Dividend Policy

Lakehead University

Winter 2005

Types of Dividend

Dividends are usually paid in cash, and this four times a year.
A company may also pay a stock dividend:

• A 2% stock dividend, for instance, is such that shareholders

receive 1 share for each 50 shares they own.

• A 2-for-1 stock split is a 100% stock dividend.

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 Dividend Payment Procedure

Dividends are normally paid quarterly and, if conditions permit,

the dividend is increased once a year.
Suppose for example that a corporation paid $0.50 per quarter in
2003. Its annual dividend is then $2.00.
If the corporation decided to increase the annual dividend to
$2.08, say, then the quarterly dividend would be $0.52.

Dividend Payment Procedure

The procedure for paying dividends is as follows:

Declaration Date: On January 15, say, corporation XYZ announces
that it will pay a dividend on February 16 of the same year.

Holder-of-Record Date: At the close of business on the

holder-of-record date, January 30, say, XYZ clsoes its stock
transfer book and makes a list of shareholders to that date. If XYZ
is not notified of the purchase of its stock by an individual before 5
PM on the record date, the individual does not get the dividend.

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 Dividend Payment Procedure

Ex-Dividend Date: To avoid conflict, the convention is that the

right to the dividend remains with the stock until two days
before the holder-of-record date. Whoever buys the stock on
or after the ex-dividend date does not receive the dividend.
In the present example, the ex-dividend date would be
January 28.

Dividend Payment Procedure

Jan 15 Declaration date

Jan 27 Dividend goes with the stock
Jan 28 Ex-dividend date
Jan 30 Holder-of-record date
Feb 16 Payment date

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 Fall in Stock Price on the Ex-Dividend Date

d0 ≡ dividend announced
p̃0 ≡ stock price one day before the ex-dividend date
p0 ≡ stock price on ex-dividend date

∞
dt
p0 = ∑
t=1 (1 + rs )
t

p̃0 = p0 + d0 ⇒ p̃0 − p0 = d0 .

Without taxes, the stock price should fall by d0 on the

ex-dividend date.

Fall in Stock Price on the Ex-Dividend Date (Taxes)

Suppose dividends are taxed at the rate td , and suppose capital

gains are taxed at the rate tcg .
The day prior to the ex-dividend date, shareholders expect to
receive (1 − td )d0 and tcg ( p̃0 − p0 ) if capital losses are tax
deductible. Then

p̃0 = p0 + (1 − td )d0 + tcg ( p̃0 − p0 ),

and thus
1 − td
p̃0 − p0 = × d0 .
1 − tcg

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 Dividend Irrelevance Theory

XYZ, an all-equity firm has 100 shares outstanding and a cash

flow of $10,000 (including liquidation) over the next two years.
The firm can then pay a dividend of $100 per shares in each of
these two periods, which gives a stock price
D1 D2 100 100
P0 = + = + = $173.55
1 + rs (1 + rs )2 1.10 (1.10)2
where rs = 10% is the return required by shareholders (XYZ’s
cost of capital when an all-equity firm).

Dividend Irrelevance Theory

Suppose that XYZ wants to change its dividend policy. Instead

of paying $100 per year to each shareholder, it will pay $120 per
share the first year and whatever remains after liquidation of the
firm on the second year.
To finance the greater dividend, XYZ has to either raise debt or
equity.

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 Dividend Irrelevance Theory

Equity Is Issued
If equity is issued new shares have to be issued in exchange of
100 × 20 = $2, 000 after one year.
There is no increase in leverage and thus the new shareholders
will also require a return of 10%, i.e. a payment of $2,200 at the
end of the second year.
This means that there will be 10, 000 − 2, 200 = $7, 800 available
to the old shareholders at time 2.

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Dividend Irrelevance Theory

Equity Is Issued
The new stock price is then
120 78 120 100 − 22
P00 = + = +
1.10 (1.10)2 1.10 (1.10)2
120 100 22
= + −
1.10 (1.10)2 (1.10)2
120 100 20 × 1.10
= + −
1.10 (1.10)2 (1.10)2
120 100 20
= + −
1.10 (1.10)2 1.10
100 100
= +
1.10 (1.10)2
= $173.55

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 Dividend Irrelevance Theory

Debt Is Issued
Note that the price did not change when equity was issued to
finance the dividend.
What happens if, instead, the firm issues debt to pay the extra
$20 dividend per share?
Suppose the firm borrows $2,000 in year 1 and repay
$2, 000 × (1 + rd ) at the end of year 2.

