Chapter 5

Dividends and
dividend policy
Instructor: Dr. Venkata Krishna
Reddy
 Key Concepts and Skills
 Understand dividend types and how
they are paid
 Understand the issues surrounding
dividend policy decisions
 Understand the difference between
cash and stock dividends
 Understand why share repurchases
are an alternative to dividends

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 Content Outline
5.1 Dividend and Dividend Policy
5.2 Determinants of Dividend Policy
5.3 Cash Dividends and Dividend Payment
5.4 Does Dividend Policy Matter?
5.5 Some Real-World Factors Favoring a
Low and High Payout
5.6 A Resolution of Real-World Factors
5.7 Stock Repurchase: An
Alternative to Cash Dividends
5.8 Stock Dividends and Stock Splits
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 5.1 Dividend and Dividend Policy
Meaning of Dividend
 The term dividend refers to that part of the earnings
(Profits) of a company which is distributed among its
shareholders on the basis of their shareholding. It is
the reward to the shareholders from their
investments made by the company.
 Generally the shareholders would prefer to receive
higher rate of dividend in or to achieve their capital
appreciation.
 But the company would prefer to retention of profit as
a desirable decision because it provide funds for
financing the expansion and growth of the firms.
 Regular cash dividend – cash payments made directly
to stockholders, usually each quarter.
 Extra cash dividend – indication that the “extra”
amount may not be repeated in the future.
 Special cash dividend – similar to extra dividend, but4
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 5.1 Dividend and Dividend Policy
Dividend Policy
 Most of the companies to follow certain principles for
the declaration of dividend. But dividend should be
declared only out of divisible profit. If the company
incur loss at any particular year it should not be
distributed dividend in that year.
 Dividend policy means it is the policy of the
company with regard to quantum of profits to be
distributed as dividend. The basic concept of the
dividend policy is that the company desires and take
any future action regarding the payment of dividend
with help of the company law board.
 According to Weston and Brighan define dividend
policy as “Dividend policy determines the division of
earnings between payment to shareholders and
retained earnings ( Company to be reinvested in its core business,
or to pay debt).
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 5.2 Determinants of Dividend Policy
Determinants of Dividend Policy
 The payment of dividend actually involves some
legal as well as financial consideration. The following
are the important factors which determine the
dividend policy of a firm.
 Legal Restrictions: Business organization must be
legally restricted from the declaration and payment
of dividend.
√ Dividends can be paid only out of current profits of the
company or past years accumulated profits.
√ Dividends could not be paid out of capital
 General state of economy: During the periods of the
economic depression the company must maintain large sums of
money as reserves in order to meet out liquidity position of the
company.
 Age of the Company: The age of the company must decide the
dividend policy of the concern. If newly established
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 5.2 Determinants of Dividend Policy
Determinants of Dividend Policy
 Nature of Industry: Industries with steady market
can declare a higher rate of dividends while cyclical
industries should follow a lower rate of dividends
policy.
 Government Policy: Time to time Government announces
policies with regard to the business and capital market straight
away it affect the profit earning capacity of the firm.
 State of Capital Market: Suppose the firm realise difficult to raise
resources from the capital market because of either weak
financial position or unfavourable conditions in the capital
market. So the movement of capital market is greatly influenced
in the determination of rate of dividend.
 Past year Dividend Rate: Whenever the company formulate the
dividend policy, the directors of the company must consider the
dividend paid in past several years. The current dividend rate
should be calculated as the average of past years rates.
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 5.2 Determinants of Dividend Policy
Determinants of Dividend Policy
 Stability of Dividends: Stable dividend rate is one of
the important factor for formulating dividend policy.
Irrespective of the profitability of the company it
may declare constant rate of dividends.
Automatically that should be establish the reputation
of the company among the shareholders.
 Taxation Policy: If the Government announces the high rate of
taxation it may reduce the earnings of the company and
consequently the company shall declare only lower rate of
dividend.
 Liquid Resources: A company earns a good profit but it could not
be announce a dividends to the shareholders because of
insufficient liquid resources.
 Restrictions by Lenders: Lenders especially financial institution,
banks may impose certain restriction on payment of dividend to the
shareholders in order to protect their own interest. Based upon
these restrictions the companies may retain huge amount of profits 8
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 5.3 Cash Dividends and Dividend
Payment
Cash Dividends
 Dividend is paid to the shareholders in the form of
cash is called cash dividend. The usual practice
followed by the company is to pay dividend in cash
four times a year (quarter). It results in out flow of
fund from the firm. Hence the firm should maintain
adequate cash resources for payment of cash
Standard Method of Cash Dividend Payment
dividend.
 The decision to pay a dividend rests in the hands of
the board of directors of the corporation. When a
dividend has been declared, it becomes a debt of
the firm and cannot be rescinded easily. Sometime
after it has been declared, a dividend is distributed
to all shareholders as of some specific date.
 Commonly, the amount of the cash dividend is
expressed in terms of dollars per share (Dividend per
share). 12/15/2024 9
 5.3 Cash Dividends and Dividend
Payment
Dividend Payment
 Declaration Date – The date on which the
board of directors passes a resolution to
pay a dividend.
 Ex-dividend Date
Occurs two business days before date of
record
If you buy stock on or after this date, you
will not receive the dividend
Stock price generally drops by about the
amount of the dividend
 Date of Record – Holders of record are
determined and they will receive the
dividend payment 12/15/2024 10
 5.3 Cash Dividends and Dividend
Payment
Dividend Payment

