1. MBA 656: ADVANCED FINANCIAL
MANAGEMENT
DIVIDEND POLICY

2. What are Dividends?
 Dividends are corporate distributions to its shareholders
proportionate to the number of shares held by the latter.
Dividends may be in the form of cash dividends, bonus
issue (stock dividends), and property dividends.
 A dividend is a distribution of corporate income to its
shareholders on a pro rata basis. Potential buyers and
sellers of a corporation’s shares are keenly interested in a
company’s dividends policies and practices. Dividends are
distributed out of accumulated earnings of the corporation
except of a liquidating dividend which represents a return
to the shareholders of their investment.

3. Types of Dividends
Type
Form of Payment
Cash Dividends
Cash
Stock Dividends
Shares of stock
Property Dividends
Non-cash assets
Scrip / Liability
Dividends
Notes or other evidence
corporate indebtedness

4. Relevant Dates
 Date of Declaration
Date when the board of directors (BOD) formally approves and
announces the dividend. Reduction in RE is recognized in the
accounts.
 Date of Record
Set by the BOD, the date on which all persons whose names are
recorded as stockholders will receive a declared dividend at a
specified future time. No entry made on this date.
 Date of Payment
Set by the BOD, the actual date on which the payment of dividend
is made. Entry is made on this date to record the settlement of
dividend.

5. Dividend Payment Timeline

6. Entries made:
Assuming there are 50,000 outstanding shares as of date of record:

7. Tax Treatment of Dividends

8. Dividend Reinvestment Plans (DRIPs)
 Enable stockholders to use dividends received on the firm’s
stock to acquire additional shares, even fractional shares, at
little or no transaction cost.
 With DRIPs, plan participants typically can acquire shares at
about 5% below the prevailing market price.
 From its point of view, the firm can issue new shares to
participants more economically.

9. Is it
relevant to
have a
Dividend
Policy?

10. Residual Theory of Dividends
 A school of thought that suggests that the dividend
paid by a frim should be viewed as a residual -- the
amount left over after all acceptable investment
opportunities have been undertaken.
 Suggests that the required return of investors is not
influenced by the firm’s dividend policy – a premise
that in turn implies that dividend policy is irrelevant.

11. Three Steps in Making a Dividend Decision:
STEP 1: Determine the optimal level of capital
expenditures, which would be the level generated by
the point of intersection of the investment
opportunities schedule (IOS) and weighted marginal
cost of capital (WMCC) (as discussed in ‘The Cost of
Capital’)

12. STEP 2: Estimate the total amount of equity financing
needed to support the expenditures generated in Step
1using the optimal capital structure proportions (as
discussed in ‘Leverage & Capital Structure’)

13. STEP 3: Because the cost of retained earnings is less
than the cost of new common stock, use retained
earnings to meet the equity requirement determined
in Step2. If retained earnings are inadequate to meet
this need, sell common stock. If the available retained
earnings are in excess of this need, distribute the
residual as dividends.

14. Sample analysis:

15. Dividend Irrelevance Theory
By Merton H Miller and Franco Modigliani
Suggests that in a perfect world, the firm’s value is
determined solely by the earning power and risk of its
assets (investments) and that the manner in which it
splits its earnings stream between dividends and
internally retained (and reinvested) funds does not affect
this value.

16. Dividend Relevance Theory
By Myron J. Gordon and John Lintner
There is a direct relationship between a firm’s dividend
policy and its market value.
“A bird in the hand is worth two in the bush”

17. What is a Dividend Policy?
The firm’s plan of action to be
Followed whenever a dividend
decision is made.

18. Factors Affecting Dividend Policy
 Legal Constraints
 Contractual Constraints
 Internal Constraints
 Growth Prospects
 Owner Considerations
 Market Considerations

19. Types of Dividend Policies
 Constant-Payout-Ratio Dividend Policy
 Regular Dividend Policy
 Low-Regular-and-Extra Dividend Policy

20. Constant-Payout-Ratio Dividend Policy
• A dividend policy based on the payment of a certain
percentage of earnings to owners in each dividend
period
• Dividend payout ratio – indicates the percentage of each
dollar earned that is distributed to the owners in the
form of cash. It is calculated by dividing the firm’s cash
dividend per share by its earnings per share (EPS)

22. Regular Dividend Policy
 A dividend policy which is based on the payment of a
fixed-rate dividend in each period. This policy provides
the owners with generally positive information, thereby
minimizing their uncertainty. Often, firms that use this
policy increase the regular dividend once a proven
increase in earnings has occurred. Under this policy,
dividends are almost never increased.

23. • Often a regular dividend policy is built around a target
dividend-payout ratio.
• Target Dividend-Payout ratio is a dividend policy under
which the firm attempts to payout a certain percentage
of earnings as a stated dollar dividend and adjusts that
dividend toward a target payout as proven earnings
increases occurs.

