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Topic 8:

Dividend Policy

By :
Kharul Azhar Bin Ramli

Stock Returns:
P1 - Po +

Return =

D1

Po
=

P1 - +
Po
Po
Capital Gain

D1
Po

Dividend Yield

Dilemma: Should the firm


use retained earnings for:

a) Financing profitable
capital
investments?
b) Paying dividends to
stockholders?

Financing Profitable
Capital Investments:
If we retain earnings for profitable
investments, dividend yield will be
zero, but the stock price will increase,
resulting in a higher capital gain.

Return =

P1 - Po
Po

D1
Po

Paying Dividends:
If we pay dividends, stockholders
receive an immediate cash reward for
investing, but the capital gain will
decrease, since this cash is not
invested in the firm.

Return =

P1 - Po
Po

D1
Po

So, dividend policy


really involves two
decisions:
How

much of the firms


earnings should be
distributed to shareholders
as dividends, and
How much should be
retained for capital
investment?

Is Dividend Policy
Important?
Three viewpoints:
1) Dividends are Irrelevant
2) High Dividends are Best
3) Low Dividends are Best

Three viewpoints:
1) Dividends are Irrelevant.
If we assume perfect
markets (no taxes, no
transaction costs, etc.)
dividends do not matter. If
we pay a dividend,
shareholders dividend yield
rises, but capital gains
decrease.

Dividends are Irrelevant


With perfect markets, investors
are concerned only with total
returns and do not care whether
returns come in the form of
capital gains or dividend yields.

Return =

P1 - Po
Po

D1
Po

Dividends are Irrelevant


Therefore, one dividend policy
is as good as another.

Return =

P1 - Po
Po

D1
Po

High Dividends are Best


Some investors may prefer a
certain dividend now over a risky
expected capital gain in the
future.

Return =

P1 - Po
Po

D1
Po

Low Dividends are Best


Dividends

are taxed
immediately. Capital gains are
not taxed until the stock is sold.
Therefore, taxes on capital gains
can be deferred indefinitely.

Do Dividends
Matter?

Other Considerations:
1) Residual Dividend
Theory
2) Clientele Effects
3) Information Effects
4) Agency Costs
5) Expectations Theory

Other Considerations
1) Residual Dividend Theory:
The firm pays a dividend only if
it has retained earnings left
after financing all profitable
investment opportunities.
This would maximize capital
gains for stockholders and
minimize flotation costs of
issuing new common stock.

Other Considerations
2) Clientele Effects:
Different investor clienteles prefer
different dividend payout levels.
Some firms, such as utilities, pay
out over 70% of their earnings as
dividends. These attract a
clientele that prefers high
dividends.
Growth-oriented firms which pay
low (or no) dividends attract a
clientele that prefers price
appreciation to dividends.

Other Considerations
3) Information Effects:
Unexpected dividend increases
usually cause stock prices to rise,
and unexpected dividend decreases
cause stock prices to fall.
Dividend changes convey
information to the market
concerning the firms future
prospects.

Other Considerations
4) Agency Costs:
Paying dividends may reduce
agency costs between managers
and shareholders.
Paying dividends reduces retained
earnings and forces the firm to
raise external equity financing.
Raising external equity subjects
the firm to scrutiny of regulators
(SEC) and investors and therefore
helps monitor the performance of
managers.

Other Considerations
5) Expectations Theory:
Investors form expectations
concerning the amount of a firms
upcoming dividend.
Expectations are based on past
dividends, expected earnings,
investment and financing decisions,
the economy, etc.
The stock price will likely react if
the actual dividend is different from
the expected dividend.

1)

Dividend
Policies

Constant Dividend Payout Ratio:


If directors declare a constant
payout ratio of, for example,
30%, then for every dollar of
earnings available to
stockholders, 30 cents would be
paid out as dividends.
The ratio remains constant over
time, but the dollar value of
dividends changes as earnings
change.

