dividend theory and policy

1. DIVIDEND
THEORY &
POLICY

2. – In the absence of dividends, corporate earnings accrue to the
benefit of shareholders as retained earnings and are automatically
reinvested in the firm.
– When a cash dividend is declared, those funds leave the firm
permanently and irreversibly.
– Distribution of earnings as dividends may starve the company of
funds required for growth and expansion, and this may cause the
firm to seek additional external capital.
Corporate Profits After Tax
Retained Earnings
Dividends
Dividends a Financing Decision

3. Factors determining dividend policy of
a firm
1. Dividend Payout (D/P) Ratio
2. Stability of Dividends
3. Legal, contractual & internal restrictions
4. Owners’ considerations
5. Clientele effect
6. Capital market considerations
7. Inflation

4. Dividend Payout (D/P) Ratio
1. D/P Ratio indicates the percentage earnings distributed
to shareholders in cash, calculated dividing the cash
dividend per share by its earnings per share
2. Optimum dividend policy should strike a balance
between current dividends & future growth which
maximizes price of firm’s share
3. In practice, investors in general have a clear-cut
preference for dividends because of uncertainty &
imperfect capital markets.
4. Thus a low D/P ratio may cause a decline in share
prices, while a high ratio may lead to rise in the
market price of the shares.

5. Stability of Dividends
• Refers to the payment of a certain minimum amount of
dividend regularly
1. Constant dividend per share policy: it is a policy of
paying a certain fixed amount per share as dividend
2. Constant /target payout ratio: it is a policy to pay a
constant % of net earnings as dividend to shareholders
in each dividend period
3. Stable rupee plus extra dividend: it is a policy based
on paying a fixed dividend to shareholders
supplemented by an additional dividend when
earnings warrant it

6. Legal, contractual & internal restrictions
• Legal stipulations do not require a dividend
declaration but they specify the conditions under
which dividends must be paid –
• (i) capital impairment: firm can not pay dividends out of its paid-up capital,
adversely affecting the security of its lenders
• (ii) net profits: firm can not pay cash dividends greater than the amount of
current profits plus the accumulated retained earnings
• (iii) insolvency: firm would not pay dividend if it leads to insolvency
• The contractual restrictions on payment of dividends
are imposed by loan agreements
• The internal constraints impinging on the dividend
restrictions relate to growth prospects, availability of
funds, earning stability, and control

7. Remaining Factors
• Owners’ considerations: The dividend policy is also likely
to be affected by the owners’ consideration of (a) tax status
of the shareholders,(b) their opportunities for investment
and (c) dilution of ownership
• Capital market considerations: While a firm which has easy
access to the capital market can follow a liberal dividend
policy, a firm having only limited access to the capital
markets is likely to adopt low dividend payout ratio as they
are likely to rely, to a greater extent, on retained earnings as
a source of financing their investments.
• Inflation: With rising prices, funds generated from
depreciation may be inadequate to replace obsolete
equipments. As a result, the D/P ratio tends to be low
during periods of inflation.

8. Dividend Payments
Dividend Reinvestment Plans (DRIPs)
• Involve shareholders deciding to use the cash dividend
proceeds to buy more shares of the firm
– DRIPs will buy as many shares as the cash dividend allows with the
residual deposited as cash
– Leads to shareholders owning odd lots (less than 100 shares)
• Firms are able to raise additional common stock capital
continuously at no cost and fosters an on-going relationship
with shareholders.

9. Dividend Payments
Stock Dividends / Bonus Shares
• Stock dividends simply amount to distribution of additional
shares to existing shareholders
• They represent nothing more than recapitalization of earnings
of the company. (that is, the amount of the stock dividend is
transferred from the R/E account to the common share
account.
• Because of the capital impairment rule stock dividends reduce
the firm’s ability to pay dividends in the future.

