II Chapter 5: Payout (Dividend) Policy

How Companies Pay Out Cash to Shareholders

Companies can pay out cash to shareholders through cash dividends and stock repurchases.

Dividend Payment Procedures

Companies follow a dividend declaration procedure similar to that defined in the following paragraph. This procedure usually revolves around a declaration date, an ex-dividend date, a record date, and a payment date.

The date the board of directors announces to pay the dividend is the declaration date . After declaring this date, the company is obligated to make the payment. The company will pay the dividend only to the registered shareholders of record on a specific date which is called record date . While registration takes three business days, anyone purchasing the company’s stock at least three business days before the date of record can claim the right to receive the dividend. Therefore, the date two business days before the date of record is called ex-dividend date . The company sends a dividend check to each of the registered shareholders at the date which is called payment date .

Stock Repurchases: An Alternative to Cash Dividends

Another way to pay cash to its shareholders is repurchase of its own share of stock, in another words known as a buyback . A company sometimes repurchases stock to distribute excess funds, especially when the stock price is considered as undervalued. Stock repurchase is the distribution of earnings to shareholders by repurchasing shares of its stock.

There are four types for stock repurchases;

1. Open-market repurchase.
2. Tender Offer
3. Dutch auction.
4. Targeted Repurchase

Advantages of Repurchases

The principal advantages of repurchases are as follows;

1. A company can repurchase stock to distribute excess cash without changing the amount of dividends.
2. When a company has more equity than its target capital structure, the company can directly change its capital structure by repurchasing.
3. A company can repurchase stock to minimize the “dilution effect” associated with exercising the stock options that have been given to employees as bonuses.
4. Due to the signaling effects, stock repurchase is perceived as a positive signal that the company’s stock is undervalued in the financial markets.
5. Repurchases have a tax advantage over dividends due to the deferred tax on capital gains.

Stock Dividend and Stock Splits

Stock dividends and stock splits are related to the company’s dividend payout policies. The stock dividend is a type of dividend paid out for additional shares of stock to the current shareholders. Stock dividend is a dividend paid in the form of additional shares of stock rather than cash.

Stock split involves exchanging old shares of stock more than one new share. When a stock split is declared, each old share of stock is split up into more than one new shares. Stock split is an action taken by a company to increase the number of shares outstanding.

The Theories of Investors Preferences

The three theories of investor preferences for dividend yield versus capital gains; the dividend irrelevance theory, the bird-in-the-hand theory, and the tax effect theory are discussed.

Dividend Irrelevance Theory

Merton Miller and Franco Modigliani (1961) (MM) argued that while dividend policy does not have any impact on either the value of the company’s stock and its cost of capital, the value of the company is determined only by the earnings power and risk of its investments ( Merton H. Miller and Franco Modigliani, (1961) ). This is called a dividend irrelevance theory set in a perfect world where

1. investors can buy and sell stocks without any transaction costs,
2. companies can issue stocks without any costs,
3. there are no taxes and transaction costs,
4. the markets are perfectly efficient,
5. investors are completely rational and
6. there are no conflicts of interest between managers and owners.

Dividend irrelevance theory states that a company’s dividend policy has no effect on whether its value or its cost of capital.

Bird-in-the-Hand Theory: Dividends are preferred

As a counterpart to Modigliani and Miller’s (1961) dividend irrelevance theorem, Myron Gordon (1963) and John Lintner (1962) proposed their arguments for dividends. In particular, they argued that investors are more certain of receiving dividend payments than receiving capital gains resulting from retained earnings that are called the bird-in-the-hand dividend theory . Birdin-the-hand dividend theory states that a company’s value will be maximized by setting a high dividend payout ratio.

Tax Preference Theory: Capital Gains are preferred

The difference in the tax treatment of dividends versus capital gains influences investor’s preferences. While dividends are taxed at a higher rate than capital gains before 2003, the Jobs and Growth Act of 2003 equalized the tax rates on dividends and capital gains. However, there is still a tax advantage for capital gains returns relative to dividend income. While capital gains taxes are deferred until the stock is actually sold, taxes on dividend income is immediately paid when the dividends are received. Although dividends and capital gains are taxed nearly equally, the present value of taxes paid in the future has a lower effective cost than the value paid today. Also, if investors do not prefer to sell their stocks, they will not incur any obligation to pay taxes.

Other Dividend Policy Issues

While a risk, time value, and taxation which are discussed in the previous part is important, managers have to consider some additional factors in setting the company’s optimal dividend payout policy. Three of these views are discussed in this section..

