Dividend Policy - Business Finance - ثاني ثانوي

Link to digitalston 7.3 Dividend Policy www.len.edu.sa Key Terms Cash dividends Ex dividend Financial transaction costs Payout ratio Yield Date of record Pay date/Distribution date Share dividends Dilution Stock split Distribution from earnings pard into the bank accounts. of shareholders After a corporation has earned profits, management must decide what to do with these earnings. The company can retain earnings and increase each stockholder's investment in the company, reduce debt, or distribute earnings as a cash dividend. If the earnings are distributed, the cash flows out of the company. If the earnings are retained, management will put the funds to work by purchasing income-earning assets or retiring outstanding debt. Fahd needs to consider alternative strategies for the use of retained earnings to present to the board of directors. Figure 7.2 below shows simplified balance sheets outlining three options for the company, assuming there is SAR 10 million in retained earnings at the end of the year. The options are: ■ Option 1 - increase assets. The retained earnings increase the cash available for the company to purchase additional assets to help increase sales. • Option 2 - reduce debt. The earnings created can be used to reduce debt from SAR 30 million to SAR 20 million. This could lower debt costs for the company in the following years. ■ Option 3 - pay dividends. The company would use the full SAR 10 million to pay dividends. This would not change the balance sheet because the funds that come into the company would be used to pay dividends to shareholders. 276Business Finance

All Numbers in SAR (million) Balance Sheet Start of Year Option 1 Option 2 Increase Assets Reduce Debt Option 3 Pay Dividends Assets 100 110 100 100 Liabilities and Equity Debt 30 30 20 30 Equity Share Capital 40 40 40 40 Retained Earnings 30 40 40 30 100 110 100 100 In Option 1 and Option 2. the company retains all the earnings, so retained earnings increase by SAR 10 million. If earnings are distributed as cash dividends, the company's equity is not increased. Fahd's company board wants the business to grow, so investing in additional assets is needed. However, Fahd could recommend the use of alternative sources of funds. Money may be borrowed, but this could increase the financial risk to the company. Funds may be obtained by issuing additional stock, but it may not make sense to distribute earnings and then issue new shares to raise equity. The retention of the earnings would achieve the same effect and not involve the costs associated with selling new stock. Few companies distribute all their earnings, and many distribute no earnings. Since the stockholders are the owners of the company and are entitled to the earnings, the question becomes what do the stockholders want-additional investment in the company or cash dividends? This would seem to be an easy question for Fahd to answer but it is not. Usually, many different stockholders own shares and some may seek income through dividends while others may seek capital gains. وزارة التعليم FIGURE 7.2 Options for Retained Earnings CHAPTER 7 Stocks and Bonds 277

. Why might certain individuals prefer dividends to capital gains? Financat transm costs Costs involved in the buying ar selling of financial produces High-growth companies will often hold retained earnings to help grow the business. Stock investors in these growth stocks are more likely to want to see the value of their stock increase over time. Other companies may not have high growth, but they are known for paying dividends on a regular basis. These dividend stocks are often purchased by individuals who are more interested in the payment of dividends rather than the growth of the value of the stock. It is important for Fahd to understand the company's investing shareholders as owners, and the transaction costs involved in financial decisions. Financial transaction costs are costs involved in the buying or selling of financial products. Taxes typically have a major impact on financial decisions. However, in Saudi Arabia, Saudi citizens and citizens from Gulf Cooperation Council (GCC) nations don't pay income taxes on dividends or capital gains (profits from security sales). Instead, the citizens of Saudi Arabia pay Zakat, 2718Business Finance

which is imposed at 2.5% on income allocated specifically for Zakat. In some countries, such as the United States, dividends and capital gains are taxed at different rates. Fahd's company does have to pay Zakat of 2.5%. This has an impact on Fahd's funding strategy for the company, Dividend payments for both common and preferred stock are paid from retained earnings after taxes and Zakat are paid. Payments for debt are considered an expense and therefore lower the overall net profit of the company, reducing the taxes and Zakat paid on profits. 7.3a Cash Dividends For a Saudi citizen, receiving dividends or selling stock to receive capital gains can have the same impact on income, depending upon transaction fees. For Fahd's company, there is an impact on how retained earnings are used to fund the operation of the business: ■If the company chooses the option to retain all earnings to support future growth, the equity of the stockholder increases. ■If the company decides to pay out all the retained earnings in cash dividends, then the stockholders have increased their overall return by receiving dividends. Dividend policy is a question of how much of a company's earnings should be distributed. Companies that pay cash dividends usually have a policy that is either stated or implicitly known by the investment community. If a company pays a cash dividend, the amount is often stable and well known. The proportion of the earnings distributed is measured by the payout ratio, which is: Dividend per share Payout ratio = Earnings per share Раурие The ratio of dividends to earnings per share EXAMPLE A company announces a dividend of SAR 3 per share, having previously announced earnings of SAR 10 per share. Therefore, the payout ratio is- 10 3 or 30%. وزارة التعليم CAPTER 7 Stocks and Bands 279

