DIVIDEND POLICY
A dividend policy is the guideline a firm uses regarding the declaration of dividends.
Whether dividends should be declared or not is discretionary , i.e., it depends on the
management prerogative of the board of directors.
According to Shim (2006), a firm’s dividend policy is important for the following reasons:
1. It influences the attitude of investors. For example, the stockholders look
favorably upon a corporation whose dividends are cut, since they associate the
cutback, with corporate financial problems. Furthermore, in setting a dividend
policy, the management must ascertain and fulfill the objectives of the company
owner/s. Otherwise, the stockholders may sell their shares which may bring
down the market price of the stocks. In some cases, stockholders dissatisfaction
may lead to the seizure of control of the company by an outsider.
2. It impacts the financing program and capital budget of the firm.
3. It affects the firm’s cash flow position. A company with a poor liquidity position
may be forced to restrict dividend payments.
4. It lowers the stockholders’ equity, since dividends are paid from the retained
earnings. As such, the debt-to-equity ratio will be higher.
Important Date of Dividends
In the declaration of dividends, four dates are considered:
1. The declaration date which is the date when the company declares the
dividends.
2. The ex-dividend date which is the date when the stockholders are no longer
entitled to receive dividends. The ex-dividend date starts two days before the
record date. For instance, if the record date is March 31, stockholders who
bought the stock on March 29 are no longer entitled to the dividends, therefore,
the previous stockholders will receive them.
3. The record date which is the cut-off date for the stockholders who will receive the
dividends. This date specifies which stockholders are entitled to receive the
dividends, i.e., individuals or firms that purchased stocks prior to this date.
4. The payment date which is the date when the dividends are to be paid.
Example:
An example of a normal dividend announcement is as follows:
“The Board of Directors, at their meeting on December 31, 2019, declared a dividend of
Php10 per share, payable March 31, 2020, to the stockholders of record as of January
31, 2020”.
The pertinent dates are:
Date of declaration December 19, 2019
Date of record January 31, 2020
Date of payment March 31, 2020
Tax Treatment of Dividends
Dividends are taxed at a person’s individual tax rate while capital gain taxes are
assessed according to the length of time an investor holds his investment. The tax rate
charged on the capital gain can be as low as half the rate imposed on the dividend
income. If the stock to be sold is not listed in the Philippine Stock Exchange, the capital
gain is subject to a final tax of 5% for gains not exceeding Php100,000 and a final tax
of 10% for gains exceeding that amount. The sale of shares which are listed in and sold
through the Philippine Stock Exchange are subject to the stock transaction tax imposed
at the rate of ½ of 1 percent of the gross selling price. The difference in tax treatment is
one of the reasons why so many investors prefer to have an intact equity investment
rather than receive dividends.
Stockholders receiving a hefty income prefer a low dividend-payout ratio. In this way,
they avoid double taxation and even compound their wealth at a faster rate.
There is a significant controversy surrounding the profits paid out as dividends because
they are subject to double taxation. The firms pays income taxes on the profit it earned
and the stockholders who receive the dividends from the firm are taxed at their
personal income tax rates. In effect, they pay the government twice.
Dividend Reinvestment Plan
The dividend reinvestment plan (DRIP) is plan where the stockholders are allowed to
use the dividends they receive to acquire additional shares of stock of the company
without having to go to the process of buying the stocks from the stockbroker.
A DRIP helps enhance the market appeal of the firm’s shares. Moreover, the
stockholder benefits from reinvesting the dividends without incurring, or incurring only
minimal , floatation costs since they can buy stocks directly from the company.
In this scheme, the stockholders can also acquire stocks at around 5% below the
prevailing market price.
