UNIT - ONE

DIVIDEND POLICY AND THEORIES

1.1. Meaning of Dividend

Dividend refers to the portion of net profits which is distributed among the shareholders.
It may also be termed as the part of the profit after tax and interest of a businessconcern, which is
distributed among its shareholders.

1.2. TYPES OF DIVIDEND/FORMS OF DIVIDEND

Dividend may be distributed among the shareholders in different forms. Hence, Dividends are
classified into:
A. Cash dividend
B. Stock dividend
C. Bond dividend
D. Property dividend

A. Cash Dividend
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid
periodically out the business concerns EAIT (Earnings after interest and tax). Cash dividends are
common and popular types followed by majority of the business concerns.
B. Stock Dividend
Stock dividend is paid in the form of the company stock. Under this type, cash is retained by the
business concern. Stock dividend is bonus issue. This issue is given only to the existing
shareholders of the business concern.

C. Bond Dividend
Bond dividend is also known as script dividend. If the company does not have sufficient funds to
pay cash dividend, the company promises to pay the shareholder at a future specific date with the
help of issue of bond or notes.

D. Property Dividend
Property dividends are paid in the form of some assets other than cash. It will distribute under the
exceptional circumstance. This dividend is one of tax escaping mechanism because there is no
tax on property dividend in many countries including Ethiopia.

1.3. Dividend payment chronology

There are four relevant dates associated with dividends are as follows: ambiguity
1. Declaration date. This is the date on which the board of directors declares the dividend. On
this date, the payment of the dividend becomes a legal liability of the firm. On this day the
border of director announce important information like:
➢ Amount of dividend per share
➢ Record day and all needed document to be recorded
➢ Payment day

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2. Ex-dividend dates. The ex-dividend dates are the dates when the right to the dividend leaves
the shares. The right to a dividend stays with the stock until 2 business days before the date of
record. On these two business days prior to the record date, the right to the dividend is no longer
with the shares, and the seller is the one who will receive the dividend. The buyer who acquires
within these two days can’t enjoy from the declared dividend. For example, if the record day is
Monday, the two days before this day are Saturday and Sunday but these days are not business
days thus the ex-dividend days are Friday and Thursday of last week.

3. Date of record. This is the date upon which the believed stockholders are entitled to receive
the dividend. All necessary information of the believed stockholders are identify and recorded,
like address, bank account number and so on.

4. Date of payment. This is the date when the company distributes its dividend checks to its
stockholders. Dividends are usually paid in cash. A cash dividend is typically expressed in
dollars and cents per share.

1.4. Dividend policy

Different companies adopt different dividend policy because dividend policy can affect the
operation, financing and investing activities of the company. Dividend policies of the firm can be
categorized in to six groups.
1. Stable per-share dividend policy: Many companies use a stable dividend-per-share policy
since it is looked upon favorably by investors. Dividend stability implies a low-risk company.
Even in a year that the company shows a loss rather than profit the dividend should be
maintained to avoid negative connotations to current and prospective investors.
2. Constant dividend-payout-ratio policy: With this policy a constant percentage of earnings is
paid out in dividends. Because net income varies, dividend paid will also vary using this
approach. The problem this policy causes is that if company’s earnings drop drastically or there
is a loss, the dividends paid will be sharply curtailed or nonexistent.

3. Non-constant dividend-payout-ratio policy: With this policy a non-constant percentage of

earnings is paid out in dividends. Because the payout ratio varies, dividend paid will also vary
using this approach.
4. Compromise dividend policy. Is a policy to pay a low dollar amount per share plus a
percentage increment in good years. While this policy affords flexibility, it also creates
uncertainty in the minds of investors as to the amount of dividends they are likely to receive.

5. Residual-dividend policy. When a company’s investment opportunities are not stable,

management may want to consider a fluctuating dividend policy. With this kind of policy the
amount of earnings retained depends upon the availability of investment opportunities in a
particular year. Dividends paid represent the residual amount from earnings after the company’s
investment needs are fulfilled.

