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CHAPTER 14
DIVIDENDS AND DIVIDEND POLICY
CHAPTER 14 QUIZ
CHAPTER ORGANIZATION
The heart of the dividend policy question is just this: Should the firm pay out money to its shareholders, or should the
firm take that money and invest it for its shareholders?
D1
P0 
RE  g
All things equal, a higher dividend as well as a higher growth rate would cause P0 to increase, but a higher dividend
causes g to be lower and vice versa. Also, a lower required rate of return, R, would cause P0 to rise, and normally a
stock with a higher dividend is less risky, i.e., has a lower required rate of return.
14.1

Cash Dividends and Dividend Payment
Cash Dividends
- Regular: normal dividends, usually paid on a quarterly basis.
- Extra: paid over and above the regular dividend; may or may not be repeated.
- Special: one-time dividend paid over and above the regular dividend; will not be repeated.
- Liquidating: results from the liquidation of all or part of the corporation.

Standard Method of Cash Dividend Payment - The Board of Directors declares a dividend, after which the
dividend becomes a liability of the firm.

Dividend Payment: A Chronology
1. Declaration date – the dividend is declared by the Board of Directors and becomes a liability of the firm.
2. Ex-dividend date – occurs two business days prior to the date of record; if you purchase the stock on or
after the ex-dividend date, you will not receive the dividend.
3. Date of record – firm prepares the list of stockholders who will receive dividends.
4. Date of payment – checks are mailed.
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
More on the Ex-Dividend Date
Prior to the ex-dividend date, an investor that purchases a share of stock also acquires the right to receive the
next dividend payment. Once the ex-dividend date arrives, however, the buyer receives only the stock; thus, the
value of the stock will fall by the amount of the dividend. In other words, we expect to observe a drop in the
share price of a dividend-paying stock on the ex-dividend date. In reality, the price drop is approximately equal
to the after-tax value of the dividend.
Dividend reinvestment plans (DRIPS) allow investors to reinvest dividend income back into the issuing company
without paying commissions. Many plans also allow shareholders to buy additional shares directly from the company,
often on a set schedule. This again avoids commissions, although in some cases you pay a small service fee. You are
still liable for any taxes owed on the dividend payments. This is one way for an investor to use dollar cost averaging
when investing in individual stocks. Some plans even allow you to buy at below market prices. You can also get
additional information on DRIPS and direct investment at http://www.directinvesting.com and
http://www.dripinvestor.com.
14.2
Does Dividend Policy Matter?
The question we will be discussing here is whether the firm should pay out cash now or invest the cash and pay
it out later. Dividend policy, therefore, is the time pattern of dividend payout. In particular, should the firm pay
out a large percentage of its earnings now or a small (or even zero) percentage?

An Illustration of the Irrelevance of Dividend Policy
As with the other decisions we have looked at, dividend policy will only matter if it affects the wealth of
stockholders. The idea behind the irrelevance argument is that if the firm has a lower payout ratio now, it will
reinvest the capital into the firm, grow the firm faster and pay higher dividends later. On the other hand, if the
firm has a higher payout ratio now, it will reinvest less capital back into the firm and pay lower dividends later.
As long as the required return is earned on investments, it is irrelevant which choice the firm makes.
If we could increase dividends without changing anything else, then the firm would increase in value. However, there
is a trade-off between paying higher dividends and doing other things in the firm. The irrelevance argument says that
this trade-off is essentially a zero-sum game and that choosing one dividend policy over another will not impact the
stock price.
Recall the dividend growth model: P0 = D1 / (RE – g). In the absence of market imperfections, such as taxes, transaction
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costs, and information asymmetry, it can be shown that an increase in the future dividend, D1, will reduce earnings
retention and reinvestment. This will reduce the growth rate, g. Therefore, both the numerator and the denominator
increase and the net effect on P0 is zero.

A Test
1. True or false: Dividends are irrelevant (False)
2. True or false: Dividend policy is irrelevant (True – absent market imperfections, and maybe even with market
imperfections)
It is important to understand that the only thing that can make dividend policy relevant is if there is some market
imperfection that affects investors’ desire for dividends now versus later.

