Chapter 19:

Dividend Policy
 Forms of Dividend Payments
Cash Dividend - Payment of cash by the firm to
its shareholders.

Stock Dividend - Distribution of additional

shares to a firm’s shareholders.
 Cash Dividend

Declaration Ex-dividend Record Payment

date date date date

Share
price
falls
Miller and Modigliani’s (MM) dividend
irrelevance proposition

• Dividend policy has no impact on the value of the

firm. In perfect capital markets, holding fixed
the investment and borrowing policies of a
firm, the firm’s choice of dividend policy is
irrelevant and does not affect the initial share
price.

• The value of a company is determined by the

company’s assets and the cash flow that they
generate and its risk(not the way dividends are
distributed)
 Example of the Irrelevance of
Dividends
Consider an all equity firm which will be liquidated in
2 years. The total cash flow the firm will generate is
£5000 per year.
Under the current dividend policy all earnings are
distributed to shareholders and there are 100
shares issued. The shareholders required rate of
return is 10% thus the share price is £86.777
5000/1.1 + 5000/(1.1)^2= 8677.77/100= 86.77.
 Example of the Irrelevance of
Dividends
• Suppose that shareholders convince the managers
to distribute £6000 next year. The extra £1000
being raised through equity. Assuming that the
required rate of return is maintained the new
shareholders will demand a dividend of £1100 in
year 2.
Year 1 Year 2
Dividends to old shareholders 6000 3900
Note that investments of both new and
old shareholders have a NPV=0 so value
6000 3900 was not created
1.1  1.12
P  £86.777
100
 Miller and Modigliani’s (MM)
dividend irrelevance proposition
• MM (1961) suggested that since an increase in dividends
is offset by a decrease somewhere else dividend policy is
irrelevant. The value is determined by earnings power and
risk.
 Home-made dividends

• Can be created by shareholders selling a portion

or reinvesting dividends.

• Dividend policy has no impact on the value of

the firm because investors can create whatever
income stream they prefer by using
homemade dividends (ADRs).
 MM dividend irrelevance proposition
• Assumptions for the model:
– There are no taxes
– There are no transaction costs
– All investors can borrow and lend at the same interest rate
– All investors have free access to all relevant information
– Investors are indifferent between dividends and capital
gains
 In practice is it really irrelevant?
• Reason to pay low dividends
– Tax??
– Transaction costs
– Dividend restrictions
– Retaining cash may reduce distress
costs

• Reasons to pay high Dividends

– Desire for current income (e.g. retired)
– Behavioural/self control
– Tax exempt investors
– Retaining cash can lead to agency costs
 Is it irrelevant?
Do any of the previous factors dominate?
• The Clientele effect- Different groups of investors
desire different levels of dividends. Supply and demand
will make the price rise or fall. When at equilibrium
changes in the dividend policy will not be relevant
• Information content of dividends (signaling)- share
prices generally rise with upwards revisions of
dividends and fall with downwards revisions.
This is an indication of revised expectations not of
dividend policy.
• If there are restrictions on financing and if investment
and debt policies are not fixed then dividend policy may
have an impact since the amount retained will impact
on the investment policy
 Alternative to Dividends: Share
Repurchases (buy backs)

• Buying own shares back from shareholders

• If commissions, taxes and other imperfections

are ignored cash dividends and repurchases
are equivalent dividend policy
irrelevance
 Share Repurchases (buy backs)

• Open Market Repurchases- the firm buys shares

in the open market like any other investor

• Tender Offer- the firm offers to buy shares at a

pre-specified price during a short period of time
(the offer is normally at a 10% to 20% premium).

• Targeted Repurchase- shares are bought

directly from a major shareholder
 Cash Dividends or Repurchases?
• Repurchases have tax advantages.
• Dividends send 2 positive signals to the market. The firm
expects to be profitable and it will not keep excess cash
(free cash problem).
– Firms could set aside cash to repurchase (combining
the advantages of the 2 methods).
• The firm could announce a repurchase and not do it
(dodging the books). Thus monitoring is needed.
• A fixed repurchase strategy forces the managers to
buy shares even when they believe the share is
overvalued.
 Establishing the dividend policy in
practice- Residual Dividend
• Model
If markets are not perfect how should firms
define their payout?

