Dividend Policy

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Contents :

Introduction Type of dividend Dividend and corporate finance Divided VS Interests Dividend payments Dividend Policy Dividend Reinvestment Plans (DRIPs) Dividend Payments

Stock Dividends versus Stock Splits Modigliani and Millers Dividend Irrelevance theory

Implications Effect on the Company Effect on Shareholders

The Bird-in-the-Hand Argument Dividend Policy in Practice

Assumptions Residual Theory of Dividends Homemade Dividends

Assumption M&M versus Gordons Bird in the Hand Theory

Lintners Work on Dividend Adjustment Welcome to the Real World!

Transactions Costs Dividends and Signaling Agency theory The Excess Cash

Share Repurchases Borrowing to Pay Dividends Overall framework

Divid e n d Po lic y
Wh a t is It ?
Dividend Policy refers to the explicit or implicit decision of the Board of Directors regarding the amount of residual earnings (past or present) that should be distributed to the shareholders of the corporation.

This decision is considered a financing decision because the profits of the corporation are an important source of financing available to the firm.

Types of Dividends
Dividends are a permanent distribution of residual earnings/property of the corporation to its owners. Dividends can be in the form of:
Cash Additional Shares of Stock (stock dividend) Property

If a firm is dissolved, at the end of the process, a final dividend of any residual amount is made to the shareholders this is known as a liquidating dividend.

Dividends and Corporate Financing

In the absence of dividends, corporate earnings accrue to the benefit of shareholders as retained earnings and are automatically reinvested in the firm. When a cash dividend is declared, those funds leave the firm permanently and irreversibly. Distribution of earnings as dividends may starve the company of funds required for growth and expansion, and this may cause the firm to seek additional external capital.

Co rp o ra t e Pro fit s Aft e r Ta x

Re t a in e d Ea rn in g s Divid e n ds

Dividends versus Interest Obligations

Interest
Interest is a payment to lenders for the use of their funds for a given period of time Timely payment of the required amount of interest is a legal obligation Failure to pay interest (and fulfill other contractual commitments under the bond indenture or loan contract) is an act of bankruptcy and the lender has recourse through the courts to seek remedies Secured lenders (bondholders) have the first claim on the firms assets in the case of dissolution or in the case of bankruptcy

Dividends
A dividend is a discretionary payment made to shareholders The decision to distribute dividends is solely the responsibility of the board of directors Shareholders are residual claimants of the firm (they have the last, and residual claim on assets on dissolution and on profits after all other claims have been fully satisfied)

Dividend Payments
Declaration Date Holder of Record Date Ex-dividend Date Payment Date

Dividend Payments

Declaration Date
this is the date on which the Board of Directors meet and declare the dividend. In their resolution the Board will set the date of record, the date of payment and the amount of the dividend for each share class. when CARRIED, this resolution makes the dividend a current liability for the firm.

Date of Record
is the date on which the shareholders register is closed after the trading day and all those who are listed will receive the dividend.

Ex dividend Date
is the date that the value of the firms common shares will reflect the dividend payment (ie. fall in value) ex means without. At the start of trading on the ex-dividend date, the share price will normally open for trading at the previous days close, less the value of the dividend per share. This reflects the fact that purchasers of the stock on the exdividend date and beyond WILL NOT receive the declared dividend.

Date of Payment
is the date the cheques for the dividend are mailed out to the shareholders.

Dividend Payments
2 business days prior to the Date of Record
Da t e o f Pa ym e n t

De c la ra t io n Da t e

Da t e o f Re c o rd

The Board Meets and passes the motion to create the dividend

Ex Dividend Date is d e t e rm in e d by the Date of Record. The market value of the shares drops by the value of the dividend per share on market openingcompared to the previous days close.

Trade Settlement and the Ex Dividend Date

Changes in the Settlement Cycle In June 1995 the settlement cycle for all non-money-market Canadian and U.S. securities was reduced from five business days (T + 5) to three business days (T + 3).

The rationale for the change stems from the 1987 stock market crash when it was realized that a securities market failure could result in a credit market failure. The gridlock created in 1990 by the bankruptcy of Drexel Burnham Lambert, a large U.S. broker, increased the need to minimize the risks involved in the clearing and settlement of securities.

