FIN 072 | Financial Markets

Module #23 Student Activity Sheet

Name: _________________________________________________________________ Class number: ______

Section: ____________ Schedule: _______________________________________ Date: _______________

Lesson Title: Dividend Policy Materials:

Learning Targets: Calculator, reviewer notebook,
At the end of this module, I should have: textbook
1. Described the dividend policy;
2. Explained the dividend theories; References:
3. Solved problems using Residual Dividend Model; and Timbang, F. (2016). Financial
4. Applied the effects of stock dividends, stock splits, and stock Management Part 2. Quezon City:
repurchases. C & E Publishing, Inc.

Brigham, E. F., Houston, J. F.,

Hsu, J.-M., Kong, Y. K., & Bany-
Ariffin, A. (2018). Essentials of
Financial Management. Pasig City:
Cengage Learning Asia Pte. Ltd.

Schweser. (2012). Schwesernotes

CFA Level 1 Book 4: Corporate
Finance, Portfolio Management,
and Equity Investment. United
States of America: Kaplan, Inc.

A. LESSON PREVIEW/REVIEW

Welcome back! Let us review the lesson on the previous day.

Clemson Software is considering a new project whose data are shown below. The required equipment has a 3-
year tax life, after which it will be worthless, and it will be depreciated by the straight-line method over 3 years.
Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the
project's Year 1 cash flow?

Equipment cost (depreciable basis) P65,000

Straight-line depreciation rate 33.333%
Sales revenues, each year P60,000
Operating costs (excl. depreciation) P25,000
Tax rate 35.0%

Solution

Answer

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 FIN 072 | Financial Markets
Module #23 Student Activity Sheet

Name: _________________________________________________________________ Class number: ______

Section: ____________ Schedule: _______________________________________ Date: _______________

B. MAIN LESSON

Content and Skill-Building (40 mins)

What is dividend policy?

• The decision to pay out earnings versus retaining and reinvesting them.
• Dividend policy includes
– High or low dividend payout?
– Stable or irregular dividends?
– How frequent to pay dividends?
– Announce the policy?

Dividend Irrelevance Theory

• Investors are indifferent between dividends and retention-generated capital gains.
• Investors can create their own dividend policy
– If they want cash, they can sell stock.
– If they don’t want cash, they can use dividends to buy stock.
• Proposed by Modigliani and Miller and based on unrealistic assumptions (no taxes or brokerage costs),
hence may not be true. Need an empirical test.

Why Investors Might Prefer Dividends

• May think dividends are less risky than potential future capital gains.
• If so, investors would value high-payout firms more highly, i.e., a high payout would result in a high P0.

Why Investors Might Prefer Capital Gains

• May want to avoid transactions costs
• Maximum tax rate is the same as on dividends, but …
– Taxes on dividends are due in the year they are received, while taxes on capital gains are due
whenever the stock is sold.
– If an investor holds a stock until his/her death, beneficiaries can use the date of the death as the
cost basis and escape all previously accrued capital gains.

What’s the information content, or signaling, hypothesis?

• Investors view dividend increases as signals of management’s view of the future.
– Since managers hate to cut dividends, they won’t raise dividends unless they think the increase
is sustainable.
• However, a stock price increase at the time of a dividend increase could reflect higher expectations for
future EPS, not a desire for dividends.

What’s the clientele effect?

• Different groups of investors, or clienteles, prefer different dividend policies.
• Firm’s past dividend policy determines its current clientele of investors.
• Clientele effects impede changing dividend policy. Taxes and brokerage costs hurt investors who have
to switch companies.

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 FIN 072 | Financial Markets
Module #23 Student Activity Sheet

Name: _________________________________________________________________ Class number: ______

Section: ____________ Schedule: _______________________________________ Date: _______________

What’s catering theory?

• A theory that suggests that investors’ preference for dividends varies over time and that corporations
adapt their dividend policy to cater to the current desires of investors.
– Corporate managers are more likely to initiate dividends when dividend-paying stocks are in
favor.
– Corporate managers are more likely to omit dividends when capital gains are preferred.

The Residual Dividend Model

• Find the retained earnings needed for the capital budget.
• Pay out any leftover earnings (the residual) as dividends.
• This policy minimizes flotation and equity signaling costs, hence minimizes the WACC.

Residual Dividend Model

Residual Dividend Model: Calculating Dividends Paid

• Calculate portion of capital budget to be funded by equity.
– Of the P800,000 capital budget, 0.6(P800,000) = P480,000 will be funded with equity.
• Calculate excess or need for equity capital.
– There will be P600,000 – P480,000 = P120,000 left over to pay as dividends.
• Calculate dividend payout ratio.
– P120,000/P600,000 = 0.20 = 20%.