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 5.4 Does Dividend Policy Matter?
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
Illustration of Irrelevance
 Consider a firm that can either pay out dividends of
$10,000 per year for each of the next two years or
can pay $9,000 this year, reinvest the other $1,000
into the firm and then pay $11,120 next year.
Investors require a 12% return.
 Market Value with constant dividend = $16,900.51
 Market Value with reinvestment = $16,900.51
 If the company will earn the required return,
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 5.5 Some Real-World Factors Favoring a Low and
High Payout
Low Payout Please
 Why might a low payout be desirable?
 Individuals in upper income tax brackets might prefer lower
dividend payouts, given the immediate tax liability, in favor of
higher capital gains with the deferred tax liability
 Flotation costs – low payouts can decrease the amount of
capital that needs to be raised, thereby lowering flotation costs
 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 that need current income, i.e. retirees
 Groups that are prohibited from spending principal (trusts and endowments)
 Uncertainty resolution – no guarantee that the higher future dividends
will materialize
 Taxes: Dividend exclusion for corporations
 Tax-exempt investors don’t have to worry about differential treatment
between dividends and capital gains 13
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 5.6 A Resolution of Real-World Factors
Dividends and Signals
 Asymmetric information – managers have more
information about the health of the company than
investors
 Changes in dividends convey information
Dividend increases
 Management believes it can be sustained
 Expectation of higher future dividends, increasing present value
 Signal of a healthy, growing firm
Dividend decreases
 Management believes it can no longer sustain the current level
of dividends
 Expectation of lower dividends indefinitely; decreasing present
value
 Signal of a firm that is having financial difficulties

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 5.6 A Resolution of Real-World Factors
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
Implications of the Clientele Effect
 What do you think will happen if a firm
changes its policy from a high payout to a
low payout?
 What do you think will happen if a firm
changes its policy from a low payout to a15
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 5.6 A Resolution of Real-World Factors
Dividend Policy in Practice
 Residual dividend policy
 Constant growth dividend policy – dividends
increased at a constant rate each year
 Constant payout ratio – pay a constant
percent of earnings each year
 Compromise dividend policy

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 5.6 A Resolution of Real-World Factors
Residual Dividend Policy
 Determine capital budget
 Determine target capital structure
 Finance investments with a combination of debt
and equity in line with the target capital
structure
 Remember that retained earnings are equity
 If additional equity is needed, issue new shares
 If there are excess earnings, then pay the
remainder
Example out inDividend
– Residual dividends
Policy
 Given  Finding dividend
 Need $5 million for new 40% financed with debt (2 m)
investments 60% financed with equity (3m)
 Target capital structure: NI – equity financing = $1 million,
D/E = 2/3 paid out as dividends 17
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 5.6 A Resolution of Real-World Factors
Compromise Dividend Policy
 Goals, ranked in order of importance
Avoid cutting back on positive NPV projects to
pay a dividend
Avoid dividend cuts
Avoid the need to sell equity
Maintain a target debt/equity ratio
Maintain a target dividend payout ratio
 Companies want to accept positive NPV
projects, while avoiding negative signals

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 5.7 Stock Repurchase: An Alternative
to Cash Dividends
Stock Repurchase
 Company buys back its own shares of stock
 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
 This is another argument for dividend policy
irrelevance in the absence of taxes or other
imperfections
Real-World Considerations
 Stock repurchase allows investors to decide if they
want the current cash flow and associated tax
consequences
 In our current tax structure, repurchases may be
more desirable due to the options provided
stockholders 12/15/2024 19
 5.7 Stock Repurchase: An Alternative
to Cash Dividends
Information Content of Stock Repurchases
 Stock repurchases send 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
Example:
 The stockRepurchase
price oftenAnnouncement
increases when repurchases
are announced
“America West Airlines announced that its Board of Directors
has authorized the purchase of up to 2.5 million shares of its
Class B common stock on the open market as circumstances
warrant over the next two years …
“Following the approval of the stock repurchase program by
the company’s Board of Directors earlier today. W. A. Franke,
chairman and chief officer said ‘The stock repurchase program
reflects our belief that America West stock may be an
attractive investment opportunity for the Company, and it
underscores our commitment to enhancing long-term
shareholder value.’
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 5.8 Stock Dividends and Stock Splits
Stock Dividends
 Pay additional shares of stock instead of cash
 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
Stock
Large stock dividend – more than 20 to 25%
Splits
 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
 Common explanation for split is to return
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 Review Questions
 What are the different types of dividends and how is a
dividend paid?
 What is the clientele effect and how does it affect
dividend policy relevance?
 What is the information content of dividend changes?
 What is the difference between a residual dividend
policy and a compromise dividend policy?
 What are stock dividends and how do they differ from
cash dividends?
 How are share repurchases an alternative to dividends
and why might investors prefer them?

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End of
Chapter-5