CHAPTER ONE

DIVIDEND POLICY

Overview:
Dear students, in your study of Financial Management-I you have discussed the two major decision
areas of corporate finance Investment Decision and Financing Decision. In this chapter of the course
Financial Management-II, we will give you the extended explanation of the third important decision area
of corporate finance Dividend Policy.

Learning Objectives:
After studying this chapter, students should be able to:
 List out the various forms of dividend.
 Identify important dates related to dividend payments.
 Explain the importance of dividends to investors.
 Discuss the effect of declaring dividends on share prices.
 Identify real world factors favoring low dividend payout policy.
 Enumerate real world factors favoring high dividend payout policy.
 Mention the advantages of a stable dividend policy.
 Explain the nature of stock repurchase and stock splits.

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1.1. Basics of Dividends
In this chapter we will discuss many of the issues that affect a firm’s cash distribution policy.
As we will see, most firms establish a policy that considers their forecasted cash flows and
forecasted capital expenditures, and then try to stick to it. The policy can be changed, but this
can cause problems because such changes inconvenience shareholders, send unintended
signals, and convey the impression of dividend instability, all of which have negative
implications for stock prices. Still, economic circumstances do change, and occasionally such
changes require firms to change their dividend policies.
One of the most striking examples of a dividend policy change occurred in May 1994 in U.S.A., when
FPL Group, a utility holding company whose primary subsidiary is Florida Power & Light, announced
a cut in its quarterly dividend from $0.62 per share to $0.42. At the same time, FPL stated that it
would buy back 10 million of its common shares over the next three years to bolster its stock price.
Several analysts called the FPL decision a watershed event for the electric utility industry. FPL saw
that its circumstances were changing—its core electric business was moving from a regulated
monopoly environment to one of increasing competition, and the new environment required a stronger
balance sheet and more financial flexibility than was consistent with a 90 percent payout policy.
What did the market think about FPL’s dividend policy change? The company’s stock price fell by 14
percent the day the announcement was made. In the past, hundreds of dividend cuts followed by
sharply lower earnings had conditioned investors to expect the worst when a company reduces its
dividend—this is the signaling effect, which is discussed later in the chapter. However, over the next
few months, as they understood FPL’s actions better, analysts began to praise the decision and to
recommend the stock. As a result, FPL’s stock outperformed the average utility and soon exceeded the
pre-announcement price.
Successful companies earn income. That income can then be reinvested in operating assets,
used to acquire securities, used to retire debt, or distributed to stockholders. If the decision is
made to distribute income to stockholders, three key issues arise: (1) How much should be
distributed? (2) Should the distribution be as cash dividends, or should the cash be passed on to
shareholders by buying back some of the stock they hold? (3) How stable should the
distribution be; that is, should the funds paid out from year to year be stable and dependable,
which stockholders would probably prefer, or be allowed to vary with the firms’ cash flows
and investment requirements, which would probably be better from the firm’s standpoint?
These three issues are the primary focus of this chapter, but we also consider two related issues,
stock dividends and stock splits.

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Dividends are that portion of a firm’s net earnings paid to the shareholders. Preference
shareholders are entitled to a fixed rate of dividend irrespective of the firm’s earnings. Equity
holders’ dividends fluctuate year after year. It depends on what portion of earnings is to be
retained by the firm and what portion is to be paid off. As dividends are distributed out of net
profits, the firm’s decisions on retained earnings have a bearing on the amount to be
distributed. Retained earnings constitute an important source of financing investment
requirements of a firm. However, such opportunities should have enough growth potential
and sufficient profitability. There is an inverse relationship between these two–larger
retentions, lesser dividends and vice versa. Thus two constituents of net profits are always
competitive and conflicting.
Dividend policy has a direct influence on the two components of shareholders’ return –
dividends and capital gains. A low payout and high retention may have the effect of
accelerating earnings growth. Investors of growth companies realize their money in the form of
capital gains. Dividend yield will be low for such companies. The influence of dividend policy
on future capital gains is to happen in distant future and therefore by all means uncertain.
Share prices are a reflection of many factors including dividends. Some investors prefer
current dividends to future gains as prophesied by an English saying – A bird in hand is
worth two in the bush. Given all these constraints, it is a major decision of financial
management.
4.3. Forms of Dividends
Dividends are that potion of earnings available to shareholders. Generally, dividends are
distributed in cash, but sometimes they may also declare dividends in other forms which
are discussed below:

 Cash dividends: Most companies pay dividends in cash. The investors also, especially
the old and retired investors depend on this form of payment for want of current
income.
 Scrip dividend: In this form of dividends, equity shareholders are issued transferable
promissory notes with shorter maturity periods which may or may not have
interest bearing. This form is adopted if the firm has earned profits and it will take
some time to convert its assets into cash (having more of current sales than cash sales).