Dividend
Policies
Stable Dollar Dividend
Policy:
The firm tries to pay a fixed
dollar dividend each quarter.
Firms and stockholders
prefer stable dividends.
Decreasing the dividend
sends a negative signal!
2)

Dividend
Policies

3)

Small Regular Dividend plus YearEnd Extras

The firm pays a stable quarterly


dividend and includes an extra
year-end dividend in prosperous
years.
By identifying the year-end
dividend as extra, directors hope
to avoid signaling that this is a
permanent dividend.

Dividend
Payments
Declaration
Date: The board of

1)
directors declares the dividend,
determines the amount of the
dividend, and decides on the payment
date.
Jan.4

Jan.30

Declare
dividend

Ex-div.
date

Feb.1
Record
date

Mar. 11
Payment
date

Dividend
Payments
Ex-Dividend
Date: To receive the

2)
dividend, you have to buy the stock
before the ex-dividend date. On this
date, the stock begins trading exdividend and the stock price falls
approximately by the amount of the
Jan.4
Jan.30
Feb.1
Mar. 11
dividend.
Declare
dividend

Ex-div.
date

Record
date

Payment
date

Dividend
3) DatePayments
of Record: Two days after the

ex-dividend date, the firm receives the


list of stockholders eligible for the
dividend.
Often, a bank trust department acts
as registrar and maintains this list for
the firm.
Jan.4
Jan.30
Feb.1
Mar. 11
Declare
dividend

Ex-div.
date

Record
date

Payment
date

Dividend
Payments
4) Payment
Date: Date on which the

firm mails the dividend checks to the


shareholders of record.

Jan.4

Jan.30

Declare
dividend

Ex-div.
date

Feb.1
Record
date

Mar. 11
Payment
date

Stock Dividends and Stock


Splits
Stock Dividend: Payment of additional
shares of stock to common
stockholders.
Example: Citizens Bancorporation of
Maryland announces a 5% stock
dividend to all shareholders of record.
For each 100 shares held, shareholders
receive another five shares.
Does the shareholders wealth
increase?

Stock Dividends and Stock


Splits
Stock Split: The firm increases the
number of shares outstanding and
reduces the price of each share.
Example: Joule, Inc. announces a
3-for-2 stock split. For each 100
shares held, shareholders receive
another 50 shares.
Does this increase shareholder
wealth?
Are a stock dividend and a stock split
the same?

Stock Dividends and Stock


Splits

Stock Splits and Stock Dividends are


economically the same: The number
of shares outstanding increases and
the price of each share drops. The
value of the firm does not change.
Example: A 3-for-2 stock split is the
same as a 50% stock dividend. For
each 100 shares held, shareholders
receive another 50 shares.

Stock Dividends and Stock


Splits
Effects on Shareholder Wealth: These
will cut the company pie into more
pieces but will not create wealth. A
100% stock dividend (or a 2-for-1
stock split) gives shareholders two
half-sized pieces for each full-sized
piece they previously owned.
Example: This would double the
number of shares, but would cause a
$60 stock price to fall to $30.

Stock Dividends and Stock


Splits

Why bother?
Proponents argue that these are
used to reduce high stock prices to a
more popular trading range
(generally $15 to $70 per share).
Opponents argue that most stocks
are purchased by institutional
investors who have millions of dollars
to invest and are indifferent to price
levels. Plus, stock splits and stock
dividends are expensive!

Stock Dividend Example


An investor has 120 shares.
Does the value of the
investors shares change?
Shares outstanding:
1,000,000.
Net income = $6,000,000.
P/E = 10.
25% stock dividend.

Before the 25% stock dividend:


EPS = 6,000,000/1,000,000 = $6.
P/E = P/6 = 10, so P = $60 per share.
Value = $60 x 120 shares = $7,200.
After the 25% stock dividend:
# shares = 1,000,000 x 1.25 =
1,250,000.
EPS = 6,000,000/1,250,000 = $4.80.
P/E = P/4.80 = 10, so P = $48 per share.
Investor now has 120 x 1.25 = 150
shares.
Value = $48 x 150 = $7,200.

Stock Dividends
In-class Problem
What is the new stock price?
Shares outstanding:
250,000.
Net income = $750,000.
Stock price = $84.
50% stock dividend.

