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Dividend Policy

©2006 Thomson/South-Western

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Introduction

This chapter examines the factors that

influence a company’s choice of

dividend policy.

Pros and cons of dividend policies

Mechanics of dividend payments

Stock dividends

Share repurchase plans

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Influencing the Value of the Firm

Investment Decisions Determine the level of future earnings and future

potential dividends Financing Decisions

Influence the cost of capital, which can determine the number of acceptable investment opportunities

Dividend Decisions Influence the amount of equity capital in a firm’s

capital structure and the cost of capital

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Determinants of Dividend Policy Variations in payout Legal constraints Restrictive covenants Tax considerations Liquidity and CF

considerations Borrowing capacity

Access to capital markets

Earnings stability Growth prospects Inflation Shareholder preference Protection against

dilution

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Irrelevance of Dividends Assumptions

No taxes No Transactions costs No Issuance costs Fixed investment policy

Wealth of a shareholder is not affected by dividend policy.

Dividend can have informational content.

Signaling effect Clientele effect

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Relevance of Dividends

Assumptions

Relaxed assumptions and dividend policy

becomes important.

Risk aversion

Transaction costs

Taxes

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Relevance of Dividends

Issuance (Flotation) costs

Agency costs

Empirical evidence is mixed.

Many practitioners believe that dividends

are important. Informational content

Expensive external equity

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Passive Residual Policy

Suggests that a firm should retain its earnings as long as it has investment opportunities that promise higher rates of return than the required rate.

Dividends can fluctuate significantly. Depends on the firm’s investment

opportunities In practice, dividends can be smoothed. Growth firms will have low-dividend

payouts.

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Stable Dollar Dividend Policies Reluctance to reduce dividends Increases in dividends tend to lag

earnings. Desirability

Information content Many shareholders depend on dividends. Stability tends to reduce uncertainty. Legally desirable

Legal list

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Other Dividend Payment Policies Constant Payout Ratio

Pays a constant percent of earnings as dividends Fluctuating dividends

Small Regular Dividends Plus Extras Stockholders can depend on regular payout. Accommodates changing earnings and investment

requirements Small Firms and Dividends

Tend to pay out a smaller percent of earnings Rapid growth and limited access to capital markets

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Multinational Firms & Dividends Primary means of transferring funds to

parent company

Tax

Foreign Exchange

Political risk

Funds availability

Financing needs

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How are Dividends Paid ?

Declaration Date Board of directors announce a dividend.

Record Date Shareholders of record will receive dividends.

Ex-dividend Date 2 business days before record date

Stock trades ex-dividends

Payment Date 4 weeks after the record date

Dividend checks mailed or direct deposited

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Dividend Reinvestment Plan Cash dividend reinvested automatically

into additional shares

Purchase new or existing shares

Purchasing new shares raises new equity

capital for the firm.

No brokerage commissions

Income tax liability

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Information on Dividend Reinvestment Do a search on the Internet for dividend

reinvestment. Check out the various reinvestment plans.

Check out CSX Corporation’s dividend reinvestment plan:http://www.csx.com/docs/dividprx.html

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Stock Dividends: Payment of additional shares of C/S Stock splits are similar to stock dividends. Increases the number of shares

outstanding Accounting transaction

Transfer pre-dividend market value from retained earnings to other stockholders equity

Market price of C/S should decline in proportion to the number of new shares issued.

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Reasons for Declaring a Stock Dividend Broaden the ownership of the firm’s

shares May result in an effective increase in cash

dividends Provided the level of cash dividends is not

reduced Reduction in share price may broaden the

appeal of the stock to investors. Resulting in a real increase in market value

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Stock Repurchase

By a tender offer in the open market

or by negotiation with large holders

Treasury stock

Reduces the number of shares

outstanding

Increases EPS

Usually announced

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Stock Repurchase

Advantages Converts dividend

income into capital

gains

Greater financial

flexibility

Timing

Signal effect

Disadvantages Company may overpay

for the stock

Trigger IRS scrutiny

Tax avoidance

Some current

stockholders may be

unaware