GORDON COLLEGE

College of Business and Accountancy

Olongapo City

ACC113 – Valuation Concepts and Method

DETAILED LEARNING MODULE

Title: Dividend Policy

Module No: 8

I. Introduction
This module focuses on the use of Free Cash Flow (FCF) for cash distributions to shareholders.
The central issues addressed in this module answers the following: Can a company increase its
value through its choice of distribution policy, defined as: (1) the level of distributions, (2) the
form of distributions (cash dividends versus stock repurchases), and (3) the stability of
distributions? Do different groups of shareholders prefer one form of distribution over the
other? Do shareholders perceive distributions as signals regarding a firm’s risk and expected
future free cash flows?

II. Learning Objectives

After studying this module, you should be able to:
1. Compare and differentiate different kinds of investors.
2. Describe the three theories that have been advanced regarding whether investors in the
aggregate tend to favor high or low dividend payout ratios.
3. Discuss how signaling and the clientele effect be taken into account by a firm as it
considers its dividend decision?
4. Explain how these factors influence the desirability of a stable dividend policy versus
one that is flexible and thus varies with the company’s cash flows and investment
opportunities.

III. Topics and Key Concepts

An Overview of Cash Distributions

o Sources of Cash. FCF is defined as the amount of cash flow available for
distribution to investors after expenses, taxes, and the necessary investments in
operating capital. Thus, the source of FCF depends on a company’s investment
opportunities and its effectiveness in turning those opportunities into realities.
o Uses of Cash.
▪ Pay Interest, Repay Debt, or Issue New Debt. A company’s capital
structure choice determines its payments for interest expenses and debt
principal. A company’s value typically increases over time, even if the
company is mature, which implies its debt will also increase over time if
the company maintains a target capital structure.
▪ Purchase or Sell Short-Term Investments. A company’s working capital
policies determine its level of short-term investments, such as T-bills or
other marketable securities.
▪ Pay Dividends, Repurchase Stock, or Issue New Shares of Stock. The
remaining FCF should be distributed to shareholders, with the only
question being how much to distribute in the form of dividends versus
stock repurchases.
o Procedures for Cash Distributions
▪ Dividend Payment Procedures. Companies normally pay dividends
quarterly, and, if conditions permit, increase the dividend once each year.
• Declaration date. For accounting purposes, the declared dividend
becomes an actual liability on the declaration date.
• Holder-of-record date. At the close of business on the holder-of-
record date, the company closes its stock transfer books and makes
up a list of shareholders as of that date. If the corporation is
notified of the sale before 5 p.m. of the holder-of-record date, then
the new owner receives the dividend. However, if notification is
received after 5 p.m., the previous owner gets the dividend check.
• Ex-dividend Date. The date when the right to the dividend leaves
the stock is called the ex-dividend date.
• Payment date. The date when the company actually pays the
dividend to the holders of record.
▪ Stock Repurchase Procedures
• Stock repurchases occur when a company buys back some of its
own outstanding stock. Three situations can lead to stock
repurchases:
o The company wants to increase its leverage by issuing
debt and using the proceeds to repurchase stock.
o The company have given their employees stock options,
and companies often repurchase their own stock to sell to
employees when employees exercise the options. In this
case, the number of outstanding shares reverts to its pre-
repurchase level after the options are exercised.
o The company may have excess cash. This may be due to
a onetime cash inflow, such as the sale of a division, or
the company may simply be generating more free cash
flow than it needs to service its debt.
• Stock repurchases are usually made in one of three ways:
o A publicly owned firm can buy back its own stock
through a broker on the open market.
 o The firm can make a tender offer, under which it permits
stockholders to send in (that is,“tender”) shares in
exchange for a specified price per share. In this case, the
firm generally indicates it will buy up to a specified
number of shares within a stated time period (usually
about two weeks). If more shares are tendered than the
company wants to buy, purchases are made on a pro rata
basis.
o The firm can purchase a block of shares from one large
holder on a negotiated basis.

