Introductory Corporate Finance: Dividend Policy Dividend Policy in Practice Residual Dividend Policy StableConstant Dividend Policy Constant Payout Ratio Low Regular Plus Extra

What This Is

Dividend policy refers to a company's decision on how to distribute its earnings to shareholders. This decision affects the company's financial performance, investor expectations, and overall market value. For instance, consider Tesla, Inc., which has consistently paid a relatively low dividend of $0.12 per share. This decision reflects the company's focus on reinvesting its earnings in growth initiatives, such as expanding its electric vehicle production and battery technology.

Key Formulas & Models

• Dividend Payout Ratio = (Dividends / Earnings Before Interest and Taxes (EBIT)) – measures the proportion of earnings paid out as dividends.
  • Dividends: the amount of cash distributed to shareholders.
  • EBIT: the company's earnings before interest and taxes.
• Residual Dividend Model = (1 - Retention Ratio) × Earnings – calculates the residual dividend as a proportion of earnings retained.
  • Retention Ratio: the proportion of earnings retained by the company.
  • Earnings: the company's net income.
• Constant Payout Ratio Model = (Payout Ratio × Earnings) – calculates the constant dividend payout as a proportion of earnings.
  • Payout Ratio: the proportion of earnings paid out as dividends.
  • Earnings: the company's net income.
• Low Regular Plus Extra Dividend Model = (Regular Dividend + Extra Dividend) – calculates the total dividend payout as a combination of regular and extra dividends.
  • Regular Dividend: the fixed dividend amount.
  • Extra Dividend: the additional dividend amount paid out in excess of the regular dividend.
• Sustainable Growth Rate = (ROE × (1 - Retention Ratio)) – measures the company's long-term growth rate.
  • ROE: the company's return on equity.
  • Retention Ratio: the proportion of earnings retained by the company.
• Dividend Irrelevance Theorem = (DOL = 1) – states that the value of the firm is independent of its dividend policy.
  • DOL: the degree of operating leverage.
• Bird-in-Hand Theorem = (DOL > 1) – states that the value of the firm increases with its dividend policy.
  • DOL: the degree of operating leverage.

Step-by-Step Calculation

1. Calculate the dividend payout ratio using the company's earnings and dividend payments.
2. Determine the retention ratio by subtracting the dividend payout ratio from 1.
3. Calculate the residual dividend using the retention ratio and earnings.
4. Calculate the constant dividend payout using the payout ratio and earnings.
5. Calculate the low regular plus extra dividend using the regular dividend and extra dividend amounts.
6. Calculate the sustainable growth rate using the ROE and retention ratio.

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
  • Correction: Use market value for WACC to reflect the company's current market capitalization.
• Mistake: Ignoring flotation costs when calculating WACC.
  • Correction: Include flotation costs in the WACC calculation to reflect the true cost of capital.
• Mistake: Confusing sunk cost with opportunity cost.
  • Correction: Identify the opportunity cost as the next best alternative use of resources.
• Mistake: Assuming the dividend irrelevance theorem applies in all situations.
  • Correction: Recognize that the dividend irrelevance theorem only applies in certain situations, such as when the company has a high degree of operating leverage.

Exam / CFA Tips

• Be aware of the distinction between the dividend irrelevance theorem and the bird-in-hand theorem.
• Understand the implications of the residual dividend model and the constant payout ratio model.
• Recognize the importance of the sustainable growth rate in evaluating a company's long-term prospects.
• Be prepared to apply the low regular plus extra dividend model in situations where the company pays a combination of regular and extra dividends.

Quick Practice Problem

A company has EBIT of $10M, interest $2M, tax 25% – compute DFL (Dividend Funds from Lending).

Answer: $1.5M Explanation: DFL = EBIT - Interest - Tax = $10M - $2M - ($2M x 25%) = $1.5M

Last-Minute Cram Sheet

• Dividend policy: a company's decision on how to distribute its earnings to shareholders.
• Dividend payout ratio: the proportion of earnings paid out as dividends.
• Residual dividend model: calculates the residual dividend as a proportion of earnings retained.
• Constant payout ratio model: calculates the constant dividend payout as a proportion of earnings.
• Low regular plus extra dividend model: calculates the total dividend payout as a combination of regular and extra dividends.
• Sustainable growth rate: measures the company's long-term growth rate.
• Dividend irrelevance theorem: states that the value of the firm is independent of its dividend policy.
• Bird-in-Hand theorem: states that the value of the firm increases with its dividend policy.
• WACC: weighted average cost of capital.
• Flotation costs: the costs associated with issuing new securities.
• Sunk cost: a cost that has already been incurred and cannot be changed.
• Opportunity cost: the next best alternative use of resources.
• Degree of operating leverage (DOL): measures the sensitivity of EBIT to changes in sales.
• Return on equity (ROE): measures the company's profitability.
• Retention ratio: the proportion of earnings retained by the company.
• Dividends: the amount of cash distributed to shareholders.
• Earnings: the company's net income.
• Interest: the company's interest expenses.
• Tax: the company's tax liability.
• Regular dividend: the fixed dividend amount.
• Extra dividend: the additional dividend amount paid out in excess of the regular dividend.