According to Investor Dictionary, corporate finance is the specific area of finance dealing with the financial decisions corporations make, and the tools and analysis used to make the decisions. It may be divided as a whole between long term, capital investments decisions, and short term, working capital. Corporate finance entails many important topics. One important topic is the dividend policy. In order to fully understand dividends, you must know the different types of dividends, how they are paid, and the issues surrounding dividend policy decisions. The term dividend usually refers to cash paid out of earnings (Ross, Westerfield, & Jordan, 2011). It is the portion of corporate profits paid out to stockholders. Dividends usually come in several different forms. The basic types of cash dividends are as follows: regular cash dividends, extra dividends, special dividends, and liquidating dividends. Regular cash dividends are cash payments made directly to stockholders, usually each quarter or four times a year. Extra cash dividends mean that firms sometimes pay the regular cash dividend along with and extra cash dividend. This indicates that the extra amount may not be paid in the future.
Special cash dividends are similar with the extra dividends with the exception that special dividends definitely will not be repeated in the past. Liquidating dividends simply means that some or the entire firm has been sold. A cash dividend can be expressed as either dollars per share, a percentage of market prices, or as a percentage of earnings per share. Dividends payments are made chronologically by declaration date, ex-dividend date, date of record, and date of payment. On the declaration date, the board of directors announces the amount of the dividend and the date of record. The dividend is paid to shareholders who are holders of record as the date of the record. The dividend checks are mailed to these owners on the date of payment. The ex-dividend date occurs two business days before the date of record. If the stock is bought on or after this date, you will not receive the dividend. And the stock price generally drops by about the amount of the dividend. According to Ross, Westerfield, & Jordan, the date of record if based on its records, the corporation prepares a list on January 30 of all individuals believed to be stockholders. These are the holders of records, and January 30 is the date of record (or record date).
The word believed is important here. If you bought the stock just before this date, the corporation’s records might not reflect that fact because of mailing or other delays. Without some modification, some of the dividend checks would get mailed to the wrong people. This is the reason for the ex-dividend day convention. The ex-dividend date convention removes any misunderstanding about who is entitled to the dividend. The date of payment is the date the dividend checks are mailed. Dividend policy is the decision to pay dividends or keep the funds to reinvest in the business. The optimal dividend policy should maximize the price of the firm’s stock holding the number of shares outstanding constant. A decision to increase dividends will increase the cash dividend. It also puts pressure on the current price of the stock. Increasing dividends; however, means reinvesting fewer dollars.
Arguments have been made that dividend policy does not matter. Higher dividends today cannot impact expected dividends in the future, investments, financing, or anything else (Baker, 2009). If dividends can be increased without changing anything else, then a firm would increase in value. However, there is a trade-off between paying higher dividends and doing other things in the firm. The irrelevance argument says that this trade-off is essentially a zero sum game and that choosing one dividend policy over another will not change the stock price. An example is as follows: If a firm pays out dividends of $10,000 per year for the next two years or can pay $9,000 this year, reinvest the other $1,000 into the firm and then pay $11,120 the next year where investors require a 12% return. The market value with constant dividend is $16,900.51 and the market value with reinvestment is $16,900.51.
If the company will earn the required return, it does not matter when the dividend is paid. There are times a firm will favor a low dividend payout and times a firm will favor a high dividend payout. Two reasons for low dividends are taxes and transaction costs. With taxes, dividends were traditionally taxed as ordinary personal income for the calendar year they were received, whereas capital gains are taxed only in the year in which they are realized which is traditionally at a lower tax rate than dividends. A firm can delay this transfer from shareholders by to the IRS by omitting dividends and reinvesting the funds in zero NPV investments. Another option to avoid the dividend tax would be to repurchase stock from shareholders that are willing to sell their shares. Other reasons: flotation costs which are low payouts that can decrease the amount of capital that needs to be raised, thereby lower flotation costs, and dividend restrictions or debt contracts that might limit the percentage of income that can be paid out as dividends (Ross, Westerfield, & Jaffe, 2002).
With transaction costs, individuals who do not want dividends will reinvest them in the firm and incur unnecessary brokerage fee. This problem can be reduced through a dividend reinvestment plan. Another solution is for investors to own mutual funds, where dividends are generally reinvested into the fund at very low transaction costs. A reason for a high payout is desire for current income. Many trust and endowment funds can only spend the dividend portion of returns. In addition, many are allowed only allowed to invest in dividend paying stocks, since these represent the safer, less speculative stocks.
Some individuals will desire high dividend stocks for current income reasons. The transaction costs of creating artificial dividends from low dividend stocks by selling small amounts of stocks at regular intervals for current income can be very expensive. After reviewing dividends and dividend policy, you can conclude that dividends matter and the dividend policy may not matter. Dividends are the value of the stock that is based on the present value of expected future dividends. Dividend policy is the decision to pay dividends versus retaining funds to reinvest in the firm. The statement that if a firm reinvests capital now, it will grow and can pay higher dividends in the future is only a theory.
Baker, H.K. (2009). Dividends and dividend policy. Hoboken: John Wiley & Sons
Inc. Corporate Finance. (2011). Investor dictionary. Retrieved August 21, 2011, from http://www.investordictionary.com/definition/corporate-finance Ross, S., Westerfield, R.W., & Jaffe, J. (2002). Corporate finance. New York: McGraw-Hill. Ross, S., Westerfield, R., & Jordan, B. (2011). Essentials of corporate finance: 2010 custom edition (7th ed.). New York: McGraw-Hill.