Chapter One

Dividend and Dividend Policy

Cash Dividends and Dividend Payment

The term dividend usually refers to payment made out of a firm’s earnings to its owners, either in
the form of cash or stock. If a payment is made from sources other than current or accumulated
retained earnings, the term distribution rather than dividend is used. However, it is acceptable to
refer to a distribution from earnings as a dividend and a distribution from capital as a liquidating
dividend.
Dividends can be
A. Cash dividend form
B. Stock dividend form
The basic types of cash dividends are:
1. Regular cash dividends
2. Extra dividends
3. Special dividends
4. Liquidating dividends
The most common type of dividend is a cash dividend. Regular cash dividend is cash payment
made by a firm to its owners in the normal course of business, usually made four times a year.
Cash dividend payment reduces corporate cash and retained earnings, except in case of
liquidating dividend where paid in capital may be reduced.
Commonly, the amount of the cash dividend is expressed in terms of the birr per share (dividend
per share). It is also expressed as a percentage of the market price (the dividend yield) or as a
percentage of earnings per share (the dividend payout).

Dividend payment: A chronology

The terminologies on dividend payments are illustrated with the following example:
Thursday Wednesday Friday Monday
January January January February
15 28 30 16
Declaration date Ex- dividend date Record date Payment date

1. Declaration date: is date on which the board of directors passes a resolution to pay a
dividend.
Example, on January 15, the board of directors passes a resolution to pay a dividend of birr 1
per share on February 16 to all holders of record as of January 30.
2. Ex- dividend date: is date two business days before the date of record, establishing those
individuals entitled to a dividend. To make sure that dividend checks go to the right
people, brokerage firms and stock exchanges establish an ex- dividend date. If you buy
the stock before this date, then you are entitled to the dividend. If you buy on this date or
after, then the previous owner will get it.
Example, Wednesday, January 28, is the ex-dividend date. Before this date, the stock is said
to trade “with dividend” or “cum dividend.” Afterwards, the stock trades “ ex dividend.” The
ex- dividend date convention removes any ambiguity about who is entitled to the dividend.
Since the dividend is valuable, the stock price will be affected when it goes “ex.”
 3. Date of record: is date on which holders of record are designated to receive a dividend.
Based on its records, the corporation prepares a list on January 30 of all individuals
believed to be stockholders as of this date.
4. Date of payment: is date that the dividend checks are mailed to shareholders of record.
Example, the dividend checks are mailed on February 16.

Ex-dividend and stock price

What happens to the stock price when it goes ex, meaning the ex-dividend date arrive? Example,
suppose there is a stock that sells for birr 10 per share. The BOD declares a dividend of birr 1 per
share, and the record date is Tuesday, June 12. The ex-date will be two businesses (not calendar)
days earlier, on Friday, June 8.
If you buy the stock on Thursday, June 7, right as the market closes, you will get the birr 1
dividend because the stock is trading cum dividend. If you wait and buy the stock right as the
market opens on Friday, you will not get the birr 1 dividend. What will happen to the value of
the stock overnight?
If you thing about it, the stock is obviously worth about birr 1 less on Friday morning, so its
price will drop by this amount between close of business on Thursday and the Friday opening. In
general, we expect that the value of a share of stock will go down by about the dividend amount
when the stock goes ex dividend. The stock price will be 10-1 = birr 9 on the ex date.
Does Dividend Policy matter?
The question in dividend policy is whether the firm should payout cash now or invests the cash
and pays it out later. Dividend policy, therefore, is the time pattern of dividend payout.

Factors influencing dividend policy

The example used to illustrate the irrelevance of dividend policy ignored taxes and flotation
costs. These factors might lead us to prefer a low dividend payout.

A. Factors favoring a low dividend policy.

1. Taxes
Dividends received are taxed as ordinary income. Capital gains are taxed in much the same way,
but the tax on a capital gain is deferred until the stock is sold. This makes the effective tax rate
much lower because the present value of the tax is less.
A firm that adopts a low dividend payout will reinvest the money instead of paying it out. This
reinvestment increases the value of the firm and of the equity. All other things being equal, the
net effect is that the capital gains are taxed favorably may lead us to prefer a low dividend
policy.
Example,
Suppose all shareholders are in the 28% tax bracket and have a choice between investing in Firm
G which pays no dividend or Firm D that does pay a dividend. Firm G’s stock is currently birr
100 and has a 20% return on equity. Assume that the investor does not sell the shares and the
capital gain is untaxed. Therefore, the value of the share one year form now should from now
should be birr 120. (100(1.2) =120). On the other hand, Firm D pays a birr 20 dividend. What’s
the value of each of these shares?
Solution:
If markets are efficient, then firms that are equally risky must have the same after tax value.
Let re = required return on equity
 Tg = capital gain tax rate = 0%
Td = Tax rate on dividend income = 28%
Tc = corporate tax rate = 0%, not used in this example
Assume that firm D’s stock will be birr 100 next year after the birr 20 dividend is paid.
100 + 20 (1-0. 28)
P0 = ______________________
1.20
= birr 95.33

