Ch5. Dividend Policy — Dividend Decisions and Shareholder Value

What Is a Dividend?

Dividend: A distribution of a portion of a company’s earnings to its shareholders.

Key Dividend Dates:
Record Date:      Shareholders of record entitled to the dividend
Declaration Date: Board of directors votes to pay the dividend
Ex-Dividend Date: Shares bought on or after this date do not receive the dividend
Payment Date:     Dividend is actually paid out

MM Dividend Irrelevance Theory

MM (1961): In a perfect capital market, dividend policy does not affect firm value.

Logic:
Dividend paid → Stock price drops (by dividend amount)
             → Capital gain decreases
             → Total shareholder wealth (dividend + price) is unchanged

Assumptions: No taxes, no transaction costs, perfect information

Why dividend policy matters in the real world:

Real-world factors:
① Taxes: Different rates on dividends vs capital gains
② Signaling Effect: Dividend increase → positive signal about future earnings
③ Agency Problem: Dividends constrain managers from overinvesting free cash
④ Clientele Effect: Some investors prefer dividends (e.g., retirees needing income)

Types of Dividend Policy

① Residual Dividend Policy:
   Pay dividends only from earnings left after funding all positive-NPV projects
   → Theoretically optimal for firm value maximization
   → Results in unstable dividends

② Stable Dividend Policy:
   Maintain a constant dividend regardless of earnings fluctuations
   → Builds investor confidence
   → Paid even when earnings vary

③ Constant Payout Ratio Policy:
   Pay a fixed percentage (payout ratio) of earnings as dividends
   → Dividends vary with earnings

④ Low Dividend + Stock Dividend:
   Minimal cash dividend supplemented with additional shares

Key Dividend Metrics

Dividends Per Share (DPS):
DPS = Total Dividends Paid / Shares Outstanding

Dividend Yield:
Dividend Yield = DPS / Stock Price × 100%

Dividend Payout Ratio:
Payout Ratio = DPS / EPS × 100%
             = Total Dividends / Net Income × 100%

Dividend Coverage Ratio = EPS / DPS

Stock Buybacks vs Cash Dividends

Stock Buyback (Share Repurchase): The company purchases its own shares from the open market.

Cash Dividend vs Stock Buyback:

Cash Dividend:
- Subject to ordinary income tax (qualified dividend rates apply)
- Stock price falls by approximately the dividend amount (ex-dividend drop)
- Provides regular, predictable cash flow to shareholders

Stock Buyback:
- Tax advantage: shareholders control the timing of capital gains recognition
- EPS increases (fewer shares outstanding)
- Flexible: management has discretion over timing and amount
- Can support the stock price

Effect on Stock Price:

In a perfect market, dividends and buybacks have identical effects on total shareholder wealth.
In practice: buybacks often preferred for tax efficiency + positive signaling.

Stock Dividends and Stock Splits

Stock Dividend: Paying shareholders with additional shares instead of cash. Stock Split: Dividing existing shares into a larger number of shares.

Effects:
- Shares outstanding increase; stock price falls proportionally
- Total shareholder wealth unchanged (in a perfect market)
- Improved liquidity: lower per-share price makes the stock more accessible to retail investors

MM Dividend Irrelevance ★★★★★ : In a perfect market, dividend policy is irrelevant to firm value. A larger dividend is exactly offset by a lower stock price. Memory tip: Perfect market → dividend irrelevance

Residual Dividend Policy ★★★★★ : Fund all positive-NPV investments first; pay dividends only from what remains. Theoretically best for firm value but produces unstable dividends. Memory tip: Residual = invest first, dividend from leftovers

Dividend Payout Ratio ★★★★☆ : DPS / EPS × 100%. The fraction of earnings distributed as dividends. Memory tip: Payout ratio = DPS ÷ EPS

Practice Quiz

Q. EPS = $3.00, DPS =$ 0.90. What is the dividend payout ratio?

Payout ratio = $0.90 /$ 3.00 × 100% = 30%

Q. Why is a stock buyback generally more tax-efficient for shareholders than a cash dividend?

Cash dividends are taxed as ordinary income (or at qualified dividend rates) in the year received. With a buyback, any gain is taxed as a capital gain only when the shareholder chooses to sell — allowing deferral of the tax liability and greater flexibility in timing.