Okay, let me work through these step-by-step: 1) 1.1 million shares x $100 stated value per share = $110 million total stated value 8% of $110 million is $8.8 million in annual dividends If dividends were not paid for 4 years, the total arrearage would be 4 x $8.8 million = $35.2 million 2) 500 shares of preferred stock x 25 shares of common stock per preferred share = 12,500 shares of common stock 12,500 shares of common stock x $30 per share market price = $375,000 conversion value 3) $3 million total issue size 9.75% annual dividend

1. Financial
Management
Theory and
Practice
Tenth Edition
Eugene F. Brigham
Michael C. Ehrhardt
Chapter 18
Dividend Policy
Instructor: Saad Rafi
Institute of Business Management

2. What is “dividend policy”?
• It’s the decision to pay out earnings versus
retaining and reinvesting them.
• Do shareholder’s prefer current or deferred
income?

3. Is Dividend Policy Important?
Three viewpoints:
1) Dividends are Irrelevant. If we
assume perfect markets (no taxes,
no transaction costs, etc.) dividends
do not matter. If we pay a dividend,
shareholders’ dividend yield rises,
but capital gains decrease.

4. • With perfect markets, investors are
concerned only with total returns,
and do not care whether returns
come in the form of capital gains or
dividend yields.
• Therefore, one dividend policy is as
good as another.
P1 - Po D1
Po Po
+
Return =

5. 2) High Dividends are Best
• Some investors may prefer a certain
dividend now over a risky expected
capital gain in the future.

6. 2) High Dividends are Best
• Some investors may prefer a certain
dividend now over a risky expected
capital gain in the future.
P1 - Po D1
Po Po
+
Return =

7. 3) Low Dividends are Best
• Dividends are taxed immediately.
Capital gains are not taxed until the
stock is sold.
• Therefore, taxes on capital gains can be
deferred indefinitely.

8. Residual dividend model
• Find the retained earnings needed for the capital
budget.
• Pay out any leftover earnings (the residual) as
dividends.
• This policy minimizes flotation and equity signaling
costs, hence minimizes the WACC.
Dividends= Net Income - (Target Equity Ratio*Total
Capital Budget)

9. Residual dividend model - Example
• Capital budget: $800,000.
• Target capital structure that the company
wants to maintain: 40% debt, 60% equity.
• Forecasted net income: $600,000.
• How much of the $600,000 should we pay out
as dividends?

10. Residual dividend model - Example
• Of the $800,000 capital budget,
• Equity = 0.6($800,000) = $480,000
• Debt = 0.4($800,000) = $320,000
• With $600,000 of net income, the residual is
$600,000 - $480,000 = $120,000 = dividends
paid.
• Payout ratio = $120,000/$600,000
= 0.20 = 20%.

11. • NI = $400,000
– Need $480,000 of equity, so should retain the whole
$400,000.
– Dividends = 0. Issue new shares
– Payout = 0
• NI = $800,000:
– Need $480,000 of equity
– Dividends = $800,000 - $480,000 = $320,000.
– Payout = $320,000/$800,000 = 40%.
How would a drop in NI to $400,000 affect the
dividend? A rise to $800,000?
Residual dividend model - Example

12. Do Dividends Matter?
Other Considerations:
1) Residual Dividend Theory:
• The firm pays a dividend only if it has
retained earnings left after financing all
profitable investment opportunities.
• This would maximize capital gains for
stockholders and minimize flotation
costs of issuing new common stock.

13. Do Dividends Matter?
2) Clientele Effects:
• Different investor clienteles prefer different
dividend payout levels.
• Some firms, such as utilities, pay out over
70% of their earnings as dividends. These
attract a clientele that prefers high
dividends.
• Growth-oriented firms which pay low (or no)
dividends attract a clientele that prefers
price appreciation to dividends.

14. Do Dividends Matter?
3) Information Effects:
• Unexpected dividend increases usually
cause stock prices to rise, and
unexpected dividend decreases cause
stock prices to fall.
• Dividend changes convey information
to the market concerning the firm’s
future prospects.

