Dr. P.V. Viswanath



Economics/Finance on the Web
Student Interest


Dividend Policy
P.V. Viswanath, 1997, 1999, 2000, 2004



Introductory Material

Different types of dividends

  • Cash Dividends: Firms pay out cash to stockholders of the company on a regular basis, usually quarterly.
  • Extra Cash Dividend: An additional cash dividend paid out of cycle.
  • Stock dividend: A dividend paid out in shares of stock
  • Stock split: A stock dividend where the number of shares paid out per original share is much larger. A stock dividend (or a stock split) increases the number of share outstanding.

Dividend Payment Procedure:

Declaration date: The board of directors declares a payment
Record date: The declared dividends are distributable to shareholders of record on this date.
Payment date: The dividend checks are mailed to shareholders of record.

Ex-dividend date: A share of stock becomes ex-dividend on the date the seller is entitled to keep the dividend.   At this point, the stock is said to be trading ex-dividend.  The buyer of an ex-dividend stock is not entitled to the next dividend payment.  For example, a dividend may be declared as payable to stockholders of record on a given Friday. Since three business days are allowed for delivery of stock in a regular transaction on the New York Stock Exchange, the Exchange would declare the stock "ex-dividend" as of the opening of the market on the preceding Wednesday. That means anyone who bought it on or after that Wednesday would not be entitled to that dividend. When stocks go "ex-dividend", the stock tables include the symbol "x" following the name. (Source: http://www.nyse.com

Empirical Characteristics of Dividends:

  • Dividends follow earnings (Lintner's model)
  • Dividends are sticky
  • A firm's dividend policy tends to follow the life cycle of the firm
  Stage 1
Stage 2
Rapid expansion
Stage 3
Mature growth
Stage 4
Funding Needs Limited by size and other infrastructure limits High relative to firm value Moderate relative to firm value Low as projects dry up
Cash flows generated Negative as investments are made Cash flow low relative to firm value Cash flow increases as percentage of firm value Cash flow high relative to firm value
Dividend Policy No dividends
New Stock Issues
No or very low dividends Increase dividends Special dividends
Repurchase stock

Measures of dividend payment:

  • Dividend Yield = Dividend/Price: this ratio tends to be large for firms that are not growing. Hence their stock prices reflect current dividends to a larger extent, rather than expected future dividends. Concomitantly, their P/E ratios are also lower.
  • Dividend Payout Ratio = Dividend/Earnings: this ratio tends to be larger for more mature firms.

Dividend Irrelevance

What does dividend irrelevance mean? Obviously it cannot mean that shareholders don't value dividends. Rather, what it means is that under the right assumptions, shareholders' wealth is unaffected by the dividend decision. It will be easiest to see this by means of an example:


Stellar, Inc. has decided to invest $10 m. in a new project with a NPV of $20 m., but it has not made an announcement. The company has $10 m. in cash to finance the new project. Stellar has 10 m. shares of stock outstanding, selling for $24 each, and no debt. Hence, its aggregate value is $240 m. prior to the announcement ($24 per share).

Consider the following alternatives:

  1. Pay no dividend and finance the project with cash.

    The value of each share rises to $26 following the announcement. Each shareholder can sell 0.0385 (= 1/26) shares to obtain a $1 dividend, leaving him with .9615 shares value at $25 (26 x 0.9615).

    Hence the shareholder has one share worth $26, or one share worth $25 plus $1 in cash.

  2. Pay a dividend of $1 per share, and sell $10 m. worth of new shares to finance the project.

After the company announces the new project and pays the $1 dividend, each share will be worth $25. To raise the $10 m. needed for the project, the company must sell 400,000 (=10,000,000/25) shares. Immediately following the share issue, Stellar will have 10,400,000 shares trading for $25 each, giving the company an aggregate value of 25 x 10,400,000 = $260 m. If a shareholder does not want the $1 dividend, he can buy 0.04 shares (1/25).

Hence, the shareholder has one share worth $25 and $1 in dividends, or 1.04 shares worth $26 in total.

We see that in both cases, the shareholder obtains the same value. When will this be true? Here is a sufficient set of conditions.

Sufficient Assumptions for Dividend Irrelevance

  1. The issue of new stock (to replace excess dividends) is costless and can, therefore, cover the shortfall caused by paying excess dividends.
  2. Firms that face a cash shortfall do not respond by cutting back on projects and thereby affect future operating cash flows.
  3. Stockholders are indifferent between receiving dividends and price appreciation.
  4. Any cash remaining in the firm is invested in projects that have zero net present value. (such as financial investments) rather than used to take on poor projects (i.e. there are no agency costs of outside equity).

Implications of Dividend Irrelevance:

  • A firm cannot resurrect its image with stockholders by offering higher dividends when its true prospects are bad.
  • The price of a company's stock will not be affected by its dividend policy, all other things being the same. (Of course, the price will fall on the ex-dividend date.)