Hint:

P/E =

stock price
net income
# shares

Before the 50% stock dividend:


EPS = 750,000 / 250,000 = $3.
P/E = 84 / 3 = 28.
After the 50% stock dividend:
# shares = 250,000 x 1.50 = 375,000.
EPS = 750,000 / 375,000 = $2.
P/E = P / 2 = 28, so P = $56 per share.
(A 50% stock dividend is equivalent to a
3-for-2 stock split.)

Example stock dividend & stock


split
The current market price ABC RM14. Reconstruct financial
statement assuming:
a) A 15% stock dividend is issued
b) A two for one stock split is declared
Common Stock
Par Value (1,000,000 shares outstanding;$2 par value)
$2,000,000
Paid in capital
$8,000,000
Retained earnings
$15,000,000
Total Equity
$25,000,000

Stock Dividend

(15% stock dividend)

Common stock
Par value
$2,300,000
(a)
(1,150,000 shares outstanding;$2 par value)
Paid in Capital
$9,800,000
(b)
Retained earnings
$12,900,000
Total Equity $25,000,000
a)
b)
c)

(c)

Increase in shares outstanding: 1,000,000 x 1.15


=
1,150,000
Increase in capital surplus account: ($14 - $2)x 150,000 =
$1,800,000
Decrease in retained earnings: ($14 x 150,000)
=
$2,100,000

Stock Split

(2:1 stock split)

Common stock
Par value
$2,000,000 (a)
(2,000,000 shares outstanding;$1 par value)
Paid in capital
$8,000,000
Retained earnings
$15,000,000
Total Equity
$25,000,000
Stock split 2:1
Par price after split :
Par price before split x 1 = $2 x 1 = $1
2
2
No.of shares after split :
No of shares before split x 2 = 1,000,000 x 2 =
2,000,000
1
1

a)

Stock Repurchases
Stock

Repurchases may be
a good substitute for cash
dividends.
If the firm has excess
cash, why not buy back
common stock?

Stock Repurchases
Stock

Repurchases may be
a good substitute for cash
dividends.
If the firm has excess
cash, why not buy back
common stock?

Stock Repurchases
Repurchases

drive up the stock


price, producing capital gains for
shareholders.
Repurchases increase leverage,
and can be used to move toward
the optimal capital structure.
Repurchases signal positive
information to the marketwhich
increases stock price.

Stock Repurchases
Repurchases

may be used to
avoid a hostile takeover.

Example:
T. Boone Pickens attempted
raids on Phillips Petroleum and
Unocal in 1985. Both were
unsuccessful because the target
firms undertook stock
repurchases.

Stock Repurchases
Methods:
Buy shares in the open market
through a broker.
Buy a large block by negotiating
the purchase with a large block
holder, usually an institution
(targeted stock repurchase).
Tender offer: offer to pay a specific
price to all current stockholders.

Exercise 1 : Bonus Share(Stock dividend) and Stock Split

Equity Structure of ABC Berhad as at 30 June 2009


Common Shares (500 000 unit @RM1 par value)
500,000
Paid in Capital
500,000
Retained Earnings
500,000
TOTAL Equity
1,500,000
Market price- RM5
(1) If Co ABC decide to pay a 20% Bonus shares for the
existing shareholders,
what is the changes of the new equity structure?
(2) What is the new structure of equity of ABC Berhad after
the stock spilt
2:1 implementation?

Exercise 2 :
The Manville corporations capital structure is as follows:
Common stock($4 par;5,000,000 shares)
Paid in capital
1,000,000
Retained earnings
9,000,000
Total net worth
$30,000,000

$20,000,000

The firms earnings after taxes are $2million of which the


company
paid out 25% in cash dividends. The price of the firms common
stock
was $8.

If the firm declares a 20% stock dividend, how would the


capital structure appear?

If a 20% stock dividend is assumed, what would be the


earnings per share and dividend per share?

Exercise 3 :
Describes

the clientele effect concept of dividend

policy.
Explain the concept of residual dividend theory.
What are the motivates corporations to pay stock
dividends and split their common stock?
Differentiate between constants dividends payout
ratio & stable dollar dividend policy.
What are the advantages firms repurchase its own
shares?
Define the following:

Declaration date
Record date
Payment date
Ex-dividend date