15. Do Dividends Matter?
4) Agency Costs:
• Paying dividends may reduce agency costs
between managers and shareholders.
• Paying dividends reduces retained
earnings and forces the firm to raise
external equity financing.
• Raising external equity subjects the firm to
scrutiny of regulators (SEC) and investors
and therefore helps monitor the
performance of managers.

16. Do Dividends Matter?
5) Expectations Theory:
• Investors form expectations concerning the
amount of a firm’s upcoming dividend.
• Expectations are based on past dividends,
expected earnings, investment and financing
decisions, the economy, etc.
• The stock price will likely react if the actual
dividend is different from the expected
dividend.
– Actual dividend is higher than expected dividend
then stock price will go up and vice versa.

17. Dividend Payment Procedures
Mar 8 Mar 20 Mar 22 Apr 18
Declaration Ex-dividend date Record Date Payment Date
date
Share price falls

18. Important Dates
• Declaration date
– The date on which the board of directors passes a
resolution to pay a dividend.
• Ex-dividend date
– The date two business days before the date of record,
establishing those individuals entitled to a dividend.
• Date of record
– The date by which a holder must be on record in order
to be designated to receive a dividend.
• Payment date
– The date the dividend checks are mailed.

19. Dividend Payments
1.Stock Dividends – No of Shares will Increase
but the value of the investment remain same.
For Example: 20% stock dividend announced –
with every 10 share you will get 2 extra
shares.
2.Stock Splits – 1 Share = 2 shares 1:2
Reverse Stock Split : 2 for 1 = 2 Shares = 1 Shares
3.Stock Repurchase

20. Stock Dividend - Example
• LUX Products has 2 million shares currently
outstanding at a price of $15 per share. The
company declares a 50% stock dividend. How many
shares will be outstanding after the dividend is paid?
– Addition in Shares = 1 Million ( 2 * 0.50 = 1 Million)
– New Number of Shares: 2 + 1 = 3 Million
– Value before Stock Dividend: 2 million Shares * $15/Share
= 30 Million
– Price after Stock Dividend = Value of Stock / New No. of
Shares = 30 / 3 = Rs. 10/Shares
– Value after Stock Dividend: 3 Million Shares *
Rs.10/Shares = 30 Million

21. • After the stock dividend what is the new price
per share and what is the new value of the
firm?
– Price/share = $30 mil/3
= $10 per share
– Value of the firm = 3 million * $10
= $30 million
– The value of the firm before was 2 mil x $15 per
share, or $30 mil.
Stock Dividend - Example Cont.

22. Stock Splits - Example
• Amoeba Products has 2 million shares currently
outstanding at a price of $15 per share. The
company declares a 3 for 1 stock split. What is the
new amount of shares you will own?
New Number of shares = 2 million * 3 = 6 million
Shares
Value of Firm before Split = 2 * Rs. 15/Share = Rs. 30
Million
New Share Price = Rs. 30 million / 6 million Shares =
Rs. 5/share
Value of Firm after Split = Rs. 5/Share * 6 Million = 30
Million

23. • After the stock split what is the new price per
share and what is the new value of the firm?
– Price per share = $15 / 3
= $5 per sh.
– Value of the firm = 6 million * $5
= $30 million
– The value of the firm before was 2 mil x $15 per
share, or $30 mil.
Stock Splits – Example Cont.

24. Stock Repurchases
Reasons for repurchases:
• As an alternative to distributing cash as
dividends.
• To dispose of one-time cash from an asset
sale.
• To make a large capital structure change.