10. Dividend Payments
Stock Dividends /Bonus Shares
Implications
– reduction in the R/E account
– reduced capacity to pay future dividends
– proportionate share ownership remains unchanged
– shareholder’s wealth (theoretically) is unaffected
Effect on the Company
– conserves cash
– serves to lower the market value of firm’s stock modestly
– promotes wider distribution of shares to the extent that current owners
divest themselves of shares...because they have more
– adjusts the capital accounts
– dilutes EPS
Effect on Shareholders
– proportion of ownership remains unchanged
– total value of holdings remains unchanged
– if former DPS is maintained, this really represents an increased dividend
payout

11. CHAPTER 22 – Dividend Policy 22 - 11
Dividend Payments
Stock Dividend / Bonus Shares Example
ABC Company
Equity Accounts
as at February xx, 20x9
Common stock (215,000) $5,000,000
Retained earnings 20,000,000
Net Worth $25,000,000
The company, on March 1, 20x9 declares a 10 percent stock dividend when the current market price for
the stock is $40.00 per share.
This stock dividend will increase the number of shares outstanding by 10 percent. This will mean issuing
21,500 shares. The value of the shares is:
$40.00 (21,500) = $860,000
This stock dividend will result in $860,000 being transferred from the retained earnings account to the
common stock account:
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12. CHAPTER 22 – Dividend Policy 22 - 12
Dividend Payments
Stock Dividend /Bonus Shares Example
After the stock dividend:
ABC Company
Equity Accounts
as at March 1, 20x9
Common stock (236,500) $5,860,000
Retained earnings 19,140,000
Net worth $25,000,000
The market price of the stock will be affected by the stock dividend:
New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36
The individual shareholder’s wealth will remain unchanged.

13. CHAPTER 22 – Dividend Policy 22 - 13
Dividend Payments
Stock Splits
• Although there is no theoretical proof, there is some who believe
that an optimal price range exists for a company’s common shares.
• It is generally felt that there is greater demand for shares of
companies that are traded in the $40 - $80 dollar range.
• The purpose of a stock split is to decrease share price.
• The result is:
– increase in the number of share outstanding
– theoretically, no change in shareholder wealth
• Reasons for use:
– better share price trading range
– psychological appeal (signalling affect)

14. CHAPTER 22 – Dividend Policy 22 - 14
Dividend Payments
Stock Split Example
The Board of Directors of XYZ Company is considering using a stock split to put its
shares into a better trading range. They are confident that the firm’s stock price will
continue to rise given the firm’s outstanding financial performance. Currently, the
company’s shares are trading for $150 and the company’s shareholders equity accounts
are as follows:
Commons shares (100,000 outstanding) $1,500,000
Retained earnings 15,000,000
Net Worth $16,500,000
A 2 for 1 Stock Split:
New Share Price = P0[1/(2/1)] = $150[1/(2/1)] = $150[.5] = $75.00
The firm’s equity accounts:
Commons shares (200,000 outstanding) $1,500,000
Retained earnings 15,000,000
Net Worth $16,500,000

15. CHAPTER 22 – Dividend Policy 22 - 15
Dividend Payments
Further Stock Split Examples
A 4 for 3 Stock Split:
New Share Price = P0[1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50
The firm’s equity accounts:
Commons shares (133,333 outstanding) $1,500,000
Retained earnings 15,000,000
Net Worth $16,500,000
A 3 for 4 Reverse Stock Split:
New Share Price = P0[1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00
The firm’s equity accounts:
Commons shares (75,000 outstanding) $1,500,000
Retained earnings 15,000,000
Net Worth $16,500,000
Clearly the Board can use stock splits and reverse stock splits to place the firm’s stock in a particular
trading range.

16. CHAPTER 22 – Dividend Policy 22 - 16
Dividend Payments
Stock Split Effects
• shareholders wealth should remain unaffected:
Original Holdings: (100 shares @ $150/share) = $15,000
After a 4 for 1 split: (400 shares @ $37.50/share) = $15,000
• the above will hold true if there is no psychological appeal to
the stock split.
• There is some evidence that the share price of companies
which split stock is more bouyant because of a positive signal
being transferred to the market by this action.

17. CHAPTER 22 – Dividend Policy 22 - 17
- lowers stock price slightly - large drop in stock price
- little psychological appeal - much stronger potential
signalling effect
- recapitalization of earnings - no recapitalization
- no change in proportional - same
ownership
- odd lots created - odd lots rare
- theoretically, no value to - same
the investor
Stock Dividends versus Stock Splits
Stock Dividends Stock Splits

18. CHAPTER 22 – Dividend Policy 22 - 18
• allowed under the amended Companies Act,
1999
• reasons for use:
– Offsetting the exercise of executive stock options
– Leveraged recapitalizations
– Information or signalling effects
– Repurchase dissident shares
– Removing cash without generating expectations for future
distributions
– Take the firm private.
Share Repurchases /Buyback

