Dividend Policy

Presentation By: Arsalan Khanzada

 Market Ratios
EPS = Net Income / No. of Common Shares O/s.

Price Earnings (PE) Ratio = Mkt Price Per Share/EPS

Dividend Payout Ratio = Dividends Per Share/Earning

Per Share

Dividend Yield = Annual Dividend Per Common

Share/Market Price Per Common Share

Retention Rate (RR)= 1-PayOut Ratio

Growth Rate g = RR * ROE

 Recall: Stock Returns

Return = P1 - Po + D1
Po
 Recall: Stock Returns

Return = P1 - Po + D1
Po

P1 - Po D1
= +
Po Po
 Recall: Stock Returns

Return = P1 - Po + D1
Po

P1 - Po D1
= +
Po Po

Capital Gain
 Recall: Stock Returns

Return = P1 - Po + D1
Po

P1 - Po D1
= +
Po Po

Capital Gain Dividend Yield

 Dilemma: Should the firm use
retained earnings for:

a) Financing profitable capital

investments?
b) Paying dividends to stockholders?
 P1 - Po D1
Return = +
Po Po

If we retain earnings for profitable

investments,
 P1 - Po D1
Return = +
Po Po

If we retain earnings for profitable

investments, dividend yield will be zero,
 P1 - Po D1
Return = +
Po Po

If we retain earnings for profitable

investments, dividend yield will be zero,
but the stock price will increase, resulting
in a higher capital gain.
 P1 - Po D1
Return = +
Po Po

If we pay dividends,
 P1 - Po D1
Return = +
Po Po

If we pay dividends, stockholders receive

an immediate cash reward for investing,
 P1 - Po D1
Return = +
Po Po

If we pay dividends, stockholders receive

an immediate cash reward for investing,
but the capital gain will decrease, since
this cash is not invested in the firm.
 So, dividend policy really
involves 2 decisions:
How much of the firm’s earnings
should be distributed to
shareholders as dividends, and
How much should be retained for
capital investment.
 Is Dividend Policy Important?

Three viewpoints:
1) Dividends are Irrelevant. If we assume
perfect markets (no taxes, no
transactions costs, etc.) dividends do not
matter. If we pay a dividend,
shareholders’ dividend yield rises, but
capital gains decrease.
 D1
Po =
kc - g

Dividend irrelevance: In perfect

markets, an increase in dividends
 D1
Po =
kc - g

Dividend irrelevance: In perfect

markets, an increase in dividends
 D1
Po =
kc - g

Dividend irrelevance: In perfect

markets, an increase in dividends means
less money will be invested, so the growth
rate declines.
 D1
Po =
kc - g

Dividend irrelevance: In perfect

markets, an increase in dividends means
less money will be invested, so the growth
rate declines.
 D1
Po =
kc - g

Dividend irrelevance: In perfect

markets, an increase in dividends means
less money will be invested, so the growth
rate declines.
The increase in D1 is offset by the
decrease in g.
 D1
Po =
kc - g

Dividend irrelevance: In perfect

markets, an increase in dividends means
less money will be invested, so the growth
rate declines.
The increase in D1 is offset by the
decrease in g.
Consequently, dividend policy does not
affect stock price.
 P1 - Po D1
Return = +
Po Po

Dividend irrelevance: In perfect

markets, investors do not care if
returns come in the form of dividend
yields or capital gains.
 P1 - Po D1
Return = +
Po Po

Dividend irrelevance: In perfect

markets, investors do not care if
returns come in the form of dividend
yields or capital gains.
 P1 - Po D1
Return = +
Po Po

Dividend irrelevance: In perfect

markets, investors do not care if
returns come in the form of dividend
yields or capital gains.
 2) High Dividends are Best

Some investors may prefer a certain

dividend now over a risky expected
capital gain in the future.
 2) High Dividends are Best

Some investors may prefer a certain

dividend now over a risky expected
capital gain in the future.

P1 - Po D1
Return = +
Po Po
 3) Low Dividends are Best

Dividends are taxed immediately.

Capital gains are not taxed until the
stock is sold.
Therefore, taxes on capital gains can
be deferred indefinitely.
 Dividend Policies
1) Constant Payout Ratio Policy: if
directors declare a constant payout ratio
of, for example, 30%, then for every
dollar of earnings available to
stockholders, 30 cents would be paid out
as dividends.
the ratio remains constant over time, but
the dollar value of dividends changes as
earnings change.
 Dividend Policies
2) Stable Dollar Dividend Policy: the firm
tries to pay a fixed dollar dividend each
quarter.
firms and stockholders prefer stable
dividends. Decreasing the dividend sends
a negative signal!
 Dividend Policies
3) Small Regular Dividend plus Year-End
Extras
the firm pays a stable quarterly dividend
and includes an extra year-end dividend
in prosperous years.
By identifying the year-end dividend as
“extra,” directors hope to avoid signaling
that this is a permanent dividend.
 Jan.4 Jan.28 Feb.1 Mar. 11
Declare Ex-div. Record Payment
dividend date date date
Dividend Payments
1) Declaration Date: the board of
directors declares the dividend,
determines the amount of the dividend,
and decides on the payment date.
 Jan.4 Jan.28 Feb.1 Mar. 11
Declare Ex-div. Record Payment
dividend date date date
Dividend Payments
2) Ex-Dividend Date:
 Jan.4 Jan.28 Feb.1 Mar. 11
Declare Ex-div. Record Payment
dividend date date date
Dividend Payments
2) Ex-Dividend Date: To receive the
dividend, you have to buy the stock
before the ex-dividend date. On this
date, the stock begins trading “ex-
dividend” and the stock price falls
approximately by the amount of the
dividend.
 Jan.4 Jan.28 Feb.1 Mar. 11
Declare Ex-div. Record Payment
dividend date date date
Dividend Payments
3) Date of Record:
 Jan.4 Jan.28 Feb.1 Mar. 11
Declare Ex-div. Record Payment
dividend date date date
Dividend Payments
3) Date of Record: 4 days after the ex-
dividend date, the firm receives the list of
stockholders eligible for the dividend.
often, a bank trust department acts as
registrar and maintains this list for the
firm.
 Jan.4 Jan.28 Feb.1 Mar. 11
Declare Ex-div. Record Payment
dividend date date date
Dividend Payments
4) Payment Date: date on which the
firm mails the dividend checks to the
shareholders of record.
 Stock Dividends and Stock
Splits
Stock dividend: payment of additional
shares of stock to common stockholders.
Example: Citizens Bancorporation of
Maryland announced a 5% stock
dividend to all shareholders of record on
March 27, 1987. For each 100 shares
held, shareholders received another 5
shares.
Did the shareholders’ wealth increase?
 Stock Dividends and Stock
Splits
Stock Split: the firm increases the number
of shares outstanding and reduces the price
of each share.
Example: Joule, Inc. announced a 3-for-2
stock split. For each 100 shares held,
shareholders received another 50 shares.
Does this increase shareholder wealth?
Are a stock dividend and a stock split the
same?
 Stock Dividends and Stock
Splits
Stock Splits and Stock Dividends are
economically the same: the number of
shares outstanding increases and the
price of each share drops. The value of
the firm does not change.
Example: A 3-for-2 stock split is the
same as a 50% stock dividend. For each
100 shares held, shareholders receive
another 50 shares.
 Stock Dividends and Stock
Splits
Effects on Shareholder Wealth:
 Stock Dividends and Stock
Splits
Effects on Shareholder Wealth: these will
cut the company “pie” into more pieces
but will not create wealth. A 100% stock
dividend (or a 2-for-1 stock split) gives
shareholders 2 half-sized pieces for each
full-sized piece they previously owned.
 Stock Dividends and Stock
Splits
Effects on Shareholder Wealth: these will
cut the company “pie” into more pieces
but will not create wealth. A 100% stock
dividend (or a 2-for-1 stock split) gives
shareholders 2 half-sized pieces for each
full-sized piece they previously owned.
For example, this would double the
number of shares, but would cause a $60
stock price to fall to $30.
 Stock Dividends and Stock
Splits
Why bother?
Proponents argue that these are used to
reduce high stock prices to a “more
popular” trading range (generally $15 to
$70 per share).
Opponents argue that most stocks are
purchased by institutional investors who
have $millions to invest and are
indifferent to price levels. Plus, stock
splits and stock dividends are expensive!
 Stock Dividend Example
shares outstanding: 1,000,000
net income = $6,000,000; P/E = 10
25% stock dividend.
An investor has 120 shares. Does the
value of the investor’s shares
change?
Before the 25% stock dividend:
EPS = 6,000,000/1,000,000 = $6
P/E = P/6 = 10, so P = $60 per share.
Value = $60 x 120 shares = $7,200
After the 25% stock dividend:
# shares = 1,000,000 x 1.25 = 1,250,000.
EPS = 6,000,000/1,250,000 = $4.80
P/E = P/4.80 = 10, so P = $48 per share.
Investor now has 120 x 1.25 = 150 shares.
Value = $48 x 150 = $7,200
 Stock Repurchases

Stock Repurchases may be a good

substitute for cash dividends.
If the firm has excess cash, why not buy
back common stock?
 Stock Repurchases

Stock Repurchases may be a good

substitute for cash dividends.
If the firm has excess cash, why not buy
back common stock?
 Stock Repurchases
Repurchases drive up the stock price,
producing capital gains for
shareholders.
Repurchases increase leverage, and can
be used to move toward the optimal
capital structure.
Repurchases signal positive
information to the market - which
increases stock price.
 Stock Repurchases
Repurchases may be used to avoid a
hostile takeover.
Example: T. Boone Pickens attempted
raids on Phillips Petroleum and Unocal
in 1985. Both were unsuccessful
because the target firms undertook
stock repurchases.
 Stock Repurchases
Methods:
Buy shares in the open market through
a broker.
Buy a large block by negotiating the
purchase with a large block holder,
usually an institution. (targeted stock
repurchase)
Tender offer: offer to pay a specific
price to all current stockholders.