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 Payment of dividend in this form is done only if the firm is suffering from weak
liquidity position.
 Bond dividend: Scrip and bond dividend are the same except that they differ in
terms of maturity. Bond dividends carry longer maturity period and bear interest,
whereas scrip dividends carry shorter maturity and may or may not carry interest.
 Stock dividend (Bonus shares): Stock dividend is the distribution of additional shares to
the shareholders at no additional cost. This has the effect of increasing the number of
outstanding shares of the firm. The retained earnings are capitalized to give effect to
bonus issue. This decision has the effect of recapitalization, that is, transfer from
reserves to share capital not changing the total net worth. The investors are allotted
shares in proportion to their present shareholding. Declaration of bonus shares has a
favorable psychological effect on investors. They associate it with prosperity.
Important Dates for Cash Dividend Payments (Dividend Payment Chronology)
1. Announcement Date: The corporation’s Board of Directors announces the dividend
decision, e.g., “all shareholders of record as of 1/12/2002 will receive a cash dividend of
$0.25 per share, to be paid on 2/15/2002”.
2. Ex-Dividend Date: the first day the stock trades without the right to receive the
dividend. The stock price will fall by the amount of the dividend when it begins trading
that day.
This date will typically be two business days before the Record Date. This day will be
1/10/2002, so if you purchase the stock on or after this day, you will not receive the
$0.25 dividend (since there won’t be enough time to list you as an official stockholder of
record as of 1/12/2002). Prior to the ex-dividend date, the stock is said to be trading cum
dividend (with dividend); subsequently, it trades ex dividend.
3. Record Date: stockholder’s name must appear as a valid owner of stock on this date in
order to receive the dividend (1/12/2002).
4. Payment Date: cash dividend payments are made on this date (2/15/2002).

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1.2. Dividend Theories
Different theories have been given by various people on dividend policy. We have the
traditional theory and new sets of theories based on the relationship between dividend policy
and firm value. The modern theories can be grouped as – (a) theories that consider dividend
decision as an active variable in determining the value of the firm and (b) theories that do not
consider dividend decision as an active variable in determining the value of the firm.
Optimal Dividend Policy is the dividend policy that strikes a balance between current dividends and
future growth and maximizes the firm’s stock price. In an effort to find out the optimal dividend
policy different theories and models have been suggested by various scholars. We will
highlight some of them in the upcoming sections.
4.1.1. Traditional Approach
This approach is given by B. Graham and D. L. Dodd. They clearly emphasize the relationship
between the dividends and the stock market. According to them, the stock value responds
positively to high dividends and negatively to low dividends, that is, the share values of those
companies rises considerably which pay high dividends and the prices fall in the event of low
dividends paid.
Drawbacks of the Traditional Approach: As per this approach, there is a direct
relationship between P/E ratios and dividend pay-out ratio. High dividend pay-out ratio will
increase the P/E ratio and low dividend pay-out ratio will decrease the P/E ratio. This may
not always be true. A company’s share prices may rise in spite of low dividends due to other
factors.
4.1.2. Modern Dividend Theories
4.1.2.1. Dividend Relevance Model
A. Walter Model
Prof. James E. Walter considers dividend pay-outs are relevant and have a bearing on the
share prices of the firm. He further states, investment policies of a firm cannot be separated
from its dividend policy and both are interlinked.
The choice of an appropriate dividend policy affects the value of the firm. His model clearly
establishes a relationship between the firm’s rates of return r, its cost of capital k, to give a
dividend policy that maximizes shareholders’ wealth. The firm would have the optimum
dividend policy that will enhance the value of the firm.

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This can be studied with the relationship between r and k. If r>k, the firm’s earnings can be
retained as the firm has better and profitable investment opportunities and the firm can earn
more than what the shareholders could by re-investing, if earnings are distributed. Firms which
have r>k are called ‘growth firms’ and such firms should have a zero pay­out ratio.
If return on investment r is less than cost of capital k, the firm should have a 100% pay-out ratio
as the investors have better investment opportunities than the firm. Such a policy will maximize
the firm value.
If a firm has a ROI r equal to its cost of capital k, the firm’s dividend policy will have no impact
on the firm’s value. The dividend pay­outs can range between zero and 100% and the firm value
will remain constant in all cases. Such firms are called ‘normal firms’.
Assumptions of Walter’s Model
Walter’s Model is based on certain assumptions:
a. Financing: All financing is done through retained earnings. Retained earnings is the only
source of finance available and the firm does not use any external source of funds like
debt or new equity.
b. Constant rate of return and cost of capital: The firm’s r and k remain constant and it
follows that any additional investment made by the firm will not change the risk and return
profile.
c. 100% pay-out or retention: All earnings are either completely distributed or reinvested
entirely immediately.
d. Constant EPS and DPS: The earnings and dividends do not change and are assumed to
be constant forever.
e. Life: The firm has a perpetual life.
Walter’s formula to determine the market price is as follows:

Where P is the market price per share,

D is the dividend per share,
Ke is the cost of capital,
g is the growth rate of earnings,
E is Earnings per share,
r is IRR.

