Dividend Policy

Dividend Policy
 Passive Versus Active Dividend

Policies
 Factors Influencing Dividend Policy
 Dividend Stability
 Stock Dividends and Stock Splits
 Stock Repurchase
 Administrative Considerations
18.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
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 dividend-
yielding 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
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.
Factors Influencing
Dividend Policy
Other Issues to Consider
Funding Needs of the Firm
Liquidity
Ability to Borrow
Restrictions in Debt Contracts
(protective covenants)
Control
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.
Stock Dividends
and Stock Splits
Stock Dividend – A payment of additional shares
of stock to shareholders. Often used in place of
or in addition to a cash dividend.
Small-percentage stock dividends
 Typically less than 25% of previously
outstanding common stock.
 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?
Small-Percentage
Stock Dividends
Before 5% Stock Dividend
Common stock
($5 par; 400,000 shares) $ 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity $10,000,000
After 5% Stock Dividend
Common stock
($5 par; 420,000 shares) $ 2,100,000
Additional paid-in capital 1,700,000
Retained earnings 6,200,000
Total shareholders’ equity $10,000,000
Stock Repurchase
Stock Repurchase – The repurchase (buyback) of
stock by the issuing firm, either in the open
(secondary) market or by self-tender offer.
Reasons for stock repurchase:
Available for management stock-option plans
Available for the acquisition of other companies
“Go private” by repurchasing all shares from
outside stockholders
To permanently retire the shares

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 Passive Versus Active Dividend

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