CHAPTER 26: SHARING FIRM WEALTH:

DIVIDENDS, SHARE REPURCHASES AND OTHER PAYOUTS

PREPARED BY: ANGELO C. MATUGAS

ADVANTAGES OF PAYING DIVIDENDS
1. Cash dividends can underscore good results and provide support to the equity share
price.
2. Dividends may attract institutional investors who prefer some return in the form of
dividends. A mix of institutional and individual investors may allow a firm to raise
capital at lower cost because of the ability of the firm to reach a wider market.
3. Equity share price usually increases with the announcement of a new or increased
dividend.
4. Dividends absorb excess cash flow and may reduce agency costs that arise form
conflicts between management and shareholders.
DISADVANTAGES OF PAYING DIVIDENDS
1. Dividends are taxed to recipients.
2. Dividends can reduce internal sources of financing. Dividends may force the firm to
forgo positive NPV projects or to rely on costly external equity financing.
3. Once established, dividend cuts are hard to make without adversely affecting a firm’s
equity share price.
CONCEPT OF DIVIDEND POLICY
1. Dividend Policy – involves the decision to pay out earnings or retain them for
reinvestment in the firm.
2. Dividend – is a distribution of earnings to shareholders, generally paid in the form
of cash or stock.
3. Retained Earnings – portion of after-tax earnings not paid out as dividends
4. Dividend Payout Ratio – percentage of earnings paid to shareholders in cash
5. Optimal Dividend Policy – strikes the balance between current dividends and
future growth which maximizes the price of a firm’s stock.
DIVIDEND POLICY THEORIES
1. Dividend Policy Irrelevance Theory
2. Dividend Policy Relevance Theory
3. Residual Theory of Dividends Policy
DIVIDEND POLICY IRRELEVANCE THEORY
• Dividend Policy has no effect on either the price of a firm’s stock or its cost of
capital.
• The shareholder is indifferent to a choice between dividends today or claim on
future earnings.
• The only important determinants of a company’s market value are the expected level
and risk of its cash flows or the income produced by its assets
DIVIDEND POLICY RELEVANCE THEORY
Argument :
Given : Proceeds from liquidation: P10,000 in each of the next two years
Dividends: P10,000
Shares Outstanding: 100 shares
Dividends/share: P100
Required Return: 10%
Market Price: ?
DIVIDEND POLICY RELEVANCE THEORY
Argument :
Solution : PO = D1 / (1+R)1 + D1 / (1+R)2

PO = P100 / (1+1.1)1 + P100 / (1+1.1)2

PO = P173.55
DIVIDEND POLICY RELEVANCE THEORY
• In a world with market imperfections such as taxes, flotation costs, and transaction
costs, a company’s dividend policy affect its market value.

• Arguments :
1. Bird in Hand Theory
2. Information Content Effect
3. Clientele Effect
RESIDUAL THEORY OF DIVIDENDS POLICY
• This policy view that dividends are paid out of the residual value or leftover
earnings remaining after profitable investment opportunities are exhausted.
• Under this concept, a firm should follow these ff. steps when deciding on its payout
ratio.
• 1. Determine the optimal capital budget;
• II. Determine the amount of capital needed to finance the budget;
• III. Use retained earnings to supply the equity component to the extent possible;
• IV. Pay dividends only if more earnings are available than are needed to support the
optimal capital budget.
RESIDUAL THEORY OF DIVIDENDS POLICY
• Sample Problem: Magnum Inc. has an optimal capital structure of 40% debt and 60%
equity. Total earnings available to ordinary equity shareholders for the coming year
are expected to be P1,500,000. The firm’s marginal cost of capital is 14%. Investment
opportunities schedule below:
Project Investment IRR(%)
A P1,000,000 24
B 600,000 18
C 400,000 15
D 500,000 12
E 300,000 10
FACTORS INFLUENCING DIVIDEND POLICY
1. Restrictions on dividend payments
a. Contractual Constraints – Debt Contracts; other contracts
b. Legal Constraints – cannot exceed retained earnings
c. Internal Constraints – Shortage of Cash in the Company
d. Penalty on improperly accumulated earnings
II. Investment Opportunities
III. Alternative Sources of Capital
a. Dividend Policy
b. Cost of selling new stock
c. Ability to Substitute Debt for Equity
d. Control
IV. Effects of Dividend Policy on the Cost of Retained Earnings
TYPES OF DIVIDEND POLICY
1. Stable Dividend Policy – is characterized by the tendency to keep a stable peso
amount of dividends per share from period to period.

To illustrate: Lorelei Products, Inc. earned 400,000 last year and paid P1.40 per share
dividends on 1,000,000 outstanding shares. Because of a temporary slump in the
market, the firm expects to earn P3,600,000 this year.
TYPES OF DIVIDEND POLICY
II. Constant Dividend Payout Ratio Policy – is one in which a firm pays out a
constant percentage of earnings as dividends.

This policy is easy to administer once the firm selects the initial payout ratio. A
constant dividend payout policy will cause the dividends to be unstable and
unpredictable, if earnings fluctuate.

Dividends last year = (P1.40) (1,000,000) = P1,400,000

Dividends payout ratio = 1,400,000/4,000,000 = .35 or 35%
Dividends this year = (.35)(3,600,000) = P1,260,000
Dividends per share this year = P1,260,000/P1,000,000 = P1.26
TYPES OF DIVIDEND POLICY
III. Regular Dividends Plus Extra Policy – is on in which a firm maintains a low
regular dividend plus an extra dividend, if warranted by the firm’s earnings
performance. This policy represents a compromise between the two policies
and is common among firms that experience cyclical changes in earnings. A
regular dividends policy gives the firm flexibility but it leads to some
uncertainty among shareholders.
THANK YOU!