Chapter 6

Dividend Policy
 Introduction
 Corporate earnings distributed to stockholders are
called DIVIDENDS.
 Dividends are paid in either Cash or Stock and are
typically issued quarterly. They may be paid only out
of Retained Earnings and not from invested capital
such as Capital Stock or the excess received over stock
par value
 In general, the more stable a company’s earnings,
the more regular its issue of dividends.
 Introduction
 A company’s dividend policy is important for the
following reasons:
1. It bears upon investors attitudes.
2. It impacts the financing program and capital budget
of the firm.
3. It affects the firm’s cash flow position.
4. It lowers stockholder’s equity, since dividends are
paid from retained earnings and so results in a higher
debt to equity ratio.
 Introduction
 If a company’s cash flows and investment requirements
are volatile, the company should not establish a high
regular dividend. It would be better to establish a low
regular dividend that can be met even in years of poor
earnings.
 Relevant dates associated with dividends are as follows:
1. Declaration Date – This is the date on which Board of
Directors declares the dividend. On this date, the payment
of the dividend becomes a legal liability of the firm.
 Introduction
2. Date of Record – This is the date upon which
the stockholder is entitled to receive the dividend.
3. Date of payment – This is the date when the
company distributes its dividends checks to its
stockholders.
 Introduction
 Dividends are usually paid in Cash. A cash dividend is
typically expressed in peso and per share. However,
the dividend on preferred stock is sometimes expressed
as a percentage of par value.
 Example: On November 15, 2015, a cash dividend of
Php1.50 per share was declared on 10,000 shares of
Php10 par value common stock. The amount of the
dividend paid by the company is: Php15,000.00
(10,000 x Php1.50) = Php15,000.00
 Introduction

Example: Jones Corporation has 20,000 shares of

Php10 par value, 12% preferred stock outstanding. On
October 15, 2015, a cash dividend was declared to
holders of record as of December 15, 2015. The amount
of dividend to be paid by Jones Corporation is equal to:
Php24,000.00

20,000 shares x Php10 par value = Php200,000 x 12% = Php24,000.00

 Introduction

Some companies allow stockholders to automatically

reinvest their dividend in corporate shares instead of
receiving cash.
The advantage of the stockholder is that he or she
avoids the brokerage fees associated with buying new
shares. However, there is no tax advantage since the
stockholder must still pay ordinary income taxes on the
dividend received.
 Dividend Policy
 A Finance Manager’s objective for the company’s dividend
policy is to MAXIMIZE OWNER WEALTH while providing
adequate financing for the company.
 When a company’s earning increase, management does not
automatically raise the dividend.
 Generally, there is a time lag between increased earnings and the
payment of a higher dividend.
 Only when the management is confident that the increased
earnings will be sustained will they increase the dividend.
 Once dividends are increased, they should continue to be paid at
the higher rate.
 Dividend Policy
 The various types of dividend policies:

