Dividend

Fundament
als

Dividends refer to that portion of a firms

earnings which are paid out to the shareholders.

* Preferred Stock Dividend is fixed.
* It focuses on Common stockholders.
Cash Dividend Payment Procedures
Whether and in what amount to pay cash
dividends to corporate stockholders is decided
by the firms Board of Directors at quarterly or
semiannual meetings.
Amount of Dividends
Whether dividends should be paid, and if so, in
what amount, are important decisions that
depend primarily on the firms dividend policy.

Relevant Dates

Record Date
Specified future date, set by the firms,
directors, on which all persons whose names
are recorded as stockholders receive a
declared dividend at a specified future date.
Ex Dividend
Period, beginning 4 business days prior to
the date of record during which a stock is
sold without the right to receive the current
dividend.
Payment Date
The actual date on which the firm mails the
dividend payment to the holders of record.

Problem 13 (9) , Gitman

Wood Shoes, at the quarterly dividend meeting,

declared a cash dividend of $ 1.10 per share for
holders of record on Monday , July 10 .The firm has
300000 shares of common stock outstanding and has
set a payment date of July 31. Prior to the dividend
declaration , the firms key accounts are as follows :
Cash

$500000
Dividends Payable
$0
Retained Earnings
$ 2500000
a. Show the entries after the meeting adjourned.
b. When is the ex dividend date ?
c. After the July 31 payment date , what the value
key accounts have ?
d. What effect, if any, will the dividend have on
the firms total assets ?

Dividend Reinvestment Plans (DRP)

Plans that enable stockholders to use dividends

received on the firms stock to acquire
additional full or fractional shares at little or
no transaction (brokerage) cost are called
Dividend Reinvestment Plans.

DRP may be handled by a company by two ways

. Both allow the stockholders to elect to have
dividends reinvested in the firms shares.

In one approach, a third party is paid a fee to

buy the firms outstanding shares in the open
market on behalf of the shareholders who wish
to reinvest their dividends. Transaction cost is
lower in this approach.

Dividend Reinvestment Plans (DRP)

The second approach involves buying newly

issued shares directly from the firm without
paying any transaction costs. This approach
allows the firm to raise new capital while
permitting
owners
to
reinvest
their
dividends, frequently at about 5% below the
current market price.

The firm can justify the below market sale

price economically because it saves the
under pricing and flotation costs that would
accompany the public sale of new shares.

The Relevance of Dividend

Policy

Good investment & financing decisions

should not be sacrificed for a dividend
policy of questionable importance.
# Does dividend policy measure?
# What effect does dividend policy
have on share
price?

The Residual Theory of

Dividend

A theory that dividend paid by a firm should

be the amount left over after all acceptable
investment opportunities have been
undertaken.
Step 1 : Determine its optimum level of
expenditure
Step 2 : Using the optimal C.S. proportions
,estimate the total amount of equity
financing needed to support the expenditures
generated in * Step 1
Step 3 : Cost of retained earnings, Kr is less
than cost of new common stock, Kn

Arguments for Dividend

Irrelevance

A theory put forth by Metorn H. Millar & Franco

Modigliani (M&M) that in a perfect world, the
value of a firm is unaffected by the distribution
of dividends and is determined solely by the
earning power and risk of its assets and that
the manner in which it splits its earnings
stream between dividends and internally
retained funds does not affect this value.
M and Ms theory shows that in a perfect world:
Certainty , no taxes, no transaction cost and
no other market imperfection.
In a perfect world the value of the firm is
unaffected by the distribution of dividend.

Arguments for Dividend

Irrelevance

Firms value is determined solely by the earnings

power & risks of the assets (investments).
In response to studies showing that large
dividend changes affect share price.
Informational content
The information provided by the dividends of a
firm with respect to future earnings, which causes
owners to bid up or down the price of the firms
stock.
# An increase in dividends is viewed as a positive
signal, and investors bid up the share price.
# A decrease in dividends is viewed as a negative
signal, that causes a decrease in share price as
investors sell their
shares.