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Example: The following information relates to Alpha Ltd. Show the effect of the dividend
policy on the market price of its shares using the Walter’s Model.
Equity capitalization rate Ke 11%
Earnings per share $ 10
ROI (r) may be assumed as follows: 15%, 11% and 8%
Show the effect of the dividend policies on the share value of the firm for three different levels
of r, taking the DP ratios as zero(0%), 25%, 50%, 75% and 100%
Solution: Ke 11%, EPS 10, r 15%, DPS=0

Case I r>k (r=15%, K=11%)

Case II r=k (r=11%, K=11%)

Case III r<k (r=8%, K=11%)

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Interpretation: The above workings can be summarized as follows:
1. When r>k, that is, in growth firms, the value of shares is inversely related to DP
ratio, as the DP increases, market value of shares decline. Market value of share is
highest when DP is zero and least when DP is 100%.
2. When r=k, the market value of share is constant irrespective of the DP ratio. It is
not affected whether the firm retains the profits or distributes them.
3. In the third situation, when r<k, in declining firms, the market price of a share
increases as the DP increases. There is a positive correlation between the two.
Limitations of the Model
Walter has assumed that investments are exclusively financed by retained earnings and
no external financing is used. This model is applicable only to all equity firms.
Secondly r is assumed to be constant which again is not a realistic assumption. Finally,
Ke is also assumed to be constant and this ignores the business risk of the firm which
has a direct impact on the firm value.

B. Gordon’s Dividend Capitalization Model

Gordon also contends that dividends are relevant to the share prices of a firm. Myron
Gordon uses the Dividend Capitalization Model to study the effect of the firm’s
dividend policy on the stock price.
Assumptions
 All equity firm: The firm is an all equity firm with no debt.
 No external financing is used and only retained earnings are used to finance any
expansion schemes.
 Constant return r
 Constant cost of capital Ke
 The life of the firm is indefinite.
 Constant retention ratio: The retention ratio g=br is constant forever.
 Cost of capital greater than br, that is Ke>br
Gordon’s model assumes investors are rational and risk averse. They prefer certain
returns to uncertain returns and therefore give a premium to the constant r eturns and
discount uncertain returns. The shareholders therefore prefer current dividends to
avoid risk. In other words, they discount future dividends. Retained earnings are

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evaluated by the shareholders as risky and therefore the market price of the sh ares
would be adversely affected. Gordon explains his theory with preference for current
income. Investors prefer to pay higher price for stocks which fetch them current
dividend income. Gordon’s model can be symbolically expressed as:

Where: P is the price of the share,

E is Earnings Per Share,
b is Retention ratio,
(1 – b) is dividend payout ratio,
Ke is cost of equity capital,
br is growth rate in the rate of return on investment.

Example:
Given Ke as 11%, E is $ 10, calculate the stock value of Mahindra Tech. for (a) r=12%, (b)
r=11% and (c) r=10% for various levels of DP ratios given under:

DP ratio (1 – b) Retention ratio

A 10% 90%
B 20% 80%
C 30% 70%
D 40% 60%
E 50% 50%
Solution: Case I r>k e ( r=12%, K e =11%)

a) DP 10%, b 90%

b) DP 20%, b 80%

c) DP 30%, b 70%

d) DP 40%, b 60%

e) DP 50%, b 50%

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Case II r=k e ( r=11%, K e =11%)

a) DP 10%, b 90%

b) DP 20%, b 80%

c) DP 30%, b 70%

d) DP 40%, b 60%

e) DP 50%, b 50%

Case III r< k e ( r=10%, K e =11%)

a) DP 10%, b 90%

b) DP 20%, b 80%

c) DP 30%, b 70%

d) DP 40%, b 60%

e) DP 50%, b 50%

Interpretation: Gordon is of the opinion that dividend decision does have a bearing on the market
price of the share.
1. When r>k, the firm’s value decreases with an increase in pay­out ratio. Market
value of share is highest when DP is least and retention highest.
2. When r=k, the market value of share is constant irrespective of the DP ratio. It is
not affected whether the firm retains the profits or distributes them.
3. When r<k, market value of share increases with an increase in DP ratio.