1. Stable dividend-per-share policy.

2. Constant dividend-payout-ratio (dividend per
share/earnings per share)
3.A Compromise Policy
4. Residual-dividend policy.
 Theoretical Position
 Theoretically, a company should retain earnings rather than
distribute them when the corporate return exceeds the return
investors can obtain on the money elsewhere.
 Further, if the company obtain a return on its profit that exceed
the cost of capital, the market price of its stock will be
maximized
 Capital gains arising from the appreciation of the market price
of stock has a advantage over dividends.
 On the other hand, a company should not, theoretically, keep
funds for investment if it earns less of a return than what the
investors can earn elsewhere.
 Theoretical Position
 If the owners have better investment opportunities outside
the firm, the company should pay a high dividend.
 Although theoretical considerations from a financial point
of view should be considered when setting dividend
policy, the practically of the situation is that investors
expect to be paid dividends.
 Factors that influence
Dividend Policy
 Other factors that influence dividend policy are as follows:
1. Company Growth Rate
2. Restrictive Covenants
3. Profitability
4. Earnings Stability
5. Maintenance of Control
6. Degree of Financial Leverage
7. Ability of Finance Externally
8. Uncertainty
9. Age and Size
10. Tax Penalties
 Factors that influence
Dividend Policy
 Other factors that influence dividend policy are as follows:
1. Company Growth Rate
2. Restrictive Covenants
3. Profitability
4. Earnings Stability
5. Maintenance of Control
6. Degree of Financial Leverage
7. Ability of Finance Externally
8. Uncertainty
9. Age and Size
10. Tax Penalties
 Stock Dividends
 Stock Dividend is the issuance of additional shares of stock to stockholders.
 A stock dividend may be declared when the cash position of the firm is inadequate
and/or when the firm wishes to prompt more trading of its stock by reducing its
market price.
 With a stock dividend, retained earnings decrease but common stock and paid-in-
capital on common stock increases by the same total amount.
 A stock dividend, therefore, provides NO CHANGE in Stockholders Wealth.
 Stock Dividends increase the shares held, but the proportion of the company each
stockholder own the remain the same.
 In other words, if a stockholder has a 2 percent interest in the company before a
stock dividend, he or she will continue to have 2 percent interest after stock
dividend
 Stock Dividends
 Example: Mr James owns 200 shares of Newland Corporation.
There are 10,000 shares outstanding; therefore, Mr. James holds a 2
percent interest in the company. The company issues a stock
dividend of 10 percent.

Mr. James will then have 220 shares out of 11,000 shares
issued. His proportionate interest remain at 2 percent. (220/11,000)
 Stock Split
 A stock split involves issuing a substantial amount of additional shares and
reducing the par value of the stock on a proportional basis.
 A stock split is often prompted by a desire to reduce the market price per
share, which will make it easier for small investors to purchase shares.
 Example: Smith Corporation has 1,000 shares of Php20 par value common
stock outstanding. The total par value is Php20,000. A 4-for-1 split is issued.
After the split 4,000 shares at Php5 par value will be outstanding. The
total par value thus remain at Php20,000. Theoretically, the market price per
share of the stock should drop to one-fourth of what it was before the split.
 Stock Dividend and Stock
Split
 The difference between a stock dividend and a stock split are as follows:
1. With a stock dividend, retained earnings are reduced and there is a
pro-rata distribution of shares to stockholders. A stock split increases the
shares outstanding but does not lower retained earnings.
2.The par value of stock remains the same with stock dividend but
is proportionately reduced in a stock split.
 Similarities:
1. Cash is not paid
2. Shares outstanding increase
3. Stockholders’ equity remains the same
 Stock Repurchase
 Treasury Stock is the name given to previously issued stock
that has been purchased by the company.
 Buying Treasury Stock is an alternative to paying dividends.
 Since outstanding shares will be fewer after stock has been
repurchased, earnings per share will rise (assuming net
income is held constant)
 The increase in earnings per share may result in a higher
market price per share.
 Stock Repurchase
 Example: Travis Company earned Php2.5 million in 2015. Of this amount, it decided that 20
percent would be used to purchase treasury stock. At present there are 400,000 shares
outstanding. Market Price per share is Php18. The company can use Php500,000 (20% x
Php2.5M) to buy back 25,000 shares through a tender offer of Php20 per share.
Current EPS = Net Income = Php2.500,000 = Php6.25
Outstanding Shares 400,000

Current Price Earnings = Market Price per share = Php18 = 2.88 times
EPS Php6.25

EPS after Treasury Stock is acquired becomes = Php2,500,000 = Php6.67

375,000
The expected market price, assuming the P/E ratio remains the same is:
P/E multiple x new EPS = Expected Market Price
2.88 x Php6.67 = Php19.21
 Stock Repurchase
 To the company, the advantage from a stock repurchase include the
following:
1. If there is excess cash flow that is deemed temporary,
management may prefer to repurchase stock than to pay a higher
dividend that they feel cannot be maintained.
2. Treasury Stock can be used for future acquisition or used as a
basis for stock option.
3. If management is holding stock, they would favor a stock
repurchase rather than dividend because of the favorable tax
treatment.
4. Treasury Stock can be resold in the market if additional funds are
needed.
 Stock Repurchase
 To stockholder, the disadvantage from a stock repurchase include the following:
1. The market price of stock may benefit more than from a dividend than stock
repurchase.
2. Treasury Stock may be bought at an excessively high price to the detriment of the
remaining stockholders. A higher price may occur when share activity is limited or when a
significant amount of shares are reacquired.