Overview of Reasons for Paying Dividends:

  • Defensible:
    • Dividend Clienteles based on age, tax bracket and income.
    • Signalling
      A manager who perceives his firm's stock price to be undervalued, may choose to increase dividends to signal to the market his belief that the true market value of the stock is higher.  Managers of overvalued firms (bad firms) will not mimic the undervalued firm (good firm) manager's actions because the cost of increasing dividends is much higher for the overvalued firm manager.  For example, bad firms will be more likely to run into liquidity problems with a higher dividend, and are more likely to have to resort to expensive outside financing to pay the higher dividend.
    • Psychological Theories of Dividend Preference
      Dividends and Capital Gains may not be perfect substitutes for each other. A lack of self-control may lead an investor to prefer regular cash fdividends. If the investor must sell stock to get income he might have a tendency to sell too much stock too soon. Hence an investor might choose to invest in a firm that follows a particular type of dividend policy to minimize the total agency costs of shareholding, including the investor's human frailties.
    • Tax and Transaction Clienteles
    • Disciplinary Effects on Managers
      Contracts between the firm and its managers cannot always be designed to take into account all possible contingencies. Hence, managers may sometimes take actions that reduce firm value. For example, it may be in the interest of managers to increase firm size or to unduly reduce the riskiness of the firm in order to reduce the probability of bankruptcy, and increase the present value of their firm specific skills. This may lead them to accept negative NPV projects or to engage in undesirable mergers.

      This may lead some managers to reduce dividends to a suboptimal level. In contrast, managers, who want to assure the market of their desire to maximize firm value by reducing the amount of disposable resources (free cash flow beyond current investment needs) available to them, may choose to increase dividends. By doing so, they force themselves to submit to the discipline of the markets any time that they wish to raise funds to invest in a project. Such credible proof of a manager's unwillingness to take NPV < 0 projects will be rewarded by the market with an increase in the price of the stock.

  • Indefensible:
    • Bird-in-the-hand Fallacy
      This argument, which is often made by naive investors, is that dividends represent cash in hand, whereas reinvesting that cash in the hope of greater dividends in the future is a risky prospect. Hence, shareholders are better off with the dividend.  The proper rebuttal to this assertion is that if cash flows are priced correctly in the market, then the present value of the larger riskier future dividends is equal to the present certain dividend. Any shareholder that decides otherwise can undo the firm's dividend decision.
    • Temporary Excess Cash
      This argument is also faulty.  If the excess is a temporary situation, then paying it out now as dividends will necessitate higher costs of raising funds in the future when it becomes necessary.  It would be preferable to invest it in some short-term liquid asset.

Tax Differentials, Transaction Costs and Clienteles

A simple shareholder preference for dividends will not change the irrelevance of dividend policy because individual shareholders can always create home-made dividends. But there are two conditions under which this conclusion must be modified.

I. If dividends and capital gains are treated differently:

For individual investors, dividends are more heavily taxed than capital gains because of the tax-timing option--the ability for individual investors to postpone the tax liability on capital gains income. Hence individuals may prefer capital gains.

Corporate shareholders pay income tax at a 34% peak marginal rate, but are permitted to claim a 70% dividends-received deduction. Hence the top marginal tax rate on dividend income for a corporation is only (1-.7) x 34 = 10.2%. They have a greater preference for dividends.

Tax-exempt institutions, such as pension funds, do not have a bias in favor of capital gains or dividends.

II. Trading in shares is costly:

A shareholder who desires a high income stream would prefer real cash dividend payments over homemade dividends if the firm can sell new shares more cheaply than the shareholder can sell his/her own shares. Hence such shareholders might prefer firms with a high payout ratio, while other shareholders may prefer firms with a low payout policy.

Consequently, some investors prefer equity income in the form of dividends, while others prefer capital gains.

Clientele Effects and Equilibrium:

Taxes and transaction costs reduce the return to shareholders. Therefore, investors should invest in a company that follows the dividend policy that is optimal for themselves. Thus, a clientele group will be better off if they pay up to some maximum premium for shares of firms that follow their optimal policy. The maximum premium is the additional cost if they invest in the next best company that is otherwise identical but does not follow their optimal policy.

As long as a premium is offered, companies have the incentive to change their policy and sell shares to the clientele group offering the premium. Over time, competition among companies drives the premium to zero. In the aggregate, companies will supply enough of each type of stock so that all the positive-NPVs resulting from dividend policy choices have been extracted and the premiums have been driven to zero. In equilibrium, the marginal gain from changing dividend policy is zero.

But, whenever there are changes in tax laws, or in transaction costs, there may opportunities for firms that are willing to change dividend policies. It may be possible to earn a premium for supplying a dividend policy that is in short supply.