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 4.1.2.1. Dividend Irrelevance Model
Miller and Modigliani Model
The MM hypothesis seeks to explain that a firm’s dividend policy is irrelevant and has
no effect on the share prices of the firm. This model advocates that it is the investment
policy through which the firm can increase its share value and hence this should be
given more importance
Assumptions of the Model
 Existence of perfect capital markets: All investors are rational and have access to all information
free of cost. There is no floatation or transaction costs, securities are infinitely divisible and no
single investor is large enough to influence the share value.
 No taxes: There are no taxes, implying there is no difference between capital gains and dividends.
 Constant investment policy: The investment policy of the company does not change. The
implication is that there is no change in the business risk position and the rate of return.
Illustration of MM Theory:
XYZ, an all-equity firm has 100 shares outstanding and a cash flow of $10,000 (including
liquidation) over the next two years. The firm can then pay a dividend of $100 per shares
in each of these two periods, which gives a stock price

i.e.
Where = 10% is the return required by shareholders (XYZ’s cost of capital when an
all-equity firm). Suppose that XYZ wants to change its dividend policy. Instead of
paying $100 per year to each shareholder, it will pay $120 per share the first year and
whatever remains after liquidation of the firm on the second year. To finance the
greater dividend of $20, XYZ has to issue new equity shares.
If equity is issued new shares have to be issued in exchange of 100 20 = $2,000 after
one year. There is no increase in leverage and thus the new shareholders will also
require a return of 10%, i.e. a payment of $2,200 at the end of the second year.
This means that there will be 10,000-2,200 = $7,800 available to the old shareholders at
time 2. The new stock price is then:

The present value of this dividend policy is therefore identical to the present value of
the previous policy. In fact, no matter how the available cash is paid out as dividends,
the present value is always $173.55.
Critical Analysis of MM Hypothesis:

Floatation costs: Miller and Modigliani have assumed the absence of floatation costs.
Floatation costs refer to the cost involved in raising capital from the market, that is, the
costs incurred towards underwriting commission, brokerage and other costs. These

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costs ordinarily account to around 10%-15% of the total issue and they cannot be
ignored given the enormity of these costs.
The presence of these costs affects the balancing nature of retained earnings and
external financing. External financing is definitely costlier than retained earnings. For
instance, if a share is issued worth $ 100 and floatation costs are 12%, the net proceeds
are only $ 88.
Transaction costs: This is another assumption made by MM that there are no
transaction costs like brokerage involved in capital market. These are the costs
associated with sale of securities by investors. This theory implies that if the company
does not pay dividends, the investors desirous of current income sell part of their
holdings without any cost incurred. This is very unrealistic as the sale of securities
involves cost, investors wishing to get current income should sell higher number
of shares to get the income they are to receive.
Under-pricing of shares: If the company has to raise funds from the market it should sell
shares at a price lesser than the prevailing market price to attract new shareholders.
This follows that at lower prices, the firm should sell more shares to replace the
dividend amount.

1.3. More on Dividend Policy Decisions in the Real World

Discussed below are reasons commonly cited for favoring a high dividend policy (high
dividend yield) and reasons for favoring a low dividend policy (low dividend yield).
Real-World Factors Favoring A High Payout Policy
Taxes:
Desire for Current Income
Transaction costs may hamper homemade dividends. But the desire for high current
income is not universal. If investors self-select into clienteles according to income
desires, and the clienteles are satisfied, it is not clear a firm can gain by paying higher
dividends.
Uncertainty resolution:
Selling stock now also creates a bird in the hand just like a dividend payment. Again,
we are back to other things are the same, can paying a higher dividend make a stock
more valuable? If a firm must sell more stock or borrow more money to pay a higher