Some Real-World Factors Favoring a Low Payout
Taxes – investors that are in high marginal tax brackets might prefer lower dividend payouts. Taxes must be
paid on dividends immediately and dividends have historically been taxed as ordinary income. If the firm
reinvests the capital back into positive NPV investments, then this should lead to an increase in the stock price.
The investor can then sell the stock when she chooses and pay capital gains taxes at that time. This results in tax
deferral, and historically has provided the additional benefit of capital gains being taxed at a lower rate than
dividends. Of course, this is all subject to the current (ever-changing) tax policies.
Flotation costs – if a firm has a high dividend payout, then it will be using its cash to pay dividends instead of
investing in positive NPV projects. If the firm has positive NPV projects available, it will need to go to the
capital market to raise money for the projects. There are fees and other costs (flotation costs) associated with
issuing new securities. If the company had paid a lower dividend and used the cash on hand for projects, it
could have avoided at least some of the flotation costs.
Dividend restrictions – bond indentures often contain a provision that limits the level of dividend payments
There is a conflict of interest between stockholders and bondholders. As a result, bond indentures contain restrictive
covenants to prevent the transfer of wealth from bondholders to stockholders. Dividend restrictions are one of the most
common restrictive covenants. They normally require that dividends be foregone when net working capital falls below
a certain level or that dividends only be paid out of net income, not retained earnings that existed before the bond
agreement was signed.

Some Real-World Factors Favoring a High Payout
Desire for current income
- Individuals that want current income can either invest in companies that have high dividend payouts or they
can sell shares of stock. An advantage to dividends is that you don’t have to pay commission. Historically, a
disadvantage to dividends existed when an investor’s marginal tax rate on ordinary income was higher than the
capital gains tax rate, but currently the rates are the same.
- Trust funds and endowments may prefer current income because they may be restricted from selling stock to
meet expenses if it will reduce the fund below the initial principal amount.
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A fascinating real-world example of the desire for increased dividend payout can be found in Kirk Kerkorian’s battle
with the management at Chrysler. In late 1994, Mr. Kerkorian demanded that Chrysler use its cash hoard (about $6.6
billion at the time) to increase the cash dividend on common stock and to institute a stock repurchase program. The
management of Chrysler contended that, in the interest of prudent management, it was amassing cash with which to
ride out the next cyclical downturn. Unhappy with Chrysler’s response, Mr. Kerkorian offered $55 per share (nearly
$23 billion total) to take over Chrysler. This bid ultimately failed, but Chrysler’s management did raise the dividend.
Tax and Legal Benefits from High Dividends
- Corporate investors – taxable exclusion of at least 70% of dividends received from other corporations.
- Tax-exempt investors – tax-exempt investors do not care about the differential tax treatment between
dividends and capital gains. And in many cases tax-exempt institutions have a fiduciary responsibility to invest
money prudently. The courts have found that it is not prudent to invest in firms without an established dividend
policy.

Clientele Effects: A Resolution of Real-World Factors?
The clientele effect says that dividend policy is irrelevant because investors that prefer high payouts will invest
in firms that have high payouts; and investors that prefer low payouts will invest in firms with low payouts. If a
firm changes its payout policy, it will not affect the stock value, it will just end up with a different set of
investors. This is true as long as the “market” for dividend policy is in equilibrium. In other words, if there is
excess demand for companies with high dividend payouts, then a low payout company may be able to increase
its stock value by switching to a high payout policy. This is only possible until the excess demand is met.
14.3

Stock Repurchase: An Alternative to Cash Dividends
Cash Dividends versus Repurchase
A firm may choose to buy back outstanding shares instead of paying a cash dividend (or instead of increasing a
regular dividend). If we assume no market imperfections, then stockholder wealth is unaffected by the choice
between share repurchases and cash dividends. This is just another illustration of dividend policy irrelevance
when there are no taxes or other imperfections.
The dividend yield of DJIA firms was falling, but has increased lately. Some have suggested that a declining dividend
yield is not solely attributable to a rising market; it may also be due to declining dividend payouts. For example, in a
1987 article in the Journal of Economic Perspectives, Laurie Bagwell and John Shoven suggest that for the 10-year
period ending in 1987, dividend payments were being replaced by non-dividend cash payments. These non-dividend
cash payments were primarily in the form of cash paid out in acquisitions and in share repurchases. This may be
partially explained by taxation and agency issues. The dividend yield approximately doubled from 2000 to 2002, when
it was 2%, which may have been due to investment reductions as a result of the economic downturn. In June 2007 it
stood at 1.9% for S&P 500 firms, .48% for NASDAQ 100 firms, and 2.28% for Dow Jones Industrial Average firms
(Indexarb.com, June 2007).

