FM II Ch-2

Download as docx, pdf, or txt
Download as docx, pdf, or txt
You are on page 1of 10

Chapter Two

2. Review of Dividend and Dividend Policy


2. Introduction
The term dividend usually refers to payment made out of a firm’s earnings to its stockholders,
either in the form of cash or stock. If a payment is made from sources other than current or
accumulated retained earnings, the term distribution rather than dividend is used. However, it is
acceptable to refer to a distribution from earnings as a dividend and a distribution from capital as
a liquidating dividend.

Dividend Classification
Dividend may be distributed among the shareholders in the form of cash or stock. Hence,
Dividends are classified into:
A. Cash dividend
B. Stock dividend
C. Bond dividend
D. Property dividend

Cash Dividend
Dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid
periodically out the business concerns EAIT (Earnings after interest and tax). Cash dividends are
common and popular types followed by majority of the business concerns.
Stock Dividend
Stock dividend is the issuance of additional shares of stock to stockholders. A stock dividend
may be declared when the cash position of the firm is inadequate and/or when the firm wishes to
prompt more trading of its stock by reducing its market price. With a stock dividend, retained
earnings decrease but common stock and paid-in capital on common stock increase by the same
total amount. A stock dividend, therefore, provides no change in stockholders’ wealth. Stock
dividends increase the shares held, but the proportion of the company each stockholder owns
remains the same. In other words, if a stockholder has a 2 percent interest in the company before
a stock dividend, he or she will continue to have a 2 percent interest after the stock dividend.
This issue is given only to the existing shareholders of the business concern.

Example Mr. James owns 200 shares of Newland Corporation. There are 10,000 shares
outstanding; therefore, Mr. James holds a 2 percent interest in the company. The company issues
a stock dividend of 10 percent. Mr. James will then have 220 shares out of 11,000 shares issued.
His proportionate interest remains at 2 percent (220/11,000).

Bond Dividend
Bond dividend is also known as script dividend. If the company does not have sufficient funds to
pay cash dividend, the company promises to pay the shareholder at a future specific date with the
help of issue of bond or notes.
1
Property Dividend
Property dividends are paid in the form of some assets other than cash. It will distribute under the
exceptional circumstance.
Cash Dividend and Dividend Payment
Cash dividends come in several different forms. The basic types of cash dividends are:
 Regular cash dividends
 Extra dividends
 Special dividends
 Liquidating dividends
The most common type of dividend is a cash dividend. Commonly, public companies pay
regular cash dividends four times a year. As the name suggests, these are cash payments made
directly to shareholders, and they are made in the regular course of business. Sometimes firms
will pay a regular cash dividend and an extra cash dividend. By calling part of the payment
“extra,” management is indicating that the “extra” part may or may not be repeated in the future.
A special dividendis similar, but the name usually indicates that this dividend is viewed as a
truly unusual or one-time event and won’t be repeated. Finally, the payment of a liquidating
dividendusually means that some or all of the business has been liquidated, that is, sold off.
However it is labeled, a cash dividend payment reduces corporate cash and retained earnings,
except in the case of a liquidating dividend (which may reduce paid-in capital).

Standard Method of Cash Dividend Payment


The decision to pay a dividend rests in the hands of the board of directors of the corporation.
When a dividend has been declared, it becomes a debt of the firm and cannot be withdraw easily.
Sometime after it has been declared, a dividend is distributed to all shareholders as of some
specific date.
The amount of the dividend is expressed as dollars per share (dividend per share), as a
percentage of the market price (dividend yield), or as a percentage of earnings per share
(dividend payout).

1. Declaration date. This is the date on which the board of directors declares the dividend.
On this date, the payment of the dividend becomes a legal liability of the firm.
2. Date of record. This is the date upon which the stockholder is entitled to receive the
dividend.
3. Ex-dividend date. The ex-dividend date is the date when the right to the dividend leaves
the shares. The right to a dividend stays with the stock until 2 days before the date of
record. That is, on the second day prior to the record date, the right to the dividend is no
longer with the shares, and the seller, not the buyer of that stock, is the one who will
receive the dividend.
The market price of the stock reflects the fact that it has gone ex-dividend and will decrease
byapproximately the amount of the dividend.
Assume that the date of record is 11th (Thursday):
Ex-dividend Date Record Date
↓ ↓
Mon Tues Wed Thurs Fri
8th 9th 10th 11th 12th

2
If you buy it on the ex-dividend date (9th), you will not receive the dividend because your name
will not appear in the company’s record books until Friday (12th). If you want to buy the stock
and receive the dividend, you need to buy it on the 8th. If you want to sell the stock and still
receive the dividend, you need to sell on the 9th.

