CHAPTER ONE: DIVIDEND POLICY AND DIVIDEND THEORY

1. Introduction
The investors are interested in earning the maximum return on their investments and to
maximize their wealth. A company, on the other hand, needs to provide funds to finance
its long-term growth.
If a company pays out as dividend most of what it earns, then for business requirements
and further expansion it will have to depend upon outside resources such as issue of debt
or new shares.
Dividend policy of a firm, thus affects both the long-term financing and the wealth of
shareholders. As a result, the firm’s decision to pay dividends must be reached in such a
manner so as to equitably apportion the distributed profits and retained earnings.
Since dividend is a right of shareholders to participate in the profits and surplus of the
company for their investment in the share capital of the company, they should receive fair
amount of the profits.
1.1 Meaning of Dividend
The term dividend refers to that part of profits of a company which is distributed by the
company among its shareholders.
It is the reward of the shareholders for investments made by them in the shares of the
company.
1.2 Types of Dividend/Form of Dividend
Dividends are classified into:
a) Cash Dividend
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid
periodically out the business concerns EAIT (Earnings after interest and tax). Cash dividends are
common and popular types followed by majority of the business concerns.
b) Stock Dividend
Stock dividend is paid in the form of the company stock due to raising of more finance. Under
this type, cash is retained by the business concern. This issue is given only to the existing
shareholders of the business concern.
c) Bond Dividend
Bond dividend is also known as script dividend. If the company does not have sufficient funds to
pay cash dividend, the company promises to pay the shareholder at a future specific date with the
help of issue of bond or notes.

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d) Property Dividend
Property dividends are paid in the form of some assets other than cash. It will distribute under the
exceptional circumstance.
1.3 Standard Method of Cash Dividend Payment
The decision to pay a dividend rests in the hands of the board of directors of the corporation. A
dividend is distributable to shareholders of record on a specific date. When a dividend has been
declared, it becomes a liability of the firm and cannot be easily rescinded by the corporation.

1960 Commercial Code of Ethiopia

“Art. 458. - Payment of dividends Rights of shareholders.
(1) Dividends may only be paid to shareholders from net profit shown in the
approved balance sheet.
(2) Dividends distributed contrary to the provisions of sub. art. (1) shall be treated as
fictitious dividends and the persons making the distribution shall be criminally
and civilly liable.
(3) The date and methods of paymel1lt of dividends shall be decided by the general
meeting.
(4) Up to the date fixed for payment, the general meeting may for good reason vary
or cancel decisions of a preceding general meeting concerning the distribution
of dividends or reserves.
(5) A shareholder shall become a creditor of the company for the amount of the
dividend from the date fixed for payment.”

“Art. 459. - Claiming back of dividends.

Dividends distributed contrary to the provisions of Art. 458 may not be claimed
back from the shareholders, except in the case of family companies or where
distribution was made in the absence of a balance sheet or not in accordance
with the approved balance sheet.”

The amount of the dividend is expressed as dollars per share (dividend per share), as a
percentage of the market price (dividend yield), or as a percentage of earnings per share
(dividend payout).
The mechanics of a dividend payment can be illustrated by in the following chronology:
1) Declaration date: The board of directors declares a payment of dividends.
2) Ex-dividend date: A share of stock goes ex-dividend on the date the seller is entitled to keep
the dividend; under NYSE rules, shares are traded ex-dividend on and after the second
business day before the record date.

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3) Record date: The declared dividends are distributable to people who are shareholders of
record as of this specific date.
4) Payment date: The dividend checks are mailed to shareholders of record.
Illustration: suppose on November 11, 2010, the directors of KTZ Corporation met and
declared the regular quarterly dividend of 50 cents per share, payable to holders of record as of
Friday, December 10, payment to be made on Friday, January 7, 2011. Required determine
a) Dividend goes with stock:
b) Ex-dividend date:
c) Thursday:
d) Holder-of-record date:
Solution
e) Dividend goes with stock: Tuesday December 7
f) Ex-dividend date: Wednesday December 8
g) Thursday: December 9
h) Holder-of-record date: Friday December 10
Therefore, if Mr. A is to receive the dividend, he must buy the stock on or before December 7. If
he buys it on December 8 or later, the seller will receive the dividend because he will be the
official holder of record.
1.3.1 Stock Repurchase Procedures
Stocks repurchases occur when a company buys back some of its own outstanding stock.
Three situations can lead to stock repurchases.
1) A company may decide to increase its leverage by issuing debt and using the
proceeds to repurchase stock;
2) Many firms have given their employees stock options, and companies often
repurchase their own stock to sell to employees when employees exercise the
options. In this case, the number of outstanding shares reverts to its pre-repurchase
level after the options are exercised.
3) A company may have excess cash. This may be due to a one-time cash inflow, such
as the sale of a division, or the company may simply be generating more free cash
flow than it needs to service its debt.

