Once a company makes a profit, management must decide on what to do with those profits. They could continue to retain the profits within the company, or they could pay out the profits to the owners of the firm in the form of dividends.
Once the company decides on whether to pay dividends they may establish a somewhat permanent dividend policy, which may in turn impact on investors and perceptions of the company in the financial markets. What they decide depends on the situation of the company now and in the future. It also depends on the preferences of investors and potential investors.
Dividends are payments made to stockholders from a firm’s earnings, whether those earnings were generated in the current period or in previous periods.
Dividends may affect capital structure
- Retaining earnings increases common equity relative to debt.
- Financing with retained earnings is cheaper than issuing new common equity.
Dividend Policy and Stock Value
There are various theories that try to explain the relationship of a firm’s dividend policy and common stock value.
Dividend Irrelevance Theory
This theory purports that a firm’s dividend policy has no effect on either its value or its cost of capital. Investors value dividends and capital gains equally.
Optimal Dividend Policy
Proponents believe that there is a dividend policy that strikes a balance between current dividends and future growth that maximizes the firm’s stock price.
Dividend Relevance Theory
The value of a firm is affected by its dividend policy. The optimal dividend policy is the one that maximizes the firm’s value.
Investors and Dividend Policy
Information Content or Signaling
Signaling hypothesis says that investors regard dividend changes as signals of management’s earnings forecasts.
The clientele effect is the tendency of a firm to attract the type of investor who likes its dividend policy.
Free Cash Flow Hypothesis
All else equal, firms that pay dividends from cash flows that cannot be reinvested in positive net present value projects (free cash flows), have higher values than firms that retain free cash flows.
Dividend/Retained Earnings Decision
There are various constraints that may impact on a firm’s decision to pay out earnings in the form of dividends.
- Cash flow constraints
- Contractual constraints
- Legal constraints
- Tax considerations
- Return considerations
Types of Dividend Policies
- Constant Dollar Dividend Policy
- Constant Payout Ratio
- Regular with Extras
The Declaration Date is the date on which a firm’s board of directors issues a statement declaring a dividend.
This is the date on which the company opens the ownership books to determine who will receive the dividend.
This is the date on which the right to the next dividend no longer accompanies a stock, usually two business days prior to the holder-of-record date.
Dividend Reinvestment Plan (DRIP)
A DRIP (Dividend Reinvestment Plan) is a plan that enables a stockholder to automatically reinvest dividends received back into the stock of the paying firm. The plan may either involve the firm repurchasing existing shares or it may involve newly issued shares.
Stock Dividends vs. Stock Splits
Here, the firm issues new shares in lieu of paying a cash dividend. If 10%, shareholders would get 10 shares for each 100 shares of stock owned.
When the board votes a stock split, the firm increases the number of shares outstanding, say 2:1.
This overview was developed by Dr. Sharon Garrison.
No adaptation of its content is permitted without permission.