CHAPTER TWO

A Review of Dividends
and Dividends Policy
Introduction
 Successful companies earn income. That income can then
be reinvested in operating assets, used to acquire
securities, used to retire debt, or distributed to
stockholders.
 If the decision is made to distribute income to
stockholders, three key issues arise:
1. How much should be distributed?
2. Should the distribution be as cash dividends, or should
the cash be passed on to shareholders by buying back
some of the stock they hold?
3. How stable should the distribution be; that is, should the
funds paid out from year to year be stable and
dependable, which stockholders would probably prefer,
or be allowed to vary with the firms’ cash flows and
investment requirements, which would probably be
better from the firm’s standpoint?
Cont…
 Dividends are that portion of a firm’s net
earnings paid to the shareholders.
 Preference shareholders are entitled to a fixed
rate of dividend irrespective of the firm’s
earnings.
 Equity holders’ dividends fluctuate year after
year. It depends on what portion of earnings is to
be retained by the firm and what portion is to be
paid off.
 As dividends are distributed out of net profits, the
firm’s decisions on retained earnings have a
bearing on the amount to be distributed.
 Retained earnings constitute an important source
of financing investment requirements of a firm.
Cont…
 However, such opportunities should have enough
growth potential and sufficient profitability.
 There is an inverse relationship between these
two–larger retentions, lesser dividends and vice
versa. Thus two constituents of net profits are
always competitive and conflicting.
 Dividend policy has a direct influence on the two
components of shareholders’ return – dividends
and capital gains.
 A low payout and high retention may have the
effect of accelerating earnings growth. Investors of
growth companies realize their money in the form
of capital gains. Dividend yield will be low for such
companies.
Cont…
 The influence of dividend policy on future capital
gains is to happen in distant future and therefore
by all means uncertain.
 Share prices are a reflection of many factors
including dividends. Some investors prefer
current dividends to future gains as prophesied
by an English saying – A bird in hand is worth
two in the bush. Given all these constraints, it is
a major decision of financial management.
Forms of Dividends
 Dividends are distributed in cash, but sometimes they may also
declare dividends in other forms which are discussed below.
1. Cash dividends: Most companies pay dividends in cash. The
investors also, especially the old and retired investors depend
on this form of payment for want of current income.
2. Scrip dividend: In this form of dividends, equity shareholders
are issued transferable promissory notes with shorter maturity
periods which may or may not have interest bearing.
3. Bond dividend: Scrip and bond dividend are the same except
that they differ in terms of maturity.
 Bond dividends carry longer maturity period and bear interest,
whereas scrip dividends carry shorter maturity and may or may not
carry interest.
4. Stock dividend (Bonus shares): Stock dividend is the
distribution of additional shares to the shareholders at no
additional cost. This has the effect of increasing the
number of outstanding shares of the firm.
Important Dates for Cash Dividend Payments
1. Announcement Date: The corporation’s Board
of Directors announces the dividend decision
2. Ex-Dividend Date: the first day the stock
trades without the right to receive the dividend.
3. Record Date: stockholder’s name must appear
as a valid owner of stock on this date in order to
receive the dividend
4. Payment Date: cash dividend payments are
made on this date
 Dividend Theories
 In an effort to find out the optimal dividend policy
different theories and models have been
suggested by various scholars.
 An Optimal Dividend Policy is the dividend policy
that strikes a balance between current dividends
and future growth and maximizes the firm’s stock
price.
1. Traditional Approach:
 Is given by B. Graham and D. L. Dodd.
 States that there is a direct relationship between P/E
ratios and dividend pay-out ratio.
 High dividend pay-out ratio will increase the P/E ratio
and vice versa.
 This may not always be true. A company’s share prices
may rise in spite of low dividends due to other factors.
2. Modern Dividend Theories
I. Dividend Relevance Model
A. Walter Model
 Prof. James E. Walter considers dividend pay-outs are
relevant and have a bearing on the share prices of the
firm.
 Investment policies of a firm cannot be separated
from its dividend policy and both are interlinked.
 The choice of an appropriate dividend policy affects
the value of the firm.
 model clearly establishes a relationship between the
firm’s rates of return r, and its cost of capital k, to give
a dividend policy that maximizes shareholders’ wealth.
 If r>k, the firm’s earnings can be retained as the firm
has better and profitable investment opportunities and
the firm can earn more than what the shareholders could
by re-investing
Cont…
 Firms which have r>k are called ‘growth firms’
and such firms should have a zero payout ratio.
