Faculty of Management Sciences

Financial Management II
FAC211
Spring 2017

Chapter 13
Dividends Policy

A. Dividends Payout policy:

 It refers to firm’s decision regarding the amount of earnings that should
be distributed to the firm’s shareholders.
 A re-distribution form from earnings known as; Dividend, it has
different forms: 1. Cash Dividends
2. Stock re-purchases

 The dividend decision is considered as a Financing decision, why?

 Because; retained earnings is an important source for an internal
financing that is available for the firm, that’s why the decision
can significantly affect the firm’s external financing needs.
 If the firm needs financing; so the larger the cash dividends paid,
the greater the amount of financing that must raise externally.

B. Cash Dividends: How it works?

 Declaration date: it is the date at which the company declares the
dividend for the year.
 Ex-dividend date: it is the date at which the investor buys the stock on
it, in order to settle his name in the record date (before the record date
by 2 working days).
 Record date: it is the date on which investors must own their shares to
be capable of receiving dividend payment.
 Payment date: it is the date at which the firm mails the holders about
the dividend payment; it is set by the firm’s directors.
 Q: How do the firm’s assets & liabilities will be affected by the payout
policy?
A: As the firm’s assets & liabilities will be decreased by the amount of
dividend.
 C. The importance of dividend policy:
 Residual Theory:
 The amount of dividends which is leftover after all investment
opportunities
 To treat the dividend decision the firm should:
1. Determines the optimal level of capital expenditures
2. Estimates the total amount of debt and equity needed to
support these capital expenditures
3. Distributes the surplus amount (the residual) as dividends,
in case if the retained earnings greater than equity
 Dividend Irrelevance: (MM theory)
 In a perfect world with no taxes, no transaction costs; the
firm’s value is not affected by the distribution of dividends, but
it is determined by the earning power and risk investments
 Investors prefer higher dividend stock while the capital gain is
low, however; the firm’s value still unchanged.
 Real markets do not satisfy perfect markets’ assumptions of
MM theory, so the firm’s capital structure appears
insignificant.
 Q1: why do firm’s dividend policy and market value have positive
relation?
A1: Because; the firm’s current dividends is less risky than the future
capital gains, as it called “Bird-In-Hand” argument.
 Q2: why does the agency cost theory support the effect of dividends
on the firm value?
A2: Because; the firm is committed to pay dividends to assure
shareholders those managers are not wasting their money.
D. The basic factors of dividends policy:
Factors Description
1. Legal Constraints  If liabilities exceeds assets
 If dividends exceeds retained earnings
(so, dividends cannot be paid)
 If dividend is being paid, from the capital invested in the
firm.
2. Contractual Constraints Creditors make a written loan contract that includes some
restrictions to limit the level of dividends payment until the
firm achieves a certain level of earnings in order to protect
themselves from any bankruptcy.
3. Internal Constraints These constraints result from the firm’s ability to pay
dividends according to the firm liquidity, however; it’s
possible to borrow funds, but lenders are unwilling to make
loans bec. they produce operating benefits that will help the
firm repay the loan.
4. Growth Prospects This factor is related to how much the firm expects to grow.
For example: Firm1; has a heavily internal financing and
growing fast so, it has to payout a small percentage of
dividends (no payment). While Firm2; is in a better position
to payout large proportion of dividends (as more
established firm).

5. Owner Considerations  Owner’s investment opportunities; the firm pays out a

higher percentage of its earnings, if owners have better
opportunities externally.
 Potential dilution of ownership; if a firm pays out a high
percentage of earnings, new equity capital will have to be
raised with common stock. The result of a new stock
issue may be dilution of both control and earnings for the
existing owners.

6. Market Considerations Catering Theory: investors prefer to be paid higher dividend,

as the firm follows the market preferences because they
need income in hand to be safe in risky issues in the future.
E. The main types of dividends policy:
1. Constant payout ratio dividend policy:
The firm pays fixed percentage of earnings to the owners each period
dividends move up and down, no dividends paid when loss occur bec.
this may affect negatively the stock price as dividend is the main
indicator of the firm’s prospects.
2. Regular dividend policy:
The firm pays fixed dollar dividend each period that increases the
amount of dividends only after a proven increase in earnings, this built
around “A target dividend payout ratio”.
3. A low- regular & extra dividend policy:
It is similar to regular dividend policy , except the firm pays an extra
dividend is an additional dividend paid by the firm when firm’s
earnings is higher than normal in a given period.
 Type 2 & 3 are preferred, because they reduced uncertainty

F. Stock Dividends:
 A stock dividend is paid in stock rather than in cash.
 Investors may perceive that stock dividends increase the value of their
holdings.
 In fact, from a market value standpoint, stock dividends function much like
stock splits. The investor ends up owning more shares, but the value of
their shares is less.
 In an accounting sense, the payment of a stock dividend is a shifting of
funds between stockholders’ equity accounts rather than an outflow of
funds.

G. Stock Spilt:
 A stock split is a recapitalization that affects the number of shares
outstanding, par value, earnings per share, and market price.
 The rationale for a stock split is that it lowers the price of the stock and
makes it more attractive to individual investors.
 Stock splits are often made prior to issuing additional stock to enhance
that stock’s marketability and stimulate market activity.