4. Date of payment. This is the date when the company distributes its dividend checks to its
stockholders.
Dividends are usually paid in cash. A cash dividend is typically expressed in dollars and cents
per share. However, the dividend on preferred stock is sometimes expressed as a percentage of
par value.
Example.On November 15, 20X1, a cash dividend of $1.50 per share was declared on 10,000
shares of$10 par value common stock. The amount of the dividend paid by the company is
$15,000 (10,000×$1.50).

Example. Jones Corporation has 20,000 shares of $10 par value, 12 percent preferred stock
outstanding. On October 15, 20X1, a cash dividend was declared to holders of record as of
December 15, 20X1. The amount of dividend to be paid by Jones Corporation is equal to:

20,000 shares × $10 par value =$200,000 × 12% =$24,000


Some companies allow stockholders to automatically reinvest their dividend in corporate shares
instead of receiving cash. The advantage to the stockholder is that he or she avoids the brokerage
fees associated with buying new shares. However, there is no tax advantage since the stockholder
must still pay ordinary income taxes on the dividend received.

2.1Dividend theories

Dividend decision of the business concern is one of the crucial parts of the financial manager,
because it determines the amount of profit to be distributed among shareholders and amount of
profit to be treated as retained earnings for financing its long-term growth. Hence, dividend
decision plays very important part in the financial management. Dividend decision consists of
two important concepts which are based on the relationship between dividend decision and value
of the firm.In this section we examine three theories of investor preference:
1. The dividend irrelevance theory,
2. The “bird-in-the-hand” theory, and
3. The tax preference theory.

Irrelevance of Dividend Policy

The principal proponents of the dividend irrelevance theory are Merton Miller and Franco
Modigliani (MM). They arguedthat the firm’s value is determined only by its basic earning
power and its business risk. In other words, MM argued that the value of the firm depends only
on the income produced by its assets or its investment policy, not on how this income is split
between dividends and retained earnings.
To understand MM’s argument, recognize that any shareholder can in theory construct his own
dividend policy. For example, if a firm does not pay dividends, a shareholder who wants a 5%
dividend can “create” it by selling 5% of his stock. Conversely, if a company pays a higher
3
dividend than an investor desires, the investor can use the unwanted dividends to buy additional
shares of the company’s stock. If investors could buy and sell shares and thus create their own
dividend policy without incurring costs, then the firm’s dividend policy would truly be
irrelevant. In developing their dividend theory, MM made a number of important assumptions,
especially there are no transactions costs, no flotation costs to companies issuing securities, and
no taxes.
An Illustration of the Irrelevance of Dividend Policy: Wharton is an all-equity firm that has
existed for 10 years. The current financial managers plan to dissolve the firm in two years. The
total cash flows the firm will generate, including the proceeds from liquidation, will be $10,000
in each of the next two years.

Current Policy: Dividends Set Equal to Cash Flow At the present time, dividends at each date
are set equal to the cash flow of $10,000. There are 100 shares outstanding, so the dividend per
share is $100. The value of the stock is equal to the present value of the future dividends.
Assuming a 10 percent required return, the value of a share of stock today, P0, is:

D1 D2
Po ¿ +
(1+r ¿¿¿ 1) (1+ r ¿ ¿¿ 2)
100 100
Po ¿ +
(1.1) ¿ ¿

The firm as a whole is thus worth 100 x $173.55 = $17,355. Several members of the board of
Wharton have expressed dissatisfaction with the current dividend policy and have asked you to
analyze an alternative policy.

Alternative Policy: Initial Dividend Greater than Cash Flow Another possible policy is for
the firm to pay a dividend of $110 per share on the first date (Date 1), which is, of course, a total
dividend of $11,000. Because the cash flow is only $10,000, an extra $1,000 must somehow be
raised. One way to do this is to issue $1,000 worth of bonds or stock at Date 1. Assume that
stock is issued. The new stockholders will desire enough cash flow at Date 2 so that they earn the
required 10 percent return on their Date 1 investment.

