DIVIDEND POLICY

Dosen : Ahmad Zaki, S.E., M.Acc.

Kelas : SEMBA 48 A
Nama :
1. Khairunnisa Dias Pramesti
2. Ghiezmy Hasri Astiti

Southeastern Steel Company (SSC) was formed 5 years ago to exploit a new continuous casting
process. SSC's founders, Donald Brown and Margo Valencia, had been employed in the research
department of a major integrated-steel company; but when that company decided against using
the new process (which Brown and Valencia had developed), they decided to strike out on their
own.

One advantage of the new process was that it’s required relatively little capital compared to the
typical steel company, so Brown and Valencia have been able to avoid issuing new stock and
thus own all of the shares. However, SC has now reached the stage in which outside equity
capital is necessary if the firm is to achieve its growth targets yet still maintain its target capital
structure of :

Equity Debt
60% 40%

Therefore, Brown and Valencia have decided to take the company public. Until now, Brown and
Valencia have paid themselves reasonable salaries but routinely reinvested all after-tax earnings
in the firm; so the firm's dividend policy has not been an issue. However, before talking with
potential outside investors, they must decide on a dividend policy.

Assume that you were recently hired by Arthur Adamson & Company (AA), a national
consulting firm, which has been asked to help SC prepare for its public offering. Martha Millon,
the senior A consultant in your group, has asked you to make a presentation to Brown and
Valencia in which you review the theory of dividend policy and discuss the following questions:

Part A :
1. What is meant by the term dividend policy?
 The terms of Dividend Policy is a strategic framework that outlines how a
company distributes dividends to its shareholders. It specifies key details,
including the frequency of pay outs (monthly, quarterly, or annually), the timing
of payments, and the amount distributed.
2. Explain briefly the dividend irrelevance theory that was put forward by Modigliani and
Miller. What were the key assumptions underlying their theory?
 Asserts that a company’s dividend policy has no impact on its overall value or
stock price. Here are the key points:
a) Investor Indifference: Investors don’t differentiate between dividends and capital
gains. Their primary goal is to maximize returns, whether through dividends or
stock price appreciation.

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 b) Perfect Capital Market Assumptions:
 Efficient Markets: All information is freely available to investors.
 No Taxes: No tax discrimination between dividends and capital gains.
 Rational Investors: Investors make decisions based on rational analysis.
 No Transaction Costs: No costs associated with buying or selling shares.
c) Neutral Effect: Any increase in shareholder wealth due to dividends is offset by
raising external capital, which dilutes share ownership.
In summary, according to Modigliani and Miller, dividend policy is irrelevant in a perfect
market. Investors can create their desired income stream by buying or selling shares as
needed

3. Why do some investors prefer high-dividend-paying stocks, while other investors prefer
stocks that pay low or nonexistent dividends?
Investor preferences regarding dividend-paying stocks can vary based on several factors:
 Income Stream:
High-dividend-paying stocks appeal to investors seeking a regular income stream.
These dividends provide a consistent cash flow, especially for retirees or those
relying on investment income.
 Stability and Financial Health:
Companies with a history of paying dividends are often perceived as stable and
financially healthy. Investors may prefer such stocks because dividends signal
confidence in the company’s future prospects.
 Risk Tolerance:
Some investors prioritize capital appreciation over immediate income. They
prefer low or nonexistent dividend stocks because these companies reinvest
profits for growth. The expectation is that stock prices will rise over time.
 Tax Considerations:
Dividends are typically taxed at a different rate than capital gains. Investors may
choose dividend stocks based on their tax implications.

Part B :
Discuss (1) the information content, or signalling, hypothesis; (2) the clientele effect; (3) catering
theory; and (4) their effects on dividend policy.
1) Content Hypothesis (Signalling Hypothesis):
 Definition: The information content hypothesis posits that dividend changes
convey valuable information to investors about a company's future prospects.
 How It Works: When a company increases its dividends, it signals management's
positive view of future earnings. Conversely, a dividend cut may signal financial
distress or poor prospects.
 Effect on Dividend Policy: Firms may adjust dividends strategically to influence
investor perceptions and stock prices
2) Clientele Effect:
 Definition: The clientele effect explains how investor preferences impact stock
prices based on company policies (e.g., dividends).
 Dividend Clientele: Investors with similar preferences form groups (clientele)
based on factors like income level, tax considerations, or age.

