BY: WAFAA OMAI ADVANCED FINANCAIL MANAGEMENT The purpose of this paper is to help management must decide on the form of the dividend distribution, generally as cash dividends or via a share buyback. Various factors may be taken into consideration: where shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding. Alternatively, some companies will pay “dividends” from stock rather than in cash. The purpose of an optimal dividend policy should be to maximize shareholders’ wealth.
This depends on both current dividends and capital gains. Capital gains can be achieved by retaining risome earnings for reinvestment and dividend growth in the future. INTRODUCION Dividend represents a share profit distributed to shareholders of a corporation, according to a certain payout ratio or more precisely according to certain dividend policy. Prudent companies save their cash until opportunities arise for acquisitions that have a real effect on earnings. Barring that, companies can decide to return cash to shareholders through dividends rather than buybacks.
Shareholders can then decide for themselves whether to buy more company shares with their dividend income or to use it on something else. Although dividend payments lead to taxes for investors, they give the individual more control than do share buybacks I- What is “dividend policy”? Dividend policy decisions about when and how much of earnings should be paid as dividends. Earnings that are paid out as dividends cannot be used by the firm to invest in projects with positive net present values—that is, to increase the value of the firm.
The dividend policy that maximizes the value of the firm is said to be the optimal dividend policy. Dividend policy is controversial. Includes these elements: 1. High or low payout? 2. Stable or irregular dividends? 3. How frequent? 4. Do we announce the policy? Do investors prefer high or low payouts? There are three theories: * Dividends are irrelevant: Investors don’t care about payout. * Bird in the hand: Investors prefer a high payout. * Tax preference: Investors prefer a low payout, hence growth. Investors are indifferent between dividends and retention-generated capital gains.
If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock. A-Modigliani-Miller support irrelevance. M & M in the case of perfect markets. M&M argued that dividend policy is irrelevant it doesn’t affect the value of the firm or its cost of capital and there is no optimal dividend policy is as good as any other. Theory is based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true. Need empirical test. B- Bird in the hand theory. “Paying out some cash today reduces risk of future payoff uncertainty”.
Gordon and Linter arguing that dividends are less risky than capital gains, so a firm should set a high dividend pay put ratio and offer a high dividend yield in order to maximize its stock pricewise. , a high payout would result in a high P0. C- Tax preference theory: Tax on dividends = tax on income $ tax on capital gains. But tax on dividends must be paid now, while on capital gains would be in the future. Whatever dividends are taxed more heavily than capital gains, firms should pay reinvestment or used to repurchase shares.
Retained earnings lead to long-term capital gains, which are taxed at lower rates than dividends: 20% vs. up to 39. 6%. Capital gains taxes are also deferred. This could cause investors to prefer firms with low payouts, i. e. , a high payout results in a low P0. Which theory is most correct? * Empirical testing has not been able to determine which theory, if any, is correct. * Thus, managers use judgment when setting policy. * Analysis is used, but it must be applied with judgment. Managers hate to cut dividends, so won’t raise dividends unless they think raise is sustainable.
So, investors view dividend increases as signals of management’s view of the future. Therefore, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends. Researchers argue whether there exists an optimal dividend policy. a) Dividend irrelevance theory—a firm’s dividend policy does not affect the value of a firm. b) Dividend relevance theory—the dividend policy is an important factor in the determination of a firm’s value. II-The Residual Dividend Policy.
It is a starting point to set an optimal policy that is why change prices is a long-run decision when it is declared, managers must sustain it at the declared level otherwise any unexpected increase or decrease in dividends will affect the price of the stock. This doesn’t mean that a change individual may lead to change in price of the stock, but the change in dividend entails information about the future prosperity of the firm negatively or positively. The firm’s objective is to meet its investment needs and maintains its desired debt-equity ratio before paying dividends.
