Dividend Policy

Cash dividend
Stock Repurchase
Stock Dividends
Stock Splits

By: Prof. Dr. Mohamed Moustafa Soliman

Introduction
When a firm generates cash from operations,
what can the firm do with the cash?

1. Use the cash to fund new investments,

2. Use the cash to pay off some of its debt,
and/or
3. Distribute the cash back to the firm’s
shareholders either as a cash dividend or
as stock repurchases.
How Do Firms Distribute Cash to
their Shareholders?
Cash distributions can take two basic
forms:

1. Cash dividend

2. Share repurchase
How Do Firms Distribute Cash to
their Shareholders?

 With cash dividend, cash is paid directly

to the shareholders.

 Witha share repurchase, a company uses

cash to buy back its own shares from the
market place, thereby reducing the
number of outstanding shares.
What is Dividend Policy
Dividend refers to the portion of net income paid out to
shareholders. It is paid in cash and/or stock for making
investment and bearing risk. Dividend decision of the firm is
yet another crucial area of financial management as it affects
shareholders wealth and value of the firm. The percentage of
earning paid out in the form of cash dividend is known as
dividend payout ratio.

A company may retain some portion of its earnings to finance

new investment. Dividend policy is an integral part of the
firm's financing decision as it provides internal financing.
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Dividend policy is concerned with determining the

proportion of firm's earnings to be distributed in the form
of cash dividend and the portion of earnings to be retained.

A firm has three alternatives regarding the payment of cash

dividends:

1. It can distribute all of its earnings in the firm of

cash dividends,
2. It can retain all of its earnings for reinvestment,
3. It can distribute a part of earnings as dividend
and retain the rest for reinvestment purpose.
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
Low Payout Please
 Why might a low payout be desirable?
 Individuals in upper income tax
brackets might prefer lower dividend
payouts, with the immediate tax
consequences, in favor of higher
capital gains.
 Dividend restrictions – debt contracts

might limit the percentage of income

that can be paid out as dividends.
High Payout Please
 Why might a high payout be desirable?
 Desire for current income

-Individuals in low tax brackets

-Groups that are prohibited from spending
principal (trusts and endowments)
 Uncertainty resolution – no guarantee that the

higher future dividends will materialize.

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
Information Content of Dividends
 Stock prices generally rise with unexpected
increases in dividends and fall with
unexpected decreases in dividends

 Does this mean that the average investor

prefers a high dividend payout ratio?

 No – changes in the dividend send a signal

about management’s view concerning future
prospects
Factors Affecting Dividend Policy

1. Age of corporation. Age of the corporation

counts much in deciding the dividend policy. A
newly established company may require much
of its earnings for expansion and plant
improvement and may adopt a rigid dividend
policy while, on the other hand, an older
company can formulate a clear cut and more
consistent policy regarding dividend.
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2. Liquidity of Earning. Availability of cash and

sound financial position is also an important
factor in dividend decisions. A dividend
represents a cash outflow, the greater the
earning and the liquidity of the firm the better
the ability to pay dividend. The liquidity of a firm
depends very much on the investment and
financial decisions of the firm. If cash position is
weak, stock dividend will be not distributed and
if cash position is good, company can distribute
the cash dividend.
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3. Extent of share Distribution. Nature of

ownership also affects the dividend decisions.
A closely held company is likely to get the
assent of the shareholders for the suspension
of dividend or for following a conservative
dividend policy. On the other hand, a company
having a good number of shareholders widely
distributed, would face a great difficulty in
securing such assent because they will
emphasize to distribute higher dividend.
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4. Needs for Additional Capital. Companies

retain a part of their profits for strengthening
their financial position. The income may be
conserved for meeting the increased
requirements of working capital or of future
expansion. Small companies usually find
difficulties in raising finance for their needs of
increased working capital for expansion
programs. They having no other alternative, in
using their profits. Thus, such Companies
distribute dividend at low rates and retain a big
part of profits.
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5. Past dividend Rates. While formulating the

Dividend Policy, the directors must keep in
mind the dividend paid in past years. The
current rate should be around the average
past rat. the company should consider the
dividend policy of the rival organization.
Stock Repurchases (Stock Buyback)

 Stock repurchase is when a firm uses its cash

to repurchase some of its own stock.

 This results in a reduction in the firm’s cash

balance as well as the number of shares of
stock outstanding. Firms use one of two
methods to purchase the shares: Open
market repurchase, and tender offer.
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 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
 Information Content of Stock
Repurchases
 Stock repurchases sends a positive signal that
management believes that the current price is
low

 Tender offers send a more positive signal

than open market repurchases because the
company is stating a specific price

 The stock price often increases when

repurchases are announced
Investment or Financing Decision?
Investing Decision
Not really, as stock that is repurchased is held as
treasury stock and does not provide an expected
return like other investments.

Financing Decision
It possesses capital structure or dividend policy
motivations.

For example, a repurchase immediately changes the

debt-to-equity ratio (higher financial leverage).
 Stock Dividends
Stock Dividend -- A payment of additional shares of
stock to shareholders. Often used in place of or in
addition to a cash dividend.

 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%
Example:

 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?
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 $800,000 ($40 x 20,000 new shares)

transferred (on paper) “out of” retained
earnings.
 $100,000 transferred “into” common stock

account.(5x 20,000)
 $700,000 ($800,000 - $100,000) transferred

“into” additional paid-in-capital.

 “Total shareholders’ equity” remains

unchanged at $10 million.

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Stock Split
Stock Split -- An increase in the number of shares
outstanding by reducing the par value of the stock.

 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

 Primarily used to move the stock into a more popular

trading range and increase share demand.
Example
Assume a company with 400,000 shares of $5
par common stock splits 2-for-1. How does
this impact the shareholders’ equity accounts?