25. • ABC Company has after-tax earnings of S5
million and 2,500,000 shares of common stock
outstanding. Also suppose the stock trades at
a P/E ratio of 10. Then EPS and market price as
follows:
– EPS = EAT/Number of shares
5,000,000/2,500,000 = Rs. 2 /Share
= Market Price = EPS * P/E
= MP = 2 * 10 = 20
Stock Repurchases - Example

26. • Now suppose ABC has $1 million that it can
distribute in dividends. If it does so, the dividend
per share will be
– Dividend per share = 1 million / 2.5 Million =
$0.40/share
• However, suppose the company uses the $1
million to buy its own shares instead of paying a
dividend. Then it can purchase and retire:
– Shares Repurchase = 1 million / 20 = 50,000
– New No of Shares = 2,500,000 - 50,000 = 2,450,000
– New EPS = NI / Shares = 5,000,000/2,450,000 = 2.04
– Market Price New = New EPS * P/E = 2.04 *10 =
$20.40/Shares
Stock Repurchases - Example

27. • After the repurchase , there will be 2,450,000 shares
left outstanding
– 2,500,000 – 50,000 = 2,450,000
• If earnings don’t change EPS will then be
– EPS = $5,000,000/2,450,000
= $2.04 per share
• Finally, if the P/E remains the same, the market price
of the remaining shares will be
– Market price = EPS * P/E
= 2.04 x 10 = $ 20.40
Stock Repurchases - Example

28. • Lucky Company has after-tax earnings of PKR 10 million
and 3,500,000 shares of common stock outstanding.
Also suppose the stock trades at a P/E ratio of 15.
Calculate EPS and market price before and after Stock
Repurchase? Company has PRK 1,500,000 is available
for stock repurchase.
– EPS = EAT/Number of shares
= $10,000,000/3,500,000
= $2.86
– Market Price = EPS * P/E
= $2.86 * 15
= $42.86
Stock Repurchases – Example No 2

29. • Now suppose LUCKY has PKR1.5 million that it can
distribute in dividends. If it does so, the dividend per
share will be
– Dividends = PKR 1,500,000/3,500,000
= PKR 0.42 per share
• However, suppose the company uses the PKR1.5
million to buy its own shares instead of paying a
dividend. Then it can purchase and retire:
$1,500,000/42.86 =35,000 shares
Stock Repurchases - Example

30. • After the repurchase , there will be 3,465,000 shares
left outstanding
– 3,500,000 – 35,000 = 3,465,000
• If earnings don’t change EPS will then be
– EPS = PKR 10,000,000/3,465,000
= PKR 2.89 per share
• Finally, if the P/E remains the same, the market price
of the remaining shares will be
– Market price = EPS * P/E
= 2.89 x 15 = PKR 43.29
Stock Repurchases - Example

31. Practice Problems
12) Price stock sells for $275 per share and you own 300 shares.
– What is the current market value of your investment?
– What is the new price per share, new amount of shares you will own,
and the new market value of your investment if the firm declares a 3
for 1 stock split? If the firm declares a 15% stock dividend?
– Current Market value = 275 *300 = 82,500
– Case 1 = 3 for 1 stock split = 300*3 = 900 New Shares
– New price = 82,500/900 = 91.692
– New value after split = 91.692 * 900= 82,500
– Case 2: 15% Stock Dividend
– New No of Share = 300 * 15% = 45 New Added Share
– New No of shares after dividend = 300 + 45 = 345
– New price after Dividend = 82,500/345 = Rs. 239.13
– New Value after Dividend = 239.13 * 345 = 82,500

32. Practice Problems
3) Semi-Nowl Corporation has 1.1 million shares of
8% cumulative preferred stock outstanding with a
stated value of $100 per share. If dividends are not
paid for four years, what will be the amount of
arrearage?
4) Suppose you own 500 shares of FSU Inc. 12%
convertible preferred stock. If each preferred share
is convertible into 25 common shares, what is the
conversion value of your 5,000 preferred shares if
the common stock is trading at $30 per share?

33. Practice Problems
5) KLM Company issued $3 million of 9.75% $80 par
preferred shares in 2001. Calculate the total
amount of dividends paid on this issue per year and
the annual amount of the dividends per share.