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 1.5. FACTORS DETERMINING DIVIDEND POLICY

Profitable Position of the Firm: Dividend decision depends on the profitable position of the
business concern. When the firm earns more profit, they can distribute more dividends to the
shareholders and the reverse is true.
Liquidity Position: Liquidity position of the firms leads to easy payments of dividend. If the
firms have high liquidity, the firms can provide cash dividend otherwise, they have to pay stock
dividend.
Sources of Finance: If the firm has finance sources, it will be easy to mobilize large finance.
The firm shall not go for retained earnings.
Growth Rate of the Firm: A company that is rapidly growing, even if profitable, may have to
restrict its dividend payments in order to keep needed funds within the company for growth
opportunities.
Restrictive covenants: Sometimes there is a restriction in a credit agreement that will limit the
amount of cash dividends that may be paid.
Degree of financial leverage: A company with a high debt-to-equity ratio is more likely to retain
earnings so that it will have the needed funds to meet interest payments and debts at maturity.
Tax Policy: Tax policy of the government also affects the dividend policy of the firm. When the
government gives tax incentives, the company pays more dividends.

1.6. DIVIDEND THEORIES

There are two schools of thought on the relationship between dividend policy and the value of
the firm. These theories can be grouped in two categories:

A). Theories that consider dividend decision of the firm is irrelevant or which cannot
influence firm value
B). Theories that consider dividend decision of the firm is one of active variable which can
influence the firm value

1. Dividend Irrelevance theory

According to Professor Modigliani and Miller, dividend policy has no effect on the share price
of the company. There is no relation between the dividend rate and value of the firm. Rather the
firm investment and finance policy of the firm are active to affect the value of the firm.
Modigliani and Miller contributed a major approach to prove the irrelevance dividend concept.

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 Modigliani and Miller’s Approach:

According to MM, under a perfect market condition, the dividend policy of the company is
irrelevant and it does not affect the value of the firm.
Assumptions of MM Approach
MM approach is based on the following important assumptions:
1. Perfect capital market.
2. There is no tax.
3. The firm has fixed investment policy.
4. No risk
Criticism of MM approach

MM approach is the full of criticisms. The criticism of MM model is the assumptions of the
model because the assumptions are not realistic.

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 2. DIVIDEND RELEVANCE THEORY
Walter model:
Walter argues that the choice of dividend policies almost always affect the value of the firm. His
model shows the importance of the relationship between the firm’s rate of return ,r, and it cost of
capital ,k, in determining the dividend police that will maximize the wealth of shareholder
Walter model is based on the following assumptions:
• Internal financing
• Constant return and cost of capital (r and k)
• 100% pay-out or retention
• Constant EPS
When the above assumptions were kept, Walter says price of the share is equal to:

P= Div + (r/k) (EPS - Div)

K
Where,
P= market price per share
Div= dividend per share
EPS= earning per share
r= firm’s rate of return
K= capitalization rate or cost of equity capital

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Walter model shows the optimum dividend policy depend on the relationship between the firm’s
rate of return, r , and its cost of equity capital, k. its model also state that different dividend
policy has different impact on the value of the firm respectively from the perspective of growth
firm, normal firm and declining firm.
Growth firm, normal firm declining firm
r>k r=k r <k
r= 0.15 r=0.1 r= 0.08
k= 0.1 k=0.1 k= 0.1
EPS= 10 EPS= 10 EPS= 10

Payout ratio 0 %
Div= 0
P= 0 + (0.15/0.10)(10 - 0 ) =$150 =$100 =$80
0.1

Payout ratio 40% =$130 =$100 =$88

Payout ratio 80% =$110 =$100 =$96

Payout ratio 100% =$100 =$100 =$100

Based on the result of the model Walter conclude that the effect of dividend policy differ from
company to company i.e the same payment policy has different impact on the value the firm on
growth, normal and declining firms. Let see what he conclude based on the model result

Growth firm
Are those firms which expand rapidly because of ample investment opportunities yielding return
higher than the opportunity cost of capital? These firms can reinvest earning at rate (r) which is
higher than the rate expected by shareholders (k). they will maximize the value per share if they
follow a policy of retaining all earning for internal investment .as shown on the above table the
market value per share for the growth firm is maximum ($150) when it retain 100% earning and
the minimum is $100 when if they distributes all earning, thus the optimum payout ratio for
growth firm is zero. The market value per share P, increases as payout ratio is declines

Normal firm
Most of the firm do not have unlimited surplus- generating investment opportunities, yielding
return higher than the opportunity cost of capital. After exhausting super profitable opportunities
this firms earn on their investment rate of return equal to the cost of capital , r=k. for normal
firms with r=k, the dividend policy has not effect on the market value per share in walter model.
As shown on the table above the market value per share for normal firms is same ($100) for
different dividend payout ratio. Thus, there is no unique optimum payout ratio for normal firm
because one dividend policy is as good as the other.