You Try It A company is currently trading at SAR 200 per share. The company announces o dividend of SAR 6 per share. What is the dividend yield on the stock? Yield The return on a stock expressed as dividend per share divided by the current share price The average yield of dividend-paying companies on the Saudi Exchange was 3.25% in 2021. There were 30 companies that have been paying regular dividends for over 10 years at an average rate of 3.78%. If the SAR amount of the dividend is stable, the payout ratio will fluctuate with fluctuations in earnings. The stability of dividends coupled with fluctuations in earnings means that the amount of earnings retained varies each year and that management has decided to maintain a stable dividend at the expense of stable increases in retained earnings. In Saudi Arabia, companies distribute cash dividends on a quarterly, semi-annual, or annual basis. As earnings grow, a company can increase its cash dividends. Distributing dividends - the process Distributing dividends takes time and the process is outlined in the following three steps: PL 200 Business Finance N 2931-1645

STEP 1 The first step is the dividend meeting of the company's board of directors. If they decide to distribute a cash dividend, two important dates are established. The first date determines who is to receive the dividend. On a particular day, the ownership books of the corporation are closed, and everyone owning stock in the company at the end of that day receives the dividend. This is called the date of record. If investors buy the stock after the date of record, they do not receive the dividend. The stock is purchased excluding the dividend; this is referred to as ex dividend, for the price of the stock does not include the dividend payment. When a stock goes ex-dividend, its price is adjusted downward for the dividend. This price change makes logical sense. Date of rece The day on which an investor Foust own stock in order to receive the dividend payment Ex dividend Referring to stock purchases which do not entitle the buyer to the next dividend STEP 2 The second important date is the day that the dividend is distributed, known as the pay date or distribution date. The distribution date may be several weeks after the record date, as the company must determine the owners on the record date and process the payment. The company may not perform this task itself; instead, it may use its commercial bank, for which the bank charges a transaction fee. STEP 3 The day that the dividend is received by the stockholder is likely to be many weeks after the board of directors announced the dividend payment. Pay duts/nimation da The day on which á dividend is paid to stockholders DIVIDEND INVESTING Why might company's management decide to maintain a stable dividend? 250000 300000 180000 160000 281

EXAMPLE If a stock were selling for SAR 50 and paid a SAR 2 dividend, the stock could not be worth SAR 50 on the ex dividend date. If the price were not adjusted, an investor could buy the stock for SAR50 the day before it went ex dividend, sell it for SAR 50 on the ex dividend date, collect the SAR 2 dividend, and net SAR 2. If one investor could make the SAR 2, everyone could make the SAR 2, but such easy profits do not happen. Instead, the price of the stock becomes SAR 48 on the ex dividend date. The investor's total position remains SAR 50, consisting of the SAR 48 stock plus the SAR 2 dividend You Try It Astock is trading at SAR 40 and announces a dividend of SAR 3 per share. When the stock goes ex-dividend, what is the stock price likely to be? Fahd wants to maximize the wealth of the company's stockholders, so the dividend decision basically depends on who has the better use for the money—the stockholders or the company. Fahd is unsure of the stockholders' need for money. If the stockholders like the dividend policy, they may purchase more shares. If the stockholders do not like the company's dividend policy, they may sell their shares. However, if the sellers exceed the buyers, the value of the shares will fall, and Fahd will become aware of the stockholders' preference for cash dividends instead of the retention of earnings. Stock als given to stockholders as a return on their investment often in place of cash 7.3b Share Dividends Some companies distribute share dividends in addition to (or instead of) cash dividends. Share dividends alter the entries on the company's equity section of its balance sheet, but they have no impact on the company's P 282 Business Finance N

assets and liabilities. Since assets are neither increased nor decreased, share dividends do not affect the company's earning capacity. Share dividends transfer amounts from retained earnings to common stock and additional paid-in capital. A share dividend does not increase an investor's wealth, but it does increase the number of shares the investor owns. EXAMPLE If an investor owned 100 shares at SAR 20 per share before the stock dividend, the investor had stock worth SAR 2,000 (100 shares x SAR 20). After the stock dividend, the investor owns 110 shares (the extra 10 shares resulting from the share dividends). However, the 110 shares are also worth SAR 2,000, as the price per share falls from SAR 20 to SAR 18.18 2000 (SAR -shares). 110 The reason the stock price falls is that there are 10% more shares outstanding in the market, but there has been no increase in the company's assets and earning power. The old shares have been diluted and so the price of the stock must decline to indicate this dilution. If the price of the stock did not fall, all companies could make their stockholders wealthier by declaring stock dividends. But investors would soon realize that the stock dividend does not increase the assets and earning power of the company, and they would not be willing to pay the old price for a larger number of shares. The market price would fall to adjust for the dilution of the old shares, and that is what happens. Dilation Reduction in earnings per share as the result of issuing additional shares You Try It An investor owns 100 shares of stock trading at SAR 10 The company announces a share dividend at a rate of 1 for every 10 an investor owns. Given a share dividend does not increase an investor's wealth, what price will the shares trade at after the dividend? وزارة التعليم CLAPTEN 7 Stocks and Bonds 283