Stock repurchases are usually made in one of three ways.

1) A publicly owned firm can buy back its own stock through a broker on the open
market.

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 2) The firm can make a tender offer, under which it permits stockholders to send in
(that is, “tender”) shares in exchange for a specified price per share. In this case, the
firm generally indicates it will buy up to a specified number of shares within a stated
time period (usually about two weeks). If more shares are tendered than the company
wants to buy, purchases are made on a pro rata basis.
3) The firm can purchase a block of shares from one large holder on a negotiated basis.
1.4 Cash Distributions and Firm Value
A company can change its value of operations only if it changes the cost of capital or
investors’ perceptions regarding expected free cash flow.
This is true for all corporate decisions, including the distribution policy. Is there an optimal
distribution policy that maximizes a company’s intrinsic value? The answer depends in part
on investors’ preferences for returns in the form of dividend yields versus capital gains.
The relative mix of dividend yields and capital gains is determined by the target distribution
ratio, which is
The percentage of net income distributed to shareholders through cash dividends
or stock repurchases, and
The target payout ratio, which is the percentage of net income paid as a cash
dividend.
Notice that the payout ratio must be less than the distribution ratio because the distribution
ratio includes stock repurchases as well as cash dividends.
A high distribution ratio and a high payout ratio mean that a company pays large dividends
and has small (or zero) stock repurchases. In this situation, the dividend yield is relatively
high and the expected capital gain is low.
If a company has a large distribution ratio but a small payout ratio, then it pays low
dividends but regularly repurchases stock, resulting in a low dividend yield but a relatively
high expected capital gain yield.
If a company has a low distribution ratio, then it must also have a relatively low payout ratio,
again resulting in a low dividend yield and, it is hoped, a relatively high capital gains.
In this section, we examine three theories of investor preferences for dividend yield versus
capital gains:
1) The dividend irrelevance theory,

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 2) The dividend preference theory (also called the “bird in the hand” theory), and
3) The tax effect theory.
Dividend Irrelevance Theory
The original proponents of the dividend irrelevance theory were Merton Miller and
Franco Modigliani (MM).
They argued that the firm’s value is determined only by its basic earning power and its
business risk.
In other words, MM argued that the value of the firm depends only on the income
produced by its assets, not on how this income is split between dividends and retained
earnings.
To understand MM’s argument, recognize that any shareholder can in theory construct
his own dividend policy.
For example, if a firm does not pay dividends, a shareholder who wants a 5% dividend
can “create” it by selling 5% of his stock.
Conversely, if a company pays a higher dividend than an investor desires, the investor
can use the unwanted dividends to buy additional shares of the company’s stock.
If investors could buy and sell shares and thus create their own dividend policy without
incurring costs, then the firm’s dividend policy would truly be irrelevant.
In developing their dividend theory, MM made a number of important assumptions, especially
the absence of
Taxes and
Brokerage costs.
If these assumptions are not true, then investors who want additional dividends must incur
brokerage costs to sell shares and must pay taxes on any capital gains.
Investors who do not want dividends must incur brokerage costs to purchase shares with
their dividends. Because taxes and brokerage costs certainly exist, dividend policy may well
be relevant.

Dividend Preference (Bird-in-the-Hand) Theory

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 The principal conclusion of MM’s dividend irrelevance theory is that dividend policy does
not affect a stock’s value or risk. Therefore, it does not affect the required rate of return on
equity, rs
In contrast, Myron Gordon and John Lintner both argued that a stock’s risk declines as
dividends increase: A return in the form of dividends is a sure thing, but a return in the form
of capital gains is risky.
In other words, a bird in the hand is worth more than two in the bush. Therefore,
shareholders prefer dividends and are willing to accept a lower required return on equity.
The possibility of agency costs leads to a similar conclusion.
First, high payouts reduce the risk that managers will squander cash because there
is less cash on hand.
Second, a high-payout company must raise external funds more often than a low-
payout company, all else held equal. If a manager knows that the company will
receive frequent scrutiny from external markets, then the manager will be less
likely to engage in wasteful practices. Therefore, high payouts reduce the risk of
agency costs. With less risk, shareholders are willing to accept a lower required
return on equity.

