BF2

Lecture 8:
Dividend Policy

Dividend Policy
By: Dr. Sana Tauseef
Modified by Kidwai
(19-4-20)
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Dividend policy involves decision
about…

• The percentage of earnings to distribute

• In what form the distribution should be

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made.
• How stable should the distribution be

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Is the dividend policy relevant?

High payout is taken positively by the investors,

thus, it has a positive impact on the share price.

High retention means good future growth which

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also has a positive impact on the share price.
Payout rate = 30% ROE = 21%
g = (Retention rate)(ROE)
= (1 — Payout rate)(ROE)
= 0.7(21%) = 14.7%.
P = D1/ (k – g) 3
Dividend Irrelevance Theory proposed
by MM is based on a number of
assumptions…
• Perfect and efficient markets
• No transaction costs, brokerage cost or

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floatation costs
• No taxes

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According to Irrelevance Theory, the
dividend policy only rearranges the

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stream of future dividends without
affecting the current stock price…

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An all-equity company has 100,000 shares outstanding. The
company has a perpetual annual earnings of $100,000 and
follows a 100% payout policy. The current share price is $10
and the required return on common equity is 10%. The
company needs $100,000 at the end of the next year for an
investment project which is expected to generate $10,000
per year in future. The company has two alternatives to

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finance the investment outlay:
1. Maintain the 100% payout policy and issue $100,000
worth of new shares.
2. Omit the next year’s dividends and finance the
investment with that amount. (Retain all earnings).
Compute the current share price under the two
alternatives.
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7

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Investors are indifferent between
high/low payout since they can create
their desired dividend stream through
home made dividends…
An investor holding 10,000 shares of the company in

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previous example wants the company to take
second alternative (omit dividend) but the company
goes for first. What action the investor should take?

What if the investor likes the first plan but company

follows the second?
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When the assumptions of MM are
relaxed (for the real world), the
dividend policy becomes relevant…
Case for high payouts:

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Bird in the hand theory

Case for low payouts:

Differential tax argument

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According to bird in the hand theory,
investors prefer high payouts since
investment environment is uncertain;
therefore, the more distant an

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expected dividend is the more risky it
is…

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Bird in Hand Theory Explained
For the information given in previous
example, now assume that the cost of equity
(COE) under the second alternative (no dividend) is

expected to be 12%. This increase in COE is

because the dividends are deferred to future

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and hence are risky and as a result the
stockholders require a higher compensation.
Compute the current share price under
the two alternatives.

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 According differential tax argument,
investors prefer low payouts in order
to delay or lower the tax payments…

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Clientele Effect
• Different groups or clienteles of stockholders
prefer different dividend payout policies.
• Examples, retired individuals, pension funds,
and university endowment funds. They prefer cash

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dividend/income. Such investors are often in low
tax brackets, so taxes are of little concern.
• On the other hand if company retains profit the value
of their stock might increase, but they would be forced
to go to the trouble and expense of selling off some of
their shares to obtain cash. 19
Clientele Effect continued
• In contrast stockholders in their peak earning
years might prefer reinvestment, because they have
less need for current investment income and would
simply reinvest dividends received, after first paying

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income taxes. Such investors prefer deferment of
dividends.
• stockholders can switch firms; companies can switch
policy. Consequences of the switch:
• (1) brokerage costs, (2) the likelihood that stockholders
who are selling will have to pay capital gains taxes, and
(3) a possible shortage of investors who like the firm’s 20
newly adopted dividend policy & drop in share price.
Dividend Stability
• Stability of dividends is also important.
• Profits and cash flows vary over time.
• Many stock-holders rely on dividends to meet expenses.
• Reducing dividends to make funds available for capital
investment could send incorrect signals to investors
• Might push down the stock price because they may interpret

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the dividend cut to mean that the company’s future earnings
prospects have been diminished.
• Maximizing its stock price requires a firm to
balance its internal needs for funds against the
desires of its stockholders. How? No definitive
answer.
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Dividend Stability continued
• Although no definitive answer for dividend stability is
available following is relevant:
• Virtually every publicly owned company makes a five-
to ten-year financial forecast of earnings and dividends.

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• Today a “stable dividend policy” generally means
increasing the dividend at a reasonably steady rate.
• g = (Retention rate)(ROE)
= (1 — Payout rate)(ROE)
= 0.7(21%) = 14.7%.