Find the retained earnings needed for the capital budget. Pay out any leftover earnings (the residual) as dividends. This policy minimizes flotation and equity signaling costs, hence minimizes to find the WACC. Using the Residual Model to Calculate Dividends Paid: Dividends= Net Income-[(target Equity Ratio)(Total Capital Budget)]. Advantages and Disadvantages of the Residual Dividend Policy: * Advantages: Minimizes new stock issues and flotation costs. * Disadvantages: Results in variable dividends, sends conflicting signals, increases risk, and doesn’t appeal to any specific clientele.
Conclusion: Consider residual policy when setting target payout, but don’t follow it rigidly. The implication of the Residual Theory of Dividends is: Investment decisions are independent of the firm’s dividend policy . No firm would pass on a positive NPV project because of the lack of funds, because, by definition the incremental cost of those funds is less than the IRR of the project, so the value of the firm is maximized only if the project is undertaken. .If the firm can’t make good use of free cash flow (ie.
It has no projects with IRRs > cost of capital) then those funds should be distributed back to shareholders in the form of dividends for them to invest on their own. The firm should operate where Marginal Cost equals Marginal Revenue. A firm should fallow these four steps: 1- Determine the optimal capital budget. 2- Determine the amount of equity needed to fiance that budget 3- Use retained earnings to supply this equity to the extent possible 4- Pay dividend only if more earnings are available than are needed to support the capital budget.
The word residual implies left over and the residual theory states that dividends should be paid only put of leftover earnings. The basis of the theory is that investors prefer to have the firm retain and reinvest earnings rather than pay them out in dividends if the rate of return the firm can earn on reinvested earnings exceed the rate of return investors could obtain for themselves on other investments of comparable risk.
In the past, many firms set a specific annual dividend per share and then maintained it, increasing the annual dividend only if it seemed clear that future earnings would be sufficient to allow the new dividend to be maintained the rule was: NEVER REDUCE THE ANNUAL DIVIDEND. A) Perhaps managers change dividends (increase or decrease) only when it is necessary: * Decreases occur only when the firm is facing financial difficulty * Increases occur only when it is expected that the firm an continue to pay higher dividends long into the future If true, then changes in a firm’s dividend policy might provide information to investors, who react accordingly: * Good news—that is, a dividend increase—should cause the stock price to increase * Bad news—that is, a dividend decrease—should cause the stock price to decrease Here is an example on an Eastern Kodak corporation that will illustrate the information content of dividend policy: Kodak is the world’s foremost imaging innovator, providing leading products and services to the photographic, graphic communications and healthcare markets.
With sales of $14. 3 billion in 2005, the company is committed to a digitally-oriented growth strategy focused on helping people better use meaningful images and information in their life and work. Kodak’s payout ratio ranged from 41. 1% to 52. 5% from 1975 to 1982 and it averaged to 50% during those 8 years. Earnings were relatively stable during those years, and dividends clearly tracked earnings. After 1980, Kodak’s earnings were much less stable. Global competition intensified.
Kodak lost major suit to Polaroid and booms and recessions alternated to lead to earnings variability. Management stopped increasing dividend when earnings fell but did not cut the dividend, even when earnings failed to cover the dividend. Thus, in 1985 and 1986, the payout ratio averaged more than 100%. Maintaining the dividend was Kodak’s way of signaling to stockholders that management was confident that the earnings decline was only temporary and that earnings would soon resume their upward trend. This was indeed the case.
Kodak’s earnings increased by almost 300% from 1986 to 1990,and its 1990 dividend payout ratio was approximately 50% which is about where Kodak likes to keep it. During the period from 19991 through 1993 Kodak maintained its dividend at the 1990 level despite a huge drop in earnings in 1990 level. There are two reasons for paying a stable and predictable dividend rather than following the residual dividend policy, where the dividend paid is set equal to the actual earnings minus the amount of retained earnings necessary to finance the firm’s optimal capital budget. – Due the information content, a fluctuating payment policy would lead to greater uncertainty than would a stable policy 2- Many stockholders use dividends for current consumption and they would be put to trouble and expense if they had to sell part of their shares to obtain cash if the company cut the dividend; this is in addition to the anxiety a dividend cut would cause them. Corporation’s actions such as delaying some investment projects or even issuing new common stock make it possible for a company to avoid the problems associated with unstable dividends.
