Dividend Policy

Objectives

Study the relationship between a firm’s dividend policy and the market value of its common stock.

Review types of dividend policies followed by firms.

Dividend Payment Procedure

Dividends are generally paid quarterly. The declaration date is the date on which the

firm's board of directors announces the forthcoming dividends.

The date of record designates when the stock transfer books are to be closed (who is entitled to the dividend).

Brokerage firms terminate the right of ownership to the dividend four working days prior to the date of record. This date is called the ex- dividend date.

Dividend checks are mailed on the payment date.

Fixed Investment Decisions and Debt-Equity MixFixed Investment Decisions and Debt-Equity Mix

Choice BetweenChoice Between

large dividends,large dividends,low profit retention, low profit retention, and heavy externaland heavy externalfinancing for futurefinancing for future

investmentinvestment

small dividends,small dividends,high profit retention, high profit retention,

and low externaland low externalfinancing for futurefinancing for future

investmentinvestment

Trade-off in Firm’s Dividend Policy

View 1: Dividends Do Not Matter

Assume that the dividend decision does not change the firm's capital budgeting and financing decisions.

Assume perfect markets No transaction costs, taxes, asymmetric

information, or agency costs

Under the foregoing assumptions, it may be shown that the market value of a firm’s equity is independent of its dividend policy.

View 2: High Dividends Increase Stock Value

Dividends are more predictable than capital gains.

Dividends are less risky than capital gains and should be discounted at a lower rate.

Dividend income should have a higher value than capital gains.

View 3: Low Dividends Increase Value

This view is based on the differential tax treatment of dividend income and capital gains income Effective January 1987 federal tax eliminated the

special treatment given to capital gains income. Stocks that allow us to defer taxes will possibly

sell at a premium relative to stocks that require us to pay taxes currently.

Since high dividends hurt investors, while low dividends-high retention help the firm's investors, low dividend stocks should be more valuable.

Residual Dividend Theory

Flotation costs cause outside equity to be more expensive than inside equity, i.e., retained earnings.

Financing investments internally (and decreasing dividends) instead of issuing new stock may be favored.

Residual dividend theory says that a dividend would be paid only when internally generated funds remain after financing the firm's investments.

Other Issues in Dividend Policy

Clientele Effects Information Effects (Signaling) Agency Costs Expectations Theory

The clientele effect

If investors do in fact have a preference between dividends and capital gains, we could expect them to seek out firms that have a dividend policy consistent with these preferences.

Thus there would be a “clientele effect,” where firms draw a given clientele based on dividend policy.

However, unless there is a greater aggregate demand for a particular policy than is being satisfied in the market, dividend policy is still unimportant

The clientele effect only tells us to avoid making capricious changes in a company's dividend policy.

Information Effect

Evidences indicate that a large, unexpected change in dividends can have significant impact on the stock price.

Some argue that management frequently has inside information about the firm that it cannot make available to the investors.

This information asymmetry between management and investors may result in a lower stock price than it would be if there were no asymmetric information. In such cases, dividend policy may be an important communication tool.

It may be that investors use a change in dividend policy as a signal about the firm's "true" financial condition, especially its earning power.

Therefore, under asymmetric information, changes in dividend policy can affect the market value of a firm.

Agency Cost

A firm's dividend policy may be perceived by owners as a tool to minimize agency costs.

Higher dividend payments decrease agency costs by reducing the free cash flow available to the managers of the firm.

Higher dividends reduce retained earnings and force management to go to the capital markets to finance new investments.

Since the firm is required to provide information on its investment activities in order to raise money in the capital market, the payment of dividends indirectly results in a closer monitoring of management's investment activities.

Thus dividend policy may affect a firm’s market value by affecting the agency cost incurred by the firm.

Expectations Theory

As the time approaches for management to announce the amount of the next dividend, investors form expectations as to how much the dividend will be. The investor then compares the actual dividend announced with the expected dividend.

If the amount of the dividend is as expected, even if it represents an increase from prior years, the market price of the stock will remain unchanged. However, if the dividend is higher or lower than expected, the investors will reassess their perceptions about the firm and the value of the stock.

