Companies have to decide on the portion of the earnings to be distributed, if the distribution will be in the form of cash or stock purchases, and the stability of the distribution in order to develop a firm dividen policy. 

Target distribution ratio is the percentage of net income distributed to the shareholders through cash dividends or stock repurchases; while the target payout ratio is the percentage of net income paid out as cash dividends. As the distribution ratio includes both cash dividends and stock repurchases, the distribution ratio must be higher than the payout ratio.

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.

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. In some cases, when a company has more equity than its target capital structure, the company may issue debt and use the proceeds to repurchase stocks for adjusting its capital structure. A stock repurchase can be also used to protect against takeover attempt. Also, stock options have been given to employees as bonuses and companies repurchase their own stock to ensure sufficient stocks are available when employees exercise the options.

The company makes a public announcement to buy back its own share of stock in the open market that is the most common method. There exist certain daily buy-back limits on the number of shares in open market share repurchases. For instance, the SEC Rule 10b-18, introduced in 1983, dictates that the company cannot repurchase more than 25 % of the average daily trading volume in the US.

The company can repurchase a number of shares through a tender offer in which it offers to buy shares at a specified price.

The company specifies a price range that it is willing to pay, and shareholders offer how many shares they are willing to sell at that specific price range. The company then buys shares from the lowest priced offers. If there are not enough shares offered at the lowest price to accomplish the desired buy-back, the issuer may accept offers from the next higher priced.

The company can repurchase a block of shares at a negotiated price from major shareholders. The most important example is greenmail transactions, in which the shares are repurchased at a large premium over the current market price

The principal advantages of repurchases are as follows;

1. A company can repurchase stock to distribute excess cash without changing the amount of dividends. Because managements are reluctant to increase the dividends unless management is confident in the future. Also, they are reluctant to decrease the dividend because of the negative signal.
2. When a company has more equity than its target capital structure, the company can directly change its capital structure by repurchasing. For instance, a company may issue debt and use the proceeds to repurchase stocks for adjusting its capital structure.
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; therefore when a company engages in the stock repurchase, investors prefer to purchase additional shares.
5. Repurchases have a tax advantage over dividends due to the deferred tax on capital gains.

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. For example, in a declaration of a two-for-one stock split, each old share is split into two new shares, therefore doubling the number of shares outstanding and reducing the par value of each share to one-two of the presplit value.

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.

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. In another words, investors value a dollar of expected dividends more highly than a dollar of expected capital gains as the risk associated with capital gains is higher than that with dividends. Therefore, when a company decides to distribute more dividends, the required rate of return on equity decreases.

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.

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.

Shareholders who desire particular dividend payout policies make an investment in a company that has similar dividend payout policies. If a company change its dividend policy, shareholders who preferred the previous policy will decide to sell their shares to reinvest in another company, forcing the stock price decrease. However, the new dividend payout policy may attract new investors, thereby increasing the stock price. 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

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.

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.

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.

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 management is flexible to retain funds as needed and satisfy shareholders who prefer to get a guaranteed level of dividend payments with this policy.

The factors that affect the dividend decision are discussed as follows: 

1. Constraints on dividend payments 

2. Investment opportunities 

3. Alternative sources of capital

4. Ownership dilution

5. Effects of dividend policy on the cost of common stock equity