Dividends refer to that portion of a firm’s earnings which
are paid out to the shareholders.
Dividend
Fundamentals
Relevant Dates
 Record Date
Specified future date, set by the firm’s, 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.
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 firm’s shares.
In one approach, a third party is paid a fee to buy the firm’s

outstanding shares in the open market on behalf of the
shareholders who wish to reinvest their dividends.
Transaction cost is lower in this approach.
* 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 firm’s 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 firm’s dividend policy.
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 firm’s 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 firm’s
total assets ?
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.
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 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?
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 M’s 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
 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.
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
  Firm’s 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 firm’s 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
 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 firm’s value is unaffected by dividend policy. Firm’s
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 firm’s shareholders
to receive the dividends they expect.
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 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 firm’s value, so the
firm does not need to have a dividend policy.
Arguments for Dividend Relevance
 If dividends are increased, investor uncertainty will
decrease, lowering the required return (Ks) and increasing
the value of the firm’s stock.
 If dividends are reduced or are not paid, investor
uncertainty will increase, raising the required return (Ks)
and lowering the value of the firm’s 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
 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 firm’s 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.
Arguments for Dividend Relevance
 The theory, advanced by Gordon and Lintner, that there is a
direct relationship between a firm’s dividend policy and its
market value.
 Fundamentals to this proposition is their bird-in-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 firm’s earnings at a lower rate and
it places a higher value on the firm’s stock.
Factors Affecting Dividend Policy
 Legal Constraints
An earnings requirement limiting the amount of dividends to
the sum of the firm’s 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 firm’s 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
# 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 firm’s 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 firm’s 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 owner’s investment opportunities.
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 Factors Affecting Dividend Policy
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 firm’s 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.
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 firm’s 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 firm’s 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 firm’s future
condition, the firm’s stock price may thus be adversely affected.
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.
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
firm’s future success.
A stable and continuous dividend is a positive signal, conveying
the firm’s 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
 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.
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
shareholder’s stock decreases in proportion to the dividend in
such a way.
The shareholder’s proportion of ownership in the firm also
remains the same, and as long as the firm’s earnings remain
unchanged.
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 Other Forms of Dividends
 The Company's Viewpoint : Firm’s 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 firm’s
stock by increasing the number of shares belonging to each
shareholder.
 A stock split has no effect on the firm’s 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.