Dividend policy

• Mature companies with stable cash flows and limited growth opportunities tend to
return large amounts of their cash flows to shareholders, either by paying dividends
or by using the cash to repurchase common stock.
• In contrast, rapidly growing companies with good investment opportunities are
prone to invest most of their available cash flows in new projects and thus are less
likely to pay dividends or repurchase stock.
• Distribution policy is defined as (1) the level of distributions, (2) the form of
distributions i.e. cash dividends versus stock repurchases, and (3) the stability of
distributions

• Recall that FCF is defined as the amount of cash flow available for distribution to
investors after expenses, taxes, and the necessary investments in operating capital.
• After FCF becomes positive, how should a company use it?
• There are only five potentially “good” ways to use free cash flow:
1. Pay interest expenses
2. Pay down the principal on debt
3. Pay dividends
4. Repurchase stock
5. Buy non-operating assets such as Treasury bills or other marketable securities.

• The company’s operating plans determine its level of FCF.

• The company’s working capital policy determines the investment in current
assets/marketable securities.
• The company’s capital structure policy determines the amount of debt and interest
payments.
• The company’s dividend policy determines how the remaining FCF should be
distributed to shareholders
• How much to distribute as dividends versus stock repurchases is regarded as
Dividend Policy.

Dividend policy
A dividend policy is a set of principles regarding a corporation’s distributions to
shareholders.
1. May be established with regard to:
2. a dividend payout
3. a dividend per share
4. a growth in dividend per share, or
5. any other metric.
May include stock splits and stock dividends.
May include stock repurchases.

CASH DISTRIBUTIONS - Dividend Payment Procedures

• Declaration date & Payment date: On January 15, the board of directors passes a
resolution to pay a dividend of $1 per share on February 16 to all holders of record
as of January 30.
• Jan 15-declaration date, Feb 16-payment date & Jan 30-record date
• Ex-dividend date: To make sure that dividend checks go to the right people,
brokerage firms and stock exchanges establish an ex-dividend date. This date is two
business days before the date of record. If you buy the stock before this date, you
are entitled to the dividend. If you buy on this date or after, the previous owner will
get the dividend.
 • Jan 28-ex-dividend date. Before this date, the stock is said to trade “with dividend”
or “cum dividend.” Afterward, the stock trades “ex dividend.” This removes any
ambiguity about who is entitled to the dividend. The stock price will be affected
when the stock goes “ex.” if buyer is to receive the dividend, he must buy on or
before Jan 27.If he buys on Jan 28 or later, seller will receive the dividend because he
will be the official holder of record
• Date of record: At the close of business on the record date, Jan 30, the company
closes its stock transfer books and makes up a list of shareholders as of that date. If
the company is notified of the sale before 5 p.m. on Jan 30, then the new owner
receives the dividend. However, if notification is received after 5 p.m. on Jan 30, the
previous owner gets the dividend check.
• Date of payment: The dividend checks are mailed on February 16.

CASH DISTRIBUTIONS - Stock Repurchase Procedures

Stock repurchase may be viewed as an alternative to paying dividends in that it is another
method of returning cash to investors. It occurs when a company asks stockholders to
tender their shares & buys back its own outstanding stock. Three situations can lead to
stock repurchases
1. Company may decide to increase its leverage by issuing debt and using the proceeds
to repurchase stock.
2. Many firms have given their employees stock options & companies often repurchase
their own stock to sell to employees.
3. Company may have excess cash.
Stock repurchases are usually made in one of 3 ways.
a) A firm can buy back its own stock through a broker on the open market.
b) Firm can make a tender offer, under which it permits stockholders to send in shares
in exchange for a specified price per share.
c) The firm can purchase a block of shares from one large holder on a negotiated basis.
This is a targeted stock repurchase.
In this the market value of the share increases as the outstanding shares in the market
decreases thus increasing the per value of the stock this is one of the ways of distributing
gains to stockholder through capital gains.