 If r < k, the firm should have a 100% pay-out
ratio as the investors have better investment
opportunities than the firm. Such firms are called
declining firms
 If a firm has a ROI r=k, the firm’s dividend policy
will have no impact on the firm’s value.
 The dividend payouts can range between zero
and 100% and the firm value will remain constant
in all cases. Such firms are called ‘normal
firms’.
 Cont..
Assumptions of Walter’s Model
1. Retained earnings is the only source of finance available
and the firm does not use any external source.
2. Constant rate of return and cost of capital.
3. 100% pay-out or retention.
4. Constant EPS and DPS
5. The firm has a perpetual life.
 Walter’s formula to determine the market price per share
is:
Where: P is the market price per
share
D is the dividend per share,
Ke is the cost of capital,
g is the growth rate of
earnings,
E is Earnings per share,
r is IRR.
Cont..
 Example: The following information relates to
Alpha Ltd.
Equity capitalization rate Ke 11%
Earnings per share $ 10
ROI (r) may be assumed as follows: 15%, 11% and
8%.
 Required: Show the effect of the dividend
policies on the share value of the firm for
three different levels of r, taking the DP ratios
as 0%, 25%, 50%, 75% and 100%.
 Solution
Cont.
Cont..
Limitations of Walter’s Model
1. Applicable only to all equity firms as no
external financing is used
2. Constant r is not a realistic assumption
3. Constant Ke assumption ignores the
business risk of the firm which has a
direct impact on the firm value.
B. Gordon’s Dividend Capitalization Model
 Gordon also contends that dividends are relevant to
the share prices of a firm.
 Myron Gordon uses the Dividend Capitalization
Model to study the effect of the firm’s dividend policy
on the stock price.
 Assumptions:
 An all equity firm:
 No external financing is used (only retained earnings
are used)
 Constant return r
 Constant cost of capital Ke T
 The life of the firm is indefinite.
 Constant retention ratio (b)
 Cost of capital greater than br (growth rate in rate of
return), i.e. Ke>br
 Cont…
 Gordon’s model assumes investors are rational and
riskaverse. They prefer certain returns to uncertain
returns and therefore give a premium to the constant
returns and discount uncertain returns. The
shareholders therefore prefer current dividends to avoid
risk. In other words, they discount future dividends.
 Investors prefer to pay higher price for stocks which
fetch them current dividend income.
 Gordon’s model can be symbolically expressed as:
Where: P is the price of the share,
E is Earnings Per Share,
b is Retention ratio,
(1 – b) is dividend payout ratio
Ke is cost of equity capital,
br is growth rate in the rate of
return on investment.
Cont..
 Example: Given Ke as 11%, E is $ 10, calculate
the stock value of Mahindra Tech. for (a) r=12%,
(b) r=11% and (c) r=10% given the following
dividend pay out ratios
Cont..
Solutions: Case I r>ke ( r=12%, Ke=11%)
Cont…
Cont..
Cont…
 Interpretation: Gordon is of the opinion that
dividend decision does have a bearing on the
market price of the share.
1. When r>k, the firm’s value decreases with an
increase in payout ratio. Market value of share
is highest when DP is least and retention
highest.
2. When r=k, the market value of share is
constant irrespective of the DP ratio. It is not
affected whether the firm retains the profits or
distributes them.
3. When r<k, market value of share increases with
an increase in DP ratio.
II. Dividend Irrelevance Model
Miller and Modigliani Model.
 The MM hypothesis seeks to explain that a firm’s
dividend policy is irrelevant and has no effect on the
share prices of the firm.
 This model advocates that it is the investment policy
through which the firm can increase its share value and
hence this should be given more importance.
Assumptions of the Model
a. Existence of perfect capital markets: All investors are
rational and have access to all information free of cost
b. No taxes: There are no taxes, implying there is no
difference between capital gains and dividends.
c. Constant investment policy: The investment policy of the
company does not change. The implication is that there is
no change in the business risk position and the rate of
return.
d. No floatation costs: These costs ordinarily account to around
10%-15% of the total issue and they cannot be ignored.
Cont..
e. No transaction costs
f. Under-pricing of shares: If the company has to
raise funds from the market it should sell shares
at a price lesser than the prevailing market price
to attract new shareholders. This follows that at
lower prices, the firm should sell more shares to
replace the dividend amount.