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Dividend Irrelevance Theory

Debt Is Issued
The argument is more complex here but the increase in debt will
increase the return required by shareholders, i.e.
120 100 − 20(1 + rd )
P00 = + ,
1 + rs0 (1 + rs0 )2
where rs0 > 10%.
It can be shown that P00 = P0 .

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 Dividend Irrelevance Theory

Note that we have assumed

• No taxes, no brokerage fees

• Individuals have homogeneous beliefs

• Investment policy is not affected by the dividend policy

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Homemade Dividends

Another argument in favour of the dividend irrelevance theory is

that an investor not satisfied with the proposed stream of
dividends can always create her own personalized stream of
income by borrowing or lending.

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 Homemade Dividends

Suppose that
d1
p̃0 = d0 + ,
1 + rs
but the investor wants to receive all her dividends in period 1, i.e.
d00 = 0.

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Homemade Dividends

If d0 can be saved at the rate r, this gives

(1 + r)d0 + d1
p̃00 = 0 + .
1 + rs
If r = rs , then p̃00 = p̃0 .

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 Bird-in-the-Hand Theory

Myron Gordon and John Lintner have argued that rs decreases as

the dividend payout increases because investors are less certain
of receiving the capital gains supposed to result from retaining
earnings than they are of receiving dividend payments. That is,
take
D1
rs = + g.
P0
D1 /P0 being more certain than g, rs will decrease as D1
increases.

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Bird-in-the-Hand Theory

M&M called this theory the bird-in-the-hand fallacy since

investors tend to reinvest their dividends in securities that have
the same risk characteristics as the stock paying the dividend.

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 Taxes Preference Theory

Dividends have greater tax consequences than capital gains.

Investors in high tax brackets may prefer capital gains, and thus a
low payout ratio, to dividends.
Also, taxes on capital gains are paid only when the stock is sold,
which means that they can be deferred indefinitely.

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Optimal Dividend Policy

On the board.

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 Empirical Evidence on Dividend Policy

Empirical tests of dividend policy theories have not been too

conclusive because of two reasons:

• For a valid statistical test, things other than dividend policy

must be held constant across the firms in the sample, i.e. one
must have a sample of firms that differ in their dividend
policy only, which is not possible.

• We must also be able to measure with a high degree of

accuracy each firm’s cost of equity, another difficulty.

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Other Dividend Policy Issues

Signaling Hypothesis
The M&M dividend irrelevance theory assumes that all investors
have the same information regarding the firm’s future earnings.
In reality, however, different investors have different beliefs and
some individuals have more information than others.
More specifically, the firm managers have better information
about future earnings than outside investors.

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 Other Dividend Policy Issues

Signaling Hypothesis
It has been observed that dividend increases are often
accompanied by an increase in the stock price and dividend
decreases are often accompanied by stock price declines.
These facts can be interpreted in two different ways:

• Investors prefer dividends to capital gains;

• Unexpected dividend increases can be seen as signals of the

quality of future earnings (signaling theory).

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Other Dividend Policy Issues

Clientele Effect
Different groups (clienteles) of stockholders prefer different
dividend policies.
This may be due to the tax treatment of dividends or because
some investors are seeking cash income while others want
growth.
Changing the dividend policy may force some stockholders to
sell their shares.

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 Other Dividend Policy Issues

Clientele Effect
This is not a problem if stockholders can switch without costs but
there are

• brokerage costs;

• the likelihood that the shareholders who sell pay capital

gains taxes;

• a possible shortage of investors who like the firm’s newly

adopted dividend policy.

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Dividend Stability

Since profits vary over time, dividends should also vary.

Many stockholders, however, rely on dividends to meet expenses.
Cutting dividends may also send the wrong signal to investors
who would then bid the stock price down.
Maximizing the stock price requires a firm to balance internal
needs of funds with stockholders’ needs.

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 Dividend Stability

• Public company usually make five- to ten-year financial

forecast of earnings.

• When inflation is not persistent, “stable dividend” means

approximately the same dollar amount each year. With
inflation, “stable dividend” means a dividend that grows in
line with inflation.

• There are two components to dividend stability:

– The dividend growth rate;
– How the last dividend can help predict the next one.

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Dividend Policy in Practice

The Residual Dividend Model

Under this model, dividends are determined as follows:
1. The firm determines its optimal capital budget;

2. The firm determines the amount of equity needed given the target
capital structure;

3. Retained earnings are used to meet equity requirements to the

extent possible;

4. Dividends are paid only if more earnings are available than what is
needed.

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 Dividend Policy in Practice

The Residual Dividend Model

Under the residual dividend model, dividends are determined as
follows:
Dividends = Net Income − Target Equity Ratio × Capital Needed

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Dividend Policy in Practice

The Residual Dividend Model

Suppose a firm has a target equity ratio of 60% and needs to
spend $50m on new projects.
The firm needs .6 × 50 = $30m in equity.
If its net income is $100m, its dividend will be

100 − 30 = $70m.