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dividend now, it must necessarily return less to current stockholders in the future.
Finally, the uncertainty over future income, i.e., the firm’s business risk, is not changed
by its dividend policy.
Tax and legal benefits from high dividends:
There are investors who do not receive unfavorable tax treatment from holding high –
dividend yield, rather than low–dividend yield, securities.
Corporate Investors: A significant tax break on dividends occurs when a corporation
owns stock in another corporation. A corporate stockholder receiving either common or
preferred dividends is granted a 70 percent (or more) dividend exclusion. Since the 70
percent exclusion does not apply to capital gains, this group is taxe d unfavourably on
capital gains.
As a result of the dividend exclusion, high-dividend, low–capital gains stocks may be
more appropriate for corporations to hold. As we discuss elsewhere, this is why
corporations hold a substantial percentage of the outstanding preferred stock in the
economy.
Tax-Exempt Investors: There are some legal reasons for large institutions to favor high-
dividend yields. First, institutions such as pension funds and trust funds are often set
up to manage money for the benefit of others. The managers of such institutions have a
fiduciary responsibility to invest the money prudently. It has been considered
imprudent in courts of law to buy stock in companies with no established dividend
record.
Second, institutions such as university endowment funds and trust funds are frequently
prohibited from spending any of the principal. Such institutions might therefore prefer
to hold high–dividend yield stocks so they have some ability to spend. Like widows and
orphans, this group thus prefers current income. Unlike widows and orphans, this
group is very large in terms of the amount of stock owned.

Real-World Factors Favoring A Low Payout Policy

A. Taxes:
When the marginal tax rate for individuals exceeds that for businesses, investors may
prefer businesses to retain earnings rather than pay them out as dividends as a strategy

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to reduce taxes.
Expected return, dividends, and personal taxes - when dividends are taxes at higher
rates than capital gains for individuals, there is an argument that the higher a firm’s
dividends, the higher its cost of capital (and lower its stock value) to mak e the after-tax
returns equal between firm’s of the same risk. However, if investors self -select into
clienteles on the basis of their tax rates, and the clienteles are satisfied, it is not clear
dividend policy affects expected returns.
B. Flotation costs:
Firms that pay high dividends and simultaneously sell stock to fund growth will have
higher flotation costs than comparable firms with low payouts. Therefore, companies
choose to maintain low payout policy if they plan to undertake investments that requi re
additional funds.
C. Dividends Restrictions:
Most bond indentures (agreements) limit the dividends a firm can pay so does preferred
stocks especially when there is large amount of dividends in arrears .

1.4. Summary of factors influencing dividend policy

Factors that affect the dividend policy may be grouped into four categories (1)
constraints on dividends payments, (2) investment opportunities, (3) availability and
cost of alternative sources of capital, and (4) effects of dividend policy on the cost of
capital.
1. Bond indentures (agreements): debt contracts often limit dividends payment to earnings
generated after the loan was granted.
2. Preferred stock restrictions: typically, common dividends cannot be paid if the company
has omitted its preferred dividend. The preferred rearranges must be satisfied before
common dividends can be resumed.
3. Impairment of capital rule: Dividend payments cannot exceed the balance sheet item
“retained earnings”. This legal restriction, known as the impairment of capital rule, is
designed to protect creditors. Without the rule, a company that is in trouble might
distribute most of its assets to stockholders and leave its debtholders out in the cold.

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 4. Availability of cash: cash dividends can be paid only with cash. Thus, a shortage of cash
in the bank can restrict dividend payments; however, the availability to borrow can
offset this factor.
5. Possibility of accelerating or delaying projects: the ability to accelerate or to postpone
projects will permit a firm to adhere more closely to a stable dividend policy.
6. Cost of selling new stock: If a firm needs to finance a given level of investment, it can
obtain equity by retaining earnings or by issuing new common stock. If flotation costs
are high, that will increase the cost of capital, making it better to set a low pay-out ratio
and to finance through retention rather than through sale of new common stock. On the
other hand, a high dividend payout ratio is more feasible for a firm whose flotation costs
are low.
7. Ability to substitute debt for equity: A firm can finance a given level of investment with
either debt or equity. If the firm can adjust its debt ratio without raising costs sharply, it
can pay the expected dividend, even if earnings fluctuate, by using a variable debt ratio.
8. Control: If management is concerned about maintaining control, it may be reluctant to
sell new stock; hence the company may retain more earnings than it otherwise would.
However, if stockholders want higher dividends and a proxy fight looms, then the
dividend will be increased.

1.5. Stability of Dividends and Other Issues in Dividend Policy

Stability of Dividends

Stability of dividends is the consistency in the stream of dividend payments. It is the

payment of certain amount of minimum dividend to the shareholders. The steadiness is
a sign of good health of the firm and may take any of the following forms
Constant dividend per share: As per this form of dividend policy, a firm pays a fixed amount
of dividend per share year after year. For example, a firm may have a policy of paying 25%
dividend per share on its paidup capital of $ 10 per share. It implies that $ 2.50 is paid
out every year irrespective of its earnings. Generally, a firm following such a policy will
continue payments even if it incurs losses.
In such years when there is a loss, the amount accumulated in the dividend equalization
reserve is utilized. As and when the firm starts earning a higher amount of revenue it
will consider payment of higher dividends and in future it is expected to maintain the

