Copyright: M. S.

Humayun 1
Financial Management
Lecture No. 37
Dividend Payout

Copyright: M. S. Humayun 2
Dividend Policy Issue
Earnings and Positive Cash Flows can be allocated to the Following Cash
Outflows:
Buying assets (Capital Budgeting)
Investing in Projects (Capital Budgeting)
Paying Interest to Debtholders (ie. Banks) Value holders who receive a
slice of the Firms value in form of Interest Income.
Paying Dividends to Shareholders (ie. Payout) Value holders who receive a
slide of the Firms value in form of Dividend income.
Major Questions:
How much to Payout to Shareholders in form of Dividend?
Payout Ratio = Dividend / Net Income
Tradeoff between Dividend Income & Capital Gains. Recall Gordons Formula:
Required Return on Equity or Cost of Equity = rCE = (DIV1/Po) + g = Dividend
Yield + Capital Gains Yield
How to Finance the Dividend Payout?
Cash or Stock Dividend
Use Internal Retained Earnings OR External Financing (ie. Debt or Equity)
How often to make Dividend Payout?
Stability of Firms Track Record for Paying Regular and Growing Dividends
Quarterly, Annually, Random
Impact on Firm Value and Share Price?
Whether or not Paying Out Dividend increases Firm Value or not depends on many
things including ROE of Firm versus the Required ROR (rE ) of its shareholders
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Dividend Theories
MM Irrelevance (Miller Modigliani)
Dividend Payout is basically irrelevant because the way you
SPLIT cashflows within and amongst the Shareholders and
Debtholders has no affect on the Total Value of a Firm. Value is
determined by HOW MUCH cashflows are generated by the
working assets and the business risk of those assets.
Bird in the Hand (Gordon & Lintner)
Shareholder wealth (and Firms Value) is maximized by a HIGH
Dividend Payout because Investors think that Dividend Income is
(more immediate, regular, &) less risky than Capital Gains
Income.
Tax Preference
Shareholder wealth is maximized (and cost of equity rE is
minimized) by LOW Dividend Payout because Marginal Tax
Rate on Dividends is higher than on Capital Gains. Firms should
accumulate high Retained Earnings that can then lead to Share
Price Increase (Capital Gain) &/or Stock Repurchase
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Other Factors Affecting Dividend Policy
Signaling Theory
In minds of Investors, change in Dividend Payout signals a change about
managements forecast about future expected earnings. Increase in Dividend
Payout is seen as Positive Signal that firm will have good earnings in future
so Stock Price rises.
Clientele Effect
Investors buy stocks whose Dividend Policy they like and sell the other ones.
Change in Dividend Policy can cause change in type of shareholders. Income
Investors will invest in High Dividend Stocks. Growth Investors will invest in
those stocks offering larger Capital Gains Yield.
Agency Costs
Shareholders (owners) incur agency costs to monitor managerial spending and
decisions. High Dividend Payout forces firm to go to capital markets to raise
external capital. So, management is subjected to outside scrutiny which is an
external check on management spending.
Legal Restrictions
Debt Contracts: Loan Agreements and Bond Indentures restrict Dividend Payout
to Shareholders if earnings or net working capital is too low to pay interest.
Impairment of Capital Rule: Dividends can NOT exceed Retained Earnings
which are shown on Balance Sheet.
Cash Dividends can only be paid with cash. If cash balance (shown on Balance
Sheet too) is not enough then Sell assets, Raise Equity, or Take Loan etc.
Dividend Stability

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Dividend Stability
Dividend Stability
Most firms aim for Steadily Increasing Dividend Policy.
Earnings, Cashflows, Capital Structure, and Capital Budgets fluctuate
up and down with time but Dividend Payouts should NOT change
much known as Sticky Dividend Policy
Financial Manager acts as Stabilizer Converting fluctuating
unpredictable Incoming cash flows and Transforming them into
steady and regular cash outflows to shareholders (in form of
Dividends) and debt holders.
Standpoint of Investors: Provides low risk regular income for
shareholders, signals good future earnings, and growth compensates
for Inflation. Note: Growth = g = Ploughback x ROE = (1 Dividend
Payout) x ROE.
Standpoint of Firm: Payout small but Regular and Increasing dividends.
Keep reserve earnings in case of future capital expenditure and
investment opportunities
Steadily Growing Dividend Payout Gives Positive Signals:
Financial Stability
Less Risk or Uncertainty
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Residual Dividend Model
Residual Dividend Model: Best Practical Model for
numerical calculations of Dividend Policy. Sets Long-Term
Target Dividend Payout Ratio from which to back-calculate
short-term Dividends.
Steps in Residual Dividend Model (RDM):
Forecast Capital Budget, Earnings, Cash Flows (for next 5 years)
Conservatism: To be on safe side, underestimate the Free Cash
Flows
Determine Target Capital Structure (or Practically Speaking,
Range for Debt Ratio) and forecast required Equity (for next 5
years)
Use Retained Earnings (internal capital) to finance most of the
required Equity because RE is less costly than external financing
(higher transaction costs)
Leftover or Residual Earnings can be safely Paid Out as
Dividends in Long Term. Then divide this into Small Yet Regular
(maybe quarterly) and Steadily Increasing Dividend Payouts.