Fahd needs to determine if a share dividend would increase the ability of the company to grow. If a share dividend were a substitute for a cash dividend, the statement would be partially true, because the company still has the asset cash that would have been paid to stockholders if a cash dividend had been declared. The company, however, would still have the cash if it did not pay the share dividend, for a company could retain its cash and not pay a stock dividend. The decision to pay the share dividend does not increase the company's cash; it is the decision not to pay the cash dividend that conserves the cash. Stock split A recapitalization achieved by changing the number of shares outstanding 7.3c Stock Splits After the price of a stock has risen substantially, management may choose to split the stock. A stock split lowers the price of the stock and makes it more accessible to investors. Implicit in this statement is the belief that investors prefer lower-priced shares and that reducing the price of the stock benefits the current stockholders by widening the market for their stock. Like the stock dividend, the stock split does not alter the equity section on the balance sheet and it does not affect the assets or liabilities of the company. It does not increase the earning power of the company, and the wealth of the stockholder is not increased unless other investors prefer lower-priced stocks and increase the demand for this stock. In a two for one stock split, one old share becomes two new shares. There are no changes in the additional paid-in capital, retained earnings, or total equity. All that has happened is that there are now twice as many shares outstanding, and each share is worth half as much as an old share. Stock splits may be in any combination of terms, such as four for one or seven for four, but the most common splits are two for one or three for two. There are also reverse splits, which reduce the number of shares and raise the price of the stock. All stock splits affect the price of the stock. With a two for one split, the stock's price is cut in half. A one for ten reverse split raises the price by a factor of ten. An easy method for finding the price of the stock after the split is: 284 Business Finance WIT Pl 2021-1884 Price of stock after split Stock price before split Reciprocal of the X terms of the split

EXAMPLE If a stock is selling for SAR 54 a share and is split three for two, then the price of the stock after the split will be: You Try It 2 SAR 54 x = SAR 36 3 88 If a stock is selling for SARS.5 a share and there is a reverse split of one for two, what would the price of the stock be after the reverse split? Show your work. Fahd is evaluating whether he should recommend to the board that the company should split its stock. This would result in a lower selling price and could increase the marketability of the company shares. This could create a wider distribution of ownership and increase investor interest in the company. This increased interest and marketability may ultimately cause the value of the stock to appreciate. If demand for the stock increases, the current stockholders would benefit. However, the price increase in the stock's value in the exchange market would not increase the company's earnings. He could also recommend a reverse split. This would increase the price of the stock but would not increase the wealth of the shareholders. 7.3d Repurchase of Stock A company with cash may choose to repurchase some of its stock. Stock repurchases (stock buy-backs) decrease the number of shares outstanding. Since the earnings will be spread over fewer shares, the earnings per share وزارة التعليم CHAPTER 7 Stocks and Bands 285

should increase. The higher per-share earnings may then lead to a higher stock price in the future. Repurchased stocks by the issuing company become treasury stocks. The company can hold these stocks, re-issue them, or cancel them. These shares are not part of the company's capital, and they don't pay dividends. Fahd is considering repurchasing shares as an alternative to paying cash dividends. Instead of distributing the money as cash dividends, the company could offer to purchase the shares from the stockholders. This offers the stockholders a major advantage. They have the option to sell or retain their shares. If the stockholders believe that the company's potential is sufficient to warrant retention of the shares, they do not have to sell them. The decision to sell the shares rests with the stockholder. Figure 7.3 summarizes the stock strategies mentioned above. FIGURE 7.3 Stock Strategies Stock Policies Owner Wealth Impact Cash Dividends Share Dividends Stock Splits Receiving dividends have an impact on income, depending on transaction fees. Does not increase an investor's wealth, but it does increase the number of shares the investor owns. A stock split lowers the price of the stock and makes it more accessible to investors. If investors prefer lower-priced shares, then reducing the price of the stock benefits the current stockholders by widening the market for their stock. Company Impact Paying cash dividends lessens the growth in retained earnings fer the company used to support future growth. Share dividends alter the entries on the company's equity section of its balance sheet, they have no Impact on the company's assets and liabilities and have no affect the company's eaming capacity. Does not alter the equity section on the balance sheet and it does not affect the assets or liabilities of the company. 2016 Business Finance 2921-1086 CONTINUED p

Stock Palicies Owner Wealth Impart Repurchase of Stock repurchases (stock Stock buy-backs) decrease the number of shares outstanding, increasing the earnings per share. The higher per-share earnings may then lead to a higher stock pnce in the future. Company Impact Repurchased stocks by the issuing company become treasury stocks. The company Can hold these stocks, re-issue them, or cancel them. These shares are not part of the company's capital and they don't pay dividends. FIGURE 7.3 continued Stock Strategies Exercises Choose the correct answer. 1. A stock dividend paid from company profits reduces a firm's total equity. True/False 2. Dividends are paid on the a. declaration date. b. ex dividend date. c. date of record. d. distribution date. 3. A share dividend a. reduces the firm's cash. b. increases the firm's total equity. c. decreases the firm's stock price. d. increases the firm's assets. وزارة التعليم CHAPTER