What we see is that firm D is worth less because of its dividend policy.
The difference between the price of Firm D's stock and Firm G's stock is simply the present
value of the taxes that must be paid by the investor, which is ((0.28 x 20)/1.2 = 4.67)

Corporate Taxes
The correct dividend policy depends upon the individual tax rate and the corporate tax rate.
Previously, we ignored the effect of corporate taxation on dividend policy. For illustrative
purposes, suppose a firm has extra cash after all positive NPV projects have been undertaken.
Example: The Regional Electric Company has $1000 of extra cash (after tax).
It can retain the cash and invest it in T-bills yielding 10% or it can pay the cash to shareholders
as a dividend. Shareholders can also put the money in T-bills with the same yield. The corporate
tax rate is 34% and the individual rate is 28%. What is the amount of cash that investors will
have after 5 years under each of the following scenarios:
Options:
a. Pay dividends
b. Retain the cash for investment in the firm
Solution:
a. Pay dividends
Shareholders receive in 5 years:
$1000 (1 -0.28) (1 + 0.072)5 = birr1,019.31
(0.072 is individual’s after tax return)

b. Retain the cash for investment in the firm

The company retains the cash and invests in T-bills and pays out the proceeds 5 years from now.
(Individuals pay the taxes at the end)
Shareholders receive in 5 years:
$1000 (1 +0.066)5 (1 - .28) = birr 991.188
(0.066 is corporation’s after tax return)
In this case, dividends will be greater after taxes if the firm pays tem now. The reason is that the
firm simply cannot invest as profitability as the shareholders can on their own ( on after tax
basis.)
This example shows that for a firm with extra cash, the dividend payout decision will depend on
personal and corporate tax rates.

Conclusions on taxes:
 Pay low (no) dividends if corporate rate is less than the individual rate.
  Pay high dividends (higher tax benefit) when the individual rate is less than the
corporate rate.

2. Flotation costs
In the example used to shoe dividend policy doesn’t matter, we saw that the firm could sell some
new stock if necessary to pay dividend. However, selling new stock can be very expensive. If we
include flotation costs in the argument, then we will find that the value of the stock decreases if
we sell new stock
3. Dividend restrictions
In some cases, a corporation may face restrictions on its ability to pay dividends. A corporation
may be prohibited by law from paying dividends if the dividend amount exceeds the firm’s
retained earnings.

B. Factors favoring a high dividend policy.

In this section, we consider reasons why a firm might pay its shareholders higher dividends even
if it means the firm must issue more shares of stock to finance the dividend payments.
1. Desire for current income
In the world of no transaction cost it is argued that an individual preferring high current cash
flow but holding low dividend securities could easily sell off shares to provide the necessary
funds. Similarly, an individual desiring a low current cash flow but holding high dividend
securities could just reinvest the dividends. However, in real world the current income argument
have relevance. Here the sale of low dividend stocks would involve brokerage fees and other
transaction costs. Such a sale might also trigger capital gain taxes. Therefore, these direct cash
expense could be avoided by an investment in high dividend securities.
2. Tax and legal benefits from high dividends
Earlier we saw that dividends were taxed unfavorably for individual investors. This fact is a
powerful argument for a low payout. However, there are also a number of other investors who do
not receive unfavorable tax treatment from holding high dividend yield, rather than low dividend
yield, securities.

3. corporate investors
a significant tax break on dividends occurs when a corporation own stock in another corporation.
A corporate stockholder receiving either common or preferred dividends is granted a 70% or
more dividend exclusion. Since the 70% exclusion does not apply to capital gains, this group is
taxed unfavorably on capital gains. As a result of the dividend exclusion, high dividend, low
capital gains stocks may be more appropriate for corporations to hold. This tax advantage of
dividends also leads some corporations to hold high yielding stocks instead of long term bonds
because there is no similar tax exclusion of interest payments to corporate bondholders.

