Dividend Policy

Dividends as a Passive Residual

Can the payment of cash dividends affect
shareholder wealth?
If so, what dividend-payout ratio will
maximize shareholder wealth?

The firm uses earnings plus the additional financing

that the increased equity can support to finance any
expected positive-NPV projects.

Any unused earnings are paid out in the form of

dividends. This describes a passive dividend policy.

Irrelevance of Dividends
A. Current dividends versus retention
of earnings

M&M contend that the effect of dividend

payments on shareholder wealth is exactly
offset by other means of financing.

The dividend plus the new stock price

after dilution exactly equals the stock price
prior to the dividend distribution.

Irrelevance of Dividends
B. Conservation of value

M&M and the total-value principle ensures that

the sum of market value plus current dividends
of two firms identical in all respects other than
dividend-payout ratios will be the same.

Investors can create any dividend policy they

desire by selling shares when the dividend
payout is too low or buying shares when the
dividend payout is excessive.

Relevance of Dividends
A. Preference for dividends

Uncertainty surrounding future company

profitability leads certain investors to
prefer the certainty of current dividends.

Investors prefer large dividends.

Investors do not like to manufacture

homemade dividends, but prefer the
company to distribute them directly.

Relevance of Dividends
B. Taxes on the investor

Capital gains taxes are deferred until the

actual sale of stock. This creates a timing
option.

Capital gains are preferred to dividends,

everything else equal. Thus, high dividendyielding stocks should sell at a discount to
generate a higher before-tax rate of return.

Certain institutional investors pay no tax.

Relevance of Dividends
B. Taxes on the investor (continued)

Corporations can typically exclude 70% of dividend

income from taxation. Thus, corporations generally
prefer to receive dividends rather than capital gains.

The result is clienteles of investors with different

dividend preferences. In equilibrium, there will be
the proper distribution of firms with differing dividend
policies to exactly meet the needs of investors.

Thus, dividend-payout decisions are irrelevant.

Other Dividend Issues

Flotation costs

Transaction costs and divisibility of securities

Institutional restrictions

Financial signaling

Empirical Testing of Dividend

Policy
Tax Effect
Dividends are taxed more heavily (in PV terms) than
capital gains, so before-tax returns should be higher
for high-dividend-paying firms.
Empirical results are mixed -- recently the evidence is
largely consistent with dividend neutrality.

Financial Signaling
Expect that increases (decreases) in dividends lead to
positive (negative) excess stock returns.
Empirical results are consistent with these
expectations.

Implications for Corporate Policy

Establish a policy that will maximize shareholder wealth.

Distribute excess funds to shareholders and stabilize the absolute amount

of dividends if necessary (passive).

Payouts greater than excess funds should occur only in an environment that
has a net preference for dividends.

There is a positive value associated with a modest dividend. Could be

due to institutional restrictions or signaling effects.

Dividends in excess of the passive policy does not appear to lead to

share price improvement because of taxes and flotation costs.

Factors Influencing Dividend Policy

Legal Rules

Capital Impairment Rule -- many states prohibit

the payment of dividends if these dividends
impair capital (usually either par value of
common stock or par plus additional paid-in
capital).
Incorporation

in some states (notably Delaware)

allows a firm to use the fair value, rather than
book value, of its assets when judging whether a
dividend impairs capital.

Factors Influencing Dividend Policy

Legal Rules

Insolvency Rule -- some states prohibit the

payment of cash dividends if the company is
insolvent under either a fair market valuation
or equitable sense.

Undue Retention of Earnings Rule -- prohibits

the undue retention of earnings in excess of the
present and future investment needs of the
firm.

Factors Influencing Dividend Policy

Other Issues to Consider

Funding Needs of the Firm

Liquidity

Ability to Borrow

Restrictions in Debt Contracts (protective covenants)

Control

Dividend Stability

Dollars Per Share

Stability -- maintaining the position of the firms

dividend payments in relation to a trend line.
4

50% of earnings
paid out as dividends

Earnings per share

3
2
Dividends
per share

Time

Dividend Stability

Dollars Per Share

Dividends begin at 50% of earnings, but are stable and

increase only when supported by growth in earnings.
4

50% dividend-payout
rate with stability

Earnings per share

3
2
1

Dividends per share

Time

Valuation of
Dividend Stability

Information content -- management may be able to

affect the expectations of investors through the
informational content of dividends. A stable dividend
suggests that the company expects stable or growing
dividends in the future.

Current income desires -- some investors who desire a

specific periodic income will prefer a company with
stable dividends to one with unstable dividends.

Institutional considerations -- a stable dividend may

permit certain institutional investors to buy the
common stock as they meet the requirements to be
placed on the organizations approved list.

Types of Dividends
Regular Dividend
The

dividend that is normally expected to

be paid by the firm.

Extra dividend

A nonrecurring dividend paid to shareholders in addition to the regular

dividend. It is brought about by special circumstances.

Administrative Considerations:
Procedural Aspects
May 8

May 29

May 31

June 15

Ex-dividend Date -- The first date on which a stock

purchaser is no longer entitled to the recently
declared dividend.
The buyer and seller of the shares have several days to
settle (pay for the shares or deliver the shares). The
brokerage industry has a rule that new shareholders are
entitled to dividends only if they purchase the stock at
least two business days prior to the record date.

Administrative Considerations:
Procedural Aspects
May 8

May 29

May 31

June 15

Declaration Date -- The date that the board of

directors announces the amount and date of the
next dividend.
Payment Date -- The date when the corporation
actually pays the declared dividend.

Dividend Reinvestment Plans

Dividend Reinvestment Plan (DRIP) -- An optional plan
allowing shareholders to automatically reinvest
dividend payments in additional shares of the
companys stock.

The firm can use existing stock. A trustee (e.g., a

bank) purchases the stock on the open market and
credits current shareholders with the new shares.

The firm can issue new stock. This method raises

new funds for the firm. The plan essentially
reduces the effective dividend-payout ratio.

Some plans offer discounts and eliminate brokerage

costs for current shareholders.

Factors Favoring Paying

Dividends
1.

Tax Free Investors:

Tax exempt investors do not worry about taxation aspects of dividends

Generally, tax exempt investors will prefer high dividend paying stocks
(as their pre-tax returns are higher)

There may be demand from tax-exempt investors for high dividend stocks

If there are enough tax-exempt investors, and not enough high dividend stocks
available, the excess demand may push stock prices up

Firms may choose to pay high dividends to attract this type of investor

This is a form of the Clientele Effect in dividends

Factors Favoring Paying

Dividends
2. Agency Problems

If firm does not pay dividends then management retains

control of funds

If there are NPV > = 0 projects available, this is fine

However, if no good investments are available, there may

be incentive for management to invest in NPV < 0
projects simply to retain control of the funds

That is, management may waste money

This may offset the tax disadvantage to investors of getting the

funds paid out as dividends

Factors Favoring Paying

Dividends
3. Signaling

4.

firm s can use their dividend policy to signal to the market

the firms prospects.

Increasing dividends signals that the management is

confident in the future.

Some Investors Preference for Current Income

Some investors simply prefer current income

People who need cash flow, or live off of income from

investments

Firms may attempt to serve this clientele by paying

dividends

Factors Favoring Paying

Dividends

In the end, there does exist a tax disadvantage to

dividends

However, many firms do pay dividends

Some, or all, of these other factors must be important

in the real world.