Understanding Dividend Policy

• Dividends are distributions of a firm's assets to its shareholders.
• Firms have no obligation to pay dividends or maintain a consistent dividend policy.
• Dividends can be paid in cash or stocks.

Dividend Policy Components

• Dividend payout ratio indicates the amount of dividend paid relative to the company's earnings.
• For example, if dividend per share is $1 and earnings per share is $4, the payout ratio is 25 percent (1/4).
• Stability of dividends over time

Introduction to Dividends

• Investment and dividend decisions are interconnected financing decisions.
• The decision to invest or give a dividend requires financing.
• Contemporary discussions about shareholder power and corporate short-termism leading to high rates of dividends are linked with claims of chronic business under-investment.

Dividend Policy Trade-Offs

• Paying a large dividend means retaining less of the firm's profits necessitating reliance on external equity financing.
• A smaller dividend payment will lead to less reliance on external financing.

Dividend Considerations

• If there are no attractive investments, consider increasing dividends to give money to shareholders.
• If there are great investments but finance is difficult or expensive, lowering the dividend to use internally generated funds should be considered.

Dividend Policy & Shareholder Wealth

• Dividend Policy should aim to maximize shareholder wealth.
• A dividend payment only does so if P1 + D ≥ P0, where P0 = Previous Share Price (before dividend payout) and P1 = New Share Price (after dividend payout)
• Example: New Share price 120 + Dividend of 5 > 122 Previous Share price; the dividend payment is maximizing shareholder's wealth

Three Views on Dividends

• There are three basic views with regard to the impact of dividend policy on share prices:
• Dividend policy is irrelevant, according to Modigliani & Miller (M&M).
• High dividends will increase share prices.
• Low dividends will increase share prices.

View 1: Dividend Irrelevance

• Dividend policy is irrelevant (Modigliani & Miller).
• Irrelevance implies shareholder wealth is not affected by dividend policy whether the firm pays 0 percent or 100 percent of its earnings as dividends.
• This view is based on two assumptions: perfect capital markets and firm's investment and borrowing decisions have been made and will not be altered by dividend payment.
• Dividend policy is irrelevant to share value because there are no taxes, no transaction costs, all investors can borrow and lend at the same interest rate, all investors have free access to all relevant information, and investors are indifferent between dividends and capital gains.
• Any money paid out as dividends could quickly be replaced by having a new issue of shares.
• 'Homemade dividends' can be created by the shareholder selling part of their shares.
• Pattern of dividend makes no difference to shareholders' wealth because shareholders' wealth is determined purely by the investment returns.
• A rational investor is actually indifferent to Capital Gains and Dividends.
• A rational investor maximizes the Market Value by investing in +NPV projects which increases Share Price and increases Shareholder Wealth

View 2

• High dividends increase stock value based on "bird-in-the-hand dividend theory."
• Investors may prefer "dividend today" because it is less risky compared to "uncertain future capital gains.”
• Higher required rate for discounting a dollar of capital gain than a dollar of dividends.

View 3

• Low dividends increase stock values.
• Tax rates on capital gains and dividends range from 0 to 20 percent, depending on recipient's income and tax bracket.
• Current dividends are taxed immediately, while tax on capital gains can be deferred until the stock is sold giving capital gains a definite financial advantage for shareholders.
• Stocks that allow tax deferral (i.e., low dividends and high capital gains) sell at a premium relative to stocks that require current taxation (i.e., high dividends and low capital gains).

Other Explanations

• No single definitive answer for which dividend policy is right has yet been found, the following plausible explanations have been developed:
• The Residual Dividend Theory
• Clientele Effect
• The Information Effect
• Agency Costs
• The Expectations Theory

Residual Dividend Theory

• Determine the optimal capital budget.
• Determine the amount of equity needed for financing.
• First, use retained earnings to supply equitable investment.
• If retained earnings are still available, distribute the residual as dividends.
• Dividend policy will be influenced by investment opportunities or capital budgeting needs, and availability of internally generated capital.

The Clientele Effect

• Different groups of investors have varying preferences toward dividends.
• Some investors may prefer a fixed income stream so would prefer firms with high dividends.
• Other investors, such as wealthy investors, would prefer to defer taxes and will be drawn to firms that have low dividend payout and large capital gains creating a Clientele effect.
• Firms attract a given clientele, depending on their started dividend policy.

The Information Effect

• A large, unexpected change in dividends can have a significant impact on the stock prices.
• A firm's dividend policy may be seen as a signal about firm's financial condition.
• Thus, a high dividend could signal expectations of high earnings in the future and vice versa.
• This information effect will have a positive effect on share price.

Agency Costs

• Conflicts often exist between stockholders and a firm's management.
• The stock price of a company owned by investors who are separate from management may be less than the stock price of a closely held firm; potential difference in price is called Agency Cost.
• Dividend policy may be perceived as a tool to minimize agency costs.
• Dividend payment may require managers to issue stock to finance new investments.
• New investors are attracted only if they are convinced the capital will be used profitably.
• Payment of dividends indirectly monitors management's investment activities, and helps reduce agency costs, and may enhance the value of the firm

The Expectations Theory

• Expectation theory suggests that market reaction reflects response to the firms actions, and indicates investors’ expectations about the ultimate decision to be made by management.
• If the amount of dividend paid is equal to the dividend expected by shareholders, the market price of stock will remain unchanged.
• However, the market will react if dividend payment is not consistent with shareholders expectations.
• Deviation from expectations is more important than actual dividend payment.