If Eastman Kodak had paid out a constant percentage of earnings, it would have had to cut its dividend in several different years and this would have caused its stock price to fall sharply because investors would have taken the dividend reduction as a signal that management thought the earnings drops were permanent. However, Kodak’s stock price was relatively stable during the 1980s and early 1990s , in spite of earnings fluctuations. In the mid 1950s Lintner conducted a classic series of interviews with corporate managers about their dividend policies.
His description of how dividends are determined can be summarized by four statements: 1- Firms have long-run target dividend payout ratios. 2- Managers focus more on dividend changes than on absolute levels. Thus, paying a $2. 00 dividend is an important financial decision if last year’s dividend was $1. 00 but no big deal if last year’s dividend was $2. 00. 3- Dividend changes follow shifts in long run sustainable earnings. Transitory changes are likely to affect dividend payouts. 4- Managers are reluctant to make dividend changes that might have to be reversed.
They are particularly worried about having to rescind a dividend increase. Lintner suggests that the dividend depends in part on the firm’s current earnings and in part on the dividend for the previous year which in turn depends on that year’s earnings and the dividend in the year before. So dividend is a weighted average of current and past earnings. Note that Kodak’s long-run target payout ratio has been relatively constant expect for the depressed periods in the 1980s and in 1990s, it has fluctuated in the 40% to 50% range. Kodak like most companies establishes a target payout ratio.
The target is not hit in every year, but over time the average payout has been close to the target level. Of course, the target would change if fundamental changes in the company’s business were to occur. A policy of paying a low regular dividend plus a year-end extra good years is a comprise between a stable dividend and a constant payout rate. Such a policy gives the firm flexibility, yet investors can count on receiving at least a minimum dividend. Therefore, if a firm’s earnings and cash flows are volatile, this policy may be its best choice.
The directors can set a relatively regular dividend, low enough so that it can be maintained even in low profit years or in years when a considerable amount of retained is needed and then supplement it with an extra dividend in years when excess funds are available B) Clientele Dividend Theory: Different groups of investors, or clienteles, prefer different dividend policies. Firm’s past dividend policy determines its current clientele of investors. Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies.
Investors might choose a particular stock due to the firm’s dividend policy—that is, some investors prefer dividends and others do not. If such a clientele effect does exist, then we would expect that a firm’s stock price will change when its dividend policy (payment) is changed. Capital market imperfections include also substantial transaction costs and differential interest rates. These all interfere with the dividend irrelevancy. Argument based on perfect capital markets, meaning that an individual cannot ‘costless’ adjust her dividend pattern to fit her preferred consumption pattern.
Therefore shareholders may prefer companies to supply them with their desired dividend pattern thereby creating a certain demand for specific patterns. Investors are attracted to different company policies, and when the company policy changes, investors will adjust their stock holdings accordingly. As a result of this adjustment, the stock price will move. Unfortunately, this may mean that the shareholders may incur costs of adjustment. Therefore, an easily identifiable dividend pattern may avoid such costs to the shareholder.
At the same time, the company may incur consequential costs in the form of missed investment opportunities or costs of raising finance due to free cash flow shortage. That said, it is probably best that a company follows a consistent dividend policy that will hopefully attract the suitable clientele and minimize both adjustment costs for the investors and also the discussed consequential costs. Investors, who prefer regular cash income, are in a relatively low tax bracket and are risk averse, will probably be attracted companies that have high payouts, such as utilities companies.