Arguments for Dividend

Irrelevance

Clientele effect: The argument that a firm attracts

shareholders whose preferences for the payment
and stability of dividends correspond to the
payment pattern and stability of the firm itself.

Basically there are two types of investors

1. Investors who prefer stable dividends
2. Investors who prefer to increase basic earning
powers
Attract those investors or shareholders who are
interested to maximize the basic earnings
power ,stability of dividends & growth of the firm.

Arguments for Dividend

Irrelevance

In summery, M & M argue that, all else being

equal, an investors required return and therefore
the value of the firm is affected by the dividend
policy for three reasons :
1. The firms value is unaffected by dividend
policy. Firms value is determined solely by the
basic earning power & risk of its assets.
2.If dividends do effect value, they do so solely
because their informational content.
3.A clientele effect exists that causes a firms
shareholders to receive the dividends they expect.

Arguments for Dividend

Irrelevance
These views of M & M with respect to
dividend irrelevance are consistent with
the residual theory, which focuses on
making the best investment decisions to
maximize share value.
The proponents of dividend irrelevance
conclude that because dividends are
irrelevant to a firms value, so the firm does
not need to have a dividend policy.

Arguments for Dividend

Relevance

The theory, advanced by Gordon and Lintner,

that there is a direct relationship between a
firms dividend policy and its market value.
Fundamentals to this proposition is their birdin-the-hand argument, which suggests that
investors see current dividends as less risky than
future dividends or capital gains.
That means investors are risk averse & attach
less risk to current as opposite to future
dividends or capital gains.
A bird in the hand is worth two in the bush.
Cash Dividend reduces investor uncertainty
causing investors to discount the firms earnings
at a lower rate and it places a higher value on
the firms stock.

Arguments for Dividend

Relevance

If dividends are increased, investor uncertainty

will increase, lowering the required return (Ks)
and increasing the value of the firms stock.
If dividends are reduced or are not paid,
investor uncertainty will increase, raising the
required return (Ks) and lowering the value of
the firms stock.
Empirical studies fail to provide conclusive
evidence in support of dividend relevance
argument.
However, financial managers & stockholders
believe that dividends are relevant.

Factors Affecting Dividend

Policy

Legal Constraints
An earnings requirement limiting the amount of
dividends to the sum of the firms most present &
past retained earnings is sometimes imposed .
However, the firm is not prohibited from paying more
in dividends than its current earnings.
Contractual Constraints
Often the firms ability to pay cash dividends is
constrained by certain restrictive provisions in a loan
agreement.
These Constraints prohibit the payment of cash
dividends.
Constraints on dividends help to protect creditors
from losses due to insolvency on the part of the firm.

Factors Affecting Dividend

Policy

Internal Constraints
The firms ability to pay cash dividends is generally
constrained by the amount of excess cash
available rather than the level of retained
earnings which to charge them.
Growth Prospects
The firms financial requirements are directly
related to the degree of assets expansion that is
anticipated.
# Little or no growth firms may nevertheless
periodically needs fund to replace or renew assets.
So dividends will be more in these firms.
# If the firm is in a growth stage, it will have to
depend heavily on internal financing, and so it will
pay minimum dividends.

Factors Affecting Dividend

Policy

# A more established firm is in a better position to

pay out a large proportion of earnings because it has
multiple financing alternatives.
Owner Considerations
* In establishing a dividend policy, the firms
primary concern should be to maximize owner wealth.
The firm must establish a policy that has a favorable
effect on the wealth of the majority of owners.
* One consideration is the tax status of a firms
owners. If a firm has a large percentage of wealthy
stockholders who are in a high tax bracket, it may
decide to pay out a lower percentage of its earnings.
* A second consideration is the owners investment
opportunities.

