DIVIDEND POLICY Prepared by Lucky Yona

Coverage Dividend Fundamentals Dividend reinvestment Plans Dividend policy theories Types of dividend policies Other forms of dividends.

DIVIDEND FUNDAMENTALS Expected cash dividends are the key return variable from which owners and investors determine share price as already seen. Dividends comes out of the retained earnings Retained Earnings that is earnings that are not distributed as dividends; a form of internal financing. Dividend decision can affect external financial requirements.

DIVIDEND FUNDAMENTALS If the firm needs financing from external sources we have to remember that dividends are not paid from retained earnings as such but from cash. So the dividend decision has to be made in the light of the additional funding required. We will discuss the procedures for paying Cash dividends, reinvestment plans, policy theories and factors affecting dividend policy.

Cash Dividend Payment Procedures The payment of dividends is proposed to the shareholders by the Board of Directors. The date of payment must also be set. Relevant dates are as follows: 1.Date of record (Dividends) This is the date set by the directors, on which every person whose name is recorded as a stockholder will at a specified future date receive a dividend.

Cash Dividend Payment Procedures: Due to time needed to record shareholders stock will begin to sell Ex Dividend four or two business days prior to the date of record during which time stock will be sold with no dividend rights. (DEPENING ON LAWS) Payment Date:- The actual date on which the firm will mail the dividend payment to the holders of record. This date is also set by the directors of the firm.

Dividend Reinvestment Plans (DRPs) These are plans that enable stock holders to use dividend received on the firm’s stock to acquire additional full or fractional shares at little or no transaction costs.- Approaches used include use of third party trustees paid a fee to buy the stock from the market or buy newly issued stock directly from the firm without paying any transaction costs and at about 5% below the current market price.

Dividend Policy Theories: Many theories exist on policy but capital budgeting, and capital structure decisions as already seen are far more important than dividend decisions. In other words good investment and financing decisions should not be sacrificed for a dividend policy of questionable importance. Several questions are raised here as follows-

Dividend Policy Theories: These questions have yet to be resolved- 1.Does dividend policy matter? 2.What effect does it have on share price? 3.Are there evaluation models available? So we begin with some theories:

(a) Residual Theory of dividend A school of thought that suggests that the dividend paid should be the amount left over after all acceptable investment opportunities have been undertaken.

(a) Residual Theory of dividend This theory treats the decision in 3 steps: 1.Determine the optimal level of capital expenditures, which would be the level at which the Investment opportunities and Weighted Marginal cost of capital lines intersect. 2.Using the optimal capital structure proportions estimate the total amount of equity financing required to support step one expenditures. 3.Since Cost of retained Earnings < Cost of New Equity use retained earnings to meet the requirement until it is exhausted then use sell common stock, but if in excess pay dividends.

(a) Residual Theory of dividend This theory argues that as long as the firm’s equity need is in excess of the amount of retained earnings no cash dividend will be paid. In the case of an excess the residual amount would be distributed as cash dividends The argument for this approach is that it is sound management to ensure that the firm has the money needed to be competitive and raise share price.

Dividend Irrelevance Theories This is a theory advanced by Modigliani and Miller 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. A perfect world is one (without taxes, with certainty, no transaction costs, and no other market imperfections).

Dividend Irrelevance Theories Studies have shown that large dividend changes affect the value in the same direction- Increases in dividends lead to increased share price and vice versa. M&M argue that the effects are not due to the dividend itself but due to information content that is 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.

Dividend Irrelevance Theories M&M further argue that a clientele effect exists which is the theory that a firm will attract shareholders whose preferences with respect to the payment and stability of dividends corresponds to the payment pattern and stability of the firm itself. In summary they argue that all-else- being equal an investors required return and therefore the value of the firm are unaffected by dividend policy since value is determined by earning power &risk

Dividend Relevance Arguments: The key argument in support of this theory is by Myron J.Gordon and John Lintner who suggest that There is a direct relationship between the firms dividend policy and its market value. Another argument in support of the theory is in their bird in the hand argument Investors see current dividends as less risky than future dividends or capital gains.