Real-World Considerations in a Repurchase
Historically, one of the most important market imperfections related to cash dividends versus share repurchases
is the differential tax treatment of dividends versus capital gains. When a company does a share repurchase, the
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investor can choose whether to sell his/her shares, take the capital gain (loss) and the associated tax
consequences. When a company pays dividends, the investor does not have a choice and taxes must be paid
immediately. Historically, the lower tax rate on capital gains favored repurchases over dividends. The IRS
understands the tax differences between the two methods for returning cash to stockholders and prohibits stock
repurchase plans solely for the purpose of allowing investors to avoid taxes.
Empirical evidence suggests that repurchase announcements are often viewed by market participants as favorable
signals of future firm prospects and/or as evidence that management believes that shares are currently undervalued. As
a consequence, share prices tend to rise when a buyback is announced.

Share Repurchase and EPS
While EPS rises with a repurchase (there are fewer shares and presumably net income doesn’t decrease), the market
value of those earnings, as reflected by the P/E ratio, is the same as that under a cash dividend.
14.4
What we Know and do not Know about Dividend and Payout Policies
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14.5
Stock Dividends and Stock Splits
Stock dividend – dividend paid in shares of stock rather than in cash. Commonly expressed as a percentage,
e.g., a 25% stock dividend means you will receive 1 share for every 4 that you own. As with a cash dividend,
the stock price declines proportionally. Retained earnings are transferred to par value and capital accounts.
Stock split – new outstanding shares issued to existing stockholders, expressed as a ratio, e.g., a 2-for-1 split
means you will have 2 shares after the split for every one that you owned before the split. Again, the price drops
proportionally. Splits are usually, but not always, larger than dividends and are treated differently for
accounting purposes. Par value is adjusted to reflect the split with no impact on retained earnings.

Value of Stock Splits and Stock Dividends
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A strong case can be made that stock dividends and splits do not change either the wealth of any shareholder or
the wealth of the firm as a whole. The reason is that they are just paper transactions and simply alter the number
of shares outstanding. For example, if a firm declares a two-for-one split, all that happens is that the number of
shares is doubled, with the result that each share is worth half as much. The total value is not affected.
Proponents of stock dividends and stock splits frequently argue that a security has a proper trading range.
When the security is priced above this level, many investors do not have the funds to buy the common trading
unit of 100 shares, called a round lot. Although securities can be purchased in odd-lot form (fewer than 100
shares), the commissions are greater. Thus, firms will split the stock to keep the price in this trading range.

Reverse Splits
Given real-world imperfections, three related reasons are cited for reverse splits. First, transaction costs to
shareholders may be less after the reverse split. Second, the liquidity and marketability of a company's stock
might be improved when its price is raised to the popular trading range. Third, stocks selling at prices below a
certain level are not considered respectable, meaning that investors underestimate these firms' earnings, cash
flow, growth, and stability. Some financial analysts argue that a reverse split can achieve instant respectability.
As was the case with stock splits, none of these reasons is particularly compelling, especially the third one.
There are two other reasons for reverse splits. First, stock exchanges have minimum price per share
requirements. A reverse split may bring the stock price up to such a minimum. For example, NASDAQ delists
companies whose stock price drops below $1 per share for 30 days. Second, companies sometimes perform
reverse splits and, at the same time, buy out any stockholders who end up with less than a certain number of
shares.
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 Residual Dividend Approach – A firm which adopts this approach relies primarily on internally generated funds
to finance positive NPV projects. After allocating these funds to all positive NPV projects, the firm pays
dividends only if any residual funds remain.
1. Determine capital budget.
2. Determine target capital structure.
3. Finance investments with a combination of debt and equity in line with the target capital structure, using
additions to retained earnings as the equity component until net income is exhausted, then issue new
shares of stock if necessary.
4. Pay any excess earnings out as dividends
Managers have information about the future prospects of the firm that is not available to stockholders. Management
may not want to fully disclose this information because it could damage the firm’s competitive advantage.
Consequently, management may look for ways to “signal” this information to investors, particularly if it is good.
Investors often view changes in dividends as a signal from management. If the dividend is increased, this is viewed as
an indication that management believes the firm’s future prospects are good and that the firm will be able to maintain
the higher dividend. This causes the price to increase for two reasons: (1) the signal about good things to come, and (2)
the expectation that future dividends will be higher as well, thus increasing the present value. However, managers also
need to realize that a cut in dividends is viewed as a negative signal. If dividends need to be cut, then management
needs to think about ways to lessen the negative impact of the signal.
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Residual Dividend Policy
Lunch Special, Inc., predicts that earnings in the coming year will be $43 million. There are eight million shares, and
the company maintains a debt-equity ratio of .90.
a. Calculate the maximum investment funds available without issuing new equity and the increase in borrowing
that goes along with it.
b. Suppose the firm uses a residual dividend policy. Planned capital expenditures total $50 million. Based on this
information, what will the dividend per share be?
c. In part (b), how much borrowing will take place? What is the addition to retained earnings?
d. Suppose the company plans no capital outlays for the coming year. What will the dividend be under a residual
policy? What will new borrowing be?