Empirical Evidence

Do stocks that pay high dividends provide higher or lower returns to the investors?

Over long periods of time, the results suggest a slight advantage to the low-dividend stocks; i.e. low dividend stocks have higher prices.

Surveys of financial managers show that managers are divided between believing that dividends are important and having no opinion on the matter.

What Are We to Conclude?

As a firm's investment opportunities increase, the dividend payout ratio should decrease.

The firm's dividend policy appears to be important; however, appearances may be deceptive. The real issue may be the firm's expected earning power and the risk of the earning.

What Are We to Conclude?

If dividends influence stock price, it probably comes from the investor's desire to minimize and/or defer taxes and from the role of dividends in minimizing agency costs.

If the expectations theory has merit, the management should avoid surprising the investors when it comes to the firm's dividend decision.

Alternative Dividend Policies

Constant dividend payout ratio: The percentage of earnings paid out in dividends is

held constant. Therefore, the dollar amount of the dividend fluctuates from year to year.

Stable dollar dividend per share: Relatively stable dollar dividend is maintained. The

dividend per share is increased or decreased only after careful investigation by the management.

Small, regular dividend plus a year-end extra: Extra dividend is paid out in prosperous years.

Management's objective is to avoid the connotation of a permanent dividend increase.

Alternative Dividend Policy

Rationale for Stable Dividends Policy Investors may use the dividend policy as a surrogate for

information that is not easily accessible. The dividend policy may be useful in assessing the company's long-term earnings prospects.

Many investors rely on dividends to satisfy personal income need. If dividends fluctuate from year to year, investors may have to sell or buy stock to satisfy their current needs, thereby incurring expensive transaction costs.

Legal listings stipulate that certain types of financial institutions may only invest in companies that have a consistent dividend payment.

Stock Dividends & Stock Split

Both a stock dividend and a stock split involve issuing new shares of stock to current stockholders.

The investors' percentage ownership in the firm remains unchanged. The investor is neither better nor worse off than before the stock split/dividend.

On an economic basis there is no difference between a stock dividend and a stock split.

For accounting purposes the stock split has been defined as a stock dividend exceeding 25 percent.

Stock Dividends & Stock Split

Accounting treatment For a stock dividend, the dollar amount of the dividend is

transferred from retained earnings to the capital accounts. Rationale for a stock dividend or split

The price of stock may not fall precisely in proportion to the share increase; thus, the stockholders' value is increased.

Consider the Dell chart example. Note the two for one splits on March 3, 1998 and September 8, 1998. Also note the price changes.

If a company is encountering cash problems, it can substitute a stock dividend for a cash dividend. Investors will probably look beyond the dividend to determine the underlying reasons for conserving cash.

Stock Repurchases: Benefits

To provide an internal investment opportunity.

To modify the firm's capital structure.

To impact earnings per share, thus increasing stock price.

Stock Repurchases

Share repurchase as a dividend decision: A firm may decide to repurchase its shares, increasing

the earnings per share which should be reflected in a higher stock price.

For tax purposes the investor may prefer the firm to repurchase stock in lieu of a dividend. Dividends are taxed as ordinary income, whereas any price appreciation resulting from the stock repurchase would be taxed as a capital gain.

The investor may still prefer dividend payment because Dividends are viewed more dependable than stock repurchases. The price the firm must pay for its stock may be too high. Risk of the firm's capital structure may increase, lowering the

P/E ratio and thus the stock price.

Stock Repurchases

Financing or investment decision A stock repurchase effectively increases the debt-equity ratio

towards higher debt, thus repurchase is viewed as a financing decision.

Buying its own stock at depressed prices, a firm may consider the repurchase as an investment decision. However, this action is not a true investment opportunity, as the extreme result would mean the company would consume itself.

The Stock Repurchase Procedure A public announcement should be made detailing the amount,

purpose and procedure for the stock repurchase. Open market purchase - at the current market price. Tender offer - more formal and at a specified price. Negotiated basis - repurchasing from specific large

shareholders.

Summary

The trade-off between dividends and other sources of finance

The relationship between value and dividends

Dividend policies and practices Stock dividends, splits and

repurchases