The shortened settlement cycle requires that the payment of funds and the delivery of securities take place on the third business dayafter the trade date. This will reduce credit, market and liquidity risks by decreasing posttrade settlement exposure.

Ex Dividend Date The date is not chosen by the board of directors, rather it is determined as a result of the exchanges settlement practices and is a function of the date of

Dividend Policy Dividends, Shareholders and the Board of Directors

There is no legal obligation for firms to pay dividends to common shareholders Shareholders cannot force a Board of Directors to declare a dividend, and courts will not interfere with the BODs right to make the dividend decision because:
Board members are jointly and severally liable for any damages they may cause Board members are constrained by legal rules affecting dividends including:

Not paying dividends out of capital Not paying dividends when that decision could cause the firm to become insolvent Not paying dividends in contravention of contractual commitments (such as debt covenant agreements

Dividend Payments Dividend Reinvestment Plans (DRIPs)

Involve shareholders deciding to use the cash dividend proceeds to buy more shares of the firm
DRIPs will buy as many shares as the cash dividend allows with the residual deposited as cash Leads to shareholders owning odd lots (less than 100 shares)

Firms are able to raise additional common stock capital continuously at no cost and fosters an on-going relationship with shareholders

Dividend Payments Dividend Reinvestment Plans (DRIPs)

Stock dividends simply amount to distribution of additional shares to existing shareholders

They represent nothing more than recapitalization of earnings of the company. (that is, the amount of the stock dividend is transferred from the R/E account to the common share account.

Because of the capital impairment rule stock dividends reduce the firms ability to pay dividends in the future.

Dividend Payments
Stock Dividends

Implications
reduction in the R/E account reduced capacity to pay future dividends proportionate share ownership remains unchanged shareholders wealth (theoretically) is unaffected conserves cash serves to lower the market value of firms stock modestly promotes wider distribution of shares to the extent that current owners divest themselves of shares...because they have more adjusts the capital accounts dilutes EPS proportion of ownership remains unchanged total value of holdings remains unchanged if former DPS is maintained, this really represents an increased dividend payout

Effect on the Company

Effect on Shareholders

Stock Dividends versus Stock Splits

Stock Dividends - lowers stock price slightly
little psychological appeal recapitalization of earnings no change in proportional ownership odd lots created theoretically, no value to the investor

Stock Splits
large drop in stock price much stronger potential signalling effect no recapitalization same odd lots rare same

Mo d ig lia n i a n d Mille rs Divid e n d Irre le va n c e t h e o ry

Modigliani and Millers Dividend Irrelevance

The value of M&Ms Dividend Irrelevance argument is that in the end, it shows where value can be created with dividend policy and why.

M&Ms Dividend Irrelevance

Assumptions

No Taxes Perfect capital markets

large number of individual buyers and sellers costless information no transaction costs

All firms maximize value There is no debt

M&Ms Dividend Irrelevance

Residual Theory of Dividends

The Residual Theory of Dividends suggests that logically, each year, management should:
Identify free cash flow generated in the previous period Identify investment projects that have positive NPVs Invest in all positive NPV projects
If free cash flow is insufficient, then raise external capital in this case no dividend is paid If free cash flow exceeds investment requirements, the residual amount is distributed in the form of cash dividends.

M&Ms Dividend Irrelevance

Residual Theory of Dividends - Implication

The implication of the Residual Theory of Dividends are:

Investment decisions are independent of the firms dividend policy
No firm would pass on a positive NPV project because of the lack of funds, because, by definition the incremental cost of those funds is less than the IRR of the project, so the value of the firm is maximized only if the project is undertaken. If the firm cant make good use of free cash flow (ie. It has no projects with IRRs > cost of capital) then those funds should be distributed back to shareholders in the form of dividends for them to invest on their own. The firm should operate where Marginal Cost equals Marginal

M&Ms Dividend Irrelevance

Homemade Dividends

Shareholders can buy or sell shares in an underlying company to create their own cash flow pattern.
They dont need management declare a cash dividend, they can create their own. Conclusion: under the assumptions of M&Ms model, the investor is indifferent to the firms dividend policy.