Factors Influencing Dividend Policy
 Factors that affect the dividend policy may be
grouped into four categories
a. constraints on dividends payments,
b. investment opportunities,
c. availability and cost of alternative sources of
capital, and
d. effects of dividend policy on the cost of capital.
1. Bond indentures (agreements): debt contracts
often limit dividends payment to earnings
generated after the loan was granted.
2. Preferred stock restrictions: typically, common
dividends cannot be paid if the company has
omitted its preferred dividend.
 The preferred rearranges must be satisfied before
common dividends can be resumed.
Cont..

3. Impairment of capital rule: Dividend

payments cannot exceed the balance sheet item
“retained earnings”.
 This legal restriction, known as the impairment
of capital rule, is designed to protect creditors.
 Without the rule, a company that is in trouble
might distribute most of its assets to
stockholders and leave its debt holders out in the
cold.
4. Availability of cash: cash dividends can be
paid only with cash.
 Thus, a shortage of cash in the bank can restrict
dividend payments; however, the availability to
borrow can offset this factor.
Cont.…
6. Cost of selling new stock: If flotation costs are high, that
will increase the cost of capital, making it better to set a low
pay-out ratio and to finance through retention rather than
through sale of new common stock.
 On the other hand, a high dividend payout ratio is more
feasible for a firm whose flotation costs are low.
7. Ability to substitute debt for equity: A firm can finance a
given level of investment with either debt or equity.
 If the firm can adjust its debt ratio without raising costs
sharply, it can pay the expected dividend, even if earnings
fluctuate, by using a variable debt ratio.
8. Control: If management is concerned about maintaining
control, it may be reluctant to sell new stock; hence the
company may retain more earnings than it otherwise would.
 However, if stockholders want higher dividends and a proxy
fight looms, then the dividend will be increased.
(Reading Assign: Discuss real world factors favoring firms
a high or low dividend pay out policies)
Stability of Dividends and Other Issues in Dividend Policy
Stability of Dividends
 Stability of dividends is the consistency in the
stream of dividend payments.
 It is the payment of certain amount of minimum
dividend to the shareholders.
 The steadiness is a sign of good health of the
firm and may take any of the following forms
1. Constant dividend per share: a firm pays a
fixed amount of dividend per share year after
year.
 A firm following such a policy will continue
payments even if it incurs losses.
2. Constant DP ratio: the firm pays a constant
percentage of net earnings to the shareholders.
Cont..
3. Constant dividend per share plus extra
dividend;
A firm usually pays a fixed dividend ordinarily and
in years of good profits, additional or extra dividend
is paid over and above the regular dividend.
Advantages of Stability of Dividends
a. Build confidence amongst investors
b. Investors’ desire for current income
c. Information about firm’s profitability:
d. Institutional investors’ requirements:
Institutional investors like MFs prefer to invest
in companies which have a record of stable DP.
e. Ease of Raising additional finance
f. Stability in market price of shares
Other Dividend Policy Issues
Information Content, Or Signaling, Hypothesis
 The MM dividend irrelevance theory assumed that
everyone (investors and managers) have identical
information regarding the firm’s future earnings and
dividends.
 In reality, however, different investors have different
views on both the level of future dividend payments
and the uncertainty inherent in those payments, and
managers have better information about future
prospects than public stockholders.
 MM argued that a higher-than-expected dividend
increase is a “signal” to investors that the firm’s
management forecasts good future earnings.
Conversely, a dividend reduction, or a smaller-than-
expected increase, is a signal that management is
forecasting poor earnings in the future.
Cont..
Thus, MM argued that investors’ reactions to
changes in dividend policy do not necessarily
show that investors prefer dividends to
retained earnings.
Rather, they argue that price changes
following dividend actions simply indicate
that there is an important information, or
signaling, content in dividend
announcements.
Information Content (Signaling) Hypothesis states
that investors regard dividend changes as signals of
management’s earnings forecasts.
Cont..
Clientele Effect
 Different groups, or clienteles, of stockholders
prefer different dividend payout policies.
 For example, investors who want current
investment income should own shares in high
dividend payout firms, while investors with no
need for current investment income should own
shares in low dividend payout firms.
 MM and others have argued that one clientele is
as good as another, so the existence of a
clientele effect does not necessarily imply that
one dividend policy is better than any other.
 The Clientele Effect is the tendency of a firm to
attract a set of investors who like its dividend
policy.
Establishing the Dividend Policy in Practice
 How should a firm determine the specific
percentage of earnings that it will pay out as
dividends?
