Dividend Policy Flashcards
What does a firm dividend policy do?
Dividend policy determines what portion of a corporation’s net income is distributed to shareholders and what portion is retained for investment
A high dividend rate means a slower rate of growth. A high growth rate usually means a low dividend rate
Since both a high growth rate and a high dividend rate are desirable, the financial manager attempts to achieve the balance that maximizes the firm’s share price
Why do corporations try to maintain a stable level of dividends?
Normally, corporations try to maintain a stable level of dividends (even though profits may fluctuate considerably) because many shareholders buy stock with the expectation of receiving a certain dividend every hear. Hence, management tends not to raise dividends if the payout cannot be sustained
What is the information content or signaling hypothesis?
The desire for stability (companies usually try to maintain a stable level of dividends even if profits fluctuate significantly) has led theorists to propound the information or signaling hypothesis - which states that a change in dividend policy is a signal to the market regarding management’s forecast of future earnings. Thus, firms generally have an active policy strategy with respect to dividends
This stability often results in a stock that sells at a higher market price because shareholders perceive less risk in receiving their dividends
What are the factors that influence a company’s dividend policy?
The following factors affect a company’s dividend policy?
- Legal restrictions
- Stability of earnings
- Rate of growth
- Cash position
- Restrictions in debt agreements
- Tax position of shareholders
- Residual Theory of dividends
How does legal restrictions influence a company’s dividend policy?
Legal restrictions - dividends ordinarily CANNOT be paid out of paid-in capital. A corporation must have a balance in its retained earnings account before dividends can be paid
How does stability of earnings influence a company’s dividend policy?
Stability of earnings - a company whose earnings fluctuate greatly from year to year will tend to pay out a smaller dividend during good years so that the same dividend can be paid even if profits are much lower
For example, a company with fluctuating earnings might pay out $1 every year whether earnings per share are $10 (10% payout rate) or $1 (100% payout rate)
How does rate of growth influence a company’s dividend policy?
Rate of growth - a company with a faster rate will have a greater need to finance that growth with retained earnings. Thus, growth companies usually have lower dividend payout ratios. Shareholders hope to be able to obtain larger capital gains in the future
How does cash position influence a company’s dividend policy?
Cash position - regardless of a firm’s earnings record, cash must be available before a dividend can be paid. No dividend can be declared if all of a firm’s earnings are tied up in receivables and inventories
How does restrictions in debt agreements influence a company’s dividend policy?
Restrictions in debt agreements - restrictive covenants in bond indentures and other debt agreements often limit the dividends that a firm can declare
How does the tax position of shareholders influence a company’s dividend policy?
Tax position of shareholders - in corporations, the shareholders may not want regular dividends because the individual owners are in such high tax brackets. They may want to forgo dividends in exchange for future capital gains or wait to receive dividends in future years when they are in lower tax brackets
However, an accumulated earnings tax is assessed on a corporation if it has accumulated retained earnings beyond its reasonably expected needs
How does the residual theory of dividends influence a company’s dividend policy?
Residual theory of dividends - the amount (residual) of earnings paid as dividends depends on the available investment opportunities and the debt-equity ratio at which cost of capital is minimized
The rational investor should prefer reinvestment of retained earnings when the return exceeds what the investor could earn on investments of equal risk
However, the firm may prefer to pay dividends when investment opportunities are poor and the use of internal equity financing would move the firm away from its capital structure
What is the Date of declaration?
The date of declaration is the date the directors meet and formally vote to declare a dividend
On this date, the dividend becomes a liability to the corporation
What is the Date of record?
The date of record is the date as of which the corporation determines the shareholders who will receive the declared dividend. Essentially, the corporation closes it shareholder records on this date
Only those shareholders who own the stock on the date of record will receive the dividend. It typically falls from 2 to 6 weeks after the declaration date
What is the Date of distribution?
The date of distribution is the date on which the dividend is actually paid (when the checks are put into the mail to the investors)
The payment date is usually from 2 to 4 weeks after the date of record
What is the Ex-dividend date?
The ex-dividend date is a date establish by the stock exchanges (i.e. 4 business days before the date of record). Unlike the other important dividend dates, it is NOT established by the corporate board of directors
The period between the ex-dividend date and the date of record gives the stock exchange members time to process any transactions so that new shareholders will receive the dividends to which they are entitled
Note: Usually, a stock price will drop on the ex-dividend date by the amount of the dividend because the new investor did not receive it
