DIVIDEND POLICIES - Dividend Dividend Fundamentals...

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Unformatted text preview: Dividend Dividend Fundamentals Dividends refer to that portion of a firm’s earnings which are paid out to the shareholders. * Preferred Stock Dividend is fixed. * It focuses on Common stockholders. Cash Dividend Payment Procedures Whether and in what amount to pay cash dividends to corporate stockholders is decided by the firm’s Board of Directors at quarterly or semiannual meetings. Amount of Dividends Whether dividends should be paid, and if so, in what amount, are important decisions that depend primarily on the firm’s dividend policy. Relevant Dates Relevant Dates Record Date Specified future date, set by the firm’s, directors, on which all persons whose names are recorded as stockholders receive a declared dividend at a specified future date. Ex Dividend Period, beginning 4 business days prior to the date of record during which a stock is sold without the right to receive the current dividend. Payment Date The actual date on which the firm mails the dividend payment to the holders of record. Problem – 13 (9) , Gitman Wood Shoes, at the quarterly dividend meeting, declared a cash dividend of $ 1.10 per share for holders of record on Monday , July 10 .The firm has 300000 shares of common stock outstanding and has set a payment date of July 31. Prior to the dividend declaration , the firm’s key accounts are as follows : Cash $500000 Dividends Payable $ 0 Retained Earnings $ 2500000 a. Show the entries after the meeting adjourned. b. When is the ex dividend date ? c. After the July 31 payment date , what the value key accounts have ? d. What effect, if any, will the dividend have on the firm’s total assets ? Dividend Reinvestment Plans (DRP) Plans that enable stockholders to use dividends received on the firms stock to acquire additional full or fractional shares at little or no transaction (brokerage) cost are called Dividend Reinvestment Plans. DRP may be handled by a company by two ways . Both allow the stockholders to elect to have dividends reinvested in the firm’s shares. In one approach, a third party is paid a fee to buy the firm’s outstanding shares in the open market on behalf of the shareholders who wish to reinvest their dividends. Transaction cost is lower in this approach. Dividend Reinvestment Plans (DRP) The second approach involves buying newly issued shares directly from the firm without paying any transaction costs. This approach allows the firm to raise new capital while permitting owners to reinvest their dividends, frequently at about 5% below the current market price. The firm can justify the below market sale price economically because it saves the under pricing and flotation costs that would accompany the public sale of new shares. The Relevance of Dividend Policy Good investment & financing decisions should not be sacrificed for a dividend policy of questionable importance. # Does dividend policy measure? # What effect does dividend policy have on share price? The Residual Theory of Dividend A theory that dividend paid by a firm should be the amount left over after all acceptable investment opportunities have been undertaken. Step 1 : Determine its optimum level of expenditure Step 2 : Using the optimal C.S. proportions ,estimate the total amount of equity financing needed to support the expenditures generated in * Step 1 Step 3 : Cost of retained earnings, Kr is less than cost of new common stock, Kn Arguments for Dividend Irrelevance Arguments for Dividend Irrelevance A theory put forth by Metorn H. Millar & Franco Modigliani (M&M) that in a perfect world, the value of a firm is unaffected by the distribution of dividends and is determined solely by the earning power and risk of its assets and that the manner in which it splits its earnings stream between dividends and internally retained funds does not affect this value. M and M’s theory shows that in a perfect world: • Certainty , no taxes, no transaction cost and no other market imperfection. • In a perfect world the value of the firm is unaffected by the distribution of dividend. Arguments for Dividend Irrelevance Arguments for Dividend Irrelevance • Firm’s value is determined solely by the earnings power & risks of the assets (investments). • In response to studies showing that large dividend changes affect share price. Informational content The information provided by the dividends of a firm with respect to future earnings, which causes owners to bid up or down the price of the firm’s stock. # An increase in dividends is viewed as a positive signal, and investors bid up the share price. # A decrease in dividends is viewed as a negative signal, that causes a decrease in share price as investors sell their shares. Arguments for Dividend Irrelevance Arguments for Dividend Irrelevance Clientele effect: The argument that a firm attracts