Dividend Policy

What is Dividend Policy?

Dividend Policy

CHAPTER 22 – Dividend Policy 22 - 3

Dividend PolicyWhat 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

Dividend Policy


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

Dividend Policy


– 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.

Corporate Profits After Tax Retained Earnings

Dividends

Dividends a Financing Decision


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 firm’s 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)

The Mechanics of Dividend Payments

Dividend Policy


Dividend PaymentsMechanics of Cash Dividend Payments

• Declaration Date• Holder of Record Date• Ex-dividend Date• Payment Date


Dividend PaymentsMechanics of Cash 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 firm’s 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 ex-dividend 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 Decision and the Board of Directors

Dividend Policy


Dividend PolicyDividends, 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 BOD’s 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 Policy


Dividend PaymentsDividend 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 PaymentsStock Dividends

• 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 firm’s ability to pay dividends in the future.


Dividend PaymentsStock Dividends

Implications– reduction in the R/E account– reduced capacity to pay future dividends– proportionate share ownership remains unchanged– shareholder’s wealth (theoretically) is unaffected

Effect on the Company– conserves cash– serves to lower the market value of firm’s 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

Effect on Shareholders– proportion of ownership remains unchanged– total value of holdings remains unchanged– if former DPS is maintained, this really represents an increased dividend payout


Dividend PaymentsStock Dividend Example

ABC CompanyEquity Accounts

as at February xx, 20x9Common stock (215,000) $5,000,000Retained earnings 20,000,000Net Worth $25,000,000

The company, on March 1, 20x9 declares a 10 percent stock dividend when the current market price for the stock is $40.00 per share.

This stock dividend will increase the number of shares outstanding by 10 percent. This will mean issuing 21,500 shares. The value of the shares is:

$40.00 (21,500) = $860,000

This stock dividend will result in $860,000 being transferred from the retained earnings account to the common stock account:

next page...







$40.00 (21,500) = $860,000


next page...



After the stock dividend:


as at March 1, 20x9

Common stock (236,500) $5,860,000Retained earnings 19,140,000Net worth $25,000,000

The market price of the stock will be affected by the stock dividend:

New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36

The individual shareholder’s wealth will remain unchanged.


Dividend PaymentsStock Splits

• Although there is no theoretical proof, there is some who believe that an optimal price range exists for a company’s common shares.

• It is generally felt that there is greater demand for shares of companies that are traded in the $40 - $80 dollar range.

• The purpose of a stock split is to decrease share price.• The result is:

– increase in the number of share outstanding– theoretically, no change in shareholder wealth

• Reasons for use:– better share price trading range– psychological appeal (signalling affect)


Dividend PaymentsStock Split Example

The Board of Directors of XYZ Company is considering using a stock split to put its shares into a better trading range. They are confident that the firm’s stock price will continue to rise given the firm’s outstanding financial performance. Currently, the company’s shares are trading for $150 and the company’s shareholders equity accounts are as follows:

Commons shares (100,000 outstanding) $1,500,000Retained earnings 15,000,000Net Worth $16,500,000

A 2 for 1 Stock Split:

New Share Price = P0[1/(2/1)] = $150[1/(2/1)] = $150[.5] = $75.00

The firm’s equity accounts:Commons shares (200,000 outstanding) $1,500,000Retained earnings 15,000,000Net Worth $16,500,000


Dividend PaymentsFurther Stock Split Examples

A 4 for 3 Stock Split:New Share Price = P0[1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50


A 3 for 4 Reverse Stock Split:New Share Price = P0[1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00


Clearly the Board can use stock splits and reverse stock splits to place the firm’s stock in a particular trading range.


Dividend PaymentsStock Split Effects

• shareholders wealth should remain unaffected:

Original Holdings: (100 shares @ $150/share) = $15,000

After a 4 for 1 split: (400 shares @ $37.50/share) = $15,000

• the above will hold true if there is no psychological appeal to the stock split.

• There is some evidence that the share price of companies which split stock is more bouyant because of a positive signal being transferred to the market by this action.


- lowers stock price slightly - large drop in stock price- little psychological appeal - much stronger potential

signalling effect- recapitalization of earnings - no recapitalization- no change in proportional - same

ownership- odd lots created - odd lots rare- theoretically, no value to - same

the investor

Stock Dividends versus Stock Splits

Stock Dividends Stock Splits







$40.00 (21,500) = $860,000


next page...



After the stock dividend:


as at March 1, 20x9

Common stock (236,500) $5,860,000Retained earnings 19,140,000Net worth $25,000,000

The market price of the stock will be affected by the stock dividend:

New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36

The individual shareholder’s wealth will remain unchanged.


Dividend PaymentsStock Splits

• Although there is no theoretical proof, there is some who believe that an optimal price range exists for a company’s common shares.

• It is generally felt that there is greater demand for shares of companies that are traded in the $40 - $80 dollar range.

• The purpose of a stock split is to decrease share price.• The result is:

– increase in the number of share outstanding– theoretically, no change in shareholder wealth

• Reasons for use:– better share price trading range– psychological appeal (signalling affect)


Dividend PaymentsStock Split Example

The Board of Directors of XYZ Company is considering using a stock split to put its shares into a better trading range. They are confident that the firm’s stock price will continue to rise given the firm’s outstanding financial performance. Currently, the company’s shares are trading for $150 and the company’s shareholders equity accounts are as follows:

Commons shares (100,000 outstanding) $1,500,000Retained earnings 15,000,000Net Worth $16,500,000

A 2 for 1 Stock Split:

New Share Price = P0[1/(2/1)] = $150[1/(2/1)] = $150[.5] = $75.00



Dividend PaymentsFurther Stock Split Examples

A 4 for 3 Stock Split:New Share Price = P0[1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50


A 3 for 4 Reverse Stock Split:New Share Price = P0[1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00


Clearly the Board can use stock splits and reverse stock splits to place the firm’s stock in a particular trading range.


Dividend PaymentsStock Split Effects

• shareholders wealth should remain unaffected:

Original Holdings: (100 shares @ $150/share) = $15,000

After a 4 for 1 split: (400 shares @ $37.50/share) = $15,000

• the above will hold true if there is no psychological appeal to the stock split.

• There is some evidence that the share price of companies which split stock is more bouyant because of a positive signal being transferred to the market by this action.


- lowers stock price slightly - large drop in stock price- little psychological appeal - much stronger potential

signalling effect- recapitalization of earnings - no recapitalization- no change in proportional - same

ownership- odd lots created - odd lots rare- theoretically, no value to - same

the investor

Stock Dividends versus Stock Splits

Stock Dividends Stock Splits


Cash Dividend PaymentsThe Macro Perspective

• Figure 22 -1 illustrates:– Aggregate after-tax profits run at approximately 6% of GDP but are

highly variable– Aggregate dividends are relatively stable when compared to after-tax

profits.• They are sustained in the face of drops in profit during recessions• They are held reasonably constant in the face of peaks in aggregate

profits.

(See Figure 22 - 1 on the following slide)

Dividend Policy

Documents

Transcript of Dividend Policy