Cash Distributions and Firm Value

o A company can change its value of operations only if it changes the cost of capital
or investors’ perceptions regarding expected free cash flow. This is true for all
corporate decisions, including the distribution policy.
o The relative mix of dividend yields and capital gains is determined by the target
distribution ratio, which is the percentage of net income distributed to
shareholders through cash dividends or stock repurchases, and the target payout
ratio, which is the percentage of net income paid as a cash dividend. Notice that
the payout ratio must be less than the distribution ratio because the distribution
ratio includes stock repurchases as well as cash dividends.
o A high distribution ratio and a high payout ratio mean that a company pays large
dividends and has small (or zero) stock repurchases.
o Dividend Irrelevance Theory. The original proponents of the dividend
irrelevance theory were Merton Miller and Franco Modigliani (MM).9 They
argued that the firm’s value is determined only by its basic earning power and its
business risk. In other words, MM argued that the value of the firm depends only
on the income produced by its assets, not on how this income is split between
dividends and retained earnings.
o Dividend Preference (Bird-in-the-Hand) Theory. Myron Gordon and John
Lintner both argued that a stock’s risk declines as dividends increase: A return in
the form of dividends is a sure thing, but a return in the form of capital gains is
risky. In other words, a bird in the hand is worth more than two in the bush.
Therefore, shareholders prefer dividends and are willing to accept a lower required
return on equity.
o Tax Effect Theory: Capital Gains Are Preferred. There are two reasons why
stock price appreciation still is taxed more favorably than dividend income. First,
an increase in a stock’s price isn’t taxable until the investor sells the stock, whereas
a dividend payment is taxable immediately; a dollar of taxes paid in the future has
a lower effective cost than a dollar paid today because of the time value of money.
So even when dividends and gains are taxed equally, capital gains are never taxed
sooner than dividends. Second, if a stock is held until the shareholder dies, then no
capital gains tax is due at all: The beneficiaries who receive the stock can use its
value on the date of death as their cost basis and thus completely escape the capital
gains tax.

Clientele Effect
o Clientele effect explains the movement in a company's stock price according to the
demands and goals of its investors. These investor demands come in reaction to a
tax, dividend or other policy change which affects the shares.
 o Different groups, or clienteles, of stockholders prefer different dividend payout
policies.
o To the extent that stockholders can switch firms, a firm can change from one
dividend payout policy to another and then let stockholders who do not like the
new policy sell to other investors who do.
o However, frequent switching would be inefficient because of: (1) brokerage costs,
(2) the likelihood that stockholders who are selling will have to pay capital gains
taxes, and (3) a possible shortage of investors who like the firm’s newly adopted
dividend policy.

Information Content, or Signaling, Hypothesis

o Different investors have different views on both the level of future dividend
payments and the uncertainty inherent in those payments, and managers have
better information about future prospects than public stockholders.
o Dividend announcements have information, or signaling content about future
earnings. Investors view dividend increases as signals of management’s view of
the future. Managers hate to cut dividends: increase in dividends is a signal that
they think the increase is sustainable. Stock price increase at time of a dividend
increase could be due to either: (1) Investors interpreting it as a signal that
management thinks EPS increase is sustainable (signaling hypothesis) or Investors
preferring higher-dividend stocks (bird-in-the-hand theory).
o Larger than normal dividend signals future is bright (positive). Stock price tends
to increase while smaller than expected increase or dividend cut is negative signal.
Stock price tends to fall. Lastly, normal increase of dividends is neutral.