Cash Dividends vs. Repurchasing Stock

• Reasons for preferring repurchasing stock over paying a cash dividend
– Increase financial leverage
– Potential tax advantages
– Signaling
– Offset dilution from executive stock options
– Managerial flexibility
• A stock repurchase may be a good alternative to an increase in cash dividends.
CASH DISTRIBUTIONS AND FIRM VALUE
• A company can change its value of operations if it changes investors’ perceptions
regarding expected free cash flow.
• This is true for all corporate decisions, including distribution policy.
• Is there an optimal distribution policy that maximizes company value
• The answer depends in part on investors’ preferences for returns in the form of
dividend yields versus capital gains.
• The relative mix of dividend yields & capital gains is determined by the target
distribution ratio, which is the percentage of net income distributed to shareholders
through cash dividends or stock repurchases.
• Target payout ratio is the percentage of net income paid as cash dividend.
• Note: Payout ratio must be less than distribution ratio because distribution ratio
includes stock repurchases as well as cash dividends.
• A high distribution ratio & high payout ratio mean that company pays large
dividends & has small stock repurchases. In this situation, the dividend yield is
relatively high & expected capital gain is low.
• If company has large distribution ratio but small payout ratio, then it pays low
dividends but regularly repurchases stock, resulting in low dividend yield but a
relatively high expected capital gain yield.
• If a company has a low distribution ratio, then it must also have a relatively low
payout ratio, again resulting in a low dividend yield and, it is hoped, a relatively
high capital gain.

Dividend Policy and Company Value: Theory

We now examine theories of investor preferences for dividend yield versus capital gains:
1. The dividend irrelevance theory
2. The dividend preference theory (called “bird in the hand” theory)
3. The tax effect theory.
4. Clientele effect, Signaling effect & Agency cost effects.
Dividend Irrelevance Theory – MM
• They argued that the firm’s value is determined only by its basic earning power & its
business risk. In other words, MM argued that the value of the firm depends only on
the income produced by its assets, not on how this income is split between
dividends & retained earnings, assuming no taxes, no transaction/brokerage costs.
• A shareholder can construct his own dividend policy. If firm doesn't pay dividends &
he wants 5% dividend he can sell 5% of his stock.
• Conversely, if a company pays higher dividend than an investor desires, the investor
can use the unwanted dividends to buy additional shares of the co.
• Thus the theory states that if investors could buy & sell shares & thus create their
own dividend policy w/o incurring costs, then firm’s dividend policy would truly be
irrelevant.
• Conclusion of MM’s dividend irrelevance theory: Dividend policy does not affect a
stock’s value or risk, hence does not affect its ROE.
• In developing their dividend theory, MM made a number of important assumptions,
especially the absence of taxes and transaction/brokerage costs.
• If these assumptions are not true, then investors who want additional dividends
must sell shares and incur brokerage costs and also must pay taxes on any capital
gains.
• Investors who do not want dividends must incur brokerage costs to purchase shares
with their dividends.
• Because taxes and brokerage costs certainly exist, dividend policy may well be
relevant.
Dividend Preference (Bird-in-the-Hand) Theory
• In contrast, Myron and Lintner argued that a stock’s risk declines as dividends
increase. A return in the form of dividends is a sure thing, but a return in the form of
capital gains is risky.
• In other words, a bird in the hand is worth more than two in the bush. Therefore,
shareholders prefer dividends and are willing to accept a lower required ROE.
• The possibility of agency costs also leads to a similar conclusion.
• First, high payouts reduce the risk that managers will squander cash because there is
less cash on hand.
• Second, a high-payout company must raise external funds more often than a low
payout company, all else held equal. If a manager knows that the company will
receive frequent scrutiny from external markets, then the manager will be less likely
to engage in wasteful practices.
• Therefore, high payouts reduce the risk of agency costs. With less risk shareholders
are willing to accept a lower required return on equity.
Conclusions-The Bird-in-the-Hand Argument
Investors prefer a cash dividend to uncertain capital gains.
 Hence, investors prefer the “bird in the hand.”
 Issue: Riskiness of the stock appreciation .
If this explanation holds, a company that pays a cash dividend will have a higher value than
a similar company that does not pay a cash dividend.
Bottom line: Dividend policy affects the value of the firm.