4. tax- exempt investors

Large institutions such as pension funds, endowment funds, and trust funds favor high dividends
because of:
- Institutions such as pension and trust funds are often set up to manage money for the
benefit of others. The managers of such institutions haf 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.
 - Institutions such as university endowment funds are frequently prohibited from spending
any of the principal. Such institutions might therefore prefer high dividend yield stocks so
they have some ability to spend.
Overall, individual investors may have a desire for current income and may thus be willing to
pay the dividend tax. In addition, some very large investors such as corporations and tax free
institutions may have a very strong preference for high dividend payouts.

Clientele effects: A resolution of real world factors?

In earlier discussion, we saw that some groups (eg, wealthy individuals) prefer low pay out( or
zero payout) stocks. Other groups (eg, corporation) prefer high payout stocks. Companies with
high payouts will thus attract one group, and low payout companies will attract another. These
different groups are called clienteles. The clientele effect argument states that different groups of
investors desire different levels of dividends. When a firm chooses a particular dividend policy,
the only effect is to attract a particular clientele. If a firm changes its dividend policy, then it just
attracts a different clientele.
Example, suppose 40% of all investors prefer high dividends, but only 20% of firms pay high
dividends. Here the high dividend firms will be in short supply; thus, their stock prices will rise.
Consequently, low dividend firms will find it advantageous to switch policies until 40% of all
firms have high payouts. At this point, the dividend market is in equilibrium. Further changes in
dividend policy are pointless because all of the clienteles are satisfied
Establishing a Dividend Policy
1. Residual Dividend Approach
It is a dividend policy under which a firm pays dividends only after meeting its investment needs
while maintaining a desired debt-equity ratio. 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. Given this objective, 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. In the real world, young, fast growing firms commonly
employ a low pay out ratio, whereas older, slower growing firms in more mature industries use a
higher ratio.

Steps in residual dividend policy are:

1. determine the amount of funds that can be generated without selling new equity
2. Decide whether or not a dividend will be paid. To do this, compare the total amount that
can be generated without selling new equity with planned capital spending. If funds
needed exceed funds available, then no dividend is paid. In addition, the firm will have to
sell new equity to raise the needed financing or else postpone some planned capital
spending.
3. If funds are needed is less than funds generated, then a dividend will be paid. The amount
of the dividend is the residual, that is, that portion of the earnings that is not needed to
finance new projects
Example,
A firm has birr 1000 in earnings and a debt/equity ratio of 0.50. The firm capital structure is thus
1/3 debt and 2/3 equity.
 After tax New Additional Retained Additional
Row earnings investment debt earnings Stock Dividends
1 Br. 1,000 Br. 3,000 Br. 1,000 Br.1,000 Br. 1,000 Br. 0
2 Br. 1,000 Br. 2,000 Br. 667 Br.1,000 Br. 333 Br. 0
3 Br. 1,000 Br. 1,500 Br. 500 Br.1,000 Br. 0 Br. 0
4 Br. 1,000 Br. 1,000 Br. 333 Br. 667 Br. 0 Br. 333
5 Br. 1,000 Br. 500 Br. 167 Br. 333 Br. 0 Br. 667
6 Br. 1,000 Br. 0 Br. 0 Br. 0 Br. 0 Br. 1,000

In row 1, the new investment is birr 3,000. Additional debt of birr 1,000 and equity of birr 2,000
must raised to keep the debt/equity ratio constant. All earnings has to be retained and additional
stock to be raised for birr 1,000. Since new stock is issued, dividends are not simultaneously paid
out.
In row 2 and 3, investment drops. Additional debt needed goes down as well since it is equal to
1/3 of investment. Because the amount of new equity needed is still greater than or equal to birr
1,000, all earnings are retained and no dividend is paid.
In row 4, total investment is birr 1,000. To keep debt/equity ratio constant, 1/3 of this investment
(1/3 x 1000 = 333) has to be financed with debt. The remaining 2/3 of 1,000 = 667, comes from
internal funds, implying the residual is birr 1,000 – 667 = 333. The dividend is equal to this birr
333 residual.
In this case, note that no additional stock is issued. Since the needed investment is even lower in
row 5 and 6, new debt is reduced further, retained earnings drop, and dividends increase. Again,
no additional stock is issued.

