Dividend policy

Question 1

What is Dividend Policy? 2

Answer 1

1. Dividend policy is the decision to pay or not to pay.
2. “ Dividend policy determines the division of earnings between payments to shareholders and retained earnings”. - Weston and Bringham

Question 2

What Decision Involves in Dividend Policy? 3

Answer 2

1. To retain earnings for capital investment and other purposes;
2. To distribute earnings in the form of dividend among shareholders;
3. To retain some earnings and to distribute remaining earnings to shareholders.

Question 3

Dividends and earnings 4

Answer 3

1. The dividend decision is closely linked to the financing decision of a company.
2. The dividend decision must take account of the views and expectations of shareholders.
3. Retained earnings are preferred as a source of investment funds (pecking order theory).
4. Dividend payments reduce the earnings available for investment, increasing the need for external funds to meet investment plans

Question 4

Factors Influencing Dividend Policy legal rules 3

Answer 4

Capital Impairment Rule – many states prohibit the payment of dividends if these dividends impair “capital” (usually either par value of common stock or par plus additional paid-in capital).

Insolvency Rule – some states prohibit the payment of cash dividends if the company is insolvent under either a “fair market valuation” or “equitable” sense.

Undue Retention of Earnings Rule -- prohibits the undue retention of earnings in excess of the present and future investment needs of the firm.

Question 5

Factors Influencing Dividend Policy Other Issues to Consider 5

Answer 5

1. Funding Needs of the Firm
2. Liquidity
3. Ability to Borrow
4. Restrictions in Debt Contracts
5. Control

Question 6

Forms of Dividend Cash Distributions 3

Answer 6

1. Regular Cash Dividend
2. Extra Dividend/Special Dividend
3. Liquidating Dividend

Question 7

Forms of Dividend Noncash Distributions 4

Answer 7

1. Stock Dividend
2. Stock Split
3. Stock Repurchase
4. Dividend Reinvestment Plan

Question 8

Dividend policies 4

Answer 8

1. Fixed percentage payout ratio
2. Zero dividend payment
3. Constant or steadily increasing dividend
4. Stock Repurchase

Question 9

Fixed percentage payout ratio

Answer 9

Advantages:

• Easy to operate
• Sends signals to investors on company performance ​

Disadvantages:

• Dividends fluctuate with earnings
• Inflexible in terms of retained earnings.

Question 10

Zero dividend payment

Answer 10

Advantages:

• Desirable for investors wanting capital gains
• Cheap and easy to operate
• Allows company to re-invest earnings

Disadvantages:

• Unacceptable to most investor groups.

Question 11

Constant or steadily increasing dividend

Answer 11

Advantages:

• Acceptable to majority of investors

Disadvantages:

• Shareholders expect increasing dividends that companies may not be able to afford
• May limit companies’ ability to invest

Most commonly pursued dividend policy

Question 12

Dividend Stability

Answer 12

Dividends begin at 50% of earnings, but are stable and increase only when supported by growth in earnings.

Question 13

Stock Dividend –

Answer 13

A payment of additional shares of stock to shareholders. Often used in place of or in addition to a cash dividend.

Question 14

Stock Split

Answer 14

An increase in the number of shares outstanding by reducing the par value of the stock.

Question 15

Stock Repurchase

Answer 15

The repurchase (buyback) of stock by the issuing firm, either in the open (secondary) market or by self-tender offer.

Question 16

Reasons for stock repurchase: 4

Answer 16

1. Available for management stock-option plans
2. Available for the acquisition of other companies
3. “Go private” by repurchasing all shares from outside stockholders
4. To permanently retire the shares

Question 17

Methods of Repurchase 3

Answer 17

Fixed-price self-tender offer – An offer by a firm to repurchase some of its own shares, typically at a set price.

Dutch auction self-tender offer -- A buyer (seller) seeks bids within a specified price range, usually for a large block of stock or bonds. After evaluating the range of bid prices received, the buyer (seller) accepts the lowest price that will allow it to acquire (dispose of) the entire block.

Open-market purchase – A company repurchases its stock through a brokerage house on the secondary market.

Question 18

Possible Signaling Effect of Stock Repurchase 4

Answer 18

1. Repurchases have a positive signaling effect.
2. For example, if the stock is undervalued management may tender for shares at a “premium.” This signals that the share prices are undervalued.
3. Dutch-auction self-tenders have less signaling power likely due to a smaller tender premium.
4. Open-market purchases have only a modest positive signaling effect likely due to many programs being instituted after significant share price declines.

Question 19

Valuation of Dividend Stability 3

Answer 19

Information content – management may be able to affect the expectations of investors through the informational content of dividends. A stable dividend suggests that the company expects stable or growing dividends in the future.

Current income desires – some investors who desire a specific periodic income will prefer a company with stable dividends to one with unstable dividends.

Institutional considerations – a stable dividend may permit certain institutional investors to buy the common stock as they meet the requirements to be placed on the organizations “approved list.”

Question 20

Dividend Reinvestment Plan (DRIP)

Answer 20

An optional plan allowing shareholders to automatically reinvest dividend payments in additional shares of the company’s stock.