DIVIDENDS



Dividends and stock repurchases are the two major ways that corporations can distribute cash to their shareholders. Dividends may also be distributed in the form of stock (stock dividends and stock splits), scrip (a promise to pay at a future date), or property (typically commodities or goods from inventory). By law dividends must be paid from profits; dividends may not be paid from a corporation's capital. This law is designed to protect the corporation's creditors and is known as the impairment of capital rule, which states that dividend payments may not exceed the corporation's retained earnings as shown on its balance sheet.

Companies usually pay dividends every quarter, or four times per year. When the company is about to pay a dividend, the company's board of directors makes a dividend announcement that indicates the amount of the dividend, the date of record, and the date of payment. The date the dividend announcement is made is known as the declaration date.

The date of record is significant for the company's shareholders. All shareholders on the date of record are entitled to receive the dividend. The exdividend date is the first day on which the stock is traded without the right to receive the declared dividend. All shares traded before the ex-dividend date are bought and sold with rights to receive the dividend, or cum dividend. Since it usually takes a few business days to settle a stock transaction, the exdividend date is usually a few business days before the record date. On the ex-dividend date the trading price of the stock usually falls to account for the fact that the seller rather than the purchaser is entitled to the declared dividend.

A company's dividend policy involves deciding whether to distribute a certain amount of earnings to the company's shareholders or to retain them for reinvestment. Dividend policy is influenced by a number of factors that include various legal constraints on declaring dividends (bond indentures, impairment of capital rule, availability of cash, and penalty tax on accumulated earnings) as well as the nature of the company's investment opportunities and the effect of dividend policy on the cost of capital of common stock. Most firms have chosen to follow a dividend policy of issuing a stable or continuously increasing dividend. Relatively few firms issue a low regular dividend and declare special dividends when annual earnings are sufficient.

The effect of a company's dividend policy on the value of the company is a field of ongoing investigation and study. In 1961 Franco Modigliani (1918-) and Merton Miller (1923-) published a classic study that demonstrated that a company's dividend policy has no effect on its value under a certain set of assumptions: there are no taxes on dividends or capital gains; there are no transaction costs associated with buying or selling securities; all investors have the same information as the managers of the firm; and the firm's investment policies are fixed and known by investors. With those assumptions the authors analyzed the dividend policies of various firms and concluded that investors could create their own dividends simply by selling shares of stock instead of holding them.

Subsequent research into dividend policies has focused on removing one or more of Modigliani and Miller's assumptions. In the real world, of course, there are taxes and transaction costs associated with buying and selling securities and receiving dividends or capital gains. It is also evident that financial managers and stock analysts appear to be concerned about dividends and their effect on stock prices. After more than 30 years of research and study, though, there is little or no agreement as to the effect of dividend policy on the value of the firm.

[ David P. Bianco ]



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