2. Dividend stability
A strict residual approach might lead to a very unstable dividend payout. If investment
opportunities in one period are quite high, dividends will be low or zero. Conversely, dividends
might be high in the next period if investment opportunities are considered less promising. Stable
dividend policy is dividends are a constant proportion of earnings over an earnings cycle.
Cyclical dividend policy is dividends are a constant proportion of earnings at each pay date.
3. A compromise dividend policy
In practice, many firms appear to follow what amounts to compromise dividend policy. Such a
policy is based on five main goals. These goals are ranked more or less in order of their
importance.
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
Under the compromise approach, the debt-equity ratio is viewed as a long range goal. It is
allowed to vary in short run if necessary to avoid a dividend cut or the need to sell new equity. In
addition, financial manager has to think divided payment as target payout ratio, a firm’s long
term desired dividend to earning ratio.
One can minimize the problems of dividend instability by creating two types of dividends:
regular and extra.
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.
Other factors related to cash dividends:
Stock repurchase: An alternative to cash dividends
When a firm to pay cash to its shareholders, it normally pays a cash dividend. Another way is to
repurchase its own stock. Repurchase used to payout a firm’s earnings to its owners, which
provides more preferable tax treatment than dividends.

Cash Dividends versus Repurchase

Imagine an all equity company with excess cash of birr 300,000. The firm pays no dividends,
and its net income for the year just is birr 49,000. The market value balance sheet at the end of
the year is represented below.
Market value balance sheet
( before paying out excess cash) .
Excess cash birr 300,000 Debt birr 0
Other asset 700,000 Equity 1,000,000
Total 1,000,000 Total 1,000,000
There are 100,000 share outstanding. The total market value of the equity is 1 million, so the
stock sells for birr 10 per share. Earning per share(EPS) are 49,000/100,000 =0.49 and the price
earnings ratio(PE) is birr 10/0.49 = 20.4
One option the company is considering is a birr 300,000 /100,000 = 3 per share extra cash
dividend. Alternatively, the company is thinking of using the money to repurchase 300,000/10 =
30,000 shares of stock.
If commissions, taxes and other imperfections are ignored, the stockholders shouldn’t care which
option is chosen. What is happening here is that the firm is paying out 300,000 in cash. The new
balance sheet is represented below.
Market value balance sheet
(After paying out excess cash) .
Excess cash birr 0 Debt birr 0
Other asset 700,000 Equity 700,000
Total 700,000 Total 700,000
if cash is paid out as a dividend, there are still 100,000 shares outstanding, so each is worth birr
7.
The fact that the per share value fell from birr 10 to 7 isn’t a cause for concern. Consider a
stockholder who owns 100 shares. At birr 10 per share before the dividend, the total value is birr
1000.
After the birr 3 dividend, this same stockholder has 100 shares worth birr 7 each, for a total of
birr 700, plus 100 x 3= 300 in cash, for a combined total of birr 1,000. This just illustrates: A
cash dividend doesn’t affect a stockholder’s wealth if there are no imperfections. In this case, the
stock price simply fell by birr 3 when the stock went ex dividend.
Also, since total earnings and the number of shares outstanding haven’t changed, EPS is still
0.49. The price earning ratio, however, falls to 14.3 ( birr7/0.49 = 14.3).
Alternatively, if the company repurchases 30,000 shares, there will be 70,000 left outstanding.
The balance sheet looks the same. The company is worth birr 700,000 again, so each remaining
share is worth birr 700,000/70,000 shares = birr 10.
The stockholder with 100 shares is obviously unaffected. For example, if they were so inclined,
they could sell 30 shares and end up with birr 300 in cash and birr 700 in stock, just at they have
if the firm pays the cash dividend.
In the second case, EPS goes up since the total earnings stay the same while the number of
shares goes down. The new EPS will be birr 49,000/70,000 = 0.70 per share. However, the PE
ratio is birr 10/0.7 = 14.3, just as it was following the dividend. This is just another illustration of
dividend policy irrelevance when there are no taxes or other imperfection.
Stock Dividends and stock Splits
Stock dividend: a dividend payment made by a firm to its owner in the form of stock, diluting
the value of each share outstanding. A stock dividend is not a true dividend because it is not paid
in cash. The effect of a stock dividend is to increase the number of shares that each owner holds.
Stock split: an increase in a firm’s shares outstanding without any change in owner’s equity.
When a split is declared, each share is split up to create additional shares. For example, in a three
for one stock split, each old share is split into three new shares.

Stock splits and stock dividends have essential the same impacts on the corporation and the
shareholder: they increase the number of shares outstanding and reduce the value per share. The
accounting treatment is not the same however, and it depends on two things:
1. whether the distribution is a stock split or a stock dividend and
2. the size of the stock dividend
By convention, stock dividends of less than 20-25% are called small stock dividends. A stock
dividend greater than this 20-25% percent is called a large stock dividend.