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higher level.
Constant DP ratio: With this type of DP policy, the firm pays a constant percentage of net
earnings to the shareholders. For example, if the firm fixes its DP ratio as 25% of its
earnings, it implies that shareholders get 25% of earnings as dividend year after year. In
such years where profits are high, they get higher amount.
Constant dividend per share plus extra dividend: Under this policy, a firm usually pays
a fixed dividend ordinarily and in years of good profits, additional or extra dividend is
paid over and above the regular dividend.
Advantages of Stability of Dividends
The stability of dividends is desirable because of the following advantages:
 Build confidence amongst investors: A stable dividend policy helps to build
confidence and remove uncertainty in the minds of investors. A constant dividend
policy will not have any fluctuations suggesting to the investors that the firm’s future is
bright. In contrast, shareholders of a firm having an unstable DP will not be certain about
their future in such a firm.
 Investors’ desire for current income: A firm has different categories of investors – old
and retired persons, pensioners, youngsters, salaried class, housewives, etc. prefer current
income. Their living expenses are fairly stable from one period to another. Sharp changes in
current income, that is, dividends, may necessitate sale of shares. Stable dividend policy avoids
sale of securities and inconvenience to investors.
 Information about firm’s profitability: Investors use dividend policy (DP) as a measure of
evaluating the firm’s profitability. Dividend decision is a sign of firm’s prosperity and hence firm
should have a stable DP.
 Institutional investors’ requirements: Institutional investors like Mutual Funds prefer to invest
in companies which have a record of stable DP. A company having erratic DP is not preferred by
these institutions. Thus to attract these organizations having large quantities of investible funds,
firms follow a stable DP.
 Ease of Raising additional finance: Shares of a company with stable and regular dividend
payments appear as quality investment rather than a speculation. Investors of such companies are
known for their loyalty and whenever the firm comes with new issues, they are more responsive and
receptive. Thus raising additional funds becomes easy.

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 Stability in market price of shares: The market price of shares varies with the stability in
dividend rates. Such shares will not have wide fluctuations in the market prices which is good for
investors.
Other Dividend Policy Issues
Before we discuss how dividend policy is set in practice, we must examine two other
theoretical issues that could affect our views toward dividend policy: (1) the information
content, or signaling, hypothesis and (2) the clientele effect.
Information Content, Or Signaling, Hypothesis
When MM set forth their dividend irrelevance theory, they assumed that everyone —
investors and managers alike—has identical information regarding the 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 pu blic stockholders.
It has been observed that an increase in the dividend is often accompanied by an increase
in the price of a stock, while a dividend cut generally leads to a stock price decline. This
could indicate that investors, in the aggregate, prefer dividends to capital gains.
However, MM argued differently. They noted the well-established fact that corporations
are reluctant to cut dividends, hence 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 an important information, or signaling, content in dividend
announcements.
Information Content (Signaling) Hypothesis The theory that investors regard dividend changes as signals
of management’s earnings forecasts.
Like most other aspects of dividend policy, empirical studies of signalling have had
mixed results. There is clearly some information content in dividend announcements.
However, it is difficult to tell whether the stock price changes that follow increases or
decreases in dividends reflect only signaling effects or both signaling and dividend

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preference. Still, signaling effects should definitely be considered when a firm is
contemplating a change in dividend policy.
Clientele Effect
As we indicated earlier, different groups, or clienteles, of stoc kholders prefer different
dividend payout policies. For example, retired individuals and university endowment
funds generally prefer cash income, so they may want the firm to pay out a high
percentage of its earnings. Such investors (and pension funds) are often in low or even
zero tax brackets, so taxes are of no concern. On the other hand, stockholders in their
peak earning years might prefer reinvestment, because they have less need for current
investment income and would simply reinvest dividends receiv ed, after first paying
income taxes on those dividends.
If a firm retains and reinvests income rather than paying dividends, those stockholders
who need current income would be disadvantaged. 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. Also, some institutional investors (or trustees for individuals)
would be legally precluded from selling stock and then “spending capital.” On the other
hand, stockholders who are saving rather than spending dividends might favor the low
dividend policy, for the less the firm pays out in dividends, the less these stockholders
will have to pay in current taxes, and the less trouble and expense they will have to go
through to reinvest their after-tax dividends. Therefore, investors who want current
investment income should own shares in high dividend payout firms, while investors
with no need for current investment income should own shares in low dividend payout
firms.
To the extent that stockholders can switch firms, a firm can change from one dividend
payout policy to another and then let stockholders who do not like the new policy sell to
other investors who do. However, frequent switching would be inefficient because of (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 newly
adopted dividend policy. Thus, management should be hesitant to change its di vidend
policy, because a change might cause current shareholders to sell their stock, forcing the
stock price down. Such a price decline might be temporary, but it might also be

