Revise Lecture 30

Dividend Policies & Decisions

1. Nature of dividend decisions?

2. Why investors want dividends?

3. Three main factors affecting dividends?

4. Constraints in paying dividends?

Factors Affecting Dividend Decision

Nature of Dividend DecisionsA firm’s dividend policies have the effect of dividing the firm’s after tax profit into two categories:1. Funds to finance long-term growth

2. Funds to be distributed to shareholders

Factors Affecting Dividend Decision

Why Investors Want Dividends Most investors expect two forms of return from the purchase of common share:

1. Capital Gains2. Dividends

Factors Affecting Dividend Decision

A number of factors may be analyzed to help explain the investor’s expectation of dividends over capital gains. Perhaps the three major factors are:1. Reduction of uncertainty2. Indication of strength3. Need for current income

Constraints on Paying Dividends

While most firms recognize the investor’s demand for dividends, several factors may restrict the firm’s ability to declare and pay dividends. These are:1. Insufficient cash2. Contractual restrictions3. Legal restrictions

• Alternative Forms Of Dividends

Alternative Forms Of Dividends

In addition to the declaration of cash dividends, the firm has other options for distributing profits to shareholders.These options are the;1. Stock dividend2. Stock split3. Stock repurchase

Alternative Forms Of Dividends

Stock DividendA stock dividend occurs when the board of directors authorizes a distribution of common stock to existing shareholders.This has the effect of increasing the number of outstanding shares of the firm’s stock.

Alternative Forms Of Dividends

Stock DividendFor Example:If a shareholder owns 100 shares of common stock at a time when the firm distributes a 5 % stock dividend, the shareholder receives 5 additional shares.

Alternative Forms Of Dividends

There are several aspects of a stock dividend;

1. Conserves cash2. Indicate higher future profits3. Raises future dividends for investors4. Has high psychological value5. Retain proportional ownership for

shareholders

Stock Dividend

Conserves CashThe stock dividend allows the firm to declare a dividend without using up cash that may be needed for operations or expansion.Rather than seek additional external financing, the firm can retain funds that would otherwise be distributed to shareholders.

Stock Dividend

Indicate higher future profitsNormally a stock dividend is an indication of higher future profits. If the profits do not rise, the firm would experience a dilution of earnings as a result of the additional shares outstanding.Since a dilution of earnings is not desirable, stock dividend are usually declared only by board of directors who expect rises in earnings to offset the additional outstanding shares.

Stock Dividend

Raises future dividends for investorsIf the regular cash dividend is continued after an extra stock dividend is declared, the shareholders receive an increase in future cash dividends.For example, a firm may declare a Rs1 regular dividend and a 5% extra stock dividend. A shareholder with 100 shares receives Rs100 and 5 additional shares. If the firm continues its Rs1 dividend, this investor would receive Rs105, an increase of Rs5, in the next period.

Stock Dividend

Has high psychological valueBecause of the positive aspects of stock dividends, the dividend declaration is usually received positively by the market. This tends to encourage investment in the stock, thus supporting or raising its market price. Instead of experiencing a drop in value after a stock dividend, the price may actually rise.

Stock Dividend

Retains proportional ownership for shareholders

The stock dividend differs from an issue of new common stock. If the existing shareholders do not have the funds to purchase new stock, their proportion of the ownership in the firm will decline as new investors purchase shares.This is avoided by a stock dividend that is, in effect, nothing more than a recapitalization of the firm.

Stock Splits

• A stock split is a change in the number of outstanding shares of stock achieved through a proportional reduction or increase in the par value of the stock. Only the par value and number of outstanding shares are effected. The amounts in the common stock contributed capital and retained earnings accounts do not change.

Stock Splits

• Just as the accounting values in the equity accounts do not change, the market price of the stock will normally adjust immediately to reflect a stock split.

Stock Splits

Several reasons may be offered for the splitting of a firm’s common stock as follows;

1. Reduction of market price of stock2. Indication of growth3. Reverse split

Stock Splits

1. Reduction of market price of stockThe major goal of most stock splits is to reduce the per-share price of a firm’s common stock. A lower price per share makes the stock more affordable in round lots (100 shares) to more investors.

Stock Splits

2. Indication of growthThe firm’s management may use the stock split to inform the market that continued high growth is forecast. The stock of high growth companies would soon sell for several hundred dollars per share if it were not split periodically.

Stock Splits

3. Reverse SplitAn indication of trouble. Instead of increasing the number of outstanding shares of stock, the firm may want to reduce the number. This can be accomplished through a reverse split, which is reduction of outstanding shares. The declaration of a reverse split is an indication that the firm does not have such prospects.

Repurchase of Stock

A repurchase of stock occurs when a firm buys back outstanding shares of its own common stock. Firms repurchase stock for three major reasons;1. For stock options2. For acquisitions3. For retiring the stock

Repurchase of Stock

1. For stock optionA stock option is the right to purchase a specified number of shares of common stock during a stated period and at a stipulated price.Stock options are frequently given to senior officers of a company as an incentive to work to raise the value of the firm.

Repurchase of Stock

2. For AcquisitionsWhen a firm is seeking control of another firm, it may be willing to offer its own common stock for the stock of other firm.In this exchange of stock situation, the firm can repurchase stock to make the acquisition. This allows the takeover without increasing the number of outstanding shares and avoids a dilution of earnings.

Repurchase of Stock

3. For retiring the stockThus increasing earnings per share. When a firm retires a portion of its stock, the retirement increases the firm’s earnings per share.The repurchase of stock for the purpose of retiring it is treated as a form of cash dividend by the internal revenue service.

Repurchase of Stock

• The firm could have distributed dividends with the excess cash.

• Instead, it chose to reduce the number of shares outstanding so that future dividends could be increased. With this motive, the repurchase decision can be treated similarly to a dividend decision.