illustrative Case
Magnum, Inc. has an optimal capital structure of 40% debt and
60% equity. Total earnings available to ordinary equity
shareholders for the coming year are expected to be
P1,500,000. the firm’s marginal cost of capital is 14%.
Magnum has the following investment opportunities schedule:

Project Investment IRR (%)

A P1,000,000 24
B 600,000 18
C 400,000 15
D 500,000 12
E 300,000 10
 Factors Influencing Dividend Policy

1. Restrictions or Constraints on dividend

payments.
 Contractual constraints
 Legal constraints
 Internal constraints
 Penalty on improperly accumulated
earnings
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. Alternative Sources of Capital
 Dividend Policy
 Cost of selling new stock
 Ability to substitute debt for equity
 Control
4. Effects of Dividend Policy on the cost of
Retained Earnings (𝐾𝑠 )
 Stockholder’s desire for current versus
future income;
 Perceived riskiness of dividends versus
capital gains;
 The tax advantage of capital gains over
dividends; and
 The information content of dividends
(signaling)
 Types of Dividend Policies

1. Stable Dividend Policy

 It is characterized by the tendency to keep

a stable peso amount of dividends per
share from period to period.
Most firms follow a relatively stable dividend policy
for 4 reasons:
 Investors may view constant or steadily
increasing dividends as more certain than a
fluctuating cash dividend payment.
 Many investors believe that stable dividend
policies lead to higher stock prices.
 There is less chance to convey erroneous
informational content with a stable dividend
policy.
 Dividend stability is required for public listing
of stock at Stock Exchange.
2. Constant Dividend Payout Ratio Policy

 It is one in which a firm pays out a constant

percentage of earnings as dividends.
 It is easy to administer once the firm
selects the initial payout ratio.
 It will cause dividends to be unstable and
unpredictable, if earnings fluctuate.
3. Regular Dividends plus Extras Policy

 It is one which a firm maintains a low

regular dividend plus and extra dividend, if
warranted by the firm’s earnings
performance.
 This policy represents a compromise
between the previous two policies and is
common among the firms that experience
cyclical changes in earnings.
 Nature of Dividend

 Cash paid out of earnings

 If a payment is made sources other than
current or accumulated retained earnings, it is
called distribution
 Any direct payment by the corporation to the
shareholders may be considered a dividend
or a part of dividend policy
 Types of Dividend

Cash Dividends
1. Regular Cash Dividends
2. Extra Dividends
3. Special Dividends
4. Liquidating Dividends

Stock Dividends
 Cash Dividends
1. Regular Cash Dividends
 Most common type of dividend
 Cash payments made directly to shareholders and
made in the regular course of business

2. Extra Dividends
 Payment made by a company to its shareholders,
that the company declares to be separate from the
typical recurring dividend cycle
 May or may not be repeated in the future
3. Special Dividends
 Similar to extra dividends
 Viewed as a truly unusual or one-time event and
won’t be repeated
 Larger compared to normal dividends paid out by
the company. Generally, special dividends are
declared after exceptionally strong company
earnings results as a way to distribute the profits
directly to shareholders.
4. Liquidating Dividends
 Payment to shareholders with a partial or full
distribution of their capital investment in the
company.
 Typically paid when a company is going out of
business or has sold a portion of the enterprise.
 Distributions can only be made to shareholders
after the money owed to creditors has been paid.
Cash can only be paid to shareholders if the
company's net assets are positive.
 Cash Dividend Payment Procedures

1. Declaration Date
 Company’s board of directors meets, decides to
pay dividends and announces the specifics of tis
decision.

2. Record Date
 Firm closes its stock transfer books and makes up
a list of shareholders who are eligible to receive the
declared dividends
3. Ex-Dividend Date
 Date on which investors are cut off from receiving
a dividend.
 As a result of this, we normally expect that stock
price will decline exactly by the amount of dividend
per share on the ex-dividend date.

4. Payment Date
 Date on which the company distributes its dividend
checks to the holders of record.
 Usually set at 2 to 4 weeks after the record date
 Stock Dividends

 Dividend payment made in the form of additional

shares rather than a cash payout.
 Proportional distribution by a corporation of its own
stock to its stockholders based to the number of
shares they already own
 Reasons for Stock Dividends

 To continue dividends but conserve cash

 To reduce the market price of its stock on a per

share basis
 Stock Splits

 An increase in the number of authorized issued

and outstanding shares of stock, coupled with a
proportionate reduction in the stock’s par value

 Company may engage in a reverse split to

decrease the number of stock outstanding
 Stock Repurchase

 Act of a firm buying back its own shares of ordinary

equity shares
 Also called buyback
 Ordinary equity shares reacquired by the issuing
firm is known as treasury shares
 Stock Repurchase
 Open Market Purchase
Companies may simply purchase their own
stock.

 Tender Offer
When an investor proposes buying shares from
every shareholder of a publicly traded company for
a certain price at a certain time. The investor
normally offers a higher price per share than the
company’s stock price, providing shareholders a
greater incentive to sell their shares.
 Stock Repurchase

 Tender Offer
When an investor proposes buying shares from
every shareholder of a publicly traded company for
a certain price at a certain time. The investor
normally offers a higher price per share than the
company’s stock price, providing shareholders a
greater incentive to sell their shares.
 Stock Repurchase

 Negotiated Basis or Targeted Repurchase

Firm may repurchase shares from specific
individual or group stockholders and usually at a
price well above current market value.
Domingo Corporation has the following financial data:

Before Repurchase
Net earnings P 3,000,000
Shares Outstanding 1,000,000
Earnings per share 3
Price/Earnings ratio 10
Market price per share 30
Expected dividend 2

The company can use P 2,000,000 excess cash either to pay

a P2 cash dividend per share or to repurchase 62,700 shares
at P32 per share.
1. What will happen to the earnings per share after the
repurchase?

2. What will happen to the market price of the stock,

assuming that the price/earnings ratio remains constant?

3. In this case, does the wealth position of the firm’s

shareholders differ if the firm pays dividends or
repurchase stock? Ignore taxes and transaction costs

4. What assumptions underlie this analysis?

 𝑃 3,000,000
Earnings per share =
𝑃 1,000,000 −62700

= P 3.20

Stock Price = P 32 (10 x P3.20)

The wealth position would remain in the same for each

alternative. A stockholder would receive benefits of P2 per
share; either a P2 cash dividend or a P2 increase in stock
price
 Dividend Reinvestment Plan
 An arrangement which allows stockholders to
automatically reinvest dividends in more shares of the
company’s stock.

 Provide shareholders with numerous potential advantages,

including convenient acquisition of additional shares, low
or no transaction costs, discounts on stock purchases, and
convenient recordkeeping.

 The firm may benefit through improved shareholder

goodwill, market price support for its stock and a broaden
base of investors