Dividend Policy Guide

Dividend PolicyDividend Policy

Dividend Policy
What is It?
Dividend Policy refers to the explicit or implicit
decision of the Board of Directors regarding the
amount of residual earnings (past or present) that
should be distributed to the shareholders of the
corporation.
This decision is considered a financing decision because
the profits of the corporation are an important source of
financing available to the firm.
CHAPTER 22 – Dividend Policy 22 - 3

Types of Dividends
Dividends are a permanent distribution of residual
earnings/property of the corporation to its owners.
Dividends can be in the form of:
Cash
Additional Shares of Stock (stock dividend)
Property
If a firm is dissolved, at the end of the process, a final dividend
of any residual amount is made to the shareholders – this is
known as a liquidating dividend.

Dividends a Financing Decision
 In the absence of dividends, corporate earnings accrue to the benefit of
shareholders as retained earnings and are automatically reinvested in the
firm.
 When a cash dividend is declared, those funds leave the firm permanently
and irreversibly.
 Distribution of earnings as dividends may starve the company of funds
required for growth and expansion, and this may cause the firm to seek
additional external capital.
Corporate Profits After Tax
Retained Earnings
Dividends

Dividends versus Interest
ObligationsInterest
 Interest is a payment to lenders for the use of their funds for a given period of time
 Timely payment of the required amount of interest is a legal obligation
 Failure to pay interest (and fulfill other contractual commitments under the bond
indenture or loan contract) is an act of bankruptcy and the lender has recourse
through the courts to seek remedies
 Secured lenders (bondholders) have the first claim on the firm’s assets in the case
of dissolution or in the case of bankruptcy
Dividends
 A dividend is a discretionary payment made to shareholders
 The decision to distribute dividends is solely the responsibility of the board of
directors
 Shareholders are residual claimants of the firm (they have the last, and residual
claim on assets on dissolution and on profits after all other claims have been fully
satisfied)

Dividend Payments
Mechanics of Cash Dividend Payments
Declaration Date
Holder of Record Date
Ex-dividend Date
Payment Date

Dividend Payments
Mechanics of Cash Dividend PaymentsDeclaration Date
 this is the date on which the Board of Directors meet and declare the dividend. In their
resolution the Board will set the date of record, the date of payment and the amount of the
dividend for each share class.
 when CARRIED, this resolution makes the dividend a current liability for the firm.
Date of Record
 is the date on which the shareholders register is closed after the trading day and all those who
are listed will receive the dividend.
Ex dividend Date
 is the date that the value of the firm’s common shares will reflect the dividend payment (ie. fall
in value)
 ‘ex’ means without.
 At the start of trading on the ex-dividend date, the share price will normally open for trading at
the previous days close, less the value of the dividend per share. This reflects the fact that
purchasers of the stock on the ex-dividend date and beyond WILL NOT receive the declared
dividend.
Date of Payment
 is the date the cheques for the dividend are mailed out to the shareholders.

Declaration Date
Date of
Record
Date of
Payment
Ex Dividend Date is determined
by the Date of Record.
The market value of the shares
drops by the value of the dividend
per share on market opening…compared
to the previous day’s close.
The Board Meets
and passes the
motion to create
the dividend
2 business days prior to the Date of Record

Trade Settlement and the Ex
Dividend Date
Changes in the Settlement Cycle
 In June 1995 the settlement cycle for all non-money-market Canadian and U.S.
securities was reduced from five business days (T + 5) to three business days (T + 3).
 The rationale for the change stems from the 1987 stock market crash when it was
realized that a securities market failure could result in a credit market failure. The
gridlock created in 1990 by the bankruptcy of Drexel Burnham Lambert, a large U.S.
broker, increased the need to minimize the risks involved in the clearing and
settlement of securities.
 The shortened settlement cycle requires that the payment of funds and the delivery of
securities take place on the third business day after the trade date. This will reduce
credit, market and liquidity risks by decreasing post-trade settlement exposure.
Ex Dividend Date
 The date is not chosen by the board of directors, rather it is determined as a result of
the exchanges settlement practices and is a function of the date of record.