Tax Effect Theory: Capital Gains Are Preferred

Before 2003, individual investors paid ordinary income taxes on dividends but lower rates on
long-term capital gains.
The Jobs and Growth Act of 2003 changed this, reducing the tax rate on dividend income to
the same as on long-term capital gains.
However, there are two reasons why stock price appreciation still is taxed more favorably
than dividend income.
First, the time value of money means that a dollar of taxes paid in the future has a
lower effective cost than a dollar paid today. So even when dividends and gains are
taxed equally, capital gains are never taxed sooner than dividends.
Second, if a stock is held until the shareholder dies, then no capital gains tax is due at
all: the beneficiaries who receive the stock can use its value on the date of death as
their cost basis and thus completely escape the capital gains tax.

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 Because dividends are in some cases taxed more highly than capital gains, investors might
require a higher pre-tax rate of return to induce them to buy dividend-paying stocks.
Therefore, investors may prefer that companies minimize dividends. If so, then investors
should be willing to pay more for low-payout companies than for otherwise similar high-
payout companies.
Self-Test
What did Modigliani and Miller assume about taxes and brokerage costs when
they developed their dividend irrelevance theory?
How did the bird-in-the-hand theory get its name?
What have been the results of empirical tests of the dividend theories?
1.5 Clientele Effect
Investors have diverse preferences.
Some want more dividend income; others want more capital gains;
Still others want a balanced mix of dividend income and capital gains.
Over a period of time, investors naturally migrate to firms which have a dividend policy that
matches their preferences.
The concentration of investors in companies with dividend policies that are matched to their
preferences is called the clientele effect.
The existence of a clientele effect implies that
a) firms get investors they deserve and
b) It will be difficult for a firm to change and established dividend policy.
Generally, a clientele effect exists, which means that firms have different clienteles, that the
clienteles have different preferences, and hence that a dividend policy change might upset the
dominant clientele and thus have a negative effect on the stock’s price.
This suggests that companies should stabilize their dividend policy so as to avoid disrupting
their clienteles.
Self-Test
Define the clientele effect and explain how it affects dividend policy.
1.6 Information Content or Signaling, Hypothesis

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 When MM set forth their dividend irrelevance theory, they assumed that everyone i.e.
investors and managers alike has identical information regarding a firm’s future earnings and
dividends.
In reality, however, different investors have different views on both the level of future
dividend payments and the uncertainty inherent in those payments, and managers have better
information about future prospects than public stockholders.
It has been observed that
An increase in the dividend is often accompanied by an increase in the price of a
stock and
A dividend cut generally leads to a stock price decline.
Some have argued this indicates that investors prefer dividends to capital gains.
However, MM saw this differently. They noted the well-established fact that corporations
are reluctant to cut dividends, which implies that corporations do not raise dividends unless
they anticipate higher earnings in the future.
Thus, MM argued that a higher than expected dividend increase is a signal to investors that
the firm’s management forecasts good future earnings.
Conversely, a dividend reduction, or a smaller than expected increase, is a signal that
management is forecasting poor earnings in the future.
Thus, MM argued that investors reactions to changes in dividend policy do not necessarily
show that investors prefer dividends to retained earnings.
Rather, they argue that price changes following dividend actions simply indicate that there is
important information, or signaling, content in dividend announcements.
Self-Test
Define signaling content, and explain how it affects dividend policy.

1.7 Implications for Dividend Stability

The clientele effect and the information content in dividend announcements definitely have
implications regarding the desirability of stable versus volatile dividends.
For example, many stockholders rely on dividends to meet expenses, and they would be
seriously inconvenienced if the dividend stream were unstable.

