Dividend Fundamentals

Expected cash dividends are the key return variable from which owners and investors determine share value. Because retained earnings, earnings not distributed to owners as dividends, are a form of internal financing, the dividend decision can significantly affect the firms external financing requirements. At quarterly or semiannual meetings, a firms board of directors decides whether and in what amount to pay cash dividends to corporate shareholders. The past periods financial performance and future outlook, as well as recent dividends paid, are key inputs to dividend decision. Most companies maintain a dividend policy whereby they pay a regular dividend on a quarterly basis. Some companies pay an extra dividend to reward shareholders if theyve had a particularly good year. Many companies pay dividends according to a preset payout ratio, which measures the proportion of dividends to earnings. Relevant Dates: Date of Record: The date on which investors must own shares in order to receive the dividend payment. Ex Dividend Date: Two days prior to the date of record. The day on which a stock trades ex dividend (exclusive of dividends). Distribution Date: The day on which a dividend is paid (payment date) to stockholders. It is usually two or more weeks before stockholders who owned shares on the date of record receive their dividends.

Tax Treatment of Dividends Prior to the passage of the 2003 law, dividends received by investors were taxed as ordinary income at rates as high as 35 percent. The 2003 act reduced the tax rate on corporate dividends for most taxpayers to the tax rates applicable to capital gains, which is a maximum rate of 5 percent to 15 percent depending on the taxpayers tax bracket. Dividend Reinvestment Plans Today many firms offer dividend reinvestment plans (DRIPs), which enable stockholders to use dividends received on the firms stock to acquire additional shareseven fractional sharesat little or no transaction cost. With DRIPs, plan participants typically can acquire shares at about 5 percent below the prevailing market price. From its point of view, the firm can issue new shares to participants more economically, avoiding the underpricing and floatation costs that would accompany the public sale of new shares. Clearly, the existence of a DRIP may enhance the market appeal of a firms share.

Relevance of Dividend Policy

The financial literature has reported numerous theories and empirical findings concerning dividend policy. Although this research provides some interesting insights about dividend policy, capital budgeting and capital structure decisions are generally considered far more important than dividend decisions. In other words, firms should not sacrifice good investment and financing decisions for a dividend policy of questionable importance. Residual Theory of Dividends The residual theory of dividends suggests that dividend payments should be viewed as residualthe amount left over after all acceptable investment opportunities have been undertaken. Using this approach, the firm would treat the dividend decision in three steps as follows: Step 1: Determine the optimal level of capital expenditures which is given by the point of intersection of the investment opportunities schedule (IOS) and weighted marginal cost of capital schedule (WMCC). Step 2: Using the optimal capital structure proportions, estimate the total amount of equity financing needed to support the expenditures estimated in Step 1. Step 3: Because the cost of retained earnings is less than new equity, use retained earnings to meet the equity requirement in Step 2. If inadequate, sell new stock. If there is an excess of retained earnings, distribute the surplus amountthe residualas dividends. In sum, this theory suggests that no cash dividend is paid as long as the firms equity need is in excess of the amount of retained earnings. Furthermore, it suggests that the required return demanded by stockholders is not influenced by the firms dividend policya premise that in turn suggests that dividend policy is irrelevant.