Dividend Policy
Dividends, Shareholders and the Board of Directors
There is no legal obligation for firms to pay dividends to
common shareholders
Shareholders cannot force a Board of Directors to declare a
dividend, and courts will not interfere with the BOD’s right to
make the dividend decision because:
Board members are jointly and severally liable for any damages
they may cause
Board members are constrained by legal rules affecting dividends
including:
 Not paying dividends out of capital
 Not paying dividends when that decision could cause the firm to
become insolvent
 Not paying dividends in contravention of contractual commitments
(such as debt covenant agreements)

Dividend Payments
Dividend Reinvestment Plans (DRIPs)
Involve shareholders deciding to use the cash dividend
proceeds to buy more shares of the firm
DRIPs will buy as many shares as the cash dividend allows with the
residual deposited as cash
Leads to shareholders owning odd lots (less than 100 shares)
Firms are able to raise additional common stock capital
continuously at no cost and fosters an on-going
relationship with shareholders.

Dividend Payments
Stock Dividends
Stock dividends simply amount to distribution of
additional shares to existing shareholders
They represent nothing more than recapitalization of
earnings of the company. (that is, the amount of the stock
dividend is transferred from the R/E account to the
common share account.
Because of the capital impairment rule stock dividends
reduce the firm’s ability to pay dividends in the future.

Dividend Payments
Stock Dividends
Implications
 reduction in the R/E account
 reduced capacity to pay future dividends
 proportionate share ownership remains unchanged
 shareholder’s wealth (theoretically) is unaffected
Effect on the Company
 conserves cash
 serves to lower the market value of firm’s stock modestly
 promotes wider distribution of shares to the extent that current owners divest themselves of
shares...because they have more
 adjusts the capital accounts
 dilutes EPS
Effect on Shareholders
 proportion of ownership remains unchanged
 total value of holdings remains unchanged
 if former DPS is maintained, this really represents an increased dividend payout

Dividend Payments
Stock Splits
Although there is no theoretical proof, there is some who
believe that an optimal price range exists for a company’s
common shares.
It is generally felt that there is greater demand for shares of
companies that are traded in the $40 - $80 dollar range.
The purpose of a stock split is to decrease share price.
The result is:
increase in the number of share outstanding
theoretically, no change in shareholder wealth
Reasons for use:
better share price trading range
psychological appeal (signalling affect)

Dividend Payments
Stock Split Effects
shareholders wealth should remain unaffected:
Original Holdings: (100 shares @ $150/share) = $15,000
After a 4 for 1 split: (400 shares @ $37.50/share) = $15,000
the above will hold true if there is no psychological appeal
to the stock split.
There is some evidence that the share price of companies
which split stock is more bouyant because of a positive
signal being transferred to the market by this action.

Stock Dividends versus Stock Splits
- lowers stock price slightly - large drop in stock price
- little psychological appeal - much stronger potential
signalling effect
- recapitalization of earnings - no recapitalization
- no change in proportional - same
ownership
- odd lots created - odd lots rare
- theoretically, no value to - same
the investor
Stock Dividends Stock Splits

Cash Dividend Payments
The Macro Perspective - Question
Why are dividends smoothed and not matched to
profits?

Modigliani and Miller’s Dividend Irrelevance
Theorem
The value of M&M’s Dividend Irrelevance argument is
that in the end, it shows where value can be created
with dividend policy and why.

M&M’s Dividend Irrelevance Theorem
M&M, Dividends, and Firm Value
Start with the single-period DDM:
1
11
0
)K(
PD
P
e+
+
=[ 22-1]

Multiply by the number of shares outstanding (m) to
convert the single stock price model to a model to
value the whole firm:
1
)( 11
00
)K(
PDm
VmP
e+
+
==[ 22-2]

Assumptions
No Taxes
Perfect capital markets
large number of individual buyers and sellers
costless information
no transaction costs
All firms maximize value
There is no debt