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Effect of dividend stability
• Most observers believe that dividend
stability is desirable and that investors
prefer stocks that pay more predictable

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dividends.
• This means that the cost of equity will be
minimized, and the stock price
maximized, if a firm stabilizes its
dividends as much as possible.
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Setting the Target Payout Ratio: The
Residual Dividend Model
Management should refrain from retaining income unless they can
reinvest it to produce returns higher than shareholders themselves
earn by investing the cash in investments of equal risk.

On the other hand, internal equity (retained earnings) is cheaper

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than new common stock. This encourages firms to retain earnings so
as to avoid having to issue new stock.

Optimal payout ratio is a function of four factors: (1) investor’s

preferences for dividends versus capital gains (2) the firm’s
investment opportunities (3) its target capital structure, and (4) the
availability and cost of external capital. The last three elements
are combined in what we call the residual dividend model. 24
Residual dividend model - steps
• Under this model, a firm follows these four steps when
establishing its target payout ratio: (1) It determines the
optimal capital budget (2) it determines the amount
of equity needed to finance that budget, given its target

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capital structure (3) it uses retained earnings to
meet equity requirements to the extent possible; and (4) it
pays dividends only if more earnings are available
than are needed to support the optimal budget.
• The word residual implies “leftover,” and the residual
policy implies that dividends are paid out of
“leftover” earnings. 25
Example of Residual Dividend Model
• For example, suppose a company’s target equity ratio is 60%
and the firm plans to spend $50 million on capital projects. So
common equity needed =$(0.6)50= $30 m.
• If its net income were $100 million, its dividends would be
$100 - $30 = $70m (earnings remaining for dividends).

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• So, if the company had $100 million of earnings and a capital
budget of $50 million, it would use $30 million of the retained
earnings plus $50 — $30 = $20 million of new debt to finance
the capital budget to maintain the target debt equity ratio.

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Residual dividend model
Dividends =
Net income — Retained earnings needed to for
new investments

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or

Net income — [(Target equity ratio)(Total capital budget)]

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Dividend payout policies include…

I. Residual dividend policy

II. Constant $ dividend policy
III.Constant payout ratio policy

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Residual dividend policy is the most widely used
policy in which the earnings are used to finance the
new investments first. Usually, after using the internal
financing, the companies use debt financing and
external equity is used only as the last financing
option. This is called pecking order. 28
How to stabilize dividends with
residual dividend policy
• Strict adherence to the residual dividend policy would result in
unstable dividends. To stabilize dividends:
1. Estimate earnings and investment opportunities, on average, over
the next five years or so.
2. Use this forecasted information to find the average residual
model payout ratio and dollars of dividends during the planning

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period.
3. Then set a target payout ratio based on the average
projected data.

Thus, firms should use the residual policy to

help set their long-run target payout ratios, 29
but not as a guide to the payout in any one
year.
Low-regular-dividend-plus-extras or
repurchase (for stability)
• A company announces a low regular dividend
that sure could be maintained “through hell or
high water,” and stockholders could count on
receiving that dividend under all conditions.

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• When cash flows are high, the companies pay a
clearly designated extra dividend.
• In recent years in US many companies have
replaced the “extras” in their low-regular-
dividend-plus-extras policy with stock
repurchases. 30
Companies who want to keep a track of
regular dividends but are experiencing short-
term cash flow difficulties or have better uses
of cash can distribute new shares to current
shareholders as stock dividends (or
bonus shares)

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  Number of shares (in thousands)
  2010 2009
Authorized capital 1,380,000 1,380,000
Issued, subscribed and paid-up capital    
Ordinary shares of Rs. 10 each fully paid in 690,000 690,000
cash
Ordinary shares of Rs. 10 issued as bonus 311,880 220,800
shares
Total shares outstanding 1,001,880 910,800

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HBL’s 2010 Annual Report
Stock Dividend & Stock Split
Stock Dividend & Stock Split were discussed
in Financial Accounting in detail. So I am not
repeating the same here.

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Book closure dates & record date??
Ex- dividend??
Answer on next slide.

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Ex-Dividend Share Price =
Share Price 3 days prior to ex date – Dividend per share

• CURRENT SHARE PRICE WILL BE REDUCED BY THE

CURRENT DIVIDEND PER SHARE after ex-dividend date

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• Price of share immediately after the ex-dividend date
• P1 = P0 (1 + Ke ) – D1

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