CHAPTER FIVE

Dividend Policy

outline

The concept of dividend policy

Types of dividends

Dividend payment procedure

Factors affecting dividend payment procedure

Effects of dividend payment

Theories of dividend policy

Factors favouring a lower dividend payout policy

Other consideration affecting dividend policy

Concept of dividend policy

Dividends refer to the cash paid out of

earnings to shareholders.

Dividend policy: refers to the decision

regarding the magnitude of dividend payout,
i.e. the percentage of earnings paid out to
stockholders in the form of dividend

Dividends are generally described in terms of

dividend payout ratio, which indicates the
amount of dividends paid relative to the
companys earnings.

What is dividend policy?

Its

the decision to pay out

earnings versus retaining and
reinvesting them. Includes these
elements:
1.
2.
3.
4.

High or low payout?

Stable or irregular dividends?
How frequent?
Do we announce the policy?

Types of dividend
How do Firms distribute Dividend to their
Shareholders

Cash dividend

Stock dividend

Bond dividend

Property dividend

Stock split

Stock (share) repurchase

Stock Repurchases (Stock

Buyback)

Stock repurchase is when a firm uses its

cash to repurchase some of its own stock.

This results in a reduction in the firms

cash balance as well as the number of
shares of stock outstanding. Firms use one
of three methods to purchase the shares:
Open market repurchase, tender offer, and
direct purchase.

How do Firms Repurchase

Their Shares?

Open Market Repurchase

Here the firm acquires the stock on the
market, often buying a relatively small
number of shares everyday. This will put
upward pressure on share prices. This is
the most widely used method for stock
repurchase.

How do Firms Repurchase

Their Shares? (cont.)
Tender

Offer

A company uses this method when it wants

to buy a relatively large number of shares
very quickly.
The company makes a formal offer to buy a
specified number of shares at a stated
price.
The price is set above the market price to
attract sellers.

How do Firms Repurchase

Their Shares? (cont.)
Direct

Purchase from a large

investor
Here the firm purchases the stock
from one or more major stockholders
on a negotiated basis. This method
is not used frequently.

Effect Of Share
Repurchase

With a share repurchase, a company uses cash to

buy back its own shares from the market place,
thereby reducing the number of outstanding shares.

For Cash and Share Repurchase, the impact on the

Financial position / balance sheet will be as follows:
On the Assets side, cash will be reduced due to
cash dividend or share repurchase.
On the Equity side, there will be a corresponding
decrease.

Non-Cash Distributions: Stock

Dividends and Stock Splits

A stock dividend is a pro-rata distribution

of additional shares of stock to the firms
current stockholders. These distributions
are generally defined in terms of a fraction
paid per share.
For example, a firm might pay a stock
dividend of .20 shares of stock per share
or 2 shares for every 10 held.

Non-Cash Distributions: Stock

Dividends and Stock Splits (cont.)

Stock split is essentially a very large stock

dividend. For example, a 2-for-1 split would
entail receiving two new shares for every old
share currently held.

With a 2-for-1 split, the number of shares will

double and the share price will drop in half.

Rationale for a Stock

Dividend or Stock Split
One rationale for splits and stock dividends
is that there is an optimal price range for
the firms stock. Also, beyond a certain price
range, there might be lower demand for
shares from investors.
If the price exceeds that optimal range, it
can be brought back to the optimal range by
doing a stock split or paying stock dividend.

Dividend Payment Procedures

Generally, companies pay dividends on a

quarterly basis. There are several dates that are
important with regard to dividend payment:

(a) Announcement date: It is the date on

which dividend is formally declared by the board
of directors.
(b) Date of record: Investors who own stock
on this date receive the dividend. However, this
date was pushed forward two days to exdividend date.

Dividend Payment Procedures

(cont.)
(c) Ex-dividend date: This is two days
before the date of record and any investor
who buys shares after the ex-dividend date
is not entitled to dividend.
(d) Payment date: This is the date on
which dividend checks are mailed to the
investors.

Dividend Payment
Procedures (cont.)
Date

Explanation

Announcement Date

Dividend is
declared.

Ex-Dividend Date

Shares begin trading

Calendar Date
March 15
May 17

ex-dividend.
Record Date

Dividend will be
paid to shareholders
who own the stock on
this date.

May 19

Payment Date

Dividends are
distributed to the
shareholders of
record on the record
date.

May 27

Factors affecting dividend

policy

State of the Economy

State of the capital

Desire of shareholders

Financial Needs of the

company

market

Stability of Earnings

Legal Restrictions

Desire for Control

Contractual

Liquidity position

Restriction
EXTERNAL

INTERNAL

Dividend policy theories Why Some Firms

Have Higher Payout Ratio Than Other

Residual Theory of Dividend

Dividend Irrelevance Argument

Dividend Relevance Argument

Bird-in-hand Theory

Prospect Theory

Clientele effect

Signaling Theory

Factors favouring lower dividend

policy

Agency Cost

Taxes

Transaction Costs

Factors favouring higher

dividend policy

Agency Cost

Bird in hand

Prospect Theory

Does Dividend Policy Matter?

Modigiliani and Miller suggest that without

taxes and transaction costs, cash dividends
and share repurchases are equivalent and
the timing of the distribution is
unimportant.

This is known as the Modigiliani and Miller

dividend irrelevancy proposition.

The Irrelevance of the

Distribution Choice
The

distribution choice is irrelevant

under the following assumptions:
1. There are no taxes.
2. No transaction costs are incurred in
either buying or selling shares of stock.
3. The firms operating and investment
policies are fixed.

The Irrelevance of the

Distribution Choice (cont.)
The

dividend irrelevancy proposition

can be illustrated in two ways:
1.Timing of dividend distributions does not
affect firm value.
2.In the absence of taxes and transaction
costs, a cash dividend is equivalent to a
share repurchase.

The
Timing of
Dividend
is
Irrelevant

The Timing of Dividend is

Irrelevant (cont.)
Figure

16-2 considers two

alternatives:
1. Pay $35 million now and $135 million
in one year
2. Pay $52.5 million now and $114.875
million in one year
. In both cases, the value of share
remains the same at $15.24 per share.

Why Dividend Policy is

Important?
Transactions

are costly

Since taxes are incurred when dividends

are received and transactions costs are
incurred when buying and selling shares,
investors will prefer to select companies
whose dividend policy match up with their
own preferences. Because firms with
different dividends attract different
dividend clienteles, it is important that
dividend policy remain somewhat stable.

Why Dividend Policy is

Important? (cont.)
The

Information Conveyed by Dividend

and Share Repurchase Announcement
Investors and stock market are constantly
trying to decipher the information released
by firms to better understand what they
imply about firm values.
Firms tend to increase their dividends when
dividends can be sustained in the future. In
such cases, dividend increase is clearly
good news.

Why Dividend Policy is

Important? (cont.)

Share repurchases are also viewed very

favorably as it reveals that the firm has
generated more money than it currently
needs.

Share repurchases may also reveal that the

equity is currently underpriced.

The empirical evidence indicates that

dividends and share repurchases do in fact
convey favorable information to investors.

Why Dividend Policy is

Important? (cont.)
The

Information Conveyed by Stock

Dividends and Stock Splits
The announcement of stock dividends
and stock splits also tend to generate
positive stock returns. This increase is
harder to explain as stock dividends and
stock splits do not affect firms cash flows.
Some researchers have suggested that
firms have a preferred trading range and
stock splits help bring stock prices to that
trading range.

Why Dividend Policy is

Important? (cont.)

A second possibility is that stock splits and

stock dividends tend to attract attention.
Naturally, firm would like to attract
attention only when the prospects are
favorable.

Thus even though there is no direct effect

on cash flows, the market reacts favorably.

Capital structure
Chapter 6

Outline

The concept of capital structure

Gearing or Leverage

Types of Leverage

Theories of capital structure

Risks faced by equity investors with regards

to capital structure

Determinants of capital structure

The concept of capital structure

Capital structure is the particular mix or

combination of debt, equity a other
sources of finance that a company uses to
fund its long term investment.

The sources of funds include;

Debt
Preference shares
Equity capital

The concept of capital structure

Capital structure is normally used

interchangeably with others like gearing

or leverage.

Gearing or leverage normally refer to the

proportion of Debt financing.

Theories of capital
structure
Does capital structure decision matter?
Does capital structure decision affect the
value (Debt + Equity) of a firm?
Does capital structure decision affect the
WACC?
Does capital structure affect the NPV of a
proposed project?

The opinions on the relevance of capital

structure is mixed across different schools of
thought.

Theories of capital structure

Net income theory

Net Operating income theory

Traditional view of capital structure

Modigliani and Miller propositions I and II

(M&M I & II)

Net income theory

Net Operating Income Theory
By David Durand
Advocates for the relevance of capital
structure decisions

Capital structure decision will change the cost of

capital and thereby alter the value of the firm.
Example 1: A company expects its annual EBIT to
be 50,000 cedis. The company has 200,000 in
10% bonds and the cost of equity is 12.5%.
( There are no taxes).
What is the value of the firm given the above
scenario.

Net income theory

Assume that the firm decides to retire
100,000 cedis worth of equity by using the
proceeds of new debt issue worth the
same amount. What is the new value of
the firm? Has it increased or decreased?

5/11/15

Net Operating Income

theory

By David Durand; Also Known as the Capital

Structure Irrelevance Theory

Conclusion: CS decisions of a firm is irrelevant

and that the market value of the firm is not
affected by the CS decisions.
Assumptions:

No taxes
Debt usage does not affect the business risk of the
firm
Debt usage increases the cost of equity.

Net Operating Income

theory
Example:

Assume that a firm has an ebit level of 50000 ghana

cedis, cost of debt 10%, the total value of debt 200000
cedis and the WACC is 12.5%. Let us find out the total
value of the firm and the cost of equity

Solution
Ebit = 50,000
WACC = 12.5%
Value of firm = 50,000/0.125 = 400,000
Market value of equity = 400,000-200,000 = 200,000
Cost of Equity = [50000-(10%*200,000)]/200,000 =
15%

Net Operating Income

theory
Effect
of change in capital structure

Now assume that the leverage increases from

200,000 to 300,000 cedis. The proceeds of the loan
was used to repurchase the stock of the company.

Solution:
Ebit = 50,000
MV of firm = 50,000/0.125 = 400,000
Market value of equity = 400000-300000=100,000
Cost of equity = [50000-(10%*300000)]/100000 =
20%
The cost of equity adjusts upwards due to the
increase in debt usage. This causes the WACC to be
unchanged

Traditional theory of capital

structure
By Ezta Solomon and Fred Weston.
The theory states that a firms value
increases to a certain level of debt capital
usage after which it tends to remain constant
and then eventually begins to decrease.

In other words cost of capital is U-shaped.

Value of the firm is maximized at the

minimum point of the cost of capital (WACC)

Other theories

M&M proposition I (no taxes, bankruptcy

cost, and transaction cost)

M&M proposition II (with taxes,

transaction cost, and bankruptcy cost)

Factors affecting capital

structure

Risk
Flexibility
Cash flows
Retaining control
Purpose of finance
Asset structure
Agency costs
growth and stability
Financial leverage
Company characteristics

Internal factors

Inflation
Taxation policy
Legal requirement
Level of interest rate
Availability of funds
Seasonal variations
Tax benefits of debt
Size of the firm
Degree of competition
Requirements of investors
Etc.

External factors