Without debt, sources and uses of funds identity (sources =
uses) can be expressed as:
Where:
 X represents cash flow from operations
 I represents investment
 X – I is free cash flow
 mD1 is dividend to current shareholders at time 1
1111 mDInPX +=+[ 22-3]

Solving for dividends paid out (mD1 ):
1111 InPXmD −+=

If a firm pays out dividends that exceeds its free cash flow (X –I),
then it must issue new common shares to pay for these
dividends.
Substituting into Equation 22 – 2 we get:
The value of the firm is the value of the next period’s free cash
flow (X1 –I1) plus the next period’s equity market value…
)1(
])[(X 1111
0
K
VPnmI
V
+
=++−
=[ 22-4]

The firm value is determined as the present value of the free
cash flows to the equity holders:
The dividend is equal to the free cash flow each period, and
dividends are therefore a residual after the firm has taken care
of all of its investment requirements – this is the Residual
Theory of Dividends
)1(1
0 ∑= +
−
=
α
t
t
tt
K
IX
V[ 22-5]
Value has
nothing
to do with
dividends

Residual Theory of Dividends
The Residual Theory of Dividends suggests that
logically, each year, management should:
Identify free cash flow generated in the previous period
Identify investment projects that have positive NPVs
Invest in all positive NPV projects
 If free cash flow is insufficient, then raise external capital – in
this case no dividend is paid
 If free cash flow exceeds investment requirements, the
residual amount is distributed in the form of cash dividends.

Residual Theory of Dividends - Implication
The implication of the Residual Theory of Dividends are:
Investment decisions are independent of the firm’s dividend
policy
 No firm would pass on a positive NPV project because of the lack of
funds, because, by definition the incremental cost of those funds is
less than the IRR of the project, so the value of the firm is
maximized only if the project is undertaken.
 If the firm can’t make good use of free cash flow (ie. It has no
projects with IRRs > cost of capital) then those funds should be
distributed back to shareholders in the form of dividends for them
to invest on their own.
 The firm should operate where Marginal Cost equals Marginal
Revenue as seen in Figure 22 – 4 on the following slide:

Homemade Dividends
Shareholders can buy or sell shares in an underlying
company to create their own cash flow pattern.
They don’t need management declare a cash dividend,
they can create their own.
Conclusion: under the assumptions of M&M’s model,
the investor is indifferent to the firm’s dividend policy.

Dividend Policy in Practice
Firms smooth their dividends
Firms tend to hold dividends constant, even in the face
of increasing after-tax profit
Firms are very reluctant to cut dividends

Lintner’s Work on Dividend Adjustment
John Lintner suggested a partial adjustment model to
explain the smoothing of dividend behaviour
illustrating that firms slowly change dividends as they
move toward a new target level:
1 )-Dβ(DΔD t-
*
tt =[ 22-7]

The target dividend Dt
*
Lintner suggested is a function of the
firm’s optimal payout rate of the firm’s underlying earnings (Et)
leading to the following equation:
The coefficient on lagged dividends was estimated at 0.70
indicating an adjustment speed (b) coefficent of 0.30.
The coefficient on current earnings (c) was estimated at 0.15
)1( 11 cEDbaD t-t +−+=[ 22-8]

Implications
The speed of dividend adjustment is only about 30
percent
Firms are very reluctant to fully adjust
Firms do not follow a policy of paying a constant
proportion of earnings out as dividends
Dividend policy in practice does not follow M&M’s
irrelevance arguments because the real world does not
match the assumptions used.

Relaxing the M&M Assumptions
Welcome to the Real World!
Transactions Costs
Underwriting costs are very high, providing a strong
incentive for firms to finance growth out of free cash
flow
Facing these high underwriting costs firms:
 With high growth rates have little incentive to pay dividends
 With volatile earnings conserve cash from year to year to
finance projects and therefore pay very conservative
dividends

Share Repurchases
Simply another form of payout policy.
An alternative to cash dividend where the objective is
to increase the price per share rather than paying a
dividend.
Since there are rules against improper accumulation
of funds, firms adopt a policy of large infrequent share
repurchase programs.