Declining firms
Declining firms do not have profitable investment opportunity to invest their earning their rate of
return from their few opportunities is less than the minimum rate required by investors. Investors

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of these firms would like earning to be distributed to them so that they may either spend it or
invest somewhere to get rate of return higher than declining firm. The market value per share of
declining firm with r<k will be maximized when it does not retain nothing. As observed on the
table the market value of the share increase when this firm payout ratio is increase. Thus the
optimum dividend payout ratio is 100% payout or retains nothing

Criticism of Walter’s Model

The following are some of the important criticisms against Walter model:

• Walter model assumes that there is no extracted finance used by the firm. It is not
practically applicable.
• There is no possibility of constant return. Return may increase or decrease, depending
upon the business situation.
• According to Walter model, it is based on constant cost of capital. But it is not applicable
in uncertain world rather it is associated with risk. When risk is increase also required rate
by investor (r) is increase to compensate the uncertainty of their investment.

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 Modern dividend theories

The Bird-In-The-Hand Argument

This argument is based on the assumption that under condition of uncertainty, investors tend to
discount distant dividends (capital gain) at higher rate than they discount near dividends.
Investors behaving rationally are risk-averse and, therefore, have a preference for near dividends
to future dividends. The logic underlying the dividend effect on the value of the share can be
described as the Bird-In-The-Hand argument.
kirshman , first of all, put forward the bird in hand argument in the following words :
of two stock with identical earning and ,prospects but the one pay a large dividend than the other
,the former will undoubtedly command higher price merely because stock holder prefer present
to future values. Myopic vision plays apart in price making process. Stockholders often act upon
the principle that a bird in the hand is more worth than two in the bush and for this reason
stockholders willing to pay premium for stock with higher dividend rate the typical investor
would most certain prefer to have his dividend today and let tomorrow take care of itself.

The Clientele Effect

In our earlier discussion, we saw that some groups (wealthy individuals, for example) have an
incentive to pursue low-payout (or zero payout) stocks. Other groups (corporations, for example)
have an incentive to pursue high-payout stocks. Companies with high payouts will thus attract
one group, and low-payout companies will attract another. These different groups are called
clienteles, and what we have described is a clientele effect. The clientele effect argument states
that different groups of investors desire different levels of dividends. When a firm chooses a
particular dividend policy, the only effect is to attract a particular clientele. If a firm changes its
dividend policy, then it just attracts a different clientele.
What we are left with is a simple supply and demand argument. Suppose 40 percent of all
investors prefer high dividends, but only 20 percent of the firms pay high dividends. Here the
high-dividend firms will be in short supply; thus, their stock prices will rise. Consequently, low-
dividend firms will find it advantageous to switch policies until 40 percent of all firms have high
payouts. At this point, the dividend market is in equilibrium. Further changes in dividend policy
are pointless because all of the clienteles are satisfied. The dividend policy for any individual
firm is now irrelevant. To see if you understand the clientele effect, consider the following
statement: In spite of the theoretical argument that dividend policy is irrelevant or that firms
should not pay dividends, many investors like high dividends; because of this fact, a firm can
boost its share price by having a higher dividend payout ratio. True or false? The answer is
“false” if clienteles exist. As long as enough high-dividend firms satisfy the dividend-loving
investors, a firm won’t be able to boost its share price by paying high dividends. An unsatisfied
clientele must exist for this to happen, and there is no evidence that this is the case.