Growth companies normally pay lower dividends and reinvest more of their free cash flows in new projects and expansion, thus providing higher capital appreciation. These companies attract investors in the high tax brackets with no pressing needs for cash. Another imperfection of capital markets is the need for information which is neither costless nor universally available. Therefore, a dividend declaration which is both free and universally available is thought to signal information to the market. Managers are extremely reluctant to cut dividends because a reduction in dividend is often read by the clientele as unfavorable information.
Therefore, they generally increase dividends only if they are confident that future free cash flows will enable them to retain the established pattern. III- The Effect of Taxes on Dividend Policy A lot of controversies regarding taxes and dividend policy have attracted many academic interests. Financial theorists such as Brennan (1970), Masulis & Trueman (1988) have stipulated that taxes affect organizational corporate dividend policy. If this speculation were true, changes in corporate dividend payout would be expected whenever the government changes its income tax policy.
However, this does not always apply especially in the banking business. Linter (1956) had asserted that the major determinants of dividend policy are the anticipated level of future earnings and the pattern of past dividend. International Research Journal of Finance and Economics – (2008) . This discrepancy may have underpinned Modigliani & Miller (1961) theory, which provided a platform for the enormous debates and researches on dividend policy. Dividends are usually paid to owners or shareholders of business at specific periods.
This is apparently based on the declared earning of the company and the recommendations made by its directors. Thus, if there are no profits made, dividends are not declared. But when profits are made, the company is obligated to pay corporate tax including other statutory taxes to the government. This is an essential corporate responsibility particularly profit making companies. The taxes no doubt reduce the profits available at the disposal of the organizations, either to be retained or distributed as a dividend to shareholders of the company.
Dividend policy is the trade-off between retaining earning and paying out cash or issuing new shares to shareholders. Some firms may have low dividend payout because management is optimistic about the firm’s future and therefore wishes to retain their earnings for further expansion. It is hard to deny that taxes are important to investors. Although, dividend affects the shareholders tax liability, it does not in general alter the taxes that must be paid regardless of whether the company distributes or retains its profit (Brealey, Myers & Marcus 1999).
It is difficult to divorce dividend policy formulation of firms from the tax effect it attracts. The key tax features has to do with the taxation of dividend income and capital gains. For individual shareholders, effective tax rates on dividend are higher than the tax rates on capital gain. Dividends received are taxed as ordinary income. – Capital gains are taxed at somewhat lower rates, and the tax on a capital gain is deferred until the stock is sold. – Capital gains taxation makes the effective tax rate much lower because the present value of the tax is less.
IV-DIVIDEND POLICY IN PRACTICE: 1) Types of dividend payments: * Residual dividend policy—dividends are paid only if earnings are greater than what is needed to finance the equity portion of the firm’s optimal capital budget for the year. * Stable, predictable dividends—requires the firm to pay a dividend that is the same every year or is constant for some period and then is increased at particular intervals—that is, dividend payments are fairly predictable. * Constant payout ratio—pay the same percentage of earnings as dividends each year (dividend payout ratio =
DPS/EPS). * Low regular dividend plus extras—requires a firm to pay some minimum dollar dividend each year and then to pay an extra dividend when the firm’s performance is above normal. 2) Dividend Payment Procedures: The distribution of dividends requires the approval of the board of directors, who declare the time or date when the dividend will be distributed. The dates are categorized into four types: Declaration date: The declaration date is defined as the date on which the board of directors declares its aim for payment of dividend.
On this date, the payment date and the record date are also announced. Ex-dividend date: The ex-dividend date is defined as the date subsequent to which every share that is traded does not have any right to claim the dividend, which has been declared in the immediate past. Record date: The record date is defined as the date on or before which the shareholders who have officially recorded their ownership and are entitled to get the dividend. Payment date: The payment date is defined as the date on which the checks of dividend will be sent to shareholders or deposited to brokerage accounts. Example:
Dividends are normally paid quarterly, and, if conditions permit, the dividend is increased once each year. For example, Katz Corporation paid $0. 50 per quarter in 1997, or at an annual rate of $2. 00. In common …nancial parlance, we say that in 1997 Katz’s regular quarterly dividend was $0. 50, and its annual dividend was $2. 00. In late 1997, Katz’s board of directors met, reviewed projections for 1998, and decided to keep the 1998 dividend at $2. 00. The directors announced the $2. 00 rate, so stockholders could count on receiving it unless the company experiences unanticipated operating problems.
