You are the chief executive officer (CEO) of a start-up technology firm. The firm expects small profits but significant growth over the next few years. The firm has asked your opinion on a dividend policy for the firm. Provide your opinion on a dividend policy along with reasoning using terminology discussed in the unit lesson or the textbook. When responding to your peers, select a variable they may not have thought about pertaining to the dividend policy, and explain how it might impact the policy.
FIN 6302, Advanced Financial Management 1
Course Learning Outcomes for Unit IV Upon completion of this unit, students should be able to:
4. Outline factors that affect a firm’s dividend policy. 4.1 Examine dividend policy theories. 4.2 Examine the theories from a stockholder perspective. 4.3 Evaluate the signaling impact of dividends.
Course/Unit Learning Outcomes
4.1 Unit Lesson Chapter 14 Unit IV Essay
4.2 Unit Lesson Chapter 14 Unit IV Essay
4.3 Unit Lesson Chapter 14 Unit IV Essay
Required Unit Resources Chapter 14: Dividends and Dividend Policy
Unit Lesson This unit’s background and main premise are very similar to the last topic on capital structure. For that topic, we placed a great deal of emphasis on determining whether or not the capital structure decision impacted the value of the firm. More specifically, we questioned if capital structure would impact the worth of the stock. In this unit, we examine if the value of a stock is affected by dividend cash flows. It is important to note up front that rather than being about the actual cash flow itself, it is more about the signal that is being sent by the decision to pay or, more importantly, the decision to stop paying dividends. Although dividend policy may impact the wealth maximization of the company, it is not as important in shaping the long-term future of the company as capital budgeting and capital structure decisions. Receiving regular dividends is very important to some investors, and they will seek the companies that pay a regular dividend to shareholders. Therefore, a company’s dividend policy can affect its ability to attract certain investors. Dividends A dividend is the distribution of earnings to shareholders of a corporation. To get a good sense of dividends, let’s compare dividends to profit distributions in other forms of business. In a sole proprietorship, all profits from the business go directly to the owner automatically and are taxed on the owner’s personal tax return. In a partnership, the profits are divided among the partners and are taxed on each partner’s individual tax return. But in a corporation, because the company is a legal entity that is taxed at the business level, the profits are not automatically distributed to the owners as they are in a sole proprietorship or partnership. The profits can remain in the corporation without being distributed. When the profits remain in the company, they are represented in an account known as retained earnings. When the profits are distributed directly to stockholders, they are called dividends.
UNIT IV STUDY GUIDE
FIN 6302, Advanced Financial Management 2
UNIT x STUDY GUIDE
Dividend Payments When the board of directors of a corporation declares a dividend, all stakeholders take note. The stockholders want to know how much money they can expect in the mail and when it will arrive. The potential new investors want to see a trend in the company’s dividend payments to determine if the company’s dividend policy matches their own needs. The creditors of the company want to determine if the company has enough cash to make the dividend payment and meet its debt obligations. And finally, management of the company wants to send a positive message to these constituents. Payment of Dividend There are some dividend policy theories that support dividend irrelevance. These theories suggest that paying dividends does not impact the wealth maximization focus of companies. Proponents of dividend irrelevance believe that the company should focus on using its profits on investment opportunities that increase shareholder value. On the other hand, there are dividend policy theories that support dividend relevance. These theories suggest that stockholders believe receiving the dividend payment today is less risky than waiting for a possible increase in share price or the company investing in a project that may not provide the return that was calculated. Since companies continue to pay dividends, we will focus on the dividend relevance side of these theories and continue our discussion on dividend policy. Clearly, dividends matter in the world of finance. With that in mind, firms spend a great deal of time determining their philosophy or system of paying dividends. This system is referred to as dividend policy. Your textbook provides an interesting example of Apple’s dividend experience and how that affected Apple’s stock price. For every situation like that, one could easily find a similar situation where the outcome would be different. Although it is purely the decision of the individual firm, and although it has total autonomy in how it treats dividends, many companies do so in a similar fashion. The most common dividend policy in the United States is a regular cash dividend, which is paid quarterly. Dividend Recipients There are several key dates associated with cash dividends.
The date when dividends are declared by the board of directors is called the declaration date.
The date that the corporation will prepare the list of investors to whom dividend payments will be made is called the date of record.
The date that clarifies who receives the dividends if a sale occurs close to the date of record is called the record date.
The date that is 2 days before the date of record is called the ex-dividend date (Chen, n.d.).
Two more items to note concerning the dates associated with dividends are that if the stock is sold 2 days or less before the date of record, the seller gets the dividend, and if the purchase is made at least 3 days prior to the date of record, the buyer gets the dividend (Chen, n.d.). Based on these facts, an important question for stockholders concerns who gets the dividend. The date of record and the ex-dividend date answer that question. All shareholders on the date of record are entitled to receive the dividend. The ex-dividend date is the first day on which the stock is traded without the right to receive the declared dividend. All shares traded before the ex-dividend date are bought and sold with rights to receive the dividend (Ben-David, 2010).
FIN 6302, Advanced Financial Management 3
UNIT x STUDY GUIDE
Dividend Theories Firms develop dividend policies that are consistent with their long-term strategic plan. There are some important characteristics of dividend policies that are important to shareholders.
Perhaps the most important aspect of dividend policy is that the firm maintains a level of predictability.
Stockholders who prefer dividend-paying stocks prefer a continuous stream of fixed or increasing
Shareholders also view the firm’s dividend payment as a signal of the firm’s prospects.
Fixed or increasing dividends are often considered a positive signal, while erratic dividend payments are viewed as negative signals.