24. Low-Regular-and-Extra Dividend Policy
 A dividend policy based on paying a low regular dividend,
supplemented by an additional dividend when earnings
are higher than normal in a given period.
 An extra dividend optionally paid by the firm if earnings
are higher than normal in a given period.

25. Stock Dividends
 A stock dividend is the payment, to existing owners, of a
dividend in the form of stock.
 Accounting Aspects – the payment of a stock dividend is a
shifting between stockholders’ equity accounts rather
than an outflow of funds.
A small stock dividend is a stock dividend that represents
less than 20 to 25% of the common stock

26. Other Forms of Dividends:
Stock Dividends
A stock dividend is paid in stock rather than in cash.
Many investors believe that stock dividends increase the value of their holdings.
In fact, from a market value standpoint, stock dividends function much like stock
splits. The investor ends up owning more shares, but the value of their shares is
less.
From a book value standpoint, funds are transferred from retained earnings to
common stock and additional paid-in-capital.

27. Other Forms of Dividends:
Stock Dividends (cont)
Accounting Aspects
The current stockholder’s equity on the balance sheet
of Garrison Corporation, a distributor of prefabricated
cabinets, is as shown in the following accounts.

28. Other Forms of Dividends:
Stock Dividends (cont)
Accounting Aspects
If Garrison declares a 10% stock dividend and the
current market price of the stock is $15/share, $150,000
of retained earnings (10% x 100,000 shares x
$15/share) will be capitalized.
The $150,000 will be distributed between the common
stock (par) account and paid-in-capital in excess of par
account based on the par value of the common stock.
The resulting balances are as follows

29. Other Forms of Dividends:
Stock Dividends (cont)
Accounting Aspects
Because 10,000 new shares (10% x 100,000) have
been issued at the current price of $15/share,
$150,000 ($15/share x 10,000 shares) is shifted
from retained earnings to the common stock and
paid-in-capital accounts.

30. Other Forms of Dividends:
Stock Dividends (cont)
The Shareholder’s Viewpoint
– From a shareholder’s perspective, stock dividends result in a
dilution of shares owned.
– For example, assume a stockholder owned 100 shares at $20/share
($2,000 total) before a stock dividend.
– If the firm declares a 10% stock dividend, the shareholder will have
110 shares of stock. However, the total value of her shares will still
be $2,000.
– Therefore, the value of her share must have fallen to $18.18/share
($2,000/110).

31. Other Forms of Dividends:
Stock Dividends (cont)
The Company’s Viewpoint
– Disadvantages of stock dividends include:
• The cost of issuing the new shares
• Taxes and listing fees on the new shares
• Other recording costs
– Advantages of stock dividends include:
• The company conserves needed cash
• Signaling effect to the shareholders that the firm is retaining cash
because of lucrative investment opportunities

32. Other Forms of Dividends:
Stock Splits
A stock split is a recapitalization that affects the number of shares
outstanding, par value, earnings per share, and market price.
The rationale for a stock split is that it lowers the price of the stock and
makes it more attractive to individual investors
Delphi Company, a forest products concern, had
200,000 shares of $2-par value common stock
outstanding and declares a 2-for-1 split. The total
before and after split impact on stockholders equity is:

33. Other Forms of Dividends:
Stock Splits (cont.)

34. Other Forms of Dividends:
Stock Splits (cont.)
A reverse stock split reduces the number of shares outstanding and raises stock
price—the opposite of a stock split.
The rationale for a reverse stock split is to add respectability to the stock and convey
the meaning that it isn’t a junk stock.
Research on both stock splits and stock dividends
generally supports the theory that they do not affect the
value of shares. They are often used, however, to send
a signal to investors that good things are going to
happen.

35. Other Forms of Dividends:
Stock Repurchases
A stock repurchase is the purchasing and retiring of stock by the
issuing corporation.
A repurchase is a partial liquidation since it decreases the number
of shares outstanding.
It may also be thought of as an alternative to cash dividends.

36. Other Forms of Dividends:
Stock Repurchases (cont.)
Alternative reasons for stock repurchases:
– To use the shares for another purpose
– To alter the firm’s capital structure
– To increase EPS and ROE resulting in a higher market price
– To reduce the chance of a hostile takeover

37. Other Forms of Dividends: Stock Repurchases Viewed as a
Cash Dividend
The repurchase of stock results in a type of reverse dilution.
The net effect of the repurchase is similar to the payment of a cash dividend.
However, if the firm pays the dividend, the owner would have to pay tax on
the income.
The gain on the increase in share price as a result of the repurchase,
however, would not be taxed until sold.