Taxation of Dividends:

Historically, dividends have been taxed at a higher rate than capital gains (except for a short period in 1986). This implies that there are disadvantages to paying dividends compared to capital gains. However, not all shareholders find capital gains more attractive than dividends. Pension funds and other tax-exempt entities do not have any preference for capital gains over dividends, since they are not taxed at all. Stock brokers and dealers who trade for their own account are taxed on both dividends and capital gains at the same rate. Corporations are only taxed on 70% of their dividends, while they pay taxes on all of their capital gains. Furthermore, some investors may prefer dividends over capital gains for reasons of transactions costs. Finally, firms that do not have profitable projects to invest in, will be better off paying out earnings as dividends. Consequently, in equilibrium, different firms might have different payout ratios. One implication of the tax disadvantages of dividends relative to capital gains is that stock prices might not fall by the same amount as the dividend payment:

Suppose to represents the tax rate on ordinary dividends and tcg represents the tax rate on capital gains. Let PB denote the cum-dividend stock price, and PA the ex-dividend stock price, and P the price at which the stock was acquired. Then, for the marginal investor,

PB-(PB-P)tcg = PA-(PA-P)tcg + D(1-to), where the LHS is the after-tax gain from selling the stock cum-dividend and the RHS is the after-tax gain from selling the stock ex-dividend. This yields the relationship . By examining the empirical price drop, one may then infer the marginal tax bracket for holders of the firm's stock. Studies in 1970 found that the difference between the cum-dividend and ex-dividend prices was about 78% on average, and they concluded that there must be a tax clientele effect. They also found that the drop was largest for firms with the highest dividend yields. They argued that this was due to the fact that the investors in these firms were in the lowest tax brackets, as would be predicted by the relationship above. However, consider the possibility of dividend capture, where a low tax bracket investor can buy the cum-dividend stock, obtain the dividends sell it at the ex-dividend price, thus capturing the difference between the theoretical no-clientele effect price drop and the actual price drop.

Here is an example of dividend capture (no recommendation intended)

A Framework for Analyzing Dividend Policy

Factors to be taken into account in determining Dividend Policy:

  • Investment Opportunities: A firm with more investment opportunities should pay a lower fraction of its earnings.
  • Stability of earnings: A firm with more volatile earnings should pay, on average, a lower proportion of its earnings, so that it will not have to cut dividends.
  • Alternative sources of capital: To the extent that a firm can raise alternative capital at low cost, it can afford to pay higher dividends
  • Degree of financial leverage: If a firm has high leverage, it will probably also have covenants restricting the payment of dividends. Furthermore, to a certain extent, dividends and debt can be considered substitutes for the purpose of manager discipline.
  • Signalling incentives: To the extent that a firm can signal using other less costly means, for example debt, it should pay lower dividends.
  • Stockholder Characteristics: If a firm's stockholders want higher dividends, it should provide them.

In analyzing dividend policy, two questions need to be answered:

  • How much cash is available to be paid out as dividends?
  • How good are the projects available to the firm?

The funds available to be paid out as dividends are essentially equal to free cash flow to equity (FCFE), where FCFE = Net Income - (Capital Expenditures - Depreciation)(1- Debt Ratio) - change in Non-cash Working Capital (1-Debt Ratio).

If FCFE greatly exceed Dividends, the CFO must check to see how funds are being invested. If the actual rate of return (accounting rate of return) is greater than the required rate of return, then the NPV or projects is positive. Then, if other such NPV>0 projects are available, the excess FCFE should be employed in those projects; if not, it should be redistributed to stockholders, unless the excess slack is necessary to hedge against uncertainty or to smooth dividends.
If the actual rate of return is low relative to the required rate of return, then investment is unprofitable; it would make sense, then, that investment should be reduced and dividends increased.

On the other hand, if FCFE is much lower than the amount of dividends paid, dividends should be cut. If the rate of return on equity is greater than the cost of equity, the released funds should be invested in new projects and if funds are inadequate, funding should be sought from elsewhere. If projects are unprofitable, investment should be reduced.

  FCFE>>Dividends FCFE<<Dividends
ROE>Cost of Equity Good Projects
No Change
Good Projects
Cut Dividends
Invest in Projects
ROE<Cost of Equity Poor Projects
Increase Dividends
Reduce Investment
Poor Projects
Cut Dividends
Reduce Investment

However, the analyst should be careful to ensure that the accounting numbers are not incorrect or misleading.

Setting Dividends

The following are some important steps in the determination of a dividend policy:

1. Estimate Future Residual Funds (FCFE): Project the firm's operating cash flows and capital expenditure needs over a reasonable time horizon, say 5 years.