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  Effect on Dividend Policy: Companies tend to cater to specific clientele by
adopting dividend policies that align with their preferences. For example, some
investors seek stable dividends, while others prioritize capital gains
3) Catering Theory of Dividends:
 Overview: The catering theory suggests that managers adjust dividend policies
based on investor demand.
 How It Works: Managers pay dividends when investors favor dividend-paying
stocks (premium on payers) and avoid paying when investors prefer nonpayers.
 Effect on Dividend Policy: Companies respond to prevailing investor sentiment,
leading to fluctuations in dividend decisions
Part C :
1) Assume that SSC has an $800,000 capital budget planned for the coming year. You have
determined that its present capital structure (60% equity and 40% debt) is optimal, and its
net income is forecasted at $600,000. Use the residual dividend model to determine SSC's
total dollar dividend and payout ratio. In the process, explain how the residual dividend
model works. Then explain what would happen If expected net income was $400,000 or
$800,000.
o SSC's Scenario:
Calculate the equity needed for new projects by multiplying the total capital
budget by the equity portion (60% in SSC's case).
o Capital budget: $800,000
o Equity needed for new projects: $800,000 × 60% = $480,000
o Available for dividends: (net income) - (equity needed)
 $600,000 - $480,000 = $120,000
 Total Dollar Dividend:
 SSC's total dollar dividend would be $120,000.
 Payout Ratio:
o Payout Ratio = Total Dividends / Net Income
o Payout Ratio = $120,000 / $600,000 = 20%
o Scenarios:
o If expected net income was $400,000:
 Equity needed remains at $480,000.
 Available for dividends would be negative ($400,000 - $480,000),
so no dividends would be paid out.
o If expected net income was $800,000:
 Equity needed remains at $480,000
 Available for dividends would be higher ($800,000 - $480,000),
resulting in more available for dividends at a total of $320,000.
2) In general terms, how would a change in investment opportunities affect the payout ratio
under the residual dividend model?
The residual dividend policy is a financial approach used by companies to determine
the dividends they pay to shareholders. Here’s how it works:
 Capital Expenditures (CAPEX) and Working Capital Costs:
Before distributing dividends, the company covers its capital expenditures (such
as investments in new projects or equipment) and working capital requirements
(like inventory and accounts receivable).

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  Available Earnings:
After meeting these financial obligations, any remaining earnings are considered
available for dividends.
 Dividend Pay-out Ratio:
The dividend pay-out ratio is the proportion of available earnings paid out as
dividends
the impact of changes in investment opportunities:

 More Investment Opportunities: If the company encounters more profitable investment

opportunities (e.g., new projects, acquisitions), it will allocate more earnings toward these
opportunities. Consequently, the available earnings for dividends decrease, leading to
a lower pay-out ratio.
 Fewer Investment Opportunities: Conversely, when investment opportunities are
scarce, the company retains more earnings for distribution as dividends. This results in
a higher pay-out ratio.

In summary, the residual dividend model prioritizes capital expenditures over immediate
dividends, aiming for long-term growth. Management decisions regarding investment
opportunities directly influence the pay-out ratio. Remember that investors typically care
about overall returns, whether through dividends or capital gains

3) What are the advantages and disadvantages of the residual policy? (Hint: Don't neglect
signalling and clientele effects.)
 Advantages:
1. Efficient Capital Allocation: The residual dividend policy prioritizes
funding profitable projects before distributing dividends. By allocating
funds to projects with positive returns, companies maximize growth
potential and enhance shareholder value [1].
2. Shareholder Confidence: Demonstrating commitment to value-
generating projects increases shareholder confidence and trust in the
company's financial decisions.
3. Financial Flexibility: Residual dividends allow adjustments based on
profitability and investment opportunities, ensuring resilience and
readiness for future prospects.

 Disadvantages:
1. Conflicting Signals: A variable dividend policy may send conflicting
signals to investors. Fluctuating dividends can create uncertainty about the
company's financial stability and prospects.
2. Increased Risk: For investors, residual dividends represent an increased
level of risk, as dividend income remains uncertain. Unlike fixed dividend
policies, where payouts are predetermined, residual dividends can vary
significantly.

Part D
Describe the series of steps that most firms take in setting dividend policy in practice?