What is the value of the firm with this new dividend policy? The new stockholders invest $1,000.
They require a 10 percent return, so they will demand $1,000 x1.10 = $1,100 of the Date 2 cash
flow, leaving only $8,900 to the old stockholders. The dividends to the old stockholders will be
as follows:
Date 1 Date 2
Aggregate dividends to old stockholders 11,000 8,900
Dividends per share 110 89

The present value of the dividends per share is therefore:

4
110 89
Po ¿ +
(1.1) ¿ ¿
The firm as a whole is thus worth 100 x $173.55 = $17,355. This is the same value we had
before.
The value of the stock is not affected by this switch in dividend policy even though we have to
sell some new stock just to finance the new dividend. In fact, no matter what pattern of dividend
payout the firm chooses, the value of the stock will always be the same in this example. In other
words, for the Wharton Corporation, dividend policy makes no difference. The reason is simple:
any increase in a dividend at some point in time is exactly offset by a decrease somewhere else,
so the net effect, once we account for time value, is zero.
 Homemade Dividends
There is an alternative and perhaps more intuitively appealing explanation of why dividend
policy doesn’t matter. Homemade dividends – selling shares in the appropriate proportion to
create an equivalent cash flow to receiving the dividend stream you want. If you receive
dividends that you don’t want, you can purchase additional shares.

To illustrate assume the previous example. Suppose individual investor X prefers dividends per
share of $100 at both Dates 1 and 2. Would she be disappointed if informed that the firm’s
management was adopting the alternative dividend policy (dividends of $110 and $89 on the two
dates, respectively)? Not necessarily, because she could easily reinvest the $10 of unneeded
funds received on Date 1 by buying some more Wharton stock. At 10 percent, this investment
would grow to $11 by Date 2. Thus, X would receive her desired net cash flow of $110 - 10 =
$100 at Date 1 and $89 + 11 = $100 at Date 2.
Conversely, imagine that an investor Z, preferring $110 of cash flow at Date 1 and $89 of cash
flow at Date 2, finds that management will pay dividends of $100 at both Dates 1 and 2. This
investor can simply sell $10 worth of stock to boost his total cash at Date 1 to $110. Because this
investment returns 10 percent, Investor Z gives up $11 at Date 2 ($10 x 1.1), leaving him with
$100 - 11 = $89.
Our two investors are able to transform the corporation’s dividend policy into a different policy
by buying or selling on their own. The result is that investors are able to create a homemade
dividend policy. This means that dissatisfied stockholders can alter the firm’s dividend policy to
suit themselves. As a result, there is no particular advantage to any one dividend policy the firm
might choose.

Bird-In-The-Hand Theory

Gordon and Lintner argue that the cost of equity increases as the dividend payout isreduced,
because investors can be more sure of receiving dividends than the capitalgains that are expected
to result from retained earnings. Therefore, the theory holds that the value of the firm will be
maximized by a high dividend payout ratio, becauseinvestors regard actual dividends as being
less risky than potential capital gains.

5
This means that this theory is in direct contrast with MM theory of dividend irrelevance.
The bird-in-the-hand argument of dividend means that the near-future dividends are worth more
than a distant-future dividend of equal amount. That is, if an investor is asked whether he prefers
one bird in the hand or two in the bush, he will always select the former.
Tax Preference Theory
The tax preference theory holds that the value of the firm will be maximized by a low dividend
payout,Taxes are not paid on the gain until a stock is sold. Due to time value effects, a dollar of
taxes paid in the future has a lower effective cost than a dollar paid today.A firm that adopts a
low-dividend payout will reinvest the money instead of paying it out. This reinvestment
increases the value of the firm and of the equity. All other things being equal, the net effect is
that the expected capital gains portion of the return will be higher in the future.

2.2 Establishing the dividend policy


Dividend policy
A finance manager’s objective for the company’s dividend policy is to maximize owner wealth
while providing adequate financing for the company. When a company’s earnings increase,
management does not automatically raise the dividend. Generally, there is a time lag between
increased earnings and the payment of a higher dividend. Only when management is confident
that the increased earnings will be sustained will they increase the dividend. Once dividends are
increased, they should continue to be paid at the higher rate. The various types of dividend
policies are:

Dividend Policy Options

Dividend policy options refer to the policy options that the management formulates in regard to
earnings for distribution as dividend among shareholders concerned with the continuous course
of action to be followed over a period of several years.
Residual Dividend Approach
Residual Dividend Model A model in which the dividend paid is set equal to net income minus
the amount of retainedearnings necessary to finance thefirm’s optimal capital budget.

