CHAPTER 18 - Summary

Dividend Policy

A dividend policy is the policy a company uses to structure its dividend payout to
shareholders. Some researchers suggest the dividend policy is irrelevant, in theory, because
investors can sell a portion of their shares or portfolio if they need funds. This is the dividend
irrelevance theory, which infers that dividend payouts minimally affect a stock's price.

● Dividend-Payout Ratio
The dividend payout ratio is the ratio of the total amount of dividends paid out to
shareholders to the company's net income. It is the percentage of earnings distributed
to shareholders in the form of dividends. The sum not given to shareholders is kept by
the firm and used to pay down debt or reinvest in core activities. It is sometimes
referred to simply as the payout ratio.

● Dividends as a Passive Residual

A residual dividend is a dividend policy implemented by businesses in which the
amount of dividends given to shareholders is equal to the amount of profits left over
after the firm has paid for its capital expenditures and working capital costs.
Companies that adopt a residual dividend policy use available earnings to fund capital
expenditures before paying dividends to shareholders. This implies that the monetary
amount of dividends paid to investors will vary from year to year.

● Irrelevance of Dividends
Dividend irrelevance hypothesis asserts that dividends have no influence on a
company's stock price. A dividend is often a cash payment paid to shareholders from
a firm's profits as a reward for investing in the company. According to the dividend
irrelevance argument, dividends can harm a firm's capacity to compete in the long run
since the money would be better suited reinvested in the company to produce
earnings.

● Preference for Dividends

 Dividends may be preferred by certain investors over capital gains. Dividend
payments may alleviate their concerns about the company's viability. Dividends are
paid on a continuous basis, whereas capital gains are only realised in the future. As a
result, dividend-paying company investors resolve their uncertainties sooner than
non-dividend-paying firm investors. If investors desire early resolution of uncertainty,
they may be ready to pay a higher price for the company with the bigger dividend,
everything else being equal. If investors can provide "homemade" payouts, such a
demand is unreasonable.

● Taxes on the Investor

When we allow for taxes, we get a range of results. Retaining profits may be
advantageous if the personal tax rate on capital gains is lower than the rate on
dividend income. (In the United States, these rates have just lately been the same for
people.) Furthermore, the capital gains tax is postponed until the stock is actually sold
(when any gain is then realised). When a company holds earnings rather than paying
dividends, the shareholder has a valuable timing advantage.

● Flotation Costs
A publicly listed company incurs flotation costs when it issues new securities and
incurs expenditures such as underwriting fees, legal fees, and registration fees.
Companies must examine how these costs may affect the amount of cash they can
raise via a new offering. Flotation expenses, estimated return on equity, dividend
payments, and the percentage of earnings retained are all factors in calculating a
company's cost of fresh stock.

● Transactions Costs and Divisibility of Securities

Transaction expenses associated with the selling of securities tend to limit the
arbitrage process in the same way that debt does. Shareholders seeking current
income must pay brokerage fees on the selling of sections of their stock ownership if
the dividend received is insufficient to meet their needs.

● Institutional Restrictions
Certain institutional investors are restricted in the categories of common stock they
may acquire or the percentages of common stock they can hold in their portfolio. The
 mandated list of eligible securities for these investors is established in part by the
duration of dividend payments. Certain institutional investors are not authorised to
invest in a company's shares if it does not pay dividends or has not paid them for a
sufficiently extended length of time.

● Financial Signalling
A signalling strategy organises investment or trading around data-driven signals. A
signal-driven transaction is one that is triggered by data such as price information or
metadata such as insider trading activity. Companies' financial health can be revealed
via releasing dividends, buybacks, or debt.

● Empirical Testing of Dividend Policy

The majority of empirical research has focussed on the tax effect and financial
signalling. This is not to suggest that dividend preference, flotation costs, transaction
expenses, and institutional constraints have no influence. Rather, any influence these
elements may have is overshadowed by tax and financial signalling effects.

● Implications Corporate Policy

A corporation should strive to implement a dividend policy that maximises
shareholder equity. Most people think that if a corporation does not have enough
viable investment prospects, any extra cash should be distributed to its owners. The
company is not required to pay out the exact unused percentage of earnings each time.
Indeed, it may prefer to keep the absolute amount of dividends paid consistent from
month to period. However, in the long term, the total earnings retained, plus the extra
senior securities supported by the growing equity base, will equal to the number of
new successful investment possibilities. Dividend policy would remain a passive
residual decided by the number of investment opportunities available.

