Advantages and disadvantages of a strict residual dividend policy

Advantages and disadvantages of residual dividend policy - And signals

  • asymmetric information – managers have more information about the health of the company than investors
  • changes in dividends convey information
    • dividend increases
      • management believes it can be sustained
      • expectation of higher future dividends, increasing present value
      • signal of a healthy, growing firm
    • dividend decreases
      • management believes it can no longer sustain the current level of dividends
      • expectation of lower dividends indefinitely; decreasing present value
      • signal of a firm that is having financial difficulties
. Payment
  • declaration date – board declares the dividend and it becomes a liability of the firm
  • ex-dividend date
    • occurs two business days before date of record
    • if you buy stock on or after this date, you will not receive the dividend
    • stock price generally drops by about the amount of the dividend
  • date of record – holders of record are determined and they will receive the dividend payment
  • date of payment – checks are mailed
. Dividend policy
  • goals, ranked in order of importance
    • avoid cutting back on positive npv projects to pay a dividend
    • avoid dividend cuts
    • avoid the need to sell equity
    • maintain a target debt/equity ratio
    • maintain a target dividend payout ratio
  • companies want to accept positive npv projects, while avoiding negative signals
. Repurchase
  • company buys back its own shares of stock
    • tender offer – company states a purchase price and a desired number of shares
    • open market – buys stock in the open market
  • similar to a cash dividend in that it returns cash from the firm to the stockholders
  • this is another argument for dividend policy irrelevance in the absence of taxes or other imperfections
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