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 Further, reducing dividends to make funds available for capital investment could send
incorrect signals to investors, who might push down the stock price because they interpret the
dividend cut to mean that the company’s future earnings prospects have been diminished.
Thus, maximizing its stock price probably requires a firm to maintain a steady dividend
policy. Because sales and earnings are expected to grow for most firms, a stable dividend
policy means a company’s regular cash dividends should also grow at a steady, predictable
rate. But as we explain in the next section, most companies will probably move toward small,
sustainable, regular cash dividends that are supplemented by stock repurchases.
1.8 Types of Dividend Policy
The various types of dividend policies are discussed as follows:
1) Regular Dividend Policy
Payment of dividend at the usual rate is termed as regular dividend.
The investors such as retired persons, widows and other economically weaker persons
prefer to get regular dividends.
It must be remembered that regular dividends can be maintained only by companies of long
standing and stable earnings.
2) Stable Dividend Policy
The term ‘stability of dividends’ means consistency or lack of variability in the stream of
dividend payments.
In more precise terms, it means payment of certain minimum amount of dividend
regularly.
A stable dividend policy may be established in any of the following three forms.
Constant dividend per share: Some companies follow a policy of paying fixed
dividend per share irrespective of the level of earnings year after year.
Such firms, usually, create a ‘Reserve for Dividend Equalization’ to enable them to
pay the fixed dividend even in the year when the earnings are not sufficient or
when there are losses
Constant payout ratio: Constant pay-out ratio means payment of a fixed
percentage of net earnings as dividends every year.
The amount of dividend in such a policy fluctuates in direct proportion to the
earnings of the company.

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 Stable Birr/Dollar dividend plus extra dividend: Some companies follow a
policy of paying constant low dividend per share plus an extra dividend in the
years of high profits.
Such a policy is most suitable to the firm having fluctuating earnings from year to
year.
3) Irregular Dividend Policy
Some companies follow irregular dividend payments on account of the following:
Uncertainty of earnings.
Unsuccessful business operations.
Lack of liquid resources.
Fear of adverse effects of regular dividends on the financial standing of the company.
4) No Dividend Policy
A company may follow a policy of paying no dividends presently because of its
unfavorable working capital position or on account of requirements of funds for future
expansion and growth.
5) Residual Dividend Policy
Under the Residual approach, dividends are paid out of profits after making provision for
money required to meet upcoming capital expenditure commitments.
1.9 Stock Dividends and Stock Splits
1.9.1 Stock Dividends
Another type of dividend is paid out in shares of stock. This type of dividend is called a
stock dividend.
A stock dividend is not a true dividend because it is not paid in cash.
The effect of a stock dividend is to increase the number of shares that each owner holds.
Be-cause there are more shares outstanding, each is simply worth less.
A stock dividend is commonly expressed as a percentage.
For example, a 20 percent stock dividend means that a shareholder receives one new
share for every five currently owned (a 20 percent increase). Because every shareholder
receives 20 percent more stock, the total number of shares outstanding rises by 20 percent.
As we will see in a moment, the result is that each share of stock is worth about 20 percent
less.

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 Stock dividends of less than 20 to 25 percent are called small stock dividends.
A stock dividend greater than this value of 20 to 25 percent is called a large stock
dividend.
Example of a Small Stock Dividend, assume that KTZ Co., a consulting firm specializing in
difficult accounting problems, has 10,000 shares of stock outstanding, each selling at $66. The
total market value of the equity is $66 x 10,000 = $660,000. With a 10 percent stock dividend,
each stockholder receives one additional share for each 10 owned, and the total number of shares
outstanding after the dividend is 11,000.
Before the stock dividend, the equity portion of KTZ’s balance sheet might look like this:

After the stock dividend, the equity portion of KTZ’s balance sheet might look like this:

1.9.2 Stock Splits

A stock split is essentially the same thing as a stock dividend, except that a split is
expressed as a ratio instead of a percentage.
When a split is declared, each share is split up to create additional shares. For example, in
a three-for-one stock split, each old share issplit into three new shares.
For example, in a three-for-two split, each shareholder receives one additional share of
stock for each two held originally, so a three-for-two split amounts to a 50 percent stock
dividend.
Suppose KTZ decides to declare a two-for-one stock split. The number of shares outstanding will
double to 20,000, and the par value will be halved to $0.50 per share. The owners’ equity after
the split is represented as follows:

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1.10 A Compromise Dividend Policy
In practice, many firms appear to follow what amounts to a compromise dividend policy. Such a
policy is based on five main goals:
a. Avoid cutting back on positive NPV projects to pay a dividend.
b. Avoid dividend cuts.
c. Avoid the need to sell equity.
d. Maintain a target debt-equity ratio.
e. Maintain a target dividend payout ratio.

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