● Capital Impairment Rule

Although state laws vary greatly, many states forbid the distribution of dividends if
they weaken capital. Capital is defined in certain states as the whole par value of the
common stock.

● Insolvency Rule
 If a firm is insolvent, certain states restrict the distribution of cash dividends.
Insolvency is defined either legally as a company's total liabilities exceeding its assets
"at a reasonable appraisal," or technically as the firm's inability to pay its creditors
when obligations come due. Because the firm's capacity to fulfil its obligations is
determined by its liquidity rather than its capital, the equitable (technical) insolvency
constraint provides significant protection to creditors. When cash is scarce, a
corporation is constrained from preferring shareholders over creditors.

● Undue Retention of Earnings Rule

The Internal Revenue Code forbids unjustified profits retention. Although the term
"undue retention" is unclear, it is commonly understood to signify retention that is
much more than the company's current and future investment needs. The law's goal is
to discourage businesses from keeping earnings in order to avoid paying taxes.

● Funding Needs of the Firm

Once the legal parameters for the firm's dividend policy have been set, the next stage
is to examine the firm's finance requirements. Cash budgets, projected sources and
uses of funds statements, and anticipated cash flow statements are particularly useful
in this respect. The goal is to forecast the company's probable cash flows and cash
position in the absence of a change in dividend policy. We should include business
risk in addition to projected results to obtain a range of probable cash-flow outcomes.

● Liquidity
Many dividend decisions take a company's liquidity into account. Dividends are a
financial outflow, therefore the better a company's cash position and general liquidity,
the greater its capacity to pay a dividend. A growing and lucrative firm may not be
liquid since its cash may be invested in fixed assets and long-term working capital.
Because such a company's management often wishes to keep some liquidity buffer to
provide financial flexibility and protection against uncertainty, it may be hesitant to
sacrifice this position in order to pay a hefty dividend.

● Ability to Borrow
A liquid position is not the sole option to give financial flexibility and thereby
mitigate risk. If a company can borrow money on short notice, it may be considered
 financially flexible. This borrowing ability might take the shape of a bank's line of
credit or a revolving credit arrangement, or it can simply be the informal desire of a
financial institution to lend credit.

● Restrictions in Debt Contracts

The protective covenants in a bond indenture or loan agreement frequently include a
restriction on dividend payments. Lenders use the limitation to protect the company's
capacity to service debt. It is often defined as a maximum proportion of total earnings
kept (reinvested) in the business. When such a limitation is in place, it inevitably has
an impact on the company's dividend policy. Sometimes a company's management
appreciates a dividend restriction imposed by lenders since it eliminates the need to
justify the retention of earnings to its shareholders. It merely needs to point out the
constraint.

● Control
If a corporation gives out large dividends, it may need to obtain funds later by selling
stock in order to finance successful investment possibilities. If controlling
shareholders do not or cannot subscribe for new shares in such circumstances, the
company's controlling stake may be eroded. These shareholders may favour a modest
dividend distribution and the use of earnings to fund investment requirements.
Although such a dividend policy may not increase total shareholder wealth, it may be
in the best interests of those in power.

● Target Payout Ratios

Over time, a lot of corporations appear to adhere to the concept of a target
dividend-payout ratio. According to John Lintner, dividends are adjusted to changes
in profits, but only with a lag. When earnings reach a new level, a corporation raises
dividends only if it believes it can sustain the gain in earnings. Companies are also
hesitant to reduce the total amount of their cash dividend. Both of these considerations
contribute to explain why dividend changes frequently lag profit changes. The lag
connection becomes obvious during an economic upturn when retained earnings grow
in respect to dividends. During a recession, retained profits will fall in relation to
dividends.
● Regular and Extra Dividends
In times of success, one option for a firm to raise its cash payout to shareholders is to
announce an additional dividend in addition to the ordinary dividend, which is usually
paid quarterly or semiannually. By announcing an additional payout, the corporation
notifies investors that the payment is not an increase to the existing dividend rate.
Extra dividends are especially appropriate for organizations with changing revenues.