Th e Bird -in -t h e -Ha n d Arg u m e n t

The Bird-in-the-Hand Argument

M&Ms Assumptions Relaxed

Risk is a real world factor. Firms that reinvest free cash flow, put that money at risk there is no certainty of investment outcome those forfeit dividends that are reinvestedcould be lost

The Bird-in-the-Hand Argument

M&Ms Assumptions Relaxed Myron Gordon suggests that dividends are more stable than capital gains and are therefore more highly valued by investors.

This implies that investors perceive non-dividend paying firms to be riskier and apply a higher discount rate to value them causing the share price to fall.

The difference between the M&M and Gordon arguments are illustrated in Figure 22 - 5 on the following slide:
M&M argue that dividends and capital gains are perfect substitutes

D1 P0

OPTIMAL INVESTMENT

Go rd o n M&M

P1 P0 P0

The Bird-in-the-Hand Argument M&M versus Gordons Bird in the Hand Theory

Conclusions:
Firms cannot change underlying operational characteristics by changing the dividend The dividend should reflect the firms operations through the residual value of dividends

Divid e n d Po lic y in Pra c t ic e

Dividend Policy in Practice

Firms smooth their dividends
Firms tend to hold dividends constant, even in the face of increasing after-tax profit Firms are very reluctant to cut dividends

Dividend Policy in Practice (Lintners Work on Dividend Adjustment)

John Lintner suggested a partial adjustment model to explain the smoothing of dividend behaviour illustrating that firms slowly change dividends as they move toward a new target

Dividend Policy in Practice Lintners Work on Dividend Adjustment Implications

The speed of dividend adjustment is only about 30 percent Firms are very reluctant to fully adjust Firms do not follow a policy of paying a constant proportion of earnings out as dividends Dividend policy in practice does not follow M&Ms irrelevance arguments because the real world does not match the assumptions used

Relaxing the M&M Assumptions

Welcome to the Real World!

Transactions Costs
Underwriting costs are very high, providing a strong incentive for firms to finance growth out of free cash flow Facing these high underwriting costs firms:
With high growth rates have little incentive to pay dividends With volatile earnings conserve cash from year to year to finance projects and therefore pay very conservative dividends

Relaxing the M&M Assumptions

Welcome to the Real World! Dividends and Signalling
Under conditions of information asymmetry, shareholders and the investing public watch for management signals (actions) about what management knows. Management is therefore very cautious about dividend changesthey dont want to create high expectations (this is the reason for extra or special dividends) that will lead to disappointment, and they dont want to have investors over react to negative earnings surprises (the sticky dividend phenomenon)

Relaxing the M&M Assumptions

Welcome to the Real World! Agency Theory
Investors are wary of senior management so they seek to put controls in place. There is a fear that managers may waste corporate resources by over-investing in low or poor NPV projects. Gordon Donaldson argued this is the reason for the pecking order managements tend to use when raising capital
Shareholders would prefer to receive a dividend and then have management file a prospectus, justifying investment in projects and the need to raise the capital that was just distributed as a dividend. Shareholders are prepared to pay those additional underwriting costs as an agency cost incurred to monitor and assess management.

Relaxing the M&M Assumptions

Welcome to the Real World!
Preference for dividends versus capital gains income depends on the province of residence and taxable income level leading to tax clienteles.
High income earners tend to prefer capital gains (there is an additional tax incentive for such individuals in that they can choose the timing of the sale of their investmentremember only realized capital gains are subject to tax Low income earners tend to prefer dividends

Conclusion firms should not change dividend policy drastically since it upsets the existing ownership base.

The Excess Cash

The excess cash that a firm has in any period should be paid out as dividends in that period.
Argument: The firm has (temporary) excess cash on its hands this year, no investment projects this year and wants to give the money back to stockholders. Counter: So why not just repurchase stock? If this is a one-time phenomenon, the firm has to consider future financing needs.
Consider the cost of issuing new stock If it initiates dividends, it may need to raise capital through a stock issue just to pay dividends in the future

Share Repurchases
Simply another form of payout policy. An alternative to cash dividend where the objective is to increase the price per share rather than paying a dividend. Since there are rules against improper accumulation of funds, firms adopt a policy of large infrequent share repurchase programs

Share Repurchases
reasons for use:
Offsetting the exercise of executive stock options Leveraged recapitalizations Information or signalling effects Repurchase dissident shares Removing cash without generating expectations for future distributions Take the firm private.