Share Repurchases
 allowed under the OBCA and CBCA
 reasons for use:
 Offsetting the exercise of executive stock options
 Leveraged recapitalizations
 Information or signalling effects
 Repurchase dissident shares
 Removing cash without generating expectations for future
distributions
 Take the firm private.

Disadvantages of Share
Repurchases
 they are usually done on an irregular basis, so a shareholder cannot
depend on income from this source.
 if regular repurchases are made, there is a good chance that Revenue
Canada will rule that the repurchases were simply a tax avoidance
scheme (to avoid tax on dividends) and will assess tax
 there may be some agency problems - if managers have inside
information, they are purchasing from shareholders at a price less
than the intrinsic value of the shares.

Methods of Share Repurchases
 tender offer:
 this is a formal offer to purchase a given number of shares at a given
price over current market price.
 open market purchase:
 the purchase of shares through an investment dealer like any other
investor
 this is not designed for large block purchases.
 private negotiation with major shareholders
In any repurchase program, the securities commission requires
disclosure of the event as well as all other material information
through a prospectus.

Repurchased Shares
called treasury stock (U.S.)
non-voting (U.S.)
may not receive dividends (U.S.)
if not retired, can be resold (U.S.)
unlike the U.S., repurchases in Canada do not involve
shares that can be placed into treasury stock - they are
canceled

Repurchase Example
Current EPS
= [total earnings] / [# of shares] = $4.4 m / 1.1 m = $4.00
Current P/E ratio
= $20 / $4 = 5X
EPS after repurchase of 100,000 shares
= $4.4 m / 1.0 = $4.40
Expected market price after repurchase:
= [p/e][EPSnew] = [5][$4.40] = $22.00 per share

Effects of A Share Repurchase
EPS should increase following the repurchase if
earnings after-tax remains the same
a higher market price per outstanding share of
common stock should result
stockholders not selling their shares back to the firm
will enjoy a capital gain if the repurchase increases the
stock price.

Advantages of Share Repurchases
 signal positive information about the firm’s future cash flows
 used to effect a large-scale change in the firm’s capital structure
 increase investor’s return without creating an expectation of
higher future cash dividends
 reduce future cash dividend requirements or increase cash
dividends per share on the remaining shares, without creating a
continuing incremental cash drain
 capital gains treated more favourably than cash dividends for tax
purposes.

Disadvantages of Share
Repurchases
signal negative information about the firm’s future
growth and investment opportunities
the provincial securities commission may raise
questions about the intention
share repurchase may not qualify the investor for a
capital gain

Borrowing to Pay Dividends Is this legal? is it possible to do?
 Yes
 the firm must have the ability and capacity to borrow
 the firm must have sufficient retained earnings to allow it
to pay the dividend
 the firm must have sufficient cash on hand to pay the cash
dividend
 the firm must NOT have agreed to any limitations on the
payment of dividends under the bond indenture.
 Why?
 A possible answer is to signal to the market that the board
is confident about the firm’s ability to sustain cash
dividends into the future.

Borrowing to Pay Dividends
An Example
 The foregoing example illustrates:
 it is possible for a firm with ‘borrowing capacity’ to borrow funds to
pay cash dividends.
 this is not possible if the lenders insist on restrictive covenants that
limit or prevent this from occurring.
 the cash for the dividend must be present in the cash account.
 payment of dividends reduces both the cash account on the asset
side of the balance sheet as well as the retained earnings account on
the ‘claims’ side of the balance sheet.
 in the absence of restrictions, it is possible to transfer wealth from
the bondholders to the stockholders. (Bondholders in this example may
have thought their firm would have only a 25% debt ratio….after the dividend
the debt ratio rose to 33% and the equity cusion dropped from 75% to 66%.)

Summary and Conclusions
In this chapter you have learned:
About the different types of dividends including, regular and
special cash dividends, stock dividends, stock splits as well as
share repurchases.
M&M’s dividend irrelevance argument and the real world factors
such as transactions costs, taxes, clientele effects and signalling
tend to favour real-world dividend relevance
Tax motives and other reasons explain why firms might want to
repurchase their shares.

Dividend Policy Guide

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