Dividend policy Flashcards
What is Dividend Policy? 2
- Dividend policy is the decision to pay or not to pay.
- “ Dividend policy determines the division of earnings between payments to shareholders and retained earnings”. - Weston and Bringham
What Decision Involves in Dividend Policy? 3
- To retain earnings for capital investment and other purposes;
- To distribute earnings in the form of dividend among shareholders;
- To retain some earnings and to distribute remaining earnings to shareholders.
Dividends and earnings 4
- The dividend decision is closely linked to the financing decision of a company.
- The dividend decision must take account of the views and expectations of shareholders.
- Retained earnings are preferred as a source of investment funds (pecking order theory).
- Dividend payments reduce the earnings available for investment, increasing the need for external funds to meet investment plans
Factors Influencing Dividend Policy legal rules 3
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.
Factors Influencing Dividend Policy Other Issues to Consider 5
- Funding Needs of the Firm
- Liquidity
- Ability to Borrow
- Restrictions in Debt Contracts
- Control
Forms of Dividend Cash Distributions 3
- Regular Cash Dividend
- Extra Dividend/Special Dividend
- Liquidating Dividend
Forms of Dividend Noncash Distributions 4
- Stock Dividend
- Stock Split
- Stock Repurchase
- Dividend Reinvestment Plan
Dividend policies 4
- Fixed percentage payout ratio
- Zero dividend payment
- Constant or steadily increasing dividend
- Stock Repurchase
Fixed percentage payout ratio
Advantages:
- Easy to operate
- Sends signals to investors on company performance
Disadvantages:
- Dividends fluctuate with earnings
- Inflexible in terms of retained earnings.
Zero dividend payment
Advantages:
- Desirable for investors wanting capital gains
- Cheap and easy to operate
- Allows company to re-invest earnings
Disadvantages:
- Unacceptable to most investor groups.
Constant or steadily increasing dividend
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
Dividend Stability
Dividends begin at 50% of earnings, but are stable and increase only when supported by growth in earnings.
Stock Dividend –
A payment of additional shares of stock to shareholders. Often used in place of or in addition to a cash dividend.
Stock Split
An increase in the number of shares outstanding by reducing the par value of the stock.
Stock Repurchase
The repurchase (buyback) of stock by the issuing firm, either in the open (secondary) market or by self-tender offer.
Reasons for stock repurchase: 4
- Available for management stock-option plans
- Available for the acquisition of other companies
- “Go private” by repurchasing all shares from outside stockholders
- To permanently retire the shares
Methods of Repurchase 3
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.
Possible Signaling Effect of Stock Repurchase 4
- Repurchases have a positive signaling effect.
- For example, if the stock is undervalued management may tender for shares at a “premium.” This signals that the share prices are undervalued.
- Dutch-auction self-tenders have less signaling power likely due to a smaller tender premium.
- Open-market purchases have only a modest positive signaling effect likely due to many programs being instituted after significant share price declines.
Valuation of Dividend Stability 3
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.”
Dividend Reinvestment Plan (DRIP)
An optional plan allowing shareholders to automatically reinvest dividend payments in additional shares of the company’s stock.