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Dividend signaling hypothesis

It suggests that dividends have an impact on share price because they communicate information,
or signals, about the firm’s profitability. Presumably, firms with good news about their future
profitability will want to tell investors. Rather than make a simple announcement, dividends may
be increased to add conviction to the statement. When a firm has a target dividend-payout ratio
that has been stable over time, and the firm increases this ratio, investors may believe that
management is announcing a positive change in the expected future profitability of the firm. The
signal to investors is that management and the board of directors truly believes that things are
better than the stock price reflects. Accordingly, the price of the stock may react favorably to this
increase in dividends. The idea here is that the reported accounting earnings of a company may
not be a proper reflection of the company’s economic earnings. To the extent that dividends
provide information on economic earnings not provided by reported earnings, share price will
respond. Put another way, cash dividends speak louder than words. Thus dividends are said to be
used by investors as predictors of the firm’s future performance. Dividends convey
management’s expectations of the future. Brash

1.7. STOCK - DIVIDEND

Stock Dividend: A payment of additional or bonus shares of stock to existing shareholders.
Often used in place of or in addition to cash dividend. Stock dividend declare in percent of
outstanding shares e.g , A 5% stock dividend means five percent of outstanding shares are issued
as bonus share, if there is 100,000 outstanding shares, new additional 5,000 shares are to be print
out to cover the declared dividend. These additional shares are print out from unissued portion of
their authorized share or from treasury stock.

Why firms pay stock dividend?

There are many reasons that make the firms to pay dividend instead of cash these includes:
• To avoid double taxation (corporate tax 30% and dividend income tax 10%) if dividend
is paid in stock there is no dividend income tax.
• Stock dividend is great means to pay dividend under financial difficulty, when the
company facing stringent cash situation the best way to replace cash dividend is the
issuing of bonus shares.
• Conservation cash even if there is shortage cash of cash firms pay stock dividend if
they need it for other profitable investment
• To increase future dividend, if the company pay fixed amount per share and if that
amount is not decrease for the next dividend period then dividend of shareholder will
increase b/c their share is increased.
• Is bell or indication of higher future profit, as we said above the next dividend of
shareholder will increase if dividend per share will not change, so the next dividend
amount to be paid for the shareholder become more to cover this amount there should
be high profit.

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 • To make the share price more attractive, when the stock is divided instead of cash share
holder may sold out this new additional shares to secure their current cash at less price
in this time small investor can acquire the share b/c the price attractive for those kind of
investor.

What is the effect of stock dividend?

➢ EPS (earning per share) is decrease or increase

➢ Outstanding share is increase
➢ Equity of shareholder is not affected; about this we have more detail at the end…

Classification of stock dividend

As indicated above stock dividend is declare in percent of outstanding share, thus based on the
percent that declare stock dividend is classified as

➢ Small scale/percentage stock dividend: when it is less than 25% of outstanding shares
➢ Large scale/percentage stock dividend: when it is greater than or equals to 25% of
outstanding share.
Both have no effect on the equity of the shareholder but accounting treatment for the two kind of
stock dividend is not the same, let’s look how it is:

1. Small-percentage stock dividends

Typically less than 25% of previously outstanding common stock.

Assume a company with 400,000 shares of $5 par common stock outstanding pays a 5% stock
dividend. The pre-dividend market value is $40. How does this impact the shareholders’ equity
accounts?
➢ $800,000 ($40 x 20,000 new shares) transferred (on paper) “out of” retained earnings.
➢ $100,000 transferred “into” common stock account @ par.
➢ $700,000 ($800,000 - $100,000) transferred “into” additional paid-in-capital in excess of
par.
“Total shareholders’ equity” remains unchanged at $10 million.

Before 5% Stock Dividend

Common stock
($5 par; 400,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000

After 5% Stock Dividend

Common stock
($5 par; 420,000 shares) $ 2,100,000
Additional paid-in capital 1,700,000
Retained earnings 6,200,000
Total shareholders’ equity $10,000,000

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 2. Large-percentage stock dividends
Typically 25% or greater of previously outstanding common stock.
The material effect on the market price per share causes the transaction to be accounted for
differently. Reclassification is limited to the par value of additional shares rather than pre-stock-
dividend value of additional shares.

Assume a company with 400,000 shares of $5 par common stock outstanding pays a
100% stock dividend. The pre-stock-dividend market value per share is $40. How does
this impact the shareholders’ equity accounts?

➢ $2 million ($5 x 400,000 new shares) transferred (on paper) “out of” retained earnings.
➢ $2 million transferred “into” common stock account.

Before 100% Stock Dividend

Common stock
($5 par; 400,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000

After 100% Stock Dividend

Common stock
($5 par; 800,000 shares) $ 4,000,000
Additional paid-in capital 1,000,000
Retained earnings 5,000,000
Total shareholders’ equity $10,000,000

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