The actual payment procedure is as follows: a) Declaration date. On the declaration date – say, on November 10 – the directors meet and declare the regular dividend, issuing a statement similar to the following: “On November 10, 1997, the directors of Katz Corporation met and declared the regular quarterly dividend of 50 cents per share, payable to holders of record on December 12, payment to be made on January 2, 1998”. For accounting purposes, the declared dividend becomes an actual liability on the declaration date. If a balance sheet were constructed, the amount (0. 0$) times (Number of shares outstanding) would appear as a current liability and retained earnings would be reduced by a like amount. b) Holder-of-record date. At the close of business on the holder-of-record date, December 12, the company closes its stock transfer books and makes up a list of shareholders as of that date. If Katz Corporation is noted of the sale before 5. PM on December 12, then the new owner receives the dividend. However, if notification is received on or after December 13, the previous owner gets the dividend check. c) Ex-dividend date. Suppose that Jean Buyer buys 100 shares of stock from John Seller on December 8.
Will the company be noti…ed of the transfer in time to list Buyer as the new owner and thus pay the dividend to her. To avoid conflict, the securities industry has set up a convention under which the right to the dividend remains with the stock until four business days prior to the holder-of record date; on the fourth day before that date, the right to the dividend no longer goes with the shares. The date when the right to the dividend leaves the stock is called the ex-dividend date. In this case, the ex-dividend date is four days prior to December 12, or December 8.
Dividend goes with stock-=============December 7 Buyer would receive the dividend ————————————————————————— Ex-dividend date==================December 8 Seller would receive the dividend ————————————————————————– 10 December 9 December 10 December 11 December 12=========Holder-of-record date Therefore, if Buyer is to receive the dividend, he must buy the stock on or before December 7. If he buys it on December 8 or later, Seller will receive the dividend because he will be the o? cial holder of record. Katz’s dividend amounts to $0. 50, so the ex-dividend date is important.
Barring ‡punctuations in the stock market, one would normally expect the price of a stock to drop by approximately the amount of the dividend on the ex-dividend date. Thus, if Katz closed at $30(1/2) on December 7, it would probably open at about $30 on December 8. d) Payment Date: the company actually mails the checks to the holders of record on January 2, 3)What’s a “dividend reinvestment plan: It permits stock-holders to have dividend payments automatically reinvested in the firm’s stock. Buy additional shares of a firm’s stock on a pro rata basis using the cash dividend paid by the firm.