● Small-Percentage Stock Dividends

A small-percentage stock dividend is one that reflects an increase of less than
(usually) 25% of previously issued common shares. This sort of equity dividend
requires a transfer of funds from retained earnings to common shares and extra
paid-in capital.

● Large-Percentage Stock Dividends

Usually 25% or more of previously outstanding common shares) must be treated
differently. Though small-percentage stock dividends are unlikely to have a
significant impact on stock market value per share, large-percentage stock dividends
are projected to significantly diminish stock market price per share. Conservatism, in
the event of large-percentage stock dividends, advocates for reclassifying a sum
confined to the par value of extra shares rather than an amount tied to the stock's
pre-dividend market value.

● Stock Splits
A stock split is a multiplication or division of a company's outstanding share count
that does not affect the company's total market value or capitalization. For example, if
a corporation doubles its share count by providing each shareholder one additional
share of stock for every share they own, each shareholder would own twice as many
shares of stock. The total value of all outstanding shares, however, will not change
because no extra capital would be put into the corporation.

● Effect on Cash Dividends

The Impact on Cash Dividends A cash dividend increase may accompany a stock
dividend or stock split. Assume that an investor owns 100 shares of a company that
pays a $1 yearly dividend. The corporation declares a 10% equity dividend while also
 announcing that the cash dividend per share would stay constant. The investor will
subsequently own 110 shares, with total cash dividends of $110 instead of $100 as
previously. A stock dividend boosts the total cash dividends in this situation. The
trade-off between current dividends and profits retention, as we described before, will
determine whether this rise in cash dividend has a good effect on shareholder value.

● Reverse Stock Split

Companies use reverse stock splits to lower the number of outstanding shares in the
market. Existing shares are consolidated into fewer, proportionately more valuable
shares, resulting in an increase in the stock price of the corporation. A reverse stock
split occurs when a corporation cancels its existing outstanding stock and distributes
new shares to its owners in proportion to the number of shares they had prior to the
reverse split.

● Self-Tender Offer
A company's offer to buy back its own shares at a price much in excess of its fair
market value. A self-tender offer often excludes a specific number of shareholders; it
is not meant to halt trading in the company's shares. Rather, it is an endeavour to avert
a genuine or alleged hostile takeover. When a corporation becomes its own majority
or plurality shareholder, it either makes a hostile takeover impossible or significantly
more expensive for the company seeking to buy it out.

● Repurchasing as Part of Dividend Policy

If a company has surplus cash but no successful investment prospects, it may be in the
best interests of the shareholders to disperse the funds. The distribution might be
performed by repurchasing stock or paying out the proceeds in enhanced dividends. In
the absence of personal income taxes and transaction expenses, the two options
should have no effect on shareholders. With buyback, fewer shares remain
outstanding, resulting in higher earnings per share and, eventually, dividends per
share. As a result, the market price per share is expected to climb.

● Treasury Stock
Treasury stock, also known as treasury shares or reacquired stock, is previously
outstanding stock that the issuing corporation buys back from investors. As a result,
 the total number of outstanding shares on the open market falls. These shares were
issued but are no longer outstanding, thus therefore are not counted in dividend
distributions or earnings per share calculations (EPS). Treasury stock is a counter
equity account that is represented in the balance sheet's shareholders' equity column.
Treasury stock diminishes shareholders' equity by the price paid for the stock since it
indicates the number of shares repurchased on the open market.

● Record date - is the date, set by the board of directors when a dividend is declared, on
which an investor must be a shareholder of record to be entitled to the upcoming
dividend.
● Ex-dividend date - the first date on which a stock purchaser is no longer entitled to the
recently declared dividend.
● Declaration date - the date when the board of directors announces the amount and date
of the next dividend.
● Payment date - the date when the corporation actually pays the declared dividend.

● Dividend Reinvestment Plans

A dividend reinvestment plan (DRIP) is a scheme that allows investors to reinvest
their cash dividends in more shares or fractional shares of the underlying company on
the dividend distribution date. Although the word can refer to any automatic
reinvestment plan set up through a brokerage or investment institution, it often refers
to a formal program given by a publicly listed organization to current shareholders.
DRIPs, also known as dividend reinvestment plans, allow shareholders to reinvest the
amount of a declared dividend into additional shares purchased directly from the
corporation. Because DRIP shares are often acquired from the company's internal
reserve, they are not tradable on stock markets. Shares must also be redeemed directly
through the corporation.