Factors Affecting Dividend

Policy
A firm should not retain funds for investment in projects

A firm should not retain funds for investment in projects

yielding lower returns. If it appears that the owners have
better opportunities externally, the firm should pay out a
higher percentage of its earnings.
* A final consideration is the potential dilution of
ownership. If a firm pays out a high percentage of its
earnings, new equity capital will have to be raised with
common stock. The result of a new stock issue may be
dilution of both control and earnings for the existing
owners.
Market Considerations
Wealth of the firms owners reflected by the market
price of share. Market price of share influenced by the
dividend policy.
* Stock holders prefer fixed or increasing level of
dividends as opposed to a fluctuating pattern of
dividends.

Factors Affecting Dividend

Policy
* Stock holders prefer a policy of continuous
dividend payment. Because regularly paying a
fixed or increasing dividend eliminates uncertainty
about the frequency and magnitude of dividends.
* A final market consideration is informational
content. Shareholders often view a dividend
payment as a signal of the firms future success.
A stable and continuous dividend is a positive
signal, conveying the firms good financial health.
On the other hand, shareholders are likely to
interpret a passed dividend payment due to loss or
to very low

Types of Dividend Policies

Constant- Pay out-Ratio Dividend Policy

The 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 firms cash dividend
per share by its earning per share.
With this policy, the firm establishes that a certain
percentage of earnings is paid to owners in each
dividend period.
The problem with this policy is that if the firms
earnings drop or if a loss occurs in a given period,
the dividends may be low or even or zero.
Because dividends are considered an indicator of
firms future condition, the firms stock price may
thus be adversely affected.

Types of Dividend Policies

Regular Dividend Policy

A dividend policy based on the payment of fixed
dividend in each period.
This policy provides the owners with positive
information, thereby minimizing their uncertainty.
Firms that use this policy increase the regular dividend
once a proven increase in earnings has occurred.
Under this policy, dividends are almost never
decreased.
Low regular and Extra Dividend Policy
A dividend policy based on the paying a low regular
dividend, supplemented by an additional dividend when
earnings are higher than normal in a given period.

Types of Dividend Policies

An additional dividend optionally paid by the firm

if earnings are higher than normal in a given
period is called extra dividend.
By establishing a low regular dividend that is paid
each period, the firm gives investors the stable
income necessary to build confidence in the firm.
The extra dividend permits them to share in the
earnings from an especially good period.

Other Forms of Dividends

Stock Dividends
A stock dividend is the payment, to existing owners, of a
dividends in the form of stock.
Firms pay stock dividends as a replacement for or a
supplement to cash dividends.
Stock dividends do not have real value.
The Shareholder's Viewpoint : The shareholder receiving
a stock dividend typically receives nothing of value.
After the dividend is paid, the per-share value of the
shareholders stock decreases in proportion to the
dividend in such a way.
The shareholders proportion of ownership in the firm
also remains the same, and as long as the firms
earnings remain unchanged.

Other Forms of Dividends

The Company's Viewpoint : Firms find the stock dividend
a way to give owners something without having to use
cash.
When a firm needs to preserve cash to finance rapid
growth, a stock dividend is used.
When the shareholders recognize that the firm is
reinvesting the cash flow so as to maximize future
earnings, the market value of the firm should at least
remain unchanged.
Stock Splits
A method commonly used to lower the market price of a
firms stock by increasing the number of shares
belonging to each shareholder.
A stock split has no effect on the firms capital structure.
Stock splits increase the number of shares outstanding
and
decrease the stock value per share.

Other Forms of Dividends

Stock Repurchases
The repurchase by the firm of outstanding
common stock in the marketplace. Desired effects
of stock repurchases are that they either enhance
shareholder value or help to discourage an
unfriendly takeover.
Stock repurchase enhance shareholder value by
(1) reducing the number of shares outstanding
and thereby raising earnings per share,
(2) sending a positive signal to investors in the
marketplace that management believes that the stock
is undervalued, and
(3) providing a temporary floor for the stock price,
which may have been declining.