Residual Dividend Model: What if net income drops to P400,000? Rises to P800,000?
• If NI = P400,000 …
Dividends = P400,000 – (0.6)(P800,000) = -P80,000.
Since the dividend results in a negative number, the firm must use all of its net income to fund its budget, and
probably should issue equity to maintain its target capital structure.
Payout = P0/P400,000 = 0%.
• If NI = P800,000 …
Dividends = P800,000 – (0.6)(P800,000) = P320,000.

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 FIN 072 | Financial Markets
Module #23 Student Activity Sheet

Name: _________________________________________________________________ Class number: ______

Section: ____________ Schedule: _______________________________________ Date: _______________

Payout = P320,000/P800,000 = 40%.

How would a change in investment opportunities affect dividends under the residual policy?
• Fewer good investments would lead to smaller capital budget, hence to a higher dividend payout.
• More good investments would lead to a lower dividend payout.

Comments on Residual Dividend Policy

• Advantage
– Minimizes new stock issues and flotation costs.
• Disadvantages
– Results in variable dividends
– Sends conflicting signals
– Increases risk
– Doesn’t appeal to any specific clientele.
• Conclusion: Consider residual policy when setting long-term target payout, but don’t follow it rigidly
from year to year.

Setting Dividend Policy

• Forecast capital needs over a planning horizon, often 5 years.
• Set a target capital structure.
• Estimate annual equity needs.
• Set target payout based on the residual model.
• Generally, some dividend growth rate emerges. Maintain target growth rate if possible, varying capital
structure somewhat if necessary.

What’s a dividend reinvestment plan (DRIP)?

• Shareholders can automatically reinvest their dividends in shares of the company’s common stock. Get
more stock than cash.
• There are two types of plans:
– Open market
– New stock

Open Market Purchase Plan

• Pesos to be reinvested are turned over to trustee, who buys shares on the open market.
• Brokerage costs are reduced by volume purchases.
• Convenient, easy way to invest, thus useful for investors.

New Stock Plan

• Firm issues new stock to DRIP enrollees (usually at a discount from the market price), keeps money
and uses it to buy assets.
• Firms that need new equity capital use new stock plans.
• Firms with no need for new equity capital use open market purchase plans.
• Most NYSE listed companies have a DRIP. Useful for investors.

This document is the property of PHINMA EDUCATION

 FIN 072 | Financial Markets
Module #23 Student Activity Sheet

Name: _________________________________________________________________ Class number: ______

Section: ____________ Schedule: _______________________________________ Date: _______________

Stock Dividends vs. Stock Splits

• Stock dividend: Firm issues new shares in lieu of paying a cash dividend. If 10%, get 10 shares for
each 100 shares owned.
• Stock split: Firm increases the number of shares outstanding, say 2:1. Sends shareholders more
shares.

Stock Dividends vs. Stock Splits

• Both stock dividends and stock splits increase the number of shares outstanding, so “the pie is divided
into smaller pieces.”
• Unless the stock dividend or split conveys information, or is accompanied by another event like higher
dividends, the stock price falls so as to keep each investor’s wealth unchanged.
• But splits/stock dividends may get us to an “optimal price range.”

When and why should a firm consider splitting its stock?

• There’s a widespread belief that the optimal price range for stocks is P20 to P80. Stock splits can be
used to keep the price in this optimal range.
• Stock splits generally occur when management is confident, so are interpreted as positive signals.
• On average, stocks tend to outperform the market in the year following a split.

Skill-building Activities (with answer key)

Del Grasso Fruit Company has more positive NPV projects than it can finance under its current policies without
issuing new stock, but its board of directors had decreed that it cannot issue any new shares in the foreseeable
future. Your boss, the CFO, wants to know how the capital budget would be affected by changes in capital
structure policy and/or the target dividend payout policy. You obtained the following data, which shows the
firm's projected net income (NI), its current capital structure and dividend payout policies, and three possible
new policies. Projected net income for the coming year will not be affected by a policy change. How much
larger could the capital budget be if (1) the target debt ratio were raised to the indicated amount, other things
held constant, (2) the target payout ratio were lowered to the indicated amount, other things held constant, or
(3) the debt ratio and dividend payout were both changed by the indicated amounts?

Current ______________ Policy Changes ___________

Policy Increase Debt Lower Payout Do Both
Projected NI P175.0 P175.0 P175.0 P175.0
% Debt 25.0% 75.0% 25.0% 75.0%
% Equity 75.0% 25.0% 75.0% 25.0%
% Payout 65.0% 65.0% 20.0% 20.0%

This document is the property of PHINMA EDUCATION

 FIN 072 | Financial Markets
Module #23 Student Activity Sheet

Name: _________________________________________________________________ Class number: ______

Section: ____________ Schedule: _______________________________________ Date: _______________

Solutions

Answers:
(1)
(2)
(3)

Check for Understanding

True False Other things held constant, the higher a firm's target payout ratio, the higher its expected
growth rate should be.
True False If investors prefer firms that retain most of their earnings, then a firm that wants to maximize
its stock price should set a low payout ratio.
True False One implication of the bird-in-the-hand theory of dividends is that a given reduction in dividend
yield must be offset by a more than proportionate increase in growth in order to keep a firm's
required return constant, other things held constant.
True False Some investors prefer dividends to retained earnings (and the capital gains retained earnings
bring), while others prefer retained earnings to dividends. Other things held constant, it makes
sense for a company to establish its dividend policy and stick to it, and then it will attract a
clientele of investors who like that policy.
True False If the information content, or signaling, hypothesis is correct, then a change in a firm's
dividend policy can have an important effect on its stock price and cost of equity.

