DIVIDEND POLICY Several factors must be considered when establishing a firms dividend policy.

These include The liquidity position of the firm just because a firm has income doesnt mean that it has any cash to pay dividends. Need to repay debt oftentimes there are negative covenants that restrict the dividends that can be paid as long as the debt is outstanding. The rate of asset expansion the greater the rate of expansion of the firm, the greater the need to retain earnings to finance the expansion. Control of the firm if dividends are paid out today, equity may have to be sold in the future causing a dilution of ownership. Legal Considerations: Technically, it is illegal to pay a dividend except out of retained earnings. This is to prevent firms from liquidating themselves out from underneath the creditors. Internal Revenue Service Section 531 Improper Accumulation of funds. This is to prevent individuals from not paying dividends in order to avoid the personal income taxes on the dividend payments. Is it in the best interests of shareholders to pay out earnings as dividends or to reinvest them in the company? The answer to this depends upon the investment opportunities that the firm has. There are three fundamental policies to paying cash dividends that firms employ: 1) 2) 3) Pay a constant dollar amount each year regardless of earnings per share. This is what most firms do.

Use a constant payout ratio (for example, 50% of EPS) Pay a low, fixed dividend amount plus dividend extras or special dividends. This allows the company to avoid having to cut dividends since the basic dividend is low, but also avoids the improper accumulation of funds during good years.

A cut in dividends generally hurts a stocks price because it sends a signal to stockholders that managements outlook for the future is that the company cannot continue to pay the dividend. Most companies therefore start off with a low dividend and only increase it when they feel that the earnings prospects have improved sufficiently to allow for maintaining a higher dividend. Many companies will even borrow money in a bad year in order to avoid cutting the dividends. The market price is influenced by dividends through what is called the clientele effect. That is, some investors want dividends (such as retirees and pension funds) while others do not want dividends (wealthy individuals) but would prefer capital gains (which are taxed at a lower rate and deferred).

Flotation costs encourage a company to retain earnings in order to minimize having to sell additional stock in the future. As we saw in the cost of capital calculations, the flotation costs make new equity more expensive than retained earnings. Some companies pay no dividends. Why? Because they have good investment opportunities and reinvest the earnings. Stock Repurchases Other companies opt for a stock repurchase program rather than paying cash dividends. A stock repurchase is a valid alternative to paying cash dividends. The repurchase is made through Public Tender Offer where the company offers to buy up to a set number of shares at a fixed price. This fixed price is set at what the firm thinks the final resulting price will be after the repurchase. Since there will be fewer shares outstanding after the repurchase, the shares that are not repurchased will increase in value. The repurchase is often used to return control of the firm to a select group since their shares (which the wont sell back) will be a larger proportion of a smaller total number of shares. The Securities & Exchange Commission regulates the volume of shares that can be repurchased in order to prevent price manipulation. A stock repurchase also is a means of converting earnings to a capital gain. Since the repurchase is at a higher price, those selling realize a capital gain while those who dont sell see their share prices going up. Stock Dividends Cash is required to pay a cash dividend or engage in a stock repurchase. When cash is not available, a company can pay a stock dividend. A stock dividend is where a fractional share is paid for each share outstanding. For example, a 20% stock dividend is where one new share is issued for every five shares outstanding. Is this good for the stockholders? Assume a company has earnings of $1,000,000 and has 100,000 shares of stock outstanding. This yields an EPS of $10. If the price/earnings multiple is ten times, then the stock will be selling for $100 per share. Now suppose the firm pays a 20% stock dividend. The earnings will still be $1,000,000 but there will now be 120,000 shares outstanding and the new EPS will be $8.33. Since the risk and future prospects of the firm have not changed, the price/earnings multiple should remain 10 times earnings and the stock price will be $83.33 per share. What is the effect on the stockholder? Suppose the stockholder owned 100 shares before the stock dividend. At a market price of $100 per share, the stockholders wealth is $10,000 (100 shares * $100/share = $10,000). After the stock dividend, the stockholder has 120 shares valued at $83.33 per share which is the same $10,000 in total wealth (120 shares * $83.33/share = $10,000) and the shareholder is no better off.

The stock dividend dilutes earnings per share and stock price but has no effect on the value of the firm or the wealth of the stockholders. The lesson is that wealth cannot be created simply by passing out pieces of paper. Stock Splits A stock split is simply a stock dividend equal to or greater than 50%. Thus, we have 3-for-2 stock splits, or 2-for-1 stock splits, etc. A 2-for-1 split will dilute earnings per share in half and the market price will drop in half. Stock splits are often employed to keep the stock price at an affordable level, say between $30 and $60 per share. The idea is that this helps to increase trading activity by drawing in some marginal investors who cannot afford the stock at higher prices. Then, a 2-for-1 split may only result in the stock price falling by 48% rather than 50%. The slightly higher price will then have added a little value to shareholders as well as reduced the cost of equity to the firm. Informational Content of Dividend Policy Dividend policy is thought to convey information to shareholders about a firms future prospects as perceived by management. As previously mentioned, a cut in dividends is often interpreted as managements view that the outlook for earnings was insufficient to sustain the previous level of dividends that the firm had paid. Similarly, an increase in dividends is often interpreted to mean that management views the firms future prospects positively enough to believe that a higher level of dividends can be maintained into the future. Exceptions to these interpretations abound, however. In a recent situation, a company that was in financial difficulties actually eliminated dividends and its stock price rose. This undoubtedly reflected the fact that the investing public knew that the company was in trouble and viewed the elimination of dividends as a means of stemming the hemorrhaging of cash that was occurring and giving management more opportunity to save the company. A divergent view of dividend increases and decreases relates to the investment opportunities of the firm. While some may perceive an increase in dividends as revealing good news about the future prospects of a company, it may also signal the fact that the firm has a paucity of good investment opportunities (i.e., cannot earn stockholders required rate of return) and is thus paying out surplus funds to investors. That, in turn, implies a slowdown in the future rate of growth of the firm and of its dividend paying capacity. Thus, changes in dividend policy can result in mixed signals to investors regarding the future of the company. In theory, the tradeoff between current dividends and future dividends is a wash. As Miller and Modigliani showed, if a firm can only reinvest to earn the stockholders required rate of return (and no more), investors should be indifferent between paying earnings out as dividends or reinvesting them for higher dividends in the future (or capital gains). This is especially true since dividends are now taxed at the same rate as capital gains at the individual investors level (although capital gains taxes can be postponed).