If capital requirements were $200m, the firm would not pay any
dividend.

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 Dividend Policy in Practice

The Residual Dividend Model

Under the residual dividend model, the better the firm’s
investment opportunities, the lower the dividend paid.
Following the residual dividend policy rigidly would lead to
fluctuating dividends, something investors don’t like.

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Dividend Policy in Practice

The Residual Dividend Model

To satisfy shareholders’ taste for stable dividends, firms should

1. Estimate earnings and investment opportunities, on average

over the next five to ten years;

2. Use this information to find out the average residual payout

ratio;

3. Set a target payout ratio.

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 Dividend Policy in Practice

Note that one way to maintain a regular dividend payment is to

set a payment sufficiently low to never exceed the expected
payment given by the target payout ratio.
There are other factors influencing the dividend policy:

• Bond indentures

• Preferred stock restrictions

• Availability of cash

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Dividend Policy and Growth Rate

Let b denote the firm’s retention ratio, and let r denote the rate of
return the firm will earn, on average, on new investments.
Let It denote investment at time t and let Et denote earnings at
time t.
Note that r can be approximated by the return on equity (ROE).

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 Dividend Policy and Growth Rate

Then

Et = Et−1 + rIt−1 = Et−1 + rbEt−1 = (1 + rb)Et−1 .

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Dividend Policy and Growth Rate

The growth in dividends is then

Dt − Dt−1 (1 − b)Et − (1 − b)Et−1
g = =
Dt−1 (1 − b)Et−1
Et − Et−1
=
Et−1
= rb.

That is, the expected growth rate in dividends can be

approximated by

Return on Equity (ROE) × Retention Ratio.

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 Repurchases of Shares

Advantages of Stock Repurchases

• Repurchase announcements are viewed as positive signals by investors.

• Stockholders have a choice when a firm repurchases stocks: They can sell
or not sell.

• Dividends are sticky in the short-run because reducing them may

negatively affect the stock price. Extra cash may then be distributed
through stock repurchases.

• The target payout ratio may be achieved with the help of repurchases.

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Repurchases of Shares

Disadvantages of Stock Repurchases

• Stockholders may not be indifferent between dividends and

capital gains.

• The selling stockholders may not be fully aware of all the

implications of a repurchase.

• The corporation may pay too much for the repurchased

stocks.

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 Repurchases of Shares (vs Dividend Payment)

The day before a dividend payment, the price of a stock is

∞ ∞
dt CFt /n0
p̃0 = d0 + ∑ = d0 + ∑
t=1 (1 + r s )t
t=1 (1 + rs )
t

where CFt is the cash flow net of debt payments at time t and n0
is the initial number of shares.
Suppose that instead of paying d0 , the firm decides to repurchase
n0 shares.

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Repurchases of Shares (vs Dividend Payment)

Anybody left with a share will receive

∞
CFt /(n0 − n0 )
∑ (1 + rs)t = p̃00
t=1

The firm uses dividend money to repurchase the shares, and thus
n0 is such that
n0 p̃00 = n0 d0

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 Repurchases of Shares (vs Dividend Payment)

This gives us
∞
CFt /(n0 − n0 )
p̃00 = ∑
t=1 (1 + rs )t
∞
n0 CFt /n0
= × ∑
n0 − n0 t=1 (1 + rs )t
∞
n0 CFt /n0
= × ∑
n0 − n0 d0 / p̃00 t=1 (1 + rs )t
∞
1 CFt /n0
= × ∑
1 − d0 / p̃00 t=1 (1 + rs )t

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Repurchases of Shares (vs Dividend Payment)

∞
1 CFt /n0
p̃00 = × ∑
1 − d0 / p̃00 t=1 (1 + rs )t
∞
d0 CFt /n0
p̃00 − p̃00 ×
p̃00
= ∑ (1 + rs)t
t=1
∞
CFt /n0
p̃00 = d0 + ∑ (1 + rs)t = p̃0 .
t=1

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 Stock Splits

A stock split takes place when a firm declares that each

outstanding share now becomes more than one share.
A two-for-one split, for example, means that each outstanding
shares now becomes two separate shares.
In efficient markets, the two-for-one split of a $80 stock would
create two $40 stocks.

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