Dividend Policy

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Dividend Policy
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Dividend Policy

• The firms choice between paying out earnings as
  dividends to shareholders, or retaining earnings
  for future investments.
• Components of dividend policy
• Dividend payout ratio.
• Stability of dividends over time.

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Optimal Dividend Policy

• The Tradeoff the decision to pay a large
  dividend means simultaneously deciding to retain
  less profits. If the firm pays a higher
  dividend, shareholders dividend yield rises, but
  capital gains decrease.
• An optimal dividend policy maximizes the current
  price of common stock.

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How does dividend policy affect stock price?

• Theories of dividend policy
• Irrelevance theory
• Bird-in-the-hand theory
• Tax preference theory
• Clientele effect theory
• Signaling effect theory

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Irrelevance Theory

• Dividends are irrelevant.
• Investors can create homemade dividends by
  selling some shares for cash.

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Bird-in-the-Hand Theory

• High dividend payments are better investors
  prefer a certain dividend payment now over a
  risky future capital gain.
• As a result, shares of companies paying high
  dividends are more attractive.

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Tax Preference Theory

• Low dividend payments are better dividends are
  taxed immediately while capital gains are not
  taxed until the stock is sold. Furthermore,
  taxes on capital gains can be deferred
  indefinitely.
• Additionally, tax rate on capital gains is
  typically lower than ordinary income.

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Clientele Effect Theory

• Different investor clienteles prefer different
  payouts.
• Some firms pay out most their earnings as
  dividends. They attract a clientele that prefers
  high dividends.
• Growth-oriented firms which pay low (or no)
  dividends attract a different clientele that
  prefers price appreciation to dividends.

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Signaling Effect Theory

• Dividend changes convey information to the market
  concerning the firms future prospects.
• Therefore, unexpected dividend increases usually
  cause stock prices to rise, and unexpected
  dividend cuts cause stock prices to fall.
• It implies that a firm should avoid dividend cuts.

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Stability of Dividends over Time

• Dividends may not be smoothed as in residual
  dividend policy
• But, typically dividends are smoothed.

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Residual Dividend Policy

• Firm pays a dividend only if it has retained
  earnings left after financing all profitable
  investment opportunities.
• Dividend depends on the investment opportunities
  and earnings of the firm.
• Dividend will fluctuate as a result.

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Factors Influencing Dividend Policy

• Constraints
• Bond indentures
• Availability of cash
• Tax law
• Investment Opportunities
• Alternative Sources of Capital

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Stock Dividends and Stock Splits

• Stock dividend payment of additional shares of
  stock to common stockholders.
• Example A company announces a 5 stock dividend
  to shareholders. For each 100 shares held, they
  receive another 5 shares.

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Stock Dividends and Stock Splits

• Stock Split the firm increases the number of
  shares outstanding and reduces the price of each
  share.
• Example A company announces a 3-for-2 stock
  split. For each 100 shares held, shareholders
  receive another 50 shares.

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Stock Dividends and Stock Splits

• Does shareholders wealth change?
• If the total market value of the firm does not
  change, these will cut the company pie into
  more pieces but will not create wealth.
• For example, a 2-for-1 stock split, which would
  be equivalent to a 100 stock dividend, gives
  shareholders 2 half-sized pieces for each
  full-sized piece they previously owned.

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Stock Dividends and Stock Splits

• Proponents argue that these are used to reduce
  high stock prices to a more popular trading
  range, thus increasing liquidity.
• Opponents argue that most stocks are purchased by
  institutional investors who have millions of
  dollars to invest and are indifferent to price
  levels.