 The steps that a typical firm takes when it
establishes its target payout ratio are discussed
below.
Setting the Target Payout Ratio:
 The Residual Dividend Model
 Two points should be kept in mind:
1. The overriding objective is to maximize shareholder
value, and
2. The firm’s cash flows really belong to its
shareholders, so management should refrain from
retaining income unless they can reinvest it to
produce returns higher than shareholders could
themselves earn by investing the cash in
Cont….
 Given the fact that retained earnings are cheaper than
external equity (common stock), firms are encouraged
to retain earnings because they add to the equity base,
increase debt capacity, and thus reduce the likelihood
that the firm will have to issue common stock at a later
date to fund future investment projects.
 Dividend payouts and dividend yields varies
considerably among corporations
 Eg. Utility and financial service companies vs computer
and TV producing companies.
 If a firm wishes to avoid new equity sales, then it will
have to rely on internally generated equity to finance
new positive NPV projects.
 Dividends can only be paid out of what is left over. This
leftover is called the residual, and such a dividend
policy is called a residual dividend approach.
Cont..
 With a residual dividend policy, the firm’s objective
is to meet its investment needs and maintain its
desired debt-equity ratio before paying dividends.
 Eg. imagine that a firm has an after tax earnings of
$1000 and has a debt-equity ratio of .50. A debt-
equity ratio of .50 means that the firm has 50 cents
in debt for every $1.50 in total value. The firm’s
capital structure is thus 1/3 of debt and 2/3 of
equity.
 The first step in implementing a residual dividend
policy is to determine the amount of funds that can
be generated without selling new equity.
 The second step is to decide whether or not a
dividend will be paid. To do this, we compare the
total amount that can be generated without selling
new equity to planned capital spending.
Cont…
If funds needed exceed funds available, then
no dividend will be paid. In addition, the firm
will have to sell new equity to raise the
needed financing or else.
If funds needed are less than funds
generated, then a dividend will be paid. The
amount of the dividend will be the residual,
that is, that portion of the earnings that is not
needed to finance new projects.
Cont…
A Compromise Dividend Policy
In practice, many firms appear to follow what
amounts to a compromise dividend policy.
Such a policy is based on five main goals:
1. Avoid cutting back on positive NPV projects
to pay a dividend.
2. Avoid dividend cuts.
3. Avoid the need to sell equity.
4. Maintain a target debt-equity ratio.
5. Maintain a target dividend payout ratio
 These goals are ranked more or less in order
of their importance.
 In our strict residual approach, we assume
that the firm maintains a fixed debt-equity
ratio.
Cont…
Under the compromise approach, the debt-
equity ratio is viewed as a long-range goal. It
is allowed to vary in the short run if
necessary to avoid a dividend cut or the need
to sell new equity.
Repurchases of Shares.
 When a firm wants to pay cash to its
shareholders, it normally pays a cash
dividend. Another way is to repurchase its
own stock i.e. a firm can pay cash to its
shareholders by a repurchase of its own stock
from the shareholders as an alternative to
paying cash dividend.
Cont…
Advantages of Stock Repurchases
 Repurchase announcements are viewed as
positive signals by investors.
 Stockholders have a choice when a firm
repurchases stocks: They can sell or not sell.
 Dividends are sticky in the short-run because
reducing them may negatively affect the stock
price. Extra cash may then be distributed
through stock repurchases.
 The target payout ratio may be achieved with
the help of repurchases.
Cont..
 Stockholders may not be indifferent between
dividends and capital gains.
 The selling stockholders may not be fully aware of
all the implications of a repurchase. 
 The corporation may pay too much for the
repurchased stocks.
Stock Split and Reverse Stock Split
 A stock split is a method to increase the number
of outstanding shares by proportionately
reducing the face value of a share.
 A stock split affects only the par value and does
not have any effect on the total amount
outstanding in share capital. The reasons for
splitting shares are:
Cont..
 To make shares attractive by reducing the market
price of the share
 Indication of higher future profits:
 Higher dividend to shareholders
There is also the Reverse Stock Split. Imagine
holding $100 of stock; comprised of 10 shares
worth $10 each. Assume that the firm issues a 1
for 10 reverse stock split. You now hold one share
of stock that is worth $100.
It is often interpreted as a sign of management
pessimism about the future, since a reverse split
is the exact opposite of the conventional stock
split that was discussed above (managers don’t
feel that any future good news will increase the
stock price).
END OF CHAPTER TWO
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