Disadvantages of Share Repurchases

they are usually done on an irregular basis, so a shareholder cannot depend on income from this source. if regular repurchases are made, there is a good chance that Revenue Canada will rule that the repurchases were simply a tax avoidance scheme (to avoid tax on dividends) and will assess tax there may be some agency problems - if managers have inside information, they are purchasing from shareholders at a price less than the intrinsic value of the shares.

Methods of Share Repurchases

tender offer:
this is a formal offer to purchase a given number of shares at a given price over current market price.

open market purchase:

the purchase of shares through an investment dealer like any other investor this is not designed for large block purchases.

private negotiation with major shareholders

In any repurchase program, the securities commission requires disclosure of the event as well as all other material information through a prospectus.

Effects of A Share Repurchase

EPS should increase following the repurchase if earnings after-tax remains the same a higher market price per outstanding share of common stock should result stockholders not selling their shares back to the firm will enjoy a capital gain if the repurchase increases the stock price

Advantages of Share Repurchases

signal positive information about the firms future cash flows used to effect a large-scale change in the firms capital structure increase investors return without creating an expectation of higher future cash dividends reduce future cash dividend requirements or increase cash dividends per share on the remaining shares, without creating a continuing incremental cash drain capital gains treated more favourably than cash dividends for tax purposes.

Disadvantages of Share Repurchases

signal negative information about the firms future growth and investment opportunities the provincial securities commission may raise questions about the intention share repurchase may not qualify the investor for a capital gain

Borrowing to Pay Dividends

Signalling

Borrowing to Pay Dividends

Is this legal? is it possible to do? Yes
the firm must have the ability and capacity to borrow the firm must have sufficient retained earnings to allow it to pay the dividend the firm must have sufficient cash on hand to pay the cash dividend the firm must NOT have agreed to any limitations on the payment of dividends under the bond indenture.

Why?
A possible answer is to signal to the market that the board is confident about the firms ability to sustain cash dividends into the future.

Ove ra ll fra m e wo rk

In t ra -in d u s t ry c o n fo rm it y in d ivid e n d p o lic y

Tom Van Caneghem Hogeschool-Universiteit Brussel, Brussels, Belgium and Antwerp Management School, Universiteit Antwerpen, Antwerpen, Belgium, and Walter Aerts University of Antwerpen, Antwerpen, Belgium

Purpose The purpose of this paper is to study the impact of intra-industry conformity tendencies on dividend policy among a large sample of US firms.

Design/methodology/approach The paper explores mimetic influences on dividend policy. Consistent with prior institutional research, the paper measures mimetic pressures as institutional prevalence or the pervasiveness of a feature of dividend policy within a firms relevant environment.

Findings The results reveal a significantly positive relationship between the lagged density of firms in the industry that pay a dividend and the probability of a focal firm paying a dividend. Moreover, for firms paying a dividend, results indicate that higher similarity in dividend payout among firms in the same industry induces more conformity between a focal firm and average industry practice. Overall, results are consistent with imitation in dividend policy.

Research limitations/implications The results support the view that future research on dividend policy should value social and behavioral factors more explicitly in order to arrive at a more overall and consistent explanation of firms dividend policy. Moreover, the results also illustrate the relevance of alternative theories in explaining dividend policy.

Practical implications The results show that intra-industry benchmarking of dividend policy

 Conformity tendencies in dividend policy

Institutional templates of appropriate behavior Industry effect on dividend payout behavior

Hypothesizes :

H1. The density of other firms in the industry paying a dividend is positively related to the likelihood that the focal firm will pay a dividend. H2 .Greater dividend payout similarity within the industry increases conformity between the focal firms dividend payout and the industry practice.

Conclusion
First, consistent with H1, the density or relative number of other firms in the industry paying a dividend in a prior year is positively related to the likelihood that the focal firm will pay a dividend in the current year. Second, consistent with H2, greater dividend payout similarity within the industry in a prior year drives the extent to which a focal firms dividend payout conforms to the average industry practice in the current year. This is consistent with neo-institutional predictions, stating that institutional prevalence or higher shared agreement on a common industry dividend payout template engenders significant institutional pressure on firms to imitate industry recipes.

Cont.
The results obtained in this study suggest that dividend payout decisions are affected by actions and processes at the level of organizational fields (in casu shared agreement on dividend payout templates and competition at the industry level) and not only by technical, firm-level characteristics.