Conclusions on Dividend Policy

• As a firm's investment opportunities increase, its dividend payout ratio should decrease.
• Because of flotation costs, internally generated equity financing is preferable to selling stock, in terms of wealth of current shareholders.
• Investors use the dividend payment as a source of information of expected earnings.
• The dividend may carry greater weight than a statement by management that earnings will be increasing or decreasing.
• Relationship between stock prices and dividends may exist due to implications of dividends for taxes and agency costs desiring to minimize or defer taxes and to minimize agency costs.
• Based on expectations theory, firms should avoid surprising investors with regard to dividend policy.
• The firm's dividend policy should effectively be treated as a long-term residual.
• Dividends should be paid if internal funds remain after the firm has undertaken all acceptable investments.
• If, over the long term, the entire amount of internally generated capital is needed for reinvestment in the company, then no dividend should be paid.

Practical Constraints of Dividend

• Legal Restrictions
• Statutory restrictions may prevent a company from paying dividends.
• The Companies Act specifies that companies must pay dividends only out of realised profits including realized profits the company has made so far.
• Regulatory & Governmental
• In regulated industries regulatory requirements may impact on companies ability to pay Dividends, or regulator may require specific levels of re-investment in infrastructure in certain industries such as Water and Power.
• Contractual/Obligation based
• Dividend restrictions are often a contractual clause in debt covenants written into bonds or other forms of debt.
• Liquidity Constraints
• A firm may show a large amount of retained earnings, but it must have cash to pay dividends.
• Earnings Predictability
• A firms with stable and predictable earnings is more likely to pay larger dividends.
• Maintaining Ownership Control
• Ownership of common stock gives voting rights.
• If existing stockholders are unable to participate in a new offering, control of current stockholders is diluted as issuing new stock will be considered unattractive. Thus, the amount of dividend payment will be limited.

Alternative Dividend Policies

• Constant dividend payout ratio
• The percentage of earnings paid out in dividends is held constant.
• Because earnings are not constant, the dollar amount of dividend will vary every year.
• Stable dollar dividend per share
• This policy maintains a relatively constant dollar of dividend every year.
• Management will increase the dollar amount only if they are convinced that such increase can be maintained.
• A small regular dividend plus a year-end extra
• A company follows the policy of paying a small, regular dividend plus a year-end extra dividend in prosperous years.

Important Dates

• Declaration date; The date when the dividend is formally declared by the board of directors (for example, February 6)
• Date of record; Investors shown to own stocks on this date receive the dividend (February 16)
• Ex-dividend date; Two working days prior to date of record (for example, February 15). Shareholders buying stock on or after ex-dividend date will not receive dividends.
• Payment date; The date when dividend checks are mailed (for example, March 9)

Stock Dividends

• Stock dividend entails the distribution of additional shares of stock in lieu of cash payment.
• While the number of common stock outstanding increases, the firm's investments and future earnings prospects do not change.

Stock Splits

• A stock split involves exchanging more or less in the case of reverse split shares of stock for firm's outstanding shares.
• Although the number of common stock outstanding increases or decreases in the case of reverse split, the firm's investments and future earnings prospects do not change.
• Stock splits and stock dividends are far less frequent than cash dividends.

Stock Repurchases (Stock Buyback)

• Stock repurchase or stock buyback occurs when a firm repurchases its own stock.
• Results in a reduction in the number of shares outstanding.
• Stock repurchase has potential tax advantage as opposed to cash dividends.
• Stock repurchase increases stock price (i.e future capital gain).
• Capital gain is taxed later, when the stock is sold, whereas dividend is taxed immediately providing a tax deferral advantage of stock repurchase.

Stock Repurchase Benefits

• Provides an internal investment opportunity.
• An approach for modifying the firm's capital structure.
• Favorable impact on earnings per share.
• The elimination of a minority ownership group of stockholders.
• Minimization of the dilution in earnings per share associated with mergers.
• Reduction in the firm's costs associated with servicing small stockholders.

Investor's Preference: Dividend or Stock Repurchases

• If there are no taxes, commissions when trading stocks, and no information content assigned to a dividend, the investor should be indifferent.

Dividend Policy vs Share Repurchase (Buyback)

• Key Studies support a “substitutability hypothesis” of dividends and share buybacks
• CEO's effectively substitute share buybacks for dividends as a form of corporate payout policy because of avoidance of immediate taxation effects.
• Share Repurchases and Dividends have the following in common; they are both methods of returning value to shareholders, both are cash outflows from the business, and both are part of an overall “Corporate pay-out strategy"
• Major differences are tax implications and possible % ownership implications

A Share Repurchase

• When a firm repurchases stock when it has excess cash, it can be regarded as a dividend decision.
• If a firm issues debt and then repurchases stock, it alters the debt-equity mix and thus can be regarded as a financing or capital structure decision.
• If a firm repurchases stock because it feels the prices are depressed, the decision to repurchase may be seen as an investment decision.

Stock Repurchase Procedure

• Open Market; Shares are acquired from a stockbroker at the current market price.
• Tender Offer; An offer is made by the company to buy a specified number of shares at a predetermined price, set above the current market price.
• Purchase; Shares are made from one or more major stockholders