C. LESSON WRAP-UP

Frequently Asked Questions

1. What are stock repurchases?
Stock Repurchases
• Buying own stock back from stockholders
• Reasons for repurchases:
– As an alternative to distributing cash as dividends.
– To make a large capital structure change.
– To obtain stock for use when options are exercised.

This document is the property of PHINMA EDUCATION

 FIN 072 | Financial Markets
Module #23 Student Activity Sheet

Name: _________________________________________________________________ Class number: ______

Section: ____________ Schedule: _______________________________________ Date: _______________

2. What are the advantages of repurchases?

Advantages of Repurchases
• Stockholders can tender or not.
• Helps avoid setting a high dividend that cannot be maintained.
• Repurchased stock can be used in takeovers or resold to raise cash as needed.
• Remove a large block of stock “overhanging” the market and depressing the stock price.
• Stockholders may take as a positive signal; management thinks stock is undervalued.

3. What are the disadvantages of repurchases?

Disadvantages of Repurchases
• May be viewed as a negative signal (firm has poor investment opportunities).
• IRS could impose penalties if repurchases were primarily to avoid taxes on dividends.
• Selling stockholders may not be well informed, hence be treated unfairly.
• Firm may have to bid up price to complete purchase, thus paying too much for its own stock.

Thinking about Learning (5 mins)

How do you feel today?

I feel (unsatisfactory/satisfactory/excellent) because_______________________________________________
________________________________________________________________________________________

What are your challenges in learning the concepts in this module? If you do not have challenges, what is your
best learning for today?
________________________________________________________________________________________
_______________________________________________________________________________________

What are the questions/thoughts you want to share to your teacher today?
________________________________________________________________________________________
_______________________________________________________________________________________

KEY TO CORRECTIONS
Review
Equipment life, years 3
Equipment cost P65,000
Depreciation: Rate = 33.333% P21,667
Sales revenues P60,000
− Basis × rate = depreciation 21,667
− Operating costs (excl. deprec.) 25,000
Operating income (EBIT) P13,333
− Taxes Rate = 35.0% 4,667
EBIT(1 − T) P 8,667
+ Depreciation 21,667
Cash flow, Year 1 P30,333

This document is the property of PHINMA EDUCATION

 FIN 072 | Financial Markets
Module #23 Student Activity Sheet

Name: _________________________________________________________________ Class number: ______

Section: ____________ Schedule: _______________________________________ Date: _______________

Skill Building Activity

Current New Maximum If New Maximum IfNew Maximum If
Found as: Maximum Increase Debt Lower Payout Do Both
NI Given P175.0 P175.0 P175.0 P175.0
% Debt " 25.0% 75.0% 25.0% 75.0%
% Equity " 75.0% 25.0% 75.0% 25.0%
% Payout " 65.0% 65.0% 20.0% 20.0%
Dividends Payout % × NI P113.8 P113.8 P35.0 P35.0
Ret. earnings, RE NI − Dividends P61.3 P61.3 P140.0 P140.0
Max. cap. budget RE/% Equity P81.7 P245.0 P186.7 P560.0

Increase: New max. − Current max. = P163.3 P105.0 P478.3

Percentage increase:
New max./Current max. − 1.0 = 200.0% 128.6% 585.7%

Answer: P163.3; P105.0; P478.3

Check for Understanding

False Other things held constant, the higher a firm's target payout ratio, the higher its expected
growth rate should be.
True If investors prefer firms that retain most of their earnings, then a firm that wants to maximize
its stock price should set a low payout ratio.
True One implication of the bird-in-the-hand theory of dividends is that a given reduction in
dividend yield must be offset by a more than proportionate increase in growth in order to keep
a firm's required return constant, other things held constant.
True Some investors prefer dividends to retained earnings (and the capital gains retained earnings
bring), while others prefer retained earnings to dividends. Other things held constant, it
makes sense for a company to establish its dividend policy and stick to it, and then it will
attract a clientele of investors who like that policy.
True If the information content, or signaling, hypothesis is correct, then a change in a firm's
dividend policy can have an important effect on its stock price and cost of equity.

This document is the property of PHINMA EDUCATION