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 Identify Target Capital Structure: Firms determine their desired mix of debt and equity
financing. This helps establish the framework for dividend decisions.
 Forecast Capital Needs: Over a planning horizon (often around 5 years), firms estimate
their future capital requirements. This includes anticipated investments in projects,
acquisitions, and other growth initiatives.
 Estimate Annual Debt and Equity Needs: Based on the forecasted capital needs, firms
calculate the expected annual requirements for both debt and equity financing.
 Set Long-Run Target Pay-out Ratio: Using the residual model, firms decide on a target
pay-out ratio. The residual model prioritizes funding profitable projects before distributing
dividends. The pay-out ratio represents the proportion of earnings paid out as dividends.
 Consider Growth: Generally, some growth rate emerges from the firm’s operations. Firms
aim for growth at the target rate if possible, adjusting their capital structure as necessary
Part E
What is a dividend reinvestment plan (DRIP), and how does it work?
 A dividend reinvestment plan (DRIP) automatically uses the proceeds generated from
dividend stocks to purchase more shares of the same company. Here’s how it works:
1. Dividends and Shares: When you own dividend-paying stocks, the company
periodically pays you dividends based on the number of shares you hold. These dividends
provide cash flow without requiring you to sell any shares.
2. Automatic Reinvestment: With a DRIP, the dividends you receive are automatically
reinvested to buy additional shares of the company’s stock. This process happens
regularly—monthly, quarterly, or annually—depending on the company’s dividend
schedule.
 DRIP’ s can be advantageous for long-term growth, especially if you’re aiming to benefit
from both capital gains and reinvested dividends.

Part F
What are stock dividends and stock splits? What are the advantages and disadvantages of stock
dividends and stock splits?
1. Stock Dividends:
 Definition: Stock dividends are payments made by a corporation to its shareholders,
usually in the form of additional shares of stock rather than cash.
 Process: When a company declares a stock dividend, existing shareholders receive
additional shares proportional to their current holdings.
 Advantages:
o No Cash Outflow: Stock dividends reward shareholders without reducing the
company’s cash reserves.
o Signaling Confidence: Issuing stock dividends can signal management’s
confidence in future earnings and growth prospects.
 Attracting Investors: Some investors prefer regular income through stock dividends.

2. Stock Splits:
 Definition: Stock splits involve increasing the number of shares owned by shareholders
by issuing more shares proportionally. For example, in a 2-for-1 split, each share owned
becomes two.
 Purpose: Stock splits make shares more affordable and attractive to small investors.

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  Advantages:
o Affordability: Lower share price after a split makes the stock accessible to a
broader range of investors.
o Positive Signal: A split can signal that the company’s share price has been
performing well.
o Increased Liquidity: More shares in circulation enhance market liquidity.
 Disadvantages:
o Psychological Benefit: Splits don’t add real value; they’re mainly psychological.
o Perceived Gimmick: Frequent splits might be seen as a gimmick rather than
based on financial performance.
o Accounting Complexity: Changes in share numbers can complicate accounting
records.
Part G
What are stock repurchases? Discuss the advantages and disadvantages of a firm's repurchasing
its own shares.
Stock Repurchases (Share Buybacks): A stock repurchase, also known as a share buyback,
occurs when a company buys back its own shares from the marketplace. Here’s why companies
might choose to do this:
1. Consolidate Ownership:
 By repurchasing shares, a company can reduce the number of outstanding shares,
effectively concentrating ownership among existing shareholders.
 This consolidation can enhance management control and decision-making.
2. Preserve Stock Prices:
 Share repurchases can help stabilize or boost stock prices.
 When a company buys back its own shares, it signals confidence in its future
prospects, which can positively impact investor sentiment.
In summary, stock repurchases can be beneficial, but companies must weigh the advantages
against potential downsides.

3. Return Stock Prices to Real Value:

 If a company believes its stock is undervalued, it may repurchase shares to bring the
stock price closer to its intrinsic value.
 This benefits existing shareholders by potentially increasing the value of their
holdings.

4. Boost Financial Ratios:

 Reducing the number of outstanding shares improves financial ratios such as earnings
per share (EPS) and return on equity (ROE).
 These improved ratios can attract investors and enhance the company’s financial
image.

However, there are also drawbacks to stock repurchases:

1. Possible Taxes:
o Shareholders who sell their shares during a buyback may face capital gains taxes.

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 o This tax impact can be a disadvantage compared to dividends, which are typically
taxed at a lower rate.
2. Credit Rating Reduction:
o Using cash for buybacks instead of investing in growth opportunities could
weaken a company’s financial position.
o Credit rating agencies may view this negatively, potentially affecting the
company’s creditworthiness.
3. Loss of Investor Confidence:
o Some investors prefer dividends as a consistent income stream.