Tax Effect Theory: Capital Gains Are Preferred

• Dividends are, in some cases, taxed more highly than capital gains.
• There are two reasons why stock price appreciation still is taxed more favorably
than dividend income.
• First, the time value of money means that a dollar of taxes paid in the future has a
lower effective cost than a dollar paid today. So even when dividends and gains are
taxed equally, capital gains are never taxed sooner than dividends.
• Second, if a stock is held until the shareholder dies, then no capital gains tax is due at
all: the beneficiaries who receive the stock can use its value on the date of death as
their cost basis and thus completely escape the capital gains tax.
• So investors may prefer the companies which minimize dividends. If so then
investors should be willing to pay more for low-payout cos., than for otherwise
similar high-payout cos.
Conclusions - The Tax Argument
• Because dividends are in some cases taxed more highly than capital gains, investors
might require a higher pre-tax rate of return to induce them to buy dividend-paying
stocks.
• Therefore, investors may prefer the companies that minimize dividends. If so, then
investors should be willing to pay more for low-payout companies than for
otherwise similar high-payout companies.
• If dividends are taxed at a rate higher than capital gains, investors prefer that
companies reinvest cash flow back into the firm.
 In other words, investors prefer the lower-taxed capital gains to the higher-
taxed cash dividends.
 This advocates a zero dividend payout when dividends are taxed at a rate
higher than that of capital gains.
Bottom line: Dividend policy does affect the value of the firm.
Empirical Evidence on Distribution Policies
• It is difficult to construct a perfect empirical test of the relationship between payout
policy and the required rate of return on stock.
• First, all factors other than distribution level should be held constant. Unfortunately,
we cannot find a set of publicly owned firms that differ only in their distribution
levels.
• However, in US, recent evidence suggests that firms with higher dividend payouts
also have higher required returns. This tends to support the tax effect hypothesis.
• Agency costs is severe in countries with poor investor protection. There, companies
with high dividend payouts should be more highly valued than those with low
payouts because high payouts limit the extent to which managers can expropriate
shareholder wealth.
• Other research shows that investors prefer stable, predictable dividend payouts
(regardless of the payout level). Moreover, they interpret dividend changes as
signals about firms’ future prospects.
• More developed countries prefer capital gains as compared to poorer countries
where conditions are not stable there people prefer cash dividends.

CLIENTELE EFFECT
• Different groups, or clienteles, of stockholders prefer different dividend payout
policies. For example, retired individuals & pension funds generally prefer cash
income, so they may want the firm to pay out a high percentage of its earnings. Such
investors are often in low or even zero tax brackets, so taxes are of no concern.
• On the other hand, stockholders in their peak earning years might prefer
reinvestment, because they have less need for current investment income and
would simply reinvest dividends received—after first paying income taxes on those
dividends.
• Such stockholders might favor the low-dividend policy: the less the firm pays out in
dividends, the less these stockholders will have to pay in current taxes, and the less
trouble and expense they will have to go through to reinvest their after-tax
dividends.
Investors who want current investment income should own shares in high dividend payout
firms, while investors with no need for current income should own shares in low dividend
payout firms.

CLIENTELE Effect – change in dividend policy

• To the extent that stockholders can switch firms, a firm can change from one
dividend payout policy to another and then let stockholders who do not like the new
policy sell to other investors who do.
• However, frequent switching would be inefficient because of:
1. Brokerage costs
2. The likelihood that stockholders who are selling will have to pay capital gains taxes
3. A possible shortage of investors who like the firm’s newly adopted dividend policy.
• Thus, management should be hesitant to change its dividend policy, because a
change might cause current shareholders to sell their stock, forcing the stock price
down.
• Such a price decline might be temporary but might also be permanent
• if few new investors are attracted by the new dividend policy, then the stock price
would remain depressed. Of course, the new policy might attract an even larger
clientele than the firm had before, in which case the stock price would rise.
• Evidence from several studies suggests existence of clientele effect.
 • It’s been argued by MM and others that one clientele is as good as another, so the
existence of a clientele effect does not necessarily imply that one dividend policy is
better than any other.
• However, MM may be wrong, and neither they nor anyone else can prove that the
aggregate makeup of investors permits firms to disregard clientele effects.
• This issue, like most others in the dividend arena, is still up in the air.

