CORPORATE

FINANCE
Dividends and Dividend Policy

Ayesha Ashraf
Department of Commerce
University of Sahiwal
 Recap of Last Lecture
• Discussed;
– the effect of financial leverage on cash flows and the cost of
equity
– the impact of taxes and bankruptcy on capital structure
choice
– the basic components of the bankruptcy process
 Learning Objectives
• To Learn;
– Cash Dividends and Dividend Payment
– Does Dividend Policy Matter?
– Low Dividend Payout Vs High Dividend Payout
– Stock Repurchase: An Alternative to Cash Dividends
– What We Know and Do Not Know about Dividends and Payout
Policies
– Stock Dividends and Stock Splits
 Cash Dividends
• Regular cash dividend – cash payments made directly to
stockholders, usually each quarter
• Extra cash dividend – indication that the “extra” amount may
not be repeated in the future
• Special cash dividend – similar to extra dividend, but definitely
will not be repeated
• Liquidating dividend – some or all of the business has been
sold
 Dividend Payments
• Declaration Date – Board declares the dividend, and it becomes a
liability of the firm
• Ex-dividend Date
– Occurs two business days before date of record
– If you buy stock on or after this date, you will not receive the dividend
– Stock price generally drops by about the amount of the dividend
• Date of Record – Holders of record are determined, and they will receive
the dividend payment
• Date of Payment – checks are mailed
Example
 Does Dividend Policy Matter?
• Dividends matter – the value of the stock is based on the
present value of expected future dividends
• Dividend policy may not matter
– Dividend policy is the decision to pay dividends versus retaining
funds to reinvest in the firm
– In theory, if the firm reinvests capital now, it will grow and can pay
higher dividends in the future
 Illustration of Irrelevance
• Consider a firm that can either pay out dividends of $10,000 per year for
each of the next two years or can pay $9,000 this year, reinvest the other
$1,000 into the firm and then pay $11,120 next year. Investors require a
12% return.
– Market Value with constant dividend = $16,900.51
– Market Value with reinvestment = $16,900.51
• If the company will earn the required return, then it doesn’t matter when
it pays the dividends
 Low Payout
• Why might a low payout be desirable?
– Individuals in upper income tax brackets might prefer lower dividend
payouts, given the immediate tax liability, in favor of higher capital
gains with the deferred tax liability
– Flotation costs – low payouts can decrease the amount of capital that
needs to be raised, thereby lowering flotation costs
– Dividend restrictions – debt contracts might limit the percentage of
income that can be paid out as dividends
 High Payout
• Why might a high payout be desirable?
– Desire for current income
• Individuals that need current income, i.e., retirees
• Groups that are prohibited from spending principal (trusts and endowments)
– Uncertainty resolution – no guarantee that the higher future dividends
will materialize
– Taxes
• Dividend exclusion for corporations
• Tax-exempt investors don’t have to worry about differential treatment between
dividends and capital gains
 Dividends and Signals
• Asymmetric information – managers have more information about the
health of the company than investors
• Changes in dividends convey information
– Dividend increases
• Management believes it can be sustained
• Expectation of higher future dividends, increasing present value
• Signal of a healthy, growing firm
– Dividend decreases
• Management believes it can no longer sustain the current level of dividends
• Expectation of lower dividends indefinitely; decreasing present value
• Signal of a firm that is having financial difficulties
 Clientele Effect
• Some investors prefer low dividend payouts and will buy stock
in those companies that offer low dividend payouts
• Some investors prefer high dividend payouts and will buy stock
in those companies that offer high dividend payouts
 Implications of the Clientele Effect
• What do you think will happen if a firm changes its policy from
a high payout to a low payout?
• What do you think will happen if a firm changes its policy from
a low payout to a high payout?
• If this is the case, does dividend policy matter?
 Stock Repurchase
• Company buys back its own shares of stock
– Tender offer – company states a purchase price and a desired number
of shares
– Open market – buys stock in the open market
• Similar to a cash dividend in that it returns cash from the firm
to the stockholders
• This is another argument for dividend policy irrelevance in the
absence of taxes or other imperfections
Research: Managements’ View of Dividend Policy
• Agree or Strongly Agree
– 93.8% Try to avoid reducing dividends per share
– 89.6% Try to maintain a smooth dividend from year to year
– 41.7% Pay dividends to attract investors subject to “prudent man”
restrictions
• Important or Very Important
– 84.1% Maintaining consistency with historic dividend policy
– 71.9% Stability of future earnings
– 9.3% Flotation costs to issue new equity
 Stock Dividends
• Pay additional shares of stock instead of cash
• Increases the number of outstanding shares
• Small stock dividend
– Less than 20 to 25%
– If you own 100 shares and the company declared a 10% stock dividend, you
would receive an additional 10 shares
• Large stock dividend – more than 20 to 25%
 Stock Splits
• Stock splits – essentially the same as a stock dividend except
expressed as a ratio
– For example, a 2 for 1 stock split is the same as a 100% stock
dividend stock price is reduced when the stock splits
• Common explanation for split is to return price to a “more
desirable trading range”
 Quiz
• What are the different types of dividends, and how is a dividend paid?
• What is the clientele effect, and how does it affect dividend policy
relevance?
• What are stock dividends, and how do they differ from cash dividends?
• How are share repurchases an alternative to dividends, and why might
investors prefer them?
 Reference
For further reading see the book
• Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2015). Fundamentals of
corporate finance (11th ed.). McGraw-Hill Professional.
 Questions
• In case of any query contact me at: ayesha@uosahiwal.edu.pk
• You can also ask questions via Google Classroom
Thank you