Setting the Target Distribution Level: The Residual Distribution Model

o When deciding how much cash to distribute to stockholders, two points should be
kept in mind: (1) The overriding objective is to maximize shareholder value, and
(2) the firm’s cash flows really belong to its shareholders, so a company should
not retain income unless managers can reinvest that income to produce returns
higher than shareholders could themselves earn by investing the cash in
investments of equal risk.
o For a given firm, the optimal distribution ratio is a function of four factors:
▪ investors’ preferences for dividends versus capital gains
▪ the firm’s investment opportunities
▪ its target capital structure, and
▪ the availability and cost of external capital.
o The last three elements are combined in what we call the residual distribution
model. Under this model a firm follows these four steps when establishing its target
distribution ratio:
▪ it determines the optimal capital budget;
▪ it determines the amount of equity needed to finance that budget, given its
target capital structure;
▪ it uses reinvested earnings to meet equity requirements to the extent
possible; and
▪ it pays dividends or repurchases stock only if more earnings are available
than are needed to support the optimal capital budget.
o If a firm rigidly follows the residual distribution policy, then distributions paid in
any given year can be expressed as follows:
Other Factors Influencing Distributions
o Constraints.
▪ Bond indentures. Debt contracts often limit dividend payments to earnings
generated after the loan was granted. Also, debt contracts often stipulate that no
dividends can be paid unless the current ratio, times-interest-earned ratio, and
other safety ratios exceed stated minimums.
▪ Preferred stock restrictions. Typically, common dividends cannot be paid if the
company has omitted its preferred dividend. The preferred arrearages must be
satisfied before common dividends can be resumed.
▪ Impairment of capital rule. Dividend payments cannot exceed the balance sheet
item “retained earnings.” This legal restriction, known as the “impairment of
capital rule,” is designed to protect creditors. Without the rule, a company in
trouble might distribute most of its assets to stockholders and leave its debtholders
out in the cold. (Liquidating dividends can be paid out of capital, but they must
be indicated as such and must not reduce capital below the limits stated in debt
contracts.)
▪ Availability of cash. Cash dividends can be paid only with cash, so a shortage of
cash in the bank can restrict dividend payments. However, the ability to borrow
can offset this factor.
▪ Penalty tax on improperly accumulated earnings. To prevent wealthy individuals
from using corporations to avoid personal taxes, the Tax Code provides for a
special surtax on improperly accumulated income. Thus, if the IRS can
demonstrate that a firm’s dividend payout ratio is being deliberately held down to
help its stockholders avoid personal taxes, the firm is subject to heavy penalties.
This factor is generally relevant only to privately owned firms.
o Alternative Sources of Capital
▪ Cost of selling new stock. If a firm needs to finance a given level of investment,
it can obtain equity by retaining earnings or by issuing new common stock. If
flotation costs (including any negative signaling effects of a stock offering) are
high then the required return on new equity, re, will be well above the required
return on internally generated equity, rs, making it better to set a low payout ratio
and to finance through retention rather than through the sale of new common
stock. On the other hand, a high dividend payout ratio is more feasible for a firm
whose flotation costs are low. Flotation costs differ among firms—for example,
the flotation percentage is generally higher for small firms, so they tend to set low
payout ratios.
▪ Ability to substitute debt for equity. A firm can finance a given level of investment
with either debt or equity. As just described, low stock flotation costs permit a
more flexible dividend policy because equity can be raised either by retaining
earnings or by selling new stock. A similar situation holds for debt policy: If the
firm can adjust its debt ratio without raising costs sharply, then it can pay the
expected dividend—even if earnings fluctuate—by increasing its debt ratio.
▪ Control. If management is concerned about maintaining control, it may be
reluctant to sell new stock; hence, the company may retain more earnings than it
▪ otherwise would. However, if stockholders want higher dividends and a proxy
fight looms, then the dividend will be increased.
 Stock Splits

Publicly-traded companies all have a given number of outstanding shares of stock in their
company that have been purchased by and issued to investors. A stock split is a decision by the
company to increase the number of outstanding shares by a specified multiple. When a company
decides to split its stock, it determines the ratio for the split. There are a variety of combination
ratios open to the company. However, the most common are 2-for-1, 3-for-1, and 3-for-2 splits.

Illustration:

Company A has decided to split its stock and has settled on the most common split ratio: 2-for-1.
In this example, shareholders who’ve already purchased and been issued shares of Company A’s
stock would be given another share for every stock they already own. In such a scenario, let’s
assume that Company A has 30 million outstanding shares. After the 2-for-1 stock split, they’ll
have 60 million. However, this also means that the value of each share decreases by 50%.

There are a number of reasons for stock splits. However, there are two that are most common. The
first has to do with perceived company liquidity. With each share’s price dropping a certain
percentage – depending on the ratio that the company decides to use – investors tend to see the
company’s stock as more affordable, and therefore may be more likely to buy shares. The lower
the share price, the less risky the stock seems.

A stock split makes the stock more affordable for more investors and thus can be used to draw in
new investors who may have been reluctant or simply unable to purchase the stock at its higher,
pre-split price.

The move is a useful strategy when a company’s stock price rises to a level that prices many
investors out, or when the price has risen significantly higher than its competitors’ stock.