Dividend Stability
The key point of the residual dividend approach is that dividends are paid only after all profitable investment
opportunities are exhausted. Of course, a strict residual approach might lead to a very unstable dividend payout.
If investment opportunities in one period are quite high, dividends will be low or zero. Conversely, dividends
might be high in the next period if investment opportunities are considered less promising.
Most financial managers would agree that a stable dividend policy is in the best interests of the firm and its
stockholders. Dividend cuts in particular are viewed as highly undesirable because such cuts are often
interpreted as a sign of financial distress. Consequently, most companies will try to maintain a steady dividend
through time, increasing the dividend only when management is confident the new dividend can be sustained
indefinitely.

A Compromise Dividend Policy – Many firms seem to follow a compromise dividend policy based on the
following goals:
1.
2.
3.
4.
5.
Do not reject positive NPV projects to pay a dividend.
Avoid reducing the dividend.
Avoid issuing new equity.
Maintain a target debt-equity ratio.
Maintain a target dividend payout ratio.
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For this kind of compromise policy, both the target debt-equity ratio and the target dividend payout ratio are
regarded as long-term goals. In general, management is reluctant to increase dividends to a level that cannot be
sustained, or to decrease dividends since that would suggest an expectation of adverse future events.
In the last week of September, 1990, Unisys (the computer firm created by the 1986 merger of Burroughs and Sperry
Corporations) announced it was suspending payment of its regular quarterly dividend. The pre-merger companies had a
record of over 100 years of regular dividend payments. On the day of the announcement, the stock fell by 23% to a 52week low, the largest decline on the NYSE that day.
Similarly, in July 1995, Venture Corporation announced the suspension of its quarterly dividend following a period of
poor earnings performance. The price of the stock (which had already fallen over the preceding months) fell by
approximately one-third on the day of the announcement. Subsequent cuts followed and the firm liquidated in May,
1998.
One can minimize the problems of dividend instability by creating two types of dividends: regular and extra.
For companies using this approach, the regular dividend would most likely be a relatively small fraction of
permanent earnings, so that it could be sustained easily. Extra dividends would be granted when an increase in
earnings was expected to be temporary.
Summary and Conclusions
1. Dividend policy is irrelevant when there are no taxes or other imperfections.
2. Individual shareholder income taxes and new issue flotation costs are real-world considerations that favor a
low-dividend payout. With taxes and new issue costs, the firm should pay out dividends only after all positive
NPV projects have been fully financed.
3. There are groups in the economy that may favor a high payout. These include many large institutions such as
pension plans. Recognizing that some groups prefer a high payout and some prefer a low payout, the clientele
effect supports the idea that dividend policy responds to the needs of stockholders. For example, if 40 percent of
the stockholders prefer low dividends and 60 percent of the stockholders prefer high dividends, approximately
40 percent of companies will have a low-dividend payout, while 60 percent will have a high payout. This
sharply reduces the impact of any individual firm's dividend policy on its market price.
4. A firm wishing to pursue a strict residual dividend payout will have an unstable dividend. Dividend stability is
usually viewed as highly desirable. We therefore discussed a compromise strategy that provides for a stable
dividend and appears to be quite similar to the dividend policies many firms follow in practice.
5. A stock repurchase acts much like a cash dividend, but has a significant tax advantage. Stock repurchases are
therefore a very useful part of overall dividend policy.
To close out our discussion of dividends, we emphasize one last time the difference between dividends and dividend
policy. Dividends are important, because the value of a share of stock is ultimately determined by the dividends that
will be paid. What is less clear is whether or not the time pattern of dividends (more now versus more later) matters.
This is the dividend policy question, and it is not easy to give a definitive answer to it.
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