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permanent—if few new investors are attracted by the new dividend policy, then the
stock price would remain depressed. Of course, the new policy might attract an even
larger clientele than the firm had before, in which case the stock price would rise.
Evidence from several studies suggests that there is in fact a clientele effect. MM and
others have argued that one clientele is as good as another, so the existence of a clientele
effect does not necessarily imply that one dividend policy is better than any other. MM
may be wrong, though, and either they nor anyone else can prove that t he aggregate
makeup of investors permits firms to disregard clientele effects. This issue, like most
others in the dividend arena, is still up in the air.
Clientele Effect The tendency of a firm to attract a set of investors who like its dividend policy.

1.6. Establishing the Dividend Policy in Practice

In the preceding sections we saw that investors may or may not prefer dividends to capital
gains, but that they do prefer predictable to unpredictable dividends. Given this situation, how
should a firm determine the specific percentage of earnings that it will pay out as dividends?
While policies undoubtedly vary from firm to firm, we describe in this section the steps that a
typical firm takes when it establishes its target payout ratio.
Setting the Target Payout Ratio:
The Residual Dividend Model
When deciding how much cash to distribute to stockholders, two points should be kept in
mind: (1) The overriding objective is to maximize shareholder value, and (2) the firm’s cash
flows really belong to its shareholders, so management should refrain from retaining income
unless they can reinvest it to produce returns higher than shareholders could themselves earn
by investing the cash in investments of equal risk. On the other hand, recall from you previous
study of financial management that internal equity (retained earnings) is cheaper than external
equity (new common stock). This encourages firms to retain earnings because they add to the
equity base, increase debt capacity, and thus reduce the likelihood that the firm will have to
issue common stock at a later date to fund future investment projects.
Empirical evidences in the US show that dividend payouts and dividend yields for large
corporations vary considerably. Generally, firms in stable, cash-producing industries such as
utilities, financial services, and tobacco pay relatively high dividends, whereas companies in
rapidly growing industries such as computer and cable TV tend to pay lower dividends.

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If a firm wishes to avoid new equity sales, then it will have to rely on internally generated
equity to finance new positive NPV projects. Dividends can only be paid out of what is left
over. This leftover is called the residual, and such a dividend policy is called a residual
dividend approach.
With a residual dividend policy, the firm’s objective is to meet its investment needs and
maintain its desired debt-equity ratio before paying dividends. To illustrate, imagine that a firm
has $1,000 in earnings and a debt-equity ratio of .50. Notice that, because the debt-equity ratio is
.50, the firm has 50 cents in debt for every $1.50 in total value. The firm’s capital structure is

thus debt and equity.

The first step in implementing a residual dividend policy is to determine the amount of funds
that can be generated without selling new equity. If the firm reinvests the entire $1,000 and
pays no dividend, then equity will increase by $1,000. To keep the debt-equity ratio at .50, the
firm must borrow an additional $500. The total amount of funds that can be generated without
selling new equity is thus $1,000 +500 = $1,500.
The second step is to decide whether or not a dividend will be paid. To do this, we compare the
total amount that can be generated without selling new equity ($1,500 in this case) to planned
capital spending. If funds needed exceed funds available, then no dividend will be paid. In
addition, the firm will have to sell new equity to raise the needed financing or else (what is
more likely) postpone some planned capital spending.
If funds needed are less than funds generated, then a dividend will be paid. The amount of the
dividend will be the residual, that is, that portion of the earnings that is not needed to finance
new projects. For example, suppose we have $900 in planned capital spending. To maintain the
firm’s capital structure, this $900 must be financed by Equity and debt. So, the firm
will actually borrow . The firm will spend of the $1,000
in equity available. There is a residual, so the dividend will be $400.
In sum, the firm has after-tax earnings of $1,000. Dividends paid are $400. Retained earnings are
$600, and new borrowing totals $300. The firm’s debt-equity ratio is unchanged at .50.
Table 1.1: Example of dividend policy under the residual approach