Factors Affecting Dividend Policy
A firm’s dividend policy depends on many variables as follows:
1. Legal Constraints
There are legal prohibitions imposed on corporations from paying out dividends
sourced from the firm’s legal capital. The legal capital is the portion of the paid -in
capital arising from the issuance of capital stock which cannot be returned to the
stockholders in any from during the lifetime of the corporation. The legal capital is
established to provide a sufficient equity base that will protect the interest of the
creditors. For a par value stock, the legal capital is the total par value of the stocks
issued and subscribed while for a no-par value stock, the legal capital is the total
payments received from the stockholders including excess over the stated value.
Retained earnings in excess of the stockholders’ paid in capital should be declared
as dividends. One of the reasons why firms let the retained earnings exceed its paid-
in capital is to protect the stockholders from the payment of personal income taxes.
Example:
The stockholders’ equity of MPC Corporation revealed the following information on
December 31, 2019.
Preferred stock, Php50 par Php 1,150,000
Additional paid in capital-PS 115,000
Common stock, Php20 par 7,000,000
Additional paid in capital-CS 1,750,000
Retained earnings 2,000,000
How much is the legal capital of MPC Corporation? How much is the maximum cash
dividend that it can declare?
Answer:
Legal Capital
Preferred stock, Php50 par Php 1,150,000
Common stock, Php20 par 7,000,000
------------------------
Php 8,350,000
===============
Maximum Dividends that can be declared:
Additional paid in capital-PS Php 115,000
Additional paid in capital-CS 1,750,000
Retained earnings 2,000,000
--------------------------
Php 3,865,000
===============
However, if the preferred stock and the common stock are no par-value stock, the
legal capital is Php10,015,000 (Php1,150,000+Php115,000+
Php7,000,000+Php1,750,000) while the maximum amount of dividend that it can
declare is Php2,000,000.
2. Contractual Constraint
The ability to pay dividends is sometimes restricted by provisions or covenants that
form part of loan agreements. These are impositions made by the banks or other
financial institutions which limit or avoid the declaration of dividends so as not to
impair loan payments. In some cases, firms are only prohibited from declaring
dividends until a certain level of earnings has been reached or if the firm exceeds
certain ratios as stipulated in the contract.
3. Internal Constraints
The liquidity of the company is to be considered. The ability to pay dividends is
constrained by that amount of excess cash available rather than the level of retained
earnings against which they are charged. In this regard, companies are not
restricted from paying dividends to stockholders as long as the dividends to be
declared will not exceed its retained earnings. However, declaring dividends through
borrowings may not be advisable due to cost borrowing.
4. Growth Prospects
The financial requirements of the firm are directly related to the anticipated degree of
asset expansion. A greater amount of financing is needed to support its asset
expansion by maintaining a higher rate of reinvestment income.
If a company is aspiring to achieve a certain growth rate, the most efficient way of
attaining it is through payment of small dividends or non-declaration of dividends.
The retained earnings must be kept intact or have a high retention value to finance
capital investments.
5. Owner Considerations
The dividend policy should have a positive effect on the wealth of the majority of
owners. Some of the key considerations are the following:
a. The tax status of the owners. If the stockholders have sizable income, firm may
decide to have a small dividend pay-out ratio to let the stockholders defer the
payment of taxes until they sell their stocks . cash dividends are taxed based on
the final tax, therefore, stockholders will benefit more from delaying the tax
payments rather than availing of a lower tax rate. However, low-income
stockholders prefer a high dividend pay-out ratio.
b. The stockholders’ investment opportunities. Stockholders that have potential
investment opportunities outside the firm favor a high dividend-payout ratio. In
this way, stockholders can maximize the growth potential of their investments.
However, if a firm can match the investment opportunities outside it by having
projects yielding a high return, a lower payout ratio is justified.
c. The potential dilution of ownership. A high dividend payout ratio means that more
external financing is needed. If the firm issues new shares of stock, the shares
will be diluted. By minimizing the dividend-payout ratio, the possible dilution of
ownership is limited. It is advisable that if external financing cannot be avoided,
the issuance of long-term liabilities should be done to avoid dilution.
d. Fears of takeover. The stockholders who want to issue additional shares of
stocks may opt to device a dividend policy to retain either all or a huge part of
the retained earnings. The issuance of additional shares of stock may lead to a
possible takeover. To avoid this scenario, internal financing is done.
