Dividend Policy - Corporate Finance

Factors Affecting Dividend Policy

- Firm's Growth Prospects - Owner Considerations - Market Considerations - Legal Constraints - Contractual Constraints

Dividend Payout Procedures

1st: At quarterly or semi-annual meetings, a firm's board of directors determine if dividends are to be paid and the amount to be paid. 2nd: If a firm has started paying dividends a precedent has been set. Firms rarely break this precedent by discontinuing the payment of dividends. Firms ONLY DISCONTINUE the payment of dividends when they believe the firm's ability to generate cash is in serious jeopardy. Board members of firms that have already set a precedent of paying dividends and believe the firm can continue generating cash flow in the future usually consider whether to continue paying the current dividend, decrease or increase the dividend. 3rd: Once a firm's directors declare a dividend a statement is issued indicating the dividend amount and three important dates: the date of record, the ex-dividend date, and the payment date. These stockholders are often referred to as holders of record.

Irrelevance Theory of Dividends

Modigliani and Miller posit that in a perfect world (i.e. perfect information, no taxes, no transaction costs, and no other imperfections) firm's value is determined solely by earning power and risk of its assets or investment. Firm value is NOT DETERMINED by the manner in which the firm splits its earnings between dividends and internally retained funds. As a result of this, firms will prefer to retain funds to reinvest. In a less perfect world where dividends are taxed a CLIENTELE EFFECT may occur (i.e. investors seeking dividends may choose to invest in companies that pay). This, however, still DOES NOT affect firm value.

Stock Price Reactions to Corporate Payouts

When firms pay dividends: Market Price per share SHOULD FALL by the dividend per share paid. Market price of shares SHOULD FALL because assets of the firm would decrease by the amount of dividend paid, while the stock outstanding remains the same. The payment of the dividend will lead to a reduction in stock price because dividend paid means that cash held by the firm is NOW in the hands of the owners. When firms repurchase shares: Market prices remain unchanged because of the reduction in cash is offset by the reduction in the number of shares oustanding.

What is Dividend?

a sum of money paid regularly by a company to its shareholders out of its profits.

Impact of Dividend on Share Price

after the declaration of a stock dividend, the stock's price often increases. However, because a stock dividend increases the number of shares outstanding while the value of the company remains stable, it dilutes the book value per common share, and the stock price is reduced accordingly.

Legal Constraints

firms are unable to pay out as cash dividends any portion of the firm's legal capital (i.e. the par value of the common stock) or even the paid-in capital in excess of par. These constraints are meant to provide a sufficient equity base to protect creditors' claims. Firms that have overdue liabilities or is legally insolvent or bankrupt are prohibited from paying cash dividends.

Market Considerations

firms cater to the preferences of investors. During economic booms and bullish markets (i.e. rising stock market prices) investors prefer capital gains and may not need large dividends but during bearish markets (i.e. falling stock markets), investors may seek dividend payments.

Open-Market Share Repurchase

firms repurchase some of their outstanding shares on the open market. Firms can use their discretion to do this. Some firms may purchase fixed amounts at regular intervals. Other firms may only choose to repurchase shares when they believe share market price is relatively low.

Dutch Auction Repurchase

firms specify the amount of shares they are interested in repurchasing and provide a range of share prices that they are willing to pay. Investors respond by specifying the amount of shares they are willing to sell at any of the prices within the range. Firms can use this information to estimate demand for the stock and can thus determine the minimum price required to repurchase the desired quantity of shares. All shareholders who tendered receive the minimum price.

Tender Offer Repurchase

firms usually make an offer to repurchase a stipulated amount of shares at a specific price by a particular date. The price offered by the firm is usually much higher than the market price of the share. If shareholders DO NOT subscribe the repurchase offer the firm may cancel the offer or extend. Alternatively, if the offer is oversubscribed the firm will repurchase on a pro-rate basis (i.e. proportionally).

Firm's Growth Prospects

firms who are in the growth phase may rely heavily on retained earnings, while a mature or more established firm will not rely as heavily on retained earnings as it may have access to debt, would have accumulated a large amount of retained earnings and could afford to distribute some as dividends.

Owner Considerations

if a firm pays out a high percentage of earnings from retained earnings then new equity capital will have to be raised to finance future projects.

Contractual Constraints

restrictive provisions in loan agreements may prohibit the payment of cash dividends, or limit dividends to a certain dollar amount, or percentage of earnings until the firm achieves a certain level of earnings.

Informational Content Theory

states that investors view an increase in dividends as a positive signal so they bid up the share price. A decrease in dividends is viewed as a negative signal so investors sell their shares which thus results in a decrease in share price.

Agency Cost Theory

states the shareholders are aware that managers may not seek their best interest and thus worry that retained earnings may not be invested wisely. Firm that commit to paying dividends reassure shareholders that managers will not waste their money. Shareholders are therefore willing to pay higher prices for firms that promise regular dividend payments.

Dividend Reinvestment Plans (DRIPs)

these are plans that allow stockholders to use dividends received to purchase additional shares (even fractional shares) at little or no transaction cost. Some companies even allows persons to make the purchases directly from the company without using a broker.

Date of Record

this date is important because all persons whose names are recorded as stockholders ON THIS DATE will receive the declared dividend at a specified time in the future. This date is set by a firm's board of directors.

Ex-Dividend Date

this date is two business days BEFORE the date of record. Persons purchasing stock during this period (i.e. period between ex-dividend date and date of record WILL NOT receive the declared dividend).

Payment Date

this is the date on which the firm mails the dividend payment to the holders of record (i.e. the person whose names were recorded as stockholders on the date of record).

Stock Split

this is used to lower the market price of a firm's stock by increasing the number of shares belonging to each shareholders. A 2-for-1 stock split means we are replacing every one share with two new shares. Each share is now worth half the value of each old share (the inverse).

What is Dividend Payout Policy?

this refers to the firms' decisions concerning the distribution of dividend to shareholders, the amount of dividend to be paid, the means by which cash should be distributed (i.e. dividend payment, share repurchase).

Residual Theory of Dividends

this school of thought posits that firms pay dividends only when there is money left over after ALL acceptable investment opportunities have been undertaken

Relevance Theory of Dividends

this theory posits that dividend payment influences firm value. Two key advocates of the dividend relevance theory are Gordon and Lintner. They both suggest that there is a direct relationship between the firm's dividend policy and its market value. Gordon and Lintner asset that current dividend payments reduce investor uncertainty causing investors to discount the firm's earnings at a lower rate and thus place a higher value on the firm's stock. The opposite is also true. This is known as the Birth-in-the-hand Argument. Informational Content refers to dividend payment and non-payment, they are interpreted by investors as a signal of management's expectations of future earnings.