With a residual dividend policy, the firm’s objective is to meet its investment needs and maintain
its desired debt-equity ratio before paying dividends. The first step in implementing a residual
dividend policy is to determine the amount of funds that can be generated without selling new
equity. The second step is to decide whether or not a dividend will be paid. To do this, we
compare the total amount that can be generated without selling new equity to planned capital
spending. If funds needed exceed funds available, then no dividend will be paid.
For a given firm, the optimal payout ratio is a function of four factors:
1. Investor’s preferences for dividends versus capital gains,
2. The firm’s investment opportunities,
3. Its target capital structure, and
4. The availability and cost of external capital.

6
The last three elements are combined in what we call theresidual dividend model. Under this
model a firm follows these four stepswhen establishing its target payout ratio:
i. It determines the optimal capital budget;
ii. It determines the amount of equity needed to finance that budget,given its target capital
structure;
iii. It uses retained earnings to meet equity requirementsto the extent possible; and
iv. It pays dividends only if more earningsare available than are needed to support the
optimal capital budget. Theword residual implies “leftover,” and the residual policy
implies that dividendsare paid out of “leftover” earnings.
Stable dividend policy
A company following this type of a policy maintains a constant dividend rate irrespective of the
actual earnings level and the company tries to maintain it even when during the recession the
earnings go down below the actual dividends pay, trying to signal to the investor that this is a
temporary phase and earnings will be back up when the economy revives.
Compromise Dividend Policy

In practice, many firms appear to follow what amounts to a compromise dividend policy. Such a
policy is based on five main goals:
1. Avoid cutting back on positive NPV projects to pay a dividend.
2. Avoid dividend cuts.
3. Avoid the need to sell equity.
4. Maintain a target debt-equity ratio.
5. Maintain a target dividend payout ratio.

These goals are ranked more or less in order of their importance. In our strict residual approach,
we assume that the firm maintains a fixed debt-equity ratio. Under the run target payout ratio,
and it is the fraction of the earnings the firm expects to pay as dividends under ordinary
circumstances. Again, this ratio is viewed as a long-range goal, so it might vary in the short run
if this is necessary. As a result, in the long run, earnings growth is followed by dividend
increases, but only with a lag.
Regular and extra dividends: One can minimize the problems of dividend instability by
creating two types of dividends: regular and extra. For companies using this approach, the
regular dividend would most likely be a relatively small fraction of permanent earnings, so that it
could be sustained easily. Extra dividends would be granted when an increase in earnings was
expected to be temporary

2.3 Factors That Influence Dividend Policy


A firm’s dividend policy is a function of many factors, some of which have been described.
Other factors that influence dividend policy are as follows:
1. Company growth rate accompany that is rapidly growing, even if profitable, may have to
restrict its dividend payments in order to keep needed funds within the company for
growth opportunities.

7
2. Restrictive covenants. Sometimes there is a restriction in a credit agreement that will
limit the amount of cash dividends that may be paid.
3. Profitability. Dividend distribution is keyed to the profitability of the company.
4. Earnings stability. A company with stable earnings is more likely to distribute a higher
percentage of its earnings than one with unstable earnings.
5. Maintenance of control. Management that is reluctant to issue additional common stock
because it does not wish to dilute its control of the firm will retain a greater percentage of
its earnings. Internal financing enables control to be kept within.
6. Degree of financial leverage. A company with a high debt-to-equity ratio is more likely
to retain earnings so that it will have the needed funds to meet interest payments and
debts at maturity.
7. Ability to finance externally. A company that is capable of entering the capital markets
easily can afford to have a higher dividend payout ratio. When there is a limitation to
external sources of funds, more earnings will be retained for planned financial needs.
8. Uncertainty. Payment of dividends reduces the chance of uncertainty in stockholders’
minds about the company’s financial health.
9. Age and size. The age and size of the company bear upon its ease of access to capital
markets.
10. Tax penalties. Possible tax penalties for excess accumulation of retained earnings may
result in high dividend payouts.

2.4 Other factors related to cash dividends

Stock dividends and stock splits

Stock dividend: a dividend payment made by a firm to its owner in the form of stock, A stock
dividend may be declared when the cash position of the firm is inadequate and/or when the firm
wishes to prompt more trading of its stock by reducing its market price. With a stock dividend,
retained earnings decrease but common stock and paid-in capital on common stock increase by
the same total amount. A stock dividend, therefore, provides no change in stockholders’ wealth.
Stock dividends increase the shares held, but the proportion of the company each stockholder
owns remains the same.

