Chapter 5
Dividend decision
The Basics of Payout Policy:
Elements of Payout Policy
• The term payout policy refers to the
decisions that a firm makes regarding
whether to distribute cash to shareholders,
how much cash to distribute, and the
means by which cash should be distributed.
• Cash can be distributed as a dividend or
through stock repurchase plans.
The Basics of Payout Policy:
General Lessons
1. Rapidly growing firms generally do not pay out
cash to shareholders.
2. Slowing growth, positive cash flow generation,
and favorable tax conditions can prompt firms to
initiate cash payouts to investors.
3. Cash payouts can be made through dividends or
share repurchases.
What happens to the stock price when a firm
pays a dividend or repurchases shares?
– In theory, when a stock begins trading ex dividend, the
stock price should fall by exactly the amount of the
dividend.
– In theory, when a firm buys back shares at the going
market price, the market price of the stock should
remain the same.
Relevance of Payout Policy:
1) Residual Theory of Dividends
The residual theory of dividends is a
school of thought that suggests that the
dividend paid by a firm should be viewed as a
residual—the amount left over after all
acceptable investment opportunities have
been undertaken.
Relevance of Payout Policy:
2)The Dividend Irrelevance Theory
The dividend irrelevance theory is Miller and Modigliani’s
theory that in a perfect world, the firm’s value is determined
solely by the earning power and risk of its assets
(investments) and that the manner in which it splits its
earnings stream between dividends and internally retained
(and reinvested) funds does not affect this value.
– In a perfect world (certainty, no taxes, no transactions
costs, and no other market imperfections), the value of
the firm is unaffected by the distribution of dividends.
Relevance of Payout Policy:
Arguments for Dividend Relevance
• *Dividend relevance theory is the theory,
advanced by Gordon and Lintner, that there is a
direct relationship between a firm ’ s dividend
policy and its market value.
• *The bird-in-the-hand argument is the belief, in
support of dividend relevance theory, that
investors see current dividends as less risky than
future dividends or capital gains.
Relevance of Payout Policy: Arguments for
Dividend Relevance (cont.)
Studies have shown that large changes in dividends
do affect share price.
– Informational content 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.
– The agency cost theory says that a firm that commits
to paying dividends is reassuring shareholders that
managers will not waste their money.
– Although many other arguments related to dividend
relevance have been put forward
Factors Affecting Dividend Policy
Dividend policy represents the firm ’ s plan of
action to be followed whenever it makes a dividend
decision.
First consider five factors in establishing a dividend
policy:
1. legal constraints
2. contractual constraints
3. the firm’s growth prospects
4. owner considerations
5. market considerations
Summery of the key factors involved in establishing a
dividend policy.
A firm ’ s dividend policy should provide for
sufficient financing and maximize stockholders ’
wealth. Dividend policy is affected by legal and
contractual constraints, by growth prospects, and
by owner and market considerations. Growth
prospects affect the relative importance of retaining
earnings rather than paying them out in dividends.
The tax status of owners, the owners’ investment
opportunities, and the potential dilution of
ownership are important owner considerations.
Finally, market considerations are related to the
stockholders ’ preference for the continuous
payment of fixed or increasing streams of
dividends
Types of Dividend Policies:
1) Constant-Payout-Ratio Dividend Policy
• A firm ’ s dividend payout ratio
indicates the percentage of each
Pound earned that a firm distributes to
the owners in the form of cash. It is
calculated by dividing the firm’s cash
dividend per share by its earnings per
share.
Types of Dividend Policies:
2) Regular Dividend Policy
• Regular dividend policy
• is a dividend policy based on the
payment of a fixed-Pound dividend in
each period.
Types of Dividend Policies:
3) Low-Regular-and-Extra Dividend Policy
• A low-regular-and-extra dividend policy is a
dividend policy based on paying a low regular
dividend, supplemented by an additional
(“extra”) dividend when earnings are higher
than normal in a given period.
• An extra dividend is an additional dividend
optionally paid by the firm when earnings are
higher than normal in a given period.
Other Forms of Dividends
A stock dividend
is the payment, to existing owners, of a
dividend in the form of stock.
– In a stock dividend, investors simply
receive additional shares in proportion to
the shares they already own.
– No cash is distributed, and no real value
is transferred from the firm to investors.
Other Forms of Dividends (cont.)
A stock split
is a method commonly used to lower the
market price of a firm ’ s stock by
increasing the number of shares
belonging to each shareholder.