Conclusions - The Clientele Effect

• The clientele effect is the influence of groups of investors attracted to companies
with specific dividend policies.
 Clientele are simply a group of investors who have the same preference.
• Types of clientele:
 If an investor has a marginal tax on capital gains lower than the marginal tax
on dividends, the investor prefers a return in the form of capital gains.
 Investors who are tax exempt (e.g., pension funds) are indifferent about
dividends and capital gains.
 Some investors, by policy or restrictions, only invest in stocks that pay
dividends.
• The importance of the existence of clientele is that investors will have a preference
for stocks with a specific dividend policy.

Ex-dividend & drop in prices

INFORMATION CONTENT, OR SIGNALING HYPOTHESIS
• MM assumed that everyone, investors & managers have identical information
regarding a firm’s future earnings and dividends.
• In reality, however, managers have better information about future prospects than
public stockholders.
• It has been observed that an increase in the dividend is often accompanied by an
increase in the price of a stock and vice versa.
• Some have argued this indicates that investors prefer dividends to capital gains.
• However, MM noted that corporations are reluctant to cut dividends, which implies
that corporations do not raise dividends unless they anticipate higher earnings in the
future.
• Thus, MM argued that a higher than expected dividend increase is a signal to
investors that the firm’s management forecasts good future earnings & vice versa.
• Thus, MM argued that investors’ reactions to changes in dividend policy do not
necessarily show that investors prefer dividends to retained earnings.
• Rather, price changes following dividend actions simply indicate that there is
important information, or signaling, content in dividend announcements.
Conclusions - Dividends and Signaling
• Under MM’s theory, everyone has the same information.
• But when there is asymmetric information, dividend changes may convey
information.
Positive Information
• Dividend initiations
• Dividend increases
• Expansion Programs
Negative Information
• Dividend omissions
• Dividend reductions
Agency costs and Dividend policy

Conclusions - Agency costs and Dividend policy

• The separation of ownership and management in a corporation may lead to
suboptimal investment.
 Management may invest in negative NPV projects to enhance the company’s
size or management’s control.
• Jensen’s free cash flow hypothesis is that having free cash flow tempts management
to make investments that are not +ve NPV.
 Paying dividends or interest on debt uses this free cash flow and averts an
agency issue.
• If a company’s debt has a restriction on paying dividends, it may avoid the issue of
paying dividends.
Bottom line: Dividends may reduce agency costs and, therefore, increase the value of the
firm.
IMPLICATIONS FOR DIVIDEND STABILITY-Summary
• Clientele effect & the information content in dividend announcement definitely
have implications regarding the desirability of stable versus volatile dividends. For
example, many stockholders rely on dividends to meet expenses, and they would be
seriously inconvenienced if the dividend stream were unstable.
• Further, reducing dividends to make funds available for capital investment could
send incorrect signals to investors, who might push down the stock price because
they interpret the dividend cut to mean that the company’s future earnings
prospects have been diminished.
• Thus, maximizing its stock price probably requires a firm to maintain a steady
dividend policy. Because sales and earnings are expected to grow for most firms, a
stable dividend policy means a company’s regular cash dividends should also grow at
a steady, predictable rate. But most companies will probably move toward small,
sustainable, regular cash dividends that are supplemented by stock repurchases.

