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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 ofinternal

financing, the dividend decision can significantly affect the firms externalfinancing 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 dividendpayment.

Ex Dividend Date: Two days prior to the date of record. The day on which a stock trades exdividend (exclusive of dividends).

Distribution Date: The day on which a dividend is paid (payment date) to stockholders. It isusually 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

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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 thatdividend policy is irrelevant.