Stock Dividends

A stock dividend, a method used by companies to distribute wealth to shareholders, is a dividend

payment made in the form of shares rather than cash. Stock dividends are primarily issued in lieu
of cash dividends when the company is low on liquid cash on hand. The board of directors decides
on when to declare a (stock) dividend and in what form the dividend will be paid.

Similar to a cash dividend, a stock dividend does not increase shareholder wealth or market
capitalization. Although it increases the number of shares outstanding for a company, the price
per share must decrease accordingly. An understanding that the market capitalization of a
company remains the same explains why share price must decrease if more shares are issued.

Illustration

Allen is a shareholder of ABC Company and owns 1,000 shares. The board of directors of ABC
Company recently announced a 10% stock dividend. Assuming that the current stock price is $10
and there are 100,000 total shares outstanding, what is the effect of a 10% stock dividend on
Allen’s 1,000 shares?

1. Determine the market capitalization of ABC Company:

$10 x 100,000 shares = $1,000,000 (market capitalization)
 2. Determine the increase in shares outstanding due to a 10% stock dividend:
100,000 shares x 10% = 10,000 increase in shares outstanding

3. Determine the new total shares outstanding:

10,000 + 100,000 = 110,000 shares

4. Determine the number of shares Allen now owns:

Before the stock dividend, Allen owned 1% (1,000 / 100,000) of the total outstanding shares.
Since a stock dividend is given to all shareholders, Allen’s ownership percentage in ABC Company
remains the same.
Therefore, Allen would own 1% of the new total shares outstanding or 1% x 110,000 = 1,100.
The number is identical to increasing Colin’s 1,000 shares by the 10% stock dividend.

5. Determine the price per share of ABC Company:

A stock dividend does not increase the market capitalization of a company. The market
capitalization of ABC Company remains $1,000,000. With 110,000 total shares outstanding, the
stock price of ABC Company would be $1,000,000 / 110,000 = $9.09.

Advantages of a Stock Dividend

o Maintaining cash position
o Tax considerations for a stock dividend
o Maintaining an “investable” price range
Disadvantages of a Stock Dividend
o Market signaling and asymmetric information
o Risky projects

Dividend Reinvestment Plans

an option under which stockholders can choose to automatically reinvest their dividends in the
stock of the paying corporation.

There are two types of DRIPs: (1) plans that involve only “old stock” that is already outstanding
and (2) plans that involve newly issued stock. In either case, the stockholder must pay taxes on
the amount of the dividends, even though stock rather than cash is received.

Under the “old stock” type of plan, if a stockholder elects reinvestment then a bank, acting as
trustee, takes the total funds available for reinvestment, purchases the corporation’s stock on the
open market, and allocates the shares purchased to the participating stockholders’ accounts on a
pro rata basis. The transaction costs of buying shares (brokerage costs) are low because of volume
purchases, so these plans benefit small stockholders who do not need cash dividends for current
consumption.

The “new stock” type of DRIP uses the reinvested funds to buy newly issued stock; hence these
plans raise new capital for the firm. No fees are charged to stockholders, and many companies offer
stock at a discount of 3% to 5% below the actual market price. The companies offer discounts as a
trade-off against flotation costs that would have been incurred if new stock had been issued through
investment bankers instead of through the dividend reinvestment plans.

IV. Teaching and Learning Materials and Resources

A. Fundamentals of Financial Management by Brigham and Houston
B. Intermediate Financial Management by Brigham and Daves
 C. Laptop and Web Camera
D. Google Meet/Zoom
E. Google Quiz

V. Learning Tasks
A. Readings on Capital Structure Theory
B. Attendance and participation on webinar-style discussion

VI. References
A. Brigham, E. F., & Houston, J. F. (2015). Fundamentals of financial management (12th ed.).
Cengage Learning.
https://hostnezt.com/cssfiles/businessadmin/Fundamentals%20of%20Financial%20Mana
gement%20%2012th%20edition%20%20-%20Brigham%20Houston.pdf
B. Brigham, E. F., & Daves, P. R. (2016). Intermediate financial management (12th ed.).
Cengage Learning. http://gsme.sharif.edu/~stf/file/book_inter.pdf
VII.