 To management, the disadvantage from a stock repurchase include the following:

1. If investors feel that the company is engaging in a repurchase plan because its
management does not have alternative good investment opportunities, a drop in the
market price of stock may ensue.
4. If the reacquisition of stock makes it appear that the company is manipulating the price
of its stock on the market, the company will have problems with SEC. Further, if the BIR
concludes that the repurchase is designed to avoid the payment of tax on dividends, tax
penalties may be imposed because of th e improper accumulation of earnings as
specified in the tax code
 Exercises
1. Break-Even and Cash Break-Even Points: The following price and cost data are given
for firms A, B and C.
A B C
Selling Price per unit Php25 Php12 Php15
Variable Cost per unit Php10 Php6 Php5
Fixed Operating Costs Php30,000 Php24,000 Php100,000

Calculate (a) the break even for each firm

(b) the cash break-even point for each firm, assuming of each firm’s cost of
depreciation is Php10,000
(c) Rank these firms in terms of their risk.
2. Operating and Financial Leverages: John Tripper Soft Drinks Inc. sells 500,000 bottles
of soft drinks a year. Each bottle produced has a variable cost of Php0.25 and sells for
Php0.45. Fixed operating costs are Php50,000. The company has current interest charges of
Php6,000 and preferred dividends of Php2,400. The corporate tax rate is 40%.
(a)Calculate the degree of operating leverage, the degree of financial leverage and degree of
total leverage
(b) Do part (a) at the 750,000 bottle sales level
(c)What generalization can you make comparing (a) to (b) after first finding the break even
point.
 Assignment
1. Dividends per share: Lakeside Corporation’s net income for 2015 was Php300,000. It
retained 40%. The outstanding shares are 100,000. Determine the dividends per share.
2. Cash Dividend: The Dover Corporation has 10,000 shares of common stock outstanding.
On March 5, the company declared a cash dividend of Php5 per share payable to
stockholders of record on April 5. What is the amount of the dividend?
3. Dividend Pay-out: Most Corporation had net income of Php800,000 in 2015. Earnings
have grown at an 8% annual rate. Dividends in 2015 were Php300,000. In 2016, the net
income was Php1,100,000. This, of course, was much higher than the typical 8% annual
growth rate. It is anticipated that earnings will go back to the 8% rate in future years. The
investment in 2016 was Php700,000.
How much dividend should be paid in 2016 assuming: (a) stable dividend payout
ratio of 25%? (b) stable peso dividend policy is maintained? (c) residual-dividend policy is
maintained and 40% of 2016 investment is financed with debt? (d) the investment for 2016 is
to be financed with 80% debt and 20% retained earnings? Any net income not invested is
paid out in dividends.
4. Stock Split: The Simpson Company has 50,000 shares of common stock having a par
value of Php12 per share. The BOD decided on a 2-for-1 stock split. The market price of the
stock was Php20 before the split. (a) record the stock split, (b) What will the market price per
share be immediately after split?
 Assignment
5. EPS: Blake Company’s net income for 2015 was Php3,000,000. Of this amount, 40% will
be used to purchase treasury stock. Currently, there are 1 million shares outstanding and the
market price per share is Php9.00.
(a)How many shares can the company buy back through a tender offer of Php12 a share?
(b)What is the current earnings per share?
(c)What is the current P/E ratio?
(d)What will earnings per share be after the treasury stock acquisition?
(e)What is the expected market price per share assuming the present P/E ratio remains the
same?