2. Determine Feasible Payout Ratios: Taking into account available future free cash flow, flotation costs of new security issues, and cash flow uncertainties, determine a range of feasible target payout ratios.

3. Set Target Payout Ratio: Analyze payout ratios of comparable firms (those in the same industry and of similar size and with similar product mix and other operating characteristics) and special shareholder mix considerations and set long-term target payout ratio.

4. Set Quarterly Dividend Rate: Because of the informational content of dividends, a fluctuating regular dividend is undesirable; such a policy may also lead to shifts in the shareholder clientele and reduce firm value. Given target payout ratio and cash flow projections, set quartely dividend rate at highest sustainable level.

Dividend Policy and Leverage

Many of the same factors that affect capital structure also affect dividend policy.  (See exercises.)

However, in addition to this, there maybe some interactions between dividend policy and capital structure.  For example, it is possible to pay out more in dividends than the amount of FCFE for a while, by borrowing. This would be desirable if the firm is underlevered. On the other hand, if the firm is overleveraged, then it may be desirable to use FCFE to repay debt, and bring leverage back into line.

The Share Repurchase Alternative

Irrelevance Under Perfect Capital Markets

The value of the shareholders' wealth is not affected by share repurchases, if capital markets are perfect. This can be seen in the following example:

Buttle Wilson and Co. has $50 m. available for distribution. Buttle has 10 m. shares outstanding. It expects to earn $2.50 a share, and the current market value per share is $25. The firm has unused cash that could be used to pay a cash dividend of $5 per share, implying an ex-dividend value of $20 per share.

Alternatively, the firm could use the $50 m. to repurchase 2 m. shares ($50,000,000/$25). Following the share repurchase, each share would be worth

Thus, as long as the firm repurchases the shares at the market price of $25, a shareholder who does not sell will have the same wealth as a shareholder who does sell--$25. The difference is that the former has it in stock, the latter in cash.

If Buttle paid the $5 dividend, every shareholder would have their wealth in the same form--$5 in cash plus $20 in stock.

Impact of share repurchases on EPS:

Following the distribution of the $50 m. whether through a stock repurchase or through a dividend payment, the firm's shares will trade at a P/E ratio of 8 (= $20/$2.50).

Neither the firm's capital structure nor its capital investment policies are affected by the method of cash distribution; hence the risk-return tradeoff is the same.

Under the dividend alternative, the EPS is unchanged at $2.50, because the $50 m. paid out were unused, and the number of shares is unchanged. Each shareholder gets (EPS x P/E = $2.50 x 8 =) $20 + $5 = $25 in total value.

Under the share repurchase alternative, the projected EPS is higher at

However, shareholder value is (EPS x P/E =) $3.125 x 8 = $25, once again. The higher EPS is exactly offset by the drop in the P/E ratio from ($25/2.5 =) 10 before the stock repurchase to 8 afterwards.

The confusion over the impact of share repurchases results from the mistaken view that share repurchase will not alter the P/E ratio. But paying out cash results in a riskier firm and hence the P/E ratio must drop (the required rate of return must rise).

Reasons for share repurchase in an imperfect market:


Tax considerations:

Gains to individual shareholders from share repurchases are taxed at the capital gains rate, which is usually smaller than the tax rate on cash dividends. However, a regular policy of repurchasing shares could be disallowed by the IRS for favorable capital gains treatment.

Eliminate Small Shareholdings:

The cost of servicing a small shareholder account is roughly the same as that of servicing a large shareholder account. Hence repurchasing shares of small stockholders could reduce overall stockholder service costs.

Increase Leverage:

If the firm wishes to increase debt in its capital structure, it could borrow funds and use the proceeds to repurchases shares or offer it sshareholders the opportunity to exchange their shares for a new debt issue.

Exploit Perceived Undervaluation:

If a firm's stock is perceived by the management to be undervalued, repurchasing shares at a favorable price could increase the wealth of the firm's remaining shareholders. However, if investors believe that the share repurchase is being undertaken for this purpose, share prices will jump to reflect market belief in a higher share value. If so, the true wealth of the firm's remaining shareholders would not increase; however, the market value of their shareholdings will increase, which can be valuable for shareholders who desire liquidity.


Consolidation of Insider Control:

Firms sometimes purchase stock from contentious minority stockholders, sometimes at a premium (greenmail).  At other times, they may do so to reduce public float--to reduce the percentage of stock held by persons not affiliated with the insider group.

Protection against Takeovers

Stock repurchases may also be designed to reduce the attractiveness of the company as an acquisition candidate, thus enhancing management's security.

These objectives may not be consistent with firm value maximization.


  1. Go to Hoover's Online and select firms that have zero dividend yield.  Set the required beta between -0.5 and 100 and the debt/equity ratio between 0 and 100 as well.  Can you find a connection between the two?  Explain.  Follow-up the exceptions and explain them.

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