Dividend Policy

A regular cash dividend is the distribution of earnings to shareholders in the form of cash. If a company pays regular, steady dividends, investors will come to expect them. Regular cash dividends represent unlabeled dividends. A specially designated dividend (SDD) is one that management labels as extra, special, or year-end. Labeling dividends allows management to differentiate a SDD from a regular cash dividend and communicate this difference to stockholders. This ability to label dividends indicates how seriously management considers this communication through dividend announcements. Regular dividends should potentially convey more information than SDDs because management labels the latter as temporary dividends. Although firms often declare SDDs after experiencing good earnings over the previous year, investors should not expect the operating performance that precedes a special dividend to continue after the announcement.

The declaration date is the date on which the board of directors announces the next dividend payment. The record date, also called the holder-of-record date, is the date on which a stockholder must own a share to receive a declared dividend at some specified future time. The ex-dividend date is the date on which the stock begins trading without the right to receive the upcoming dividend. Thus, buyers of a stock selling ex dividend do not receive the current dividend. The exdividend date is generally several weeks after the declaration date and several weeks before the payment date. The payment date is the actual date on which the firm mails the dividend payment to the holders of record.

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It bears upon investor attitude. It impacts the financing program & capital budget of the firm. It affects the firms cash flow position. It lowers stockholders equity, since dividends are paid from retained earnings, & results in a higher debt-to-equity ratio.

A. Current dividends versus retention of earnings

M&M contend that the effect of dividend payments on shareholder wealth is exactly offset by other means of financing. The dividend plus the new stock price after dilution exactly equals the stock price prior to the dividend distribution.

B. Conservation of value

M&M and the total-value principle ensures that the sum of market value plus current dividends of two firms identical in all respects other than dividendpayout ratios will be the same. Investors can create any dividend policy they desire by selling shares when the dividend payout is too low or buying shares when the dividend payout is excessive.

A. Preference for dividends

Uncertainty surrounding future company profitability leads certain investors to prefer the certainty of current dividends. Investors prefer large dividends. Investors do not like to manufacture homemade dividends, but prefer the company to distribute them directly.

B. Taxes on the investor

Capital gains taxes are deferred until the actual sale of stock. This creates a timing option. Capital gains are preferred to dividends, everything else equal. Thus, high dividend-yielding stocks should sell at a discount to generate a higher before-tax rate of return. Certain institutional investors pay no tax.

B. Taxes on the investor (continued)

Corporations can typically exclude 70% of dividend income from taxation. Thus, corporations generally prefer to receive dividends rather than capital gains. The result is clienteles of investors with different dividend preferences. In equilibrium, there will be the proper distribution of firms with differing dividend policies to exactly meet the needs of investors. Thus, dividend-payout decisions are irrelevant.

Tax Effect

Financial Signaling

Dividends are taxed more heavily than capital gains, so before-tax returns should be higher for high-dividendpaying firms. Empirical results are mixed -- recently the evidence is largely consistent with dividend neutrality. Expect that increases (decreases) in dividends lead to positive (negative) excess stock returns. Empirical results are consistent with these expectations.

Legal Rules

Capital Impairment Rule -- many states prohibit the payment of dividends if these dividends impair capital (usually either par value of common stock or par plus additional paid-in capital).
Incorporation in some states (notably Delaware) allows a firm to use the fair value, rather than book value, of its assets when judging whether a dividend impairs capital.

Legal Rules

Insolvency Rule -- some states prohibit the payment of cash dividends if the company is insolvent under either a fair market valuation or equitable sense. Undue Retention of Earnings Rule -- prohibits the undue retention of earnings in excess of the present and future investment needs of the firm.

Funding Needs of the Firm Liquidity Ability to Borrow Restrictions in Debt Contracts Control

Other Issues to Consider

Assuming an idealized world of perfect capital markets and rational investors, Miller and Modigliani (M&M) conclude that the firms choice of dividend policy is irrelevant. According to their theory, M&M contend that the distribution of dividends does not affect a firms value. Instead, the earning power and risk of its assets solely determine the value of the firm. M&M also argue that shareholders are indifferent to the payment of dividends because they can create any dividend policy they desire by buying or selling shares of the stock. This controversial conclusion means that dividend policy has no affect on shareholders wealth. The view of dividend irrelevance is contrary to traditional wisdom. If dividend policy is relevant to investors, some of M&Ms assumptions must be in error.

In a perfect capital markets, there are no taxes and no flotation, transactions, or agency costs. Investors are symmetrically informed, which means that information is costless and available to everyone equally. Investors act rationally and no single investor can exert enough power to influence the price of a security.

The three big imperfections involving capital markets are taxes, asymmetric information, and agency costs. The little three frictions are transaction costs, flotation costs, and behavioral considerations.

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Are lower-income shareholders who need dividend income, Believe that current dividend payments reduce uncertainty, Are low-tax bracket shareholders who do not prefer to deter taxes, and Have little concern about dilution of ownership.

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Residual Dividend Policy. Stable Dollar Dividend Policy. Constant Payout Policy. Regular plus specially designated dividends policy

A residual dividend policy is one in which a firm pays dividends from the amount remaining after undertaking all desirable projects from internally generated cash flows. A desirable project is usually one having a positive net present value. Under this passive type of dividend policy, shareholders receive any excess cash as dividends. Both the amount of internally generated cash flows and desirable projects are unpredictable over time. Thus, an implication of this theory is that the amount of the residual dividend is likely to be highly variable and often zero. Such instability of dividend payments may result in increased uncertainty by investors.

Stock Dividend -- A payment of additional shares of stock to shareholders. Often used in place of or in addition to a cash dividend.
Small-percentage stock dividends

Typically less than 25% of previously outstanding common stock. Assume a company with 400,000 shares of $5 par common stock outstanding pays a 5% stock dividend. The predividend market value is $40. How does this impact the shareholders equity accounts?

Stock Split -- An increase in the number of shares outstanding by reducing the par value of the stock.

Similar economic consequences as a 100% stock dividend. Primarily used to move the stock into a more popular trading range and increase share demand. Assume a company with 400,000 shares of $5 par common stock splits 2-for-1. How does this impact the shareholders equity accounts?

Treasury stock is stock reacquired by the

issuing company and available for retirement or resale. Such stock is issued but not outstanding. Treasury stock has no voting rights, accrues no dividends, and is not part of the ratios measuring values per common share.