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The relationship between physical investment and dividend payout is presented for six
different levels of investment in Table 1.1. The first three rows of the table can be discussed
together, because in each of these cases no dividends are paid. In Row 1, for example, note that
new investment is $3,000. Additional debt of $1,000 and equity of $2,000 must be raised to keep
the debt-equity ratio constant. Because this latter figure is greater than the $1,000 in earnings,
all earnings are retained. Additional stock to be raised is also $1,000. In this example, because
new stock is issued, dividends are not simultaneously paid out.
In Rows 2 and 3, investment drops. Additional debt needed goes down as well, because it is
equal to of investment. Because the amount of new equity needed is still greater than or equal
to $1,000, all earnings are retained and no dividend is paid. We finally find a situation in Row 4
in which a dividend is paid. Here, total investment is $1,000. To keep the debt-equity ratio
constant, 1⁄3 of this investment, or $333, is financed by debt. The remaining, or $667, comes
from internal funds, implying that the residual is . The dividend then is
equal to this $333 residual.
In this case, note that no additional stock is issued. Because the needed investment is even
lower in Rows 5 and 6, new debt is reduced further, retained earnings drop, and dividends
increase. Again, no additional stock is issued.
Given our discussion, we expect those firms with many investment opportunities to pay a small
percentage of their earnings as dividends and other firms with fewer opportunities to pay a
high percentage of their earnings as dividends. This result appears to occur in the real world.
Young, fast-growing firms commonly employ a low payout ratio, whereas older, slower-
growing firms in more mature industries use a higher ratio.

A Compromise Dividend Policy

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In practice, many firms appear to follow what amounts to a compromise dividend policy. Such
a policy is based on five main goals:
1) Avoid cutting back on positive NPV projects to pay a dividend.
2) Avoid dividend cuts.
3) Avoid the need to sell equity.
4) Maintain a target debt-equity ratio.
5) Maintain a target dividend payout ratio.
These goals are ranked more or less in order of their importance. In our strict residual
approach, we assume that the firm maintains a fixed debt-equity ratio. Under the compromise
approach, the debt-equity ratio is viewed as a long-range goal. It is allowed to vary in the short
run if necessary to avoid a dividend cut or the need to sell new equity.
In addition to having a strong reluctance to cut dividends, financial managers tend to think of
dividend payments in terms of a proportion of income, and they also tend to think investors are
entitled to a “fair” share of corporate income. This share is the long-run target payout ratio, and
it is the fraction of the earnings the firm expects to pay as dividends under ordinary
circumstances. Again, this ratio is viewed as a long-range goal, so it might vary in the short run
if this is necessary.
As a result, in the long run, earnings growth is followed by dividend increases, but only with a
lag. 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.
Because investors look on an extra dividend as a bonus, there is relatively little disappointment
when an extra dividend is not repeated. Although the extra-dividend approach appears quite
sensible, few companies use it in practice. One reason is that a share repurchase, which we
discuss next, does much the same thing with some extra advantages.
Repurchases of Shares
When a firm wants to pay cash to its shareholders, it normally pays a cash dividend. Another
way is to repurchase its own stock i.e. a firm can pay cash to its shareholders by a repurchase
of its own stock from the shareholders as an alternative to paying cash dividend.
Advantages of Stock Repurchases

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  Repurchase announcements are viewed as positive signals by investors.
 Stockholders have a choice when a firm repurchases stocks: They can sell or not sell.
 Dividends are sticky in the short-run because reducing them may negatively affect the
stock price. Extra cash may then be distributed through stock repurchases.
 The target payout ratio may be achieved with the help of repurchases.
Disadvantages of Stock Repurchases
 Stockholders may not be indifferent between dividends and capital gains.
 The selling stockholders may not be fully aware of all the implications of a repurchase.
 The corporation may pay too much for the repurchased stocks.

1.7. Stock Split and Reverse Stock Split

A stock split is a method to increase the number of outstanding shares by proportionately
reducing the face value of a share. A stock split affects only the par value and does not have
any effect on the total amount outstanding in share capital. The reasons for splitting shares are:
 To make shares attractive: The prime reason for effecting a stock split is to reduce the market
price of a share to make it more attractive to investors. Shares of some companies enter
into higher trading zone making it out of reach to small investors. Splitting the shares will
place them in more popular trading range thus providing marketability and motivating small
investors to buy them.
 Indication of higher future profits: Share split is generally considered a method of
management communication to investors that the company is expecting high profits in future.
 Higher dividend to shareholders: When shares are split, the company does not resort to
reducing the cash dividends. If the company follows a system of stable dividend per share,
the investors would surely get higher dividends with stock split.
There is also the Reverse Stock Split. Imagine holding $100 of stock; comprised of 10 shares
worth $10 each. Assume that the firm issues a 1 for 10 reverse stock split. You now hold one
share of stock that is worth $100. There is no wealth effect in an MM world. In reality, the stock
price usually decreases when a reverse split is announced. It is often interpreted as a sign of
management pessimism about the future, since a reverse split is the exact opposite of the
conventional stock split that was discussed above (managers don’t feel that any future good
news will increase the stock price).

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