Information Content, or Signaling, Hypothesis

Ross (1977) and Bhattacharya (1979) initiated the dividend signaling hypothesis, also called, dividend information content hypothesis stating that if there is a larger than expected dividend increase, it signals to investors that managers anticipate bright future prospects of the company. On the contrary, if the dividend decreases or it is less than expected, it signals to investors that managers forecast poor future earnings. In another words, as a dividend rise conveys confidence to investors, a dividend cut conveys a lack of confidence. Signaling hypothesis states that investors regard dividend changes as signals of management’s earnings forecasts.

Clientele Effects

Different groups of investors, or clienteles, have different preferences about dividend payout policies. Some groups have a preference for stocks that pay no or low dividends (low-payout stocks) while some have a preference for stocks with high dividends (high-payout stocks) This differences in tax preferences create clientele effects.

According to the clientele effect, investors are the crucial part of a company’s policies because the changes in the policies will result in the purchase or sale of the company’s stock based upon the investor’s preferences (Farrar and Selwyn, 1967).

Clientele effect is a tendency of a company to attract a set of investors whose particular needs for current versus future cash flow match with company’s dividend payouts.

Agency Costs

Conflicts of interests that exist between the company’s managers and shareholders arise due to the separation of ownership and control. The recognition of this potential agency costs can be overcome with dividend payout policies that are set by managers. Managers generally pursue company policies that benefit themselves at the expense of minority shareholders, by retaining cash flow rather than pay it out to shareholders.

Types of Dividend Payments

In this section, several alternative dividend payout policies, residual dividend policy, a stable dollar dividend per share policy; constant dividend payout ratio, and low regular dividend plus extras are discussed.

Residual Dividend Policy

As discussed earlier, the optimal payout policy determines four factors which are investors’ preferences for dividends versus capital gains; the company’s investment opportunities; its target capital structure, and the availability and cost of external equity. The combination of these factors is called as residual dividend policy under the assumption that investors are indifferent between dividends and capital gains.

Residual dividend policy states that a company pays dividends after meeting its investment needs while supporting its optimal capital budget.

A Stable Dollar Dividend per Share

A company set a relatively stable amount of dividend per share. A significant increase in the dollar dividend rate does not occur until the management is satisfied that the higher dividend level can be justified with high future earnings. Many companies follow this dividend policy since they want investors to perceive stability in dividend payments.

Constant Dividend Payout Ratio

A company that uses this policy pays out a constant percentage of its earnings as dividends. Although the dividend to earnings ratio is stable, the amount of dividend varies year to year when profit changes. Due to uncertainty on expected dividends each year, the cost of capital will increase; hence, the company’s stock price will decrease.

Low Regular Dividend Plus Extras

A company pay a very low “regular” dividend and then supplement it with an “extra” dividend in prosperous years to avoid the connotation of a permanent dividend. This policy represents a compromise between a stable, predictable dividend and a constant payout ratio and especially suits a company whose earnings and cash needs are volatile.

The Factors Influencing Dividend Policy

In the previous parts, the theories of investors’ preferences for dividends and the other dividend policy issues are described. In this section, the factors that affect the dividend decision are discussed as follows;

1. Constraints on dividend payments : The amount of dividend that company pay out might be affected from (1) debt contracts restrictions which specify that no dividends can be distributed unless the main financial ratios exceed stated minimum, (2) impairment of capital rule which is the legal restriction FIN208U-BUSINESS FINANCE II Chapter 5: Payout (Dividend) Policy 3 designed to protect creditors, (3) availability of cash because cash dividends can be paid only in cash, (4) preferred stock restrictions because common stock dividends cannot be paid unless the company satisfies its preferred shareholders.
2. Investment opportunities : If a company has a large number of profitable capital budgeting projects, then it will have a low dividend payout ratio and vice versa.
3. Alternative sources of capital : If the flotation costs are high, and the cost of external equity is higher than the cost of internal equity, a company sets a low dividend payout ratio and finances its investments by using its own retained earnings rather than through the sale of new common stock.
4. Ownership dilution : A company may retain more earnings rather than selling new stocks if management is concerned about maintaining control.
5. Effects of dividend policy on the cost of common stock equity : There are four factors that affect dividend policy on the cost of common stock equity discussed earlier. (1) investors’ desire for current versus future income, (2) the perceived riskiness of dividends versus capital gains, (3) tax differences on capital gains versus dividends, and (4) information (signaling) content in dividend announcements.