Factors Affecting Dividends There are certain factors that affect the formulation of dividend policy. They are; 1.Legal constraints which forbid paying dividends until a certain level of earnings has been achieved. Constraints protect creditors from losses due to the firm’s insolvency.

2.Contractual constraints found in loan contracts 3.Internal Constraints in the form of little excess cash being available. Although it is possible for the firm to borrow funds to pay dividends, lenders are reluctant to make such loans because they produce no tangible or operating benefits that will help the firm repay the loan.

Factors Affecting Dividends 4.Growth Prospects in the form of required asset expansion especially for firms at the growth stage. 5.Owner considerations- the OWM motive that is policies that are favourable to a majority of share holders.

6.Market Considerations- the probable response of the market to the dividend or otherwise the type of dividend from fixed or increasing level of dividends etc

TYPES OF DIVIDEND POLICIES A dividend policy is the firm’s plan to be followed whenever a decision concerning dividend must be made. Such policies have to consider (1) Owners Wealth Maximization and (2)Provision of sufficient financing. Dividend payout ratio indicates the % of each dollar earned that is distributed to the owners in the form of cash; calculated by dividing cash dividend per share with earnings per share.

TYPES OF DIVIDEND POLICIES Constant Payout-ratio Dividend Policy A dividend policy based on the payment of a certain percentage of earnings to owners, in each dividend period. Regular Dividend Policy A dividend policy based on the payment of a fixed dollar dividend in each period.

Target Dividend Payout Ratio A policy under which the firm attempts to pay out a certain %of earnings as a stated dollar dividend adjusted towards a target payout as earnings increases occur.

TYPES OF DIVIDEND POLICIES Low-Regular-and-extra-dividend policy This is a dividend policy based on paying a low regular dividend supplemented by an additional dividend when earnings warrant it. Extra Dividend is an additional dividend optionally paid by the firm if earnings are higher than normal in a given period.

OTHER FORMS OF DIVIDENDS Stock Dividends The payment of dividends to existing shareholders in the form of shares. A small (ordinary) stock dividend is a stock dividend that represents less than 20 to 25% of the common stock outstanding at the time the dividend is declared.

OTHER FORMS OF DIVIDENDS Stock Splits- A method that is commonly used to lower market price of a firm’s stock by increasing the number of shares belonging to each shareholder. A reverse Stock split -is a method that is used to raise the market price of a firm’s stock by exchanging a certain number of outstanding shares for one new

OTHER FORMS OF DIVIDENDS Stock Repurchases This is the growing practice of repurchase by the firm of outstanding shares of its common stock in the market-place; desired effects of stock repurchase are that they enhance shareholder’s value and/or help to discourage unfriendly takeover bids.

OTHER FORMS OF DIVIDENDS The repurchase of stock increases share prices by (1) reducing the no of share outstanding thus increasing EPS. (2) It sends a positive signal to investors that stock is undervalued. (3)Provides a temporary floor for the stock price which may have been declining. This discourages unfriendly takeover bids since with the reduced shares corporate riders can gin control of the firm.

OTHER FORMS OF DIVIDENDS We can focus on the motive for repurchase since it is similar to a cash dividend payment. Accounting Treatment- Accountants record a repurchase as a reduction in cash and the establishment of a contra capital account called ‘Treasury stock’ which is shown as a deduction from the stockholders equity. This can be viewed as a cash dividend since it involves an outflow of cash to acquire these shares.

OTHER DIVIDENDS FORMS The repurchase Process Shareholders should be advised of the intention to repurchase shares. Three methods are use- direct purchase on the open market, a tender offer which is a formal offer to purchase a given no of shares of a firm’s stock at a specified price and the purchase on negotiation of a large block of share from a major stock holder.