The finding that intra-industry similarity enhances conformity is consistent with arguments emphasizing cognitive and normative legitimacy concerns as engines for dividend payout decisions. Overall, the results show that the behavior of firms at the industry level can be significant predictors of dividend payout practices at firm level. results support the view that future research on dividend policy should value social and behavioral factors more explicitly in order to arrive at a more overall and consistent explanation of firms dividend policy.

Use Dividends to Signal or Not: An Examination of the UK Dividend Pay out Patterns

by Chin- Bun Tse, Management Centre, University of Leicester

Abstract
Author examine the dividend pay out pat terns for all UK listed industrial companies featured in the FTSE All Share Index for the period 19921998. Then match the pay out patterns to different dividend policies. From author empirical observations, argue that dividend signalling does not universally apply to all firms. also reports evidence that there is no industry norm for dividend policy, particularly when firms have decided whether to use dividends to signal or not. In addition, we found that the percent age of insiders share holdings, market capitalization and as set book values are statistically significant for determining whether firms use dividends to signal or not.

Introduction
In their discussion of dividend signalling models and theories, Cope land and Wes ton (1992, p. 567) raise an unanswered is sue. They claim that al though they ex plain how an optimal dividend policy may arise, none of them can successfully explain cross- sectional differences in dividend pay outs across firms. In this paper, author apply a new approach to investigate UK listed firms pay out patterns from a signalling frame work. Specifically, author want to examine whether alternative pay out patterns observed in practice are consistent with a dividend signalling hypothesis. also investigate what special characteristics would make firms more likely to use dividends to signal.

 Review of Dividend Signal ling Literature

Price- dividend type
This is the usual method to test the dividend signalling hypothesis. Essentially, researchers use OLS regression to regress standardized share price or share re turns on dividends, along with other explanatory variables. Recently, standardized total market value has also been used as the de pendent variable in the regression analysis [Fama and French (1998)]. Event studies are also common in this group of research to look at the market re actions following dividends changes. Some researchers refer to this relationship as the pricing of dividends [see: Hand and Lands man (1999)].

Dividend- earnings studies

In these studies, researchers investigate the relationship between dividends and firms earnings. Different researchers use different earnings as explanatory variables. The impacts of past earnings, current earnings and future earnings on dividends have all been considered in this type of empirical test.

need to identify the alternative pay out pat terns of the sample firms. Then ,author link up the pay out patterns to different models of dividend behavior to see whether pay out pat terns are con sis tent with the dividend signalling hypothesis. author use three stages to establish firms dividend pay out pat terns: Initial stage: identifying alternative patterns
John son & Wichern (1998)

identified five distinct groups of dividend pay out pat terns. They are Always- increase, Smooth, Paynothing, Irregular and Follow- earnings Second stage: allocation dividends per share and earnings per share (EPS).

All per share data has been adjusted for capital changes
Third stage: fine tuning need to look at the actual earnings and dividends time series raw data and cal cu late their correlation coefficient to differentiate

Results
Results for the initial identifying stage
Smooth Follow earnings Always- increase Irregular Pay- nothing

Results for the allocation and fine- tuning stages

identified 35 potentially mis- classified companies that could be either Always- increase or Followearnings one company could be ei ther Follow- earnings or Smooth. no confidence to make a distinction between them

Always- increase (32.48%) Irregular (31.57%) Follow- earnings type with 23% 9.12% of firms smooth Pay- nothing firms are a mi nor ity with just 3.83%.

Concluding Remarks
differences in dividend pay outs across firms. Our analysis provides a partial solution to this puzzle. The answer is that not all firms are dividend signallers: some do, some do not. Signallers will exhibit pay out pat terns that are con sis tent with dividend signal ling hypothesis. The pay out patterns of many non- signallers are in consistent with dividend signalling theory. As pay out patterns are direct results of firms dividend policy, there fore not all pay out pat terns will be con sis tent with dividend signaling hypothesis.

 that dividend policy is very much set at in firm levels. Industry norm is not a major determinant for firms dividend policy. Our result also shows that the IH(insider holdings), MC (market capitalisation )and AB values(asset book value) are the major factors to determine whether firms to use dividends to signal or not.

Th a n k yo u