shareholders whose preferences for the payment and stability of dividends correspond to the payment pattern and stability of the firm itself. Basically there are two types of investors – 1. Investors who prefer stable dividends 2. Investors who prefer to increase basic earning powers Attract those investors or shareholders who are interested to maximize the basic earnings power ,stability of dividends & growth of the firm. Arguments for Dividend Irrelevance Arguments for Dividend Irrelevance In summery, M & M argue that, all else being equal, an investors required return – and therefore the value of the firm – is affected by the dividend policy for three reasons : 1. The firm’s value is unaffected by dividend policy. Firm’s value is determined solely by the basic earning power & risk of its assets. 2. If dividends do effect value, they do so solely because their informational content. 3. A clientele effect exists that causes a firm’s shareholders to receive the dividends they expect. Arguments for Dividend Irrelevance Arguments for Dividend Irrelevance These views of M & M with respect to dividend irrelevance are consistent with the residual theory, which focuses on making the best investment decisions to maximize share value. The proponents of dividend irrelevance conclude that because dividends are irrelevant to a firm’s value, so the firm does not need to have a dividend policy. Arguments for Dividend Relevance Arguments for Dividend Relevance The theory, advanced by Gordon and Lintner, that there is a direct relationship between a firm’s dividend policy and its market value. Fundamentals to this proposition is their bird­in­the­hand argument, which suggests that investors see current dividends as less risky than future dividends or capital gains. That means investors are risk averse & attach less risk to current as opposite to future dividends or capital gains. “ A bird in the hand is worth two in the bush.” Cash Dividend reduces investor uncertainty causing investors to discount the firm’s earnings at a lower rate and it places a higher value on the firm’s stock. Arguments for Dividend Relevance Arguments for Dividend Relevance If dividends are increased, investor uncertainty will increase, lowering the required return (Ks) and increasing the value of the firm’s stock. If dividends are reduced or are not paid, investor uncertainty will increase, raising the required return (Ks) and lowering the value of the firm’s stock. Empirical studies fail to provide conclusive evidence in support of dividend relevance argument. However, financial managers & stockholders believe that dividends are relevant. Factors Affecting Dividend Policy Legal Constraints An earnings requirement limiting the amount of dividends to the sum of the firm’s most present & past retained earnings is sometimes imposed . However, the firm is not prohibited from paying more in dividends than its current earnings. Contractual Constraints Often the firm’s ability to pay cash dividends is constrained by certain restrictive provisions in a loan agreement. These Constraints prohibit the payment of cash dividends. Constraints on dividends help to protect creditors from losses due to insolvency on the part of the firm. Factors Affecting Dividend Policy Internal Constraints The firms ability to pay cash dividends is generally constrained by the amount of excess cash available rather than the level of retained earnings which to charge them. Growth Prospects The firm’s financial requirements are directly related to the degree of assets expansion that is anticipated. # Little or no growth firms may nevertheless periodically needs fund to replace or renew assets. So dividends will be more in these firms. # If the firm is in a growth stage, it will have to depend heavily on internal financing, and so it will pay minimum dividends. Factors Affecting Dividend Policy # A more established firm is in a better position to pay out a large proportion of earnings because it has multiple financing alternatives. Owner Considerations * In establishing a dividend policy, the firm’s primary concern should be to maximize owner wealth. The firm must establish a policy that has a favorable effect on the wealth of the majority of owners. * One consideration is the tax status of a firm’s owners. If a firm has a large percentage of wealthy stockholders who are in a high tax bracket, it may decide to pay out a lower percentage of its earnings. * A second consideration is the owner’s investment opportunities. Factors Affecting Dividend Policy A firm should not retain funds for investment in projects yielding lower returns. If it appears that the owners have better opportunities externally, the firm should pay out a higher percentage of its earnings. * A final consideration is the potential dilution of ownership. If a firm pays out a high percentage of its earnings, new equity capital will have to be raised