6. Market Considerations
a. Shareholders value fixed or increasing level of dividends as opposed to
dividends whose amounts fluctuate.
b. Shareholders also value a policy of continuous dividend payments.
c. Stable and continuous payments (rather than fluctuating dividends over time) are
a sign of good financial health. A fluctuating dividend may send the wrong signal
in the market, making investors reluctant to invest.
d. A firm which does not have access to the financial market, tends to rely on its
internal funding through the retention of retained earnings.
Forms of Dividends
Dividend are paid in different forms:
1. Cash dividends
2. Stock dividends
3. Stock splits
4. Stock repurchases
Cash dividends
These dividends are cash directly paid to stockholders based on a certain percentage or
amount per share in the company.
Example:
The dividend is Php1.25 per share, so if a stockholder has 10,000 shares, he/she is
entitled to receive Php12,500.
Stock Dividends
A stock dividend is a kind of payment to the stockholders of a firm, usually in the form of
common or preferred stock (own stock).
Example
Common stock, Php100 par, 20,000 shares authorized, 10,000 shares issued and
outstanding have a market value of Php120 per share. The board of directors declared
a 15% sock dividend.
Before the stock dividend After the stock dividend
10,000 shares 11,500 shares
X Php120 x Php104.3478
------------------------------------ ---------------------------------
Php 1,200,000 Php 1,200,000
===================== ===================
Since every stockholders receives additional shares, and since the corporation is not
better off after the stock dividend, the value of each share decreases. In other words,
since the number of stockholders is the same before and after the stock dividend, the
total market value of the corporation remains Php1,200,000. However, because there
are 15% more shares outstanding, each shares drops in value to Php104.3478. With
each stockholder receiving a percentage of the additional shares and the market value
of each share decreasing in value, each stockholder ends up with the same total
market value as before the stock dividend.
Stock Splits
A stock split is a corporate action that increases the number of the corporation’s
outstanding shares by dividing each share. The stock’s market capitalization, however,
remains the same, just as the value of the Php100 bill does not change if it is
exchanged for two Php50s. For example, with a 2-for-1 stock split, each stockholder
receives an additional share for each share held, but the value of each share is reduced
by half; two shares are now equal to the original value of one share before the split.
Stock Repurchase
A stock repurchase is a process in which a firm buys its own shares. In some
countries , a firm can repurchase its own stocks by distributing cash to existing
shareholders in exchange for a fraction of the company’s outstanding equity. The
practical motives for acquiring back its own shares include the retirement of the stocks,
enforcement of employee stock option plans, and avoidance of possible takeover.
Acquiring its own stocks reduces the shares outstanding ad it becomes more expensive
to individuals who plan to take over the company. The company may also repurchase
shares for the purpose of keeping them as treasury stock. When the time comes, these
shares may also available for re-issuance.
EXERCISES:
1. In 2019, Akbay Ltd. Had a net income of Php5,000,000 and 2,000,000 shares of
common stock outstanding. The company’s stock currently trades at Php30 a
share. For the year 2020, Akbay plans to use its available cash o repurchase
50% of its shares in the market. The planned repurchase has no effect on the net
income or the company’s price-to earnings (P/E) RATIO. What is the expected
stock price after the stock repurchase of Akbay Ltd?
Repurchase: 50% x 2,000,000 = 1,000,000 shares
Repurchase amount: 1,000,000 shares x Php30 = Php3,000,000
Old New
EPS Php5,000,000/2,000,000 Php5,000,000/1,0000,000
Php2.50 Php5.00
PE ratio (old) Php30/Php2.50
12x
New Price of Stock Php5 x 12
After repurchase Php60