Often there are little or no brokerage fees involved with DRIPS. There are two types of plans: -Open market – New stock A-Open Market Purchase Plan * Dollars to be reinvested are turned over to trustee, who buys shares on the open market. * Brokerage costs are reduced by volume purchases. * Convenient, easy way to invest, thus useful for investors. B-New Stock Plan * Firm issues new stock to DRIP enrollees, keeps money and uses it to buy assets. * No fee are charged, plus sells stock at discount of 5% from market price, which is about equal to flotation costs of underwritten stock offering. 4-Stock Repurchases Repurchases: Buying own stock back from stockholders. * Reasons for repurchases: * As an alternative to distributing cash as dividends. * To dispose of one-time cash from an asset sale. * To make a large capital structure change. Advantages of Repurchases: * Stockholders can tender or not. * Helps avoid setting a high dividend that cannot be maintained. * Repurchased stock can be used in take-overs or resold to raise cash as needed. * Income received is capital gains rather than higher-taxed dividends. * Stockholders may take as a positive signal–management thinks stock is undervalued Disadvantages of Repurchases May be viewed as a negative signal (firm has poor investment opportunities). * IRS could impose penalties if repurchases were primarily to avoid taxes on dividends. * Selling stockholders may not be well informed, hence be treated unfairly. * Firm may have to bid up price to complete purchase, thus paying too much for its own stock. * 5-Stock Splits and Stock Dividends Some firms pay dividends in the form of stock or change the number of shares of stock that is outstanding through a stock split. Neither of these actions by themselves has economic value in the sense that each does nothing to change stockholders’ wealth. A)Stock Splits
An action taken by a firm to change the number of outstanding shares of stock and the price per share. Many firms believe their stock has an optimal price range within which their stock should trade. * If the price of the stock exceeds the price range, then the firm will execute a stock split. * If the price of the stock is below the price range, then the firm will execute a “reverse” stock split. When a “regular” stock split is initiated, generally the price of the stock actually settles above “split price. ” * Information content * Impact—increase the number of shares; lower the market price per share B) Stock Dividends
Dividends paid in the form of stock rather than cash. Like stock splits, a stock dividend does not have specific economic value: * increases the total number of shares of stock each stockholder owns * stock price per share decreases A firm might use a stock dividend to keep the price of its stock within a particular range. Both stock splits and stock dividends increase the number of outstanding shares of stock and decrease stock price. Splits and stock dividends create no economic value by themselves. Studies have shown that the market price of the stock affected by such actions might change: If investors expect future earnings and cash dividends to increase (decrease), then the price will increase (decrease) above the relative price associated with the stock split or the stock dividend. * If the future expectations do not pan out, however, the price of the stock will eventually settle at a price that yields an economic change in investors’ wealth approximately equal to zero. 6) Growth stocks Are purchased by investors willing to take more risk for greater potential price appreciation. These stocks usually have what is referred to as a high price/earnings ratio (P/E).
This ratio is obtained by dividing the current market price per share by the company’s most recent earnings per share. This ratio is an indication of the market’s current opinion about the growth potential of a stock or group of stocks: a high P/E ratio is based on anticipation that the company will do well. A growth stock usually does not pay a dividend, as the company would prefer to reinvest retained earnings in capital projects. Most technology companies are growth stocks. Note that a growth company’s stock is not always classified as growth stock. In fact, a growth company’s stock is often overvalued. Income Stock An equity security that pays regular, often steadily increasing dividends, and offers a high yield that may generate the majority of overall returns. While there is no specific breakpoint for classification, most income stocks have lower levels of volatility than the overall stock market, and offer higher-than-market dividend yields. Income stocks may have limited future growth options, thereby requiring a lower level of ongoing capital investment. The excess cash flow from profits can therefore be directed back toward investors on a regular basis.
Income stocks can come from any industry, but are most commonly found as companies operating within real estate (through real estate investment trusts, or REITs), energy sectors, utilities, natural resources and financial institutions. * Growth or Income? As already noted, growth stock offers potential for price appreciation. Growth-stock companies typically invest all or most of their earnings in expansion. They are not likely to pay much in dividends. Price fluctuations for these stocks are often larger and more irregular than for income stocks.
Other characteristics of growth stocks may include: 1 -Earnings larger at each peak of the business cycle than they were at the previous peak; 2- Average growth rate of 10% or per year; 3 High product demand with competition not on overriding concern; 4 -Earnings growth greater than that of the average business having favorable growth prospects; 5- Good potential for substantial price appreciation over the longer term. Income stocks, on the other hand, are usually issued by well-established companies with steady earnings but lower potential for price appreciation.
These companies are able to turn a large part of their earnings over to shareholders in the form of dividends because they do not choose to use the money for continued expansion. In the conclusion, Dividends might be a sounder course of action for companies looking to return cash to investors. The three big names in finance are right in according to a certain financial situation. M&M concluded that dividend decisions don not effect the shareholders wealth or the cost of capital and their assumptions were based as I mentioned on set of assumptions.