with common stock. The result of a new stock issue may be dilution of both control and earnings for the existing owners. Market Considerations ∗ Wealth of the firm’s owners reflected by the market price of share. Market price of share influenced by the dividend policy. * Stock holders prefer fixed or increasing level of dividends as opposed to a fluctuating pattern of dividends. Factors Affecting Dividend Policy * Stock holders prefer a policy of continuous dividend payment. Because regularly paying a fixed or increasing dividend eliminates uncertainty about the frequency and magnitude of dividends. * A final market consideration is informational content. Shareholders often view a dividend payment as a signal of the firm’s future success. A stable and continuous dividend is a positive signal, conveying the firm’s good financial health. On the other hand, shareholders are likely to interpret a passed dividend payment due to loss or to very low Types of Dividend Policies Types of Dividend Policies Constant­ Pay out­Ratio Dividend Policy The dividend payout ratio indicates the percentage of each dollar earned that is distributed to the owners in the form of cash. It is calculated by dividing the firm’s cash dividend per share by its earning per share. With this policy, the firm establishes that a certain percentage of earnings is paid to owners in each dividend period. The problem with this policy is that if the firm’s earnings drop or if a loss occurs in a given period, the dividends may be low or even or zero. Because dividends are considered an indicator of firm’s future condition, the firm’s stock price may thus be adversely affected. Types of Dividend Policies Types of Dividend Policies Regular Dividend Policy A dividend policy based on the payment of fixed dividend in each period. This policy provides the owners with positive information, thereby minimizing their uncertainty. Firms that use this policy increase the regular dividend once a proven increase in earnings has occurred. Under this policy, dividends are almost never decreased. Low regular and Extra Dividend Policy A dividend policy based on the paying a low regular dividend, supplemented by an additional dividend when earnings are higher than normal in a given period. Types of Dividend Policies Types of Dividend Policies An additional dividend optionally paid by the firm if earnings are higher than normal in a given period is called extra dividend. By establishing a low regular dividend that is paid each period, the firm gives investors the stable income necessary to build confidence in the firm. The extra dividend permits them to share in the earnings from an especially good period. Other Forms of Dividends Other Forms of Dividends Stock Dividends A stock dividend is the payment, to existing owners, of a dividends in the form of stock. Firms pay stock dividends as a replacement for or a supplement to cash dividends. Stock dividends do not have real value. The Shareholder's Viewpoint : The shareholder receiving a stock dividend typically receives nothing of value. After the dividend is paid, the per­share value of the shareholder’s stock decreases in proportion to the dividend in such a way. The shareholder’s proportion of ownership in the firm also remains the same, and as long as the firm’s earnings remain unchanged. Other Forms of Dividends Other Forms of Dividends The Company's Viewpoint : Firm’s find the stock dividend a way to give owners something without having to use cash. When a firm needs to preserve cash to finance rapid growth, a stock dividend is used. When the shareholders recognize that the firm is reinvesting the cash flow so as to maximize future earnings, the market value of the firm should at least remain unchanged. Stock Splits A method commonly used to lower the market price of a firm’s stock by increasing the number of shares belonging to each shareholder. A stock split has no effect on the firm’s capital structure. Stock splits increase the number of shares outstanding and decrease the stock value per share. Other Forms of Dividends Other Forms of Dividends Stock Repurchases The repurchase by the firm of outstanding common stock in the marketplace. Desired effects of stock repurchases are that they either enhance shareholder value or help to discourage an unfriendly takeover. Stock repurchase enhance shareholder value by – (1) reducing the number of shares outstanding and thereby raising earnings per share, (2) sending a positive signal to investors in the marketplace that management believes that the stock is undervalued, and (3) providing a temporary floor for the stock price, which may have been declining. ...
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This note was uploaded on 03/24/2012 for the course BBA SBM taught by Professor Goa during the Spring '09 term at East West University, Chicago.

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