Factors affecting dividend policy

Investment opportunities:
 A company with more investment opportunities will pay out less in dividends.
 A company with fewer investment opportunities will pay out more in dividends.
Expected volatility of future earnings:
 Companies with greater earnings volatility are less likely to increase dividends—a
greater chance of not maintaining the increased dividend.
Financial flexibility:
 Companies seeking more flexibility are less likely to pay dividends or to increase
dividends because they want to preserve cash.
Tax considerations
 The tax rate on dividends and how dividends are taxed relative to capital gains affect
investors’ preferences and, hence, companies’ dividend policy.
Flotation costs
 These costs make it more expensive to use newly issued stock instead of internally
generated funds.
 Smaller companies face higher flotation costs.
Contractual and legal restrictions
 Forms of restrictions:
• Impairment of capital rule
• Bond indentures
• Requirement of preferred shares
Types of dividend policies

Example: stable dividend policy

• Using a stable dividend policy, a company may attempt to align its dividend growth
rate to the company’s long-term earnings growth rate. The stable dividend policy
can be represented by a gradual adjustment process in which the expected dividend
is equal to last year’s dividend per share, plus any adjustment.
• What are dividends for FY2011 and FY2012 if the company followed a stable
dividend policy, with a target dividend payout of 10% and an adjustment factor of
0.3?

Target payout ratio

Using target payout adjustment model

Residual dividend policy

Analysis of Dividend Safety
We can evaluate the “safety” of the dividend by examining the company’s ability to meet its
dividends.
– “Safety” pertains to the ability of the company to continue to pay the dividend or
maintain a growth pattern.
– Possible ratios: Dividend coverage and free cash flow coverage
• Using dividends plus repurchases may be more appropriate for some firms.
• Values greater than 1.0 indicate ability to meet the dividend and repurchase, and
thus the greater the coverage, the greater the liquidity and ability to pay.
It is sometimes difficult to predict changes in dividend because of “surprises,” such as the
financial crisis.

Dividend Coverage Ratios

Dividend coverage ratios:
Net income
Dividend coverage ratio =
Dividends + Repurchase
Free cash flow to equity
FCFE coverage ratio =
(Dividends + Share repurchase)
A company has $200 million in earnings, pays $40 million in dividends, has cash flow from
operations of $180 million, and had capital expenditures of $60 million. The company spent
$10 million for share repurchases. Therefore:
$200
Dividend coverage ratio = = 5 times
$40 + $50
$180 - $60 $220
FCFE coverage ratio = = = 4.4 times
($40 + $10) $50
Summary

• There are three general theories on investor preference for dividends: Dividend
policy is irrelevant, the bird-in-hand argument, and the tax explanation.
• An argument for dividend irrelevance given perfect markets is that the corporate
dividend policy is irrelevant because shareholders can create their preferred cash
flow streams by selling any company’s shares.
• The clientele effect suggests that different classes of investors have differing
preferences for dividend income.
• Dividend declarations may provide information to investors regarding the
prospects of the company.
• The payment of dividends can help reduce the agency conflicts between managers
and shareholders, but can worsen conflicts of interest between shareholders and
debtholders.
• Investment opportunities, the volatility expected in future earnings, financial
flexibility, taxes, flotation costs, and contractual and legal restrictions affect
dividend policies.
• Using a stable dividend policy, a company may attempt to align its dividend
growth rate to the company’s long-term earnings growth rate.
• The stable dividend policy can be represented by a gradual adjustment process in
which the expected dividend is equal to last year’s dividend per share, plus any
adjustment.
• With a constant dividend payout ratio policy, a company applies a target dividend
payout ratio to current earnings.
• In a residual dividend policy, the amount of the annual dividend is affected by both
the earnings and the capital investment spending.
• Share repurchases usually offer more flexibility than cash dividends by not
establishing the expectation that a particular level of cash distribution will be
maintained.
• Share repurchases can signal that company officials think their shares are
undervalued. On the other hand, share repurchases could send a negative signal
that the company has few positive NPV opportunities.
• The issue of dividend safety deals with the likelihood of the dividend being
continued.
• Early warning signs of whether a company can sustain its dividend include the level
of dividend yield, whether the company borrows to pay the dividend, and the
company’s past dividend record.