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 time.
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.
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
Retained Earnings
$ 2500000

$0

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 ?
e)Ignoring general market fluctuations, what effect, if any, will
the dividend have on the firms stock price on the ex dividend
date?

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 matter?
# What effect does dividend policy
have on share price?

The Residual Theory of

Dividend

A theory that dividend paid by a firm should

be viewed as a residual - 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 Capital
Structure 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 unaffected by
the dividend policy for three reasons :
1. The firms value is determined solely by the
basic earning power & risk of its assets.
2.

3.

If dividends do effect value, they do so solely

because their informational content, which
signals management's earnings
expectations.
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 bird-inthe-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 decrease, 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.
A more established firm is in a better position to pay out
a large proportion of earnings because it has multiple
financing alternatives.

Factors Affecting Dividend

Policy

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. 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.

Factors Affecting Dividend

Policy
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.
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.
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 earnings as a negative signal.

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 Constant-Pay out- Ratio dividend 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.

Types of Dividend Policies

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.
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.

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 anddecrease 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.