An interesting extension of this topic is the scenario revolving around stock repurchases. While it is not technically a dividend, a firm can opt to repurchase its own stock. When it does so, it reduces the total number of shares outstanding. There has been evidence that stock repurchases have actually led to a rise in stock prices when firms make the decision to repurchase their shares (Nath, 2016). In general terms, institutional investors hold the philosophy that a repurchase announcement indicates that the leadership of the firm possesses the opinion that the company’s stock is undervalued. Management believes that this undervalued state sends a message to the market. They believe that this is a positive signal, and that this signal ultimately leads to an increase in stock price. Much like capital structure, there are theoretical questions concerning whether dividend policy impacts firm value. Modigliani and Miller (1958) stated that dividend policy does not matter when considering the value of the firm because an investor can create “homemade” dividends that replicate the cash flows associated with dividends. However, competing theories have arisen. Signaling theory: This theory states that if firms pay dividends, they are signaling strong future earnings. Dividend announcements can contain information about future performance. Under the assumption that managers possess inside information about their firm’s future performance, they may use various signaling devices to convey information to the market. The theory is that dividends are one of the tools used for signaling information. As a result, a big question is whether managers use dividends as a tool to convey information to the market. More importantly, this theory affects such areas as the financial structure of the firm, the flow of liquid funds, liquidity, and investor satisfaction. Not only do managers show extra care in their payout decisions, especially in changing payout decisions, but also the markets react strongly to dividend changes and, more so, to dividend omissions and initiations. The article “Signaling Theory of Dividends” by Andrew Simiyu (2014) sheds further insights on the controversy regarding the information content of dividend changes about future profitability. Dividend preference theory: This theory holds that different investors have different preferences on dividends, and their investment is an indication of those preferences. When given the choice between receiving a dividend versus having a capital gains opportunity, those who prefer dividends will be willing to pay a premium. Another slant on this theory is that these types of investors would be more willing to pay the tax on dividend income, versus having to pay a lower tax on capital gains. They would obviously have to wait for the future on these capital gains. There also is no guarantee that the decisions made by the firm with reinvested funds would lead to the anticipated gains. For these two reasons, this scenario is also called the tax preference theory or the bird-in-the-hand theory (Cotton, 2019). Agency theory: In reality, the tax code has a big impact on how dividends are valued by investors. In today’s tax code, dividends are taxed at the same preferential rate as long-term capital gains. This has resulted in greater demand for dividend-paying stocks. When earlier tax laws did not give preferential treatment to dividends, many investors preferred not to receive dividends because it increased the investor’s taxable income.
FIN 6302, Advanced Financial Management 4
UNIT x STUDY GUIDE
Recent Trends Some recent trends we see in dividend policy are listed below.
Fast-growing companies may decide not to pay a dividend and reinvest the funds in the firm. If the company decides it can earn a higher return by reinvesting the dividends rather than distributing them, it may increase shareholder wealth by more than the distribution.
Slower-growing companies with positive cash flows are more likely to pay out dividends.
Dividends can come in the form of cash payments or stock repurchases.
When the economy is weakening or is in a recession, a firm may slow share buybacks but may decide not to cut cash dividend payments.
Although we have explored many distinct theories for how firms deal with this topic, corporations in general tend to have conservative approaches to dividend payout. Empirical evidence points to the fact that the long- term stability of cash flows greatly impacts how firms behave in this arena. In general, earnings fluctuate much more than dividends as firms realize the signaling power of dividend decisions.
References Ben-David, I. (2010). Dividend policy decisions. In H. K. Baker & J. R. Nofsinger (Eds.), Behavioral finance:
Investors, corporations, and markets (pp. 435–452). Hoboken, NJ: Wiley. Chen, J. (n.d.). Lintner’s model. Retrieved from https://www.investopedia.com/terms/l/lintnersmodel.asp Cotton, D. (2019, March 28). The mystery of dividend preference and the ‘spend dividends only’ strategy.
Forbes. Retrieved from https://www.forbes.com/sites/dirkcotton/2019/03/28/the-mystery-of-dividend- preference-and-the-spend-dividends-only-strategy/#3de6744a4732
Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment.
The American Economic Review, 48(3), 261–297. Nath, T. (2016). Stock buybacks: Their benefits and drawbacks. Retrieved from
https://www.nasdaq.com/article/stock-buybacks-their-benefits-and-drawbacks-cm612997 Simiyu, A. (2014, July 31). Signaling theory of dividends. Journal of Behavioral Finance. Retrieved from
https://www.researchgate.net/publication/264348412_SIGNALING_THEORY_OF_DIVIDENDS Yanvarat, R. (n.d.). Events calendar (ID 104124790) [Photograph]. Retrieved from
Suggested Unit Resources
In order to access the following resources, click the links below. The following article explores the pros and cons of stock repurchases from the perspective of the corporation. You must go to the NASDAQ home page and then search for the following article by placing the article title in the website’s search box. The article will appear in a list of articles. Nath, T. (2016). Stock buybacks: Their benefits and drawbacks. Retrieved from https://www.nasdaq.com/ The article below takes a deeper dive into the background of how dividend decisions send a signal to the investing public. Simiyu, A. (2014, July 31). Signaling theory of dividends. Journal of Behavioral Finance. Retrieved from
FIN 6302, Advanced Financial Management 5
UNIT x STUDY GUIDE
Learning Activities (Nongraded) Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit them. If you have questions, contact your instructor for further guidance and information. Review key concepts from this unit by answering the questions in the following activity: Unit IV Check for Understanding.