19. CHAPTER 22 – Dividend Policy 22 - 19
• they are usually done on an irregular basis, so a shareholder cannot
depend on income from this source.
• if regular repurchases are made, there is a good chance that statutory
authorities will rule that the repurchases were simply a tax avoidance
scheme (to avoid tax on dividends) and will assess tax
• there may be some agency problems - if managers have inside
information, they are purchasing from shareholders at a price less than
the intrinsic value of the shares.
Disadvantages of Share Repurchases

20. CHAPTER 22 – Dividend Policy 22 - 20
• tender offer:
– this is a formal offer to purchase a given number of shares at a given
price over current market price at a given time.
• open market purchase:
– the purchase of shares through an investment dealer like any other
investor
– this is not designed for large block purchases.
• private negotiation with major shareholders
In any repurchase program, the securities commission/ SEBI requires
disclosure of the event as well as all other material information
through a prospectus.
Methods of Share Repurchases

21. CHAPTER 22 – Dividend Policy 22 - 21
• EPS should increase following the repurchase
if earnings after-tax remains the same
• a higher market price per outstanding share of
common stock should result
• stockholders not selling their shares back to
the firm will enjoy a capital gain if the
repurchase increases the stock price.
Effects of A Share Repurchase

22. CHAPTER 22 – Dividend Policy 22 - 22
• signal positive information about the firm’s future cash flows
• used to effect a large-scale change in the firm’s capital structure
• increase investor’s return without creating an expectation of higher
future cash dividends
• reduce future cash dividend requirements or increase cash dividends
per share on the remaining shares, without creating a continuing
incremental cash drain
• capital gains treated more favourably than cash dividends for tax
purposes.
Advantages of Share Repurchases

23. CHAPTER 22 – Dividend Policy 22 - 23
• signal negative information about the firm’s
future growth and investment opportunities
• the provincial securities commission may raise
questions about the intention
• share repurchase may not qualify the investor
for a capital gain
Disadvantages of Share Repurchases

24. Dividend Policy
• If the company is confident of generating more than
market returns then only it should retain higher profits
and pay less as dividends (or pay no dividends at all),
as the shareholders can expect higher share prices based
on higher ROI of the company.
• However, if the company is not confident of generating
more than market returns, it should pay out more
dividends (or 100% dividends).
• This is done for two reasons:
1. the shareholders prefer early receipt of cash (liquidity
preference theory) and
2. the shareholders can invest this cash to generate more
returns (since market returns are expected to be higher
than returns generated by the company).

25. Issues in Dividend Policy
• The subject matter of the dividend policy is whether
pay-out ratio has any impact on the market price of the
share or not.
• In other words, if we change the pay-out ratio, whether
market price of the share will change (if yes, in which
direction) or not.
• Earnings to be Distributed – High Vs. Low Payout.
• Objective – Maximize Shareholders Return.
• Effects – Taxes, Investment and Financing Decision.

26. Relevance Vs. Irrelevance
• Walter's Model
• Gordon's Model
• Modigliani and Miller Hypothesis
• The Bird in the Hand Argument
• Informational Content
• Market Imperfections

27. DIVIDEND RELEVANCE:
WALTER’S MODEL
James E. Walter Walter’s model is based on the following
assumptions:
• Internal financing (only source of financing is through retained
earnings)
• Constant return and cost of capital
• 100 per cent payout or retention
• Constant EPS and DIV
• Infinite time
• The model considers internal rate of return (IRR), market
Capitalization rate, and dividend payout ratio in determination of
share prices.
• However, it fails to appropriately calculate prices of companies
that resort to external sources of finance.
• Further, the assumption of constant cost of capital and constant
return are unrealistic.

28. Walter’s formula to determine the
market price per share

29. Optimum Payout Ratio
• Growth Firms – Retain all earnings ( if the rate of
return that the company may earn on retained
earnings, is higher than cost of equity (the
expected returns of the shareholders) then, it
would be in the interest of the firm to retain the
earnings)
• Normal Firms – Distribute all earnings (If the
company’s reinvestment rate on retained earnings
is the less than share-holders’ rate of return, the
company should not retain earnings)
• Declining Firms – No effect (If the two rates are
the same, then the company should be indifferent
between retaining and distributing)