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CORPORATE FINANCE
Dividend Policy
Dividend Policy
What is It?
Retained Earnings
Corporate Profits After Tax
Dividends
Interest
• 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)
• Declaration Date
• Holder of Record Date
• Ex-dividend Date
• Payment Date
Declaration 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.
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 Shareholders
– proportion of ownership remains unchanged
– total value of holdings remains unchanged
– if former DPS is maintained, this really represents an increased dividend payout
ABC Company
Equity Accounts
as at February xx, 20x9
Common stock (215,000) $5,000,000
Retained earnings 20,000,000
Net Worth $25,000,000
The company, on March 1, 20x9 declares a 10 percent stock dividend when the current market price for
the stock is $40.00 per share.
This stock dividend will increase the number of shares outstanding by 10 percent. This will mean issuing
21,500 shares. The value of the shares is:
This stock dividend will result in $860,000 being transferred from the retained earnings account to the
common stock account:
next page...
ABC Company
Equity Accounts
as at March 1, 20x9
The market price of the stock will be affected by the stock dividend:
D1 P
[ 22-1] P0 1
(1Ke )
m 1
(D P1)
[ 22-2] 0
mP V0
(1Ke)
• 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
mD1 X 1 nP1 I1
• 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:
X11
I [(
mn 1
)P V]
0
1
[ 22-4] V
(
1K)
• 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…
• The firm value is determined as the present value of the free cash
flows to the equity holders:
Value has
nothing
Xt It
[ 22-5] V0 to do with
t1 (
1 K) t dividends
• 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
Dividend Policy
The “Bird-in-the-Hand” Argument
M&M’s Assumptions Relaxed
ROEBVPS
InvROEK
[ 22-6] 1
P ( 2 e)
Ke
(1K
)
e K
e
• Myron Gordon suggests that dividends are more stable than capital
gains and are therefore more highly valued by investors.
22 - 5 FIGURE
OPTIMAL INVESTMENT
D1
P0
Gordon
M&M
P1 P0
P0
Conclusions:
– Firms cannot change underlying operational
characteristics by changing the dividend
– The dividend should reflect the firm’s operations
through the residual value of dividends
Dividend Policy
Dividend Policy in Practice
[ 22-7] ΔD
t *
β(D
t -D1)
t-
t
D
a(
1b)
D cE
[ 22-8]
t-
1 1
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
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
Signalling
Borrowing to Pay Dividends
Before Borrowing:
Assets: Liabilities: 0% Debt
Cash 10 Long-term Debt 0
Fixed Assets 140 Common Stock 50
Retained Earnings 100
Total Assets $150 Total Claims $150