Example: Peterson Corporation has 10,000 shares of stock outstanding, each selling at birr 66
and the following equity portion of the balance sheet before the stock dividend declared.
Common stock (birr 1 par, 10,000 shares outstanding) birr 10,000
Capital in excess of par value 200,000
Retained earnings 290,000
Total stockholder’s equity 500,000
With a 10% stock dividend, each stockholders receives one additional share for each 10 that one
owns, and the total number of shares outstanding after the dividend is 11, 000. (10,000 + 10% x
1000)

8
After the stock dividend, the balance sheet has to be adjusted for 11,000 outstanding shares of
common stock. The common stock will be 11,000 shares x 1 birr par value= 11,000 .The capital
in excess of par value is 200,000 plus the excess amount from 1000 shares of stock dividend ((66
-1) x 1000 shares = 65,000). Total capital in excess of par value is 265,000. Total stockholder’s
equity is unaffected by the stock dividend because no cash has come in or out, so retained
earnings is reduced by the entire birr 66,000. Thus, the balance of retained earnings will be
244,000 (290,000-66,000).
The equity section of the balance sheet after stock dividend would be:
Common stock (birr 1 par, 11,000 shares outstanding) birr 11,000
Capital in excess of par value 265,000
Retained earnings 224,000
Total stockholder’s equity 500,000

Stock split: an increase in a firm’s shares outstanding without any change in stockholder
equity’s. A stock split is often prompted by a desire to reduce the market price per share, which
will make it easier for small investors to purchase shares.
When a split is declared, each share is split up to create additional shares. For example, in a three
for one stock split, each old share is split into three new shares.
Example, Smith Corporation has 1,000 shares of $20 par value common stock outstanding. The
total par value is $20,000. A 4-for-1 stock split is issued. After the split 4,000 shares at $5 par
value will be outstanding. The total par value thus remains at $20,000. Theoretically, the market
price per share of the stock should also drop to one-fourth of what it was before the split.

Example, suppose that Peterson corporation decides to declare a two for one stock split. The
number of shares outstanding will double to 20,000 and the par value will be halved to 0.50 per
share. The stockholders’ equity after the split is represented as:
Common stock (birr0.50 par, 20,000 shares outstanding) birr 10,000
Capital in excess of par value 200,000
Retained earnings 290,000
Total stockholder’s equity 500,000

Reverse Splits is a corporate action in which a company reduces the number of shares it has
outstanding by a set multiple. This is the opposite of a stock split, in which a company increases
its outstanding shares by a set multiple. Example: A 1-for-4

Stock splits and stock dividends have essential the same impacts on the corporation and the
shareholder: they increase the number of shares outstanding and reduce the value per share.

The differences between a stock dividend and a stock split are as follows:

9
 With a stock dividend, retained earnings are reduced and there is a pro rata distribution of
shares to stockholders. A stock split increases the shares outstanding but does not lower
retained earnings.
 The par value of stock remains the same with a stock dividend but is proportionally
reduced in a stock split.
The similarities between a stock dividend and a stock split are:
 Cash is not paid.
 Shares outstanding increase.
 Stockholders’ equity remains the same.

Repurchase of Stock

As an alternative to paying cash dividends, a company may distribute income to its shareholders
by repurchasing its own shares. Treasury stockis the name given to previously issued stock that
has been purchased by thecompany. Buying treasury stock is an alternative to paying dividends.
Since outstanding shares will be fewer after stock has been repurchased, earnings per share will
rise (assuming net income is held constant). The increase in earnings per share may result in a
higher market price pershare.Stock repurchases are usually made in one of three ways.

Example, Travis Company earned $2.5 million in 20X1. Of this amount, it decided that 20
percent would be used to purchase treasury stock. At present there are 400,000 shares
outstanding. Market price per share is $18. The company can use $500,000 (20%×2.5 million) to
buy 25,000 shares through a tender offer of $20 per share. Current earnings per share is:
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 $2,500,000
EPS= 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑠ℎ𝑎𝑟𝑒𝑠
= 400,000
=$6.25
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 $18
The current P/E multiple is: 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
=$6.25 =2:88 times
Earnings per share after treasury stock is acquired becomes:
$2,500,000
375,000
=$6.67
The expected market price, assuming the P/E ratio remains the same, is:
P/E multiple × new earnings per share = expected market price
2:88× $6:67 = $19:21

10

You might also like

pFad - Phonifier reborn

Pfad - The Proxy pFad of © 2024 Garber Painting. All rights reserved.

Note: This service is not intended for secure transactions such as banking, social media, email, or purchasing. Use at your own risk. We assume no liability whatsoever for broken pages.


Alternative Proxies:

Alternative Proxy

pFad Proxy

pFad v3 Proxy

pFad v4 Proxy