• The optimal payout ratio is a function of:

– The firm’s investment opportunities
– The firm’s target capital structure
 Residual Dividend Model
• Investors are assumed to be indifferent between
dividends and capital gains. The firm should
distribute only what will not need for investing

 Target   Total 
   
Dividends  Net Income   equity    capital 
  budget
 
ratio
 Residual Dividend Model
Example:

 Capital budget ─ $8 million

 Target capital structure ─ 40% debt, 60% equity
 Forecasted net income ─ $6 million

How much of the forecasted net income should be

paid out as dividends?
 Residual Dividend Model:
Calculating Dividends Paid
Calculate portion of capital to be funded by equity.
0.6*$8m = $4.8m

Calculate residual dividends.

$6m – $4.8m = $1.2m (left over to pay as
dividends).

Calculate dividend payout ratio.

$1.2m / $6m = 0.20 = 20%.

  
Dividends  Net Income   Target
equity    capital
Total 

  ratio  budget  
 
 Residual Dividend Model

• Under the residual dividend model dividends and the

payout ratio vary with investment opportunities and with
earnings.

• Following such a policy leads to unstable dividends.

• Firms could use the residual policy to help set their long
run target payout ratios but not as a guide to the
payout in any one year.
 Still much to learn on defining
optimal payout targets
But there is no miracle formula to estimate
dividend payout

Theoretically we do know that

• Firm value decreases if dividends are paid
at the expense of positive NPV projects
• Firms should not issue debt or equity to
pay dividends
 What do we know about
dividend payments in practice?
• Managers smooth dividends
• Less profitable and younger firms should pay
less dividends
• Mature firms generate free cash flow.
Significant free cash flow can result in agency
costs (empire building).
• Life cycle theory says that firms trade off
agency costs with the future costs of external
equity financing.
 Stock Dividends

– Stock dividend refers to the distribution of additional

shares to a firm’s shareholders. Since each
shareholders holds more shares the price comes down.

– Stock dividend is similar to stock split as they both

increase the number of share but not the firm’s value.
Stock dividends are expressed as a percentage and
stock split as a ratio
 Impact of share dividends and
splits
• Share dividends and splits do not affect shareholders or firm
value.
– Firm has a mkt value of £100,000 and 1000 shares. If
there is a 10% stock dividend the shares increase to 1100
and the price decreases to £90.91
– If there is a 2 for 1 split there will be 2000 shares each
worth £50.

• Alternatively it can be argued that shares have a trading

range. Shares with a price above this level will not be traded.
Stock splits can put the share in its trading range.
Appendix
In the absence of external financing dividend policy
matters (even without considering the other
market imperfections)
 Effects of Dividend Policy
• Consider a firm in
ROE  15%
which the return on k  15% Inputs
new investments E1  7.50 p 
equals the cost of 7.5*1
if b  0%  V0  .15  50
capital (k=ROE) 7.5*.333
f b  66.7%  V0  .15  .667  50
*.15

When k=ROE the firm’s value is unaffected by

dividend policy

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 Effects of Dividend Policy
• Consider a growth
ROE  20%
firm in which the k  15% Inputs
return on new E1 7.50 p 

investments is higher if b  33.3%  V0 

7.5*.667
.15  .
 59.89

than the cost of 333*.2

7.5*.333
f b  66.7%  V0   150.45
capital (ROE>k). .15  .667 *.2

A growth firm maximises value by retaining dividends

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Reminder: The model is only valid if k  g
 Effects of Dividend Policy
• Consider a declining
ROE  10%
firm in which the k  15%  Inputs
return on new E1 7.50 p 

investments is smaller if b  33.3%  V0 

7.5*.667
.15  .
 42.87

than the cost of 333*.1

7.5*.333
f b  66.7%  V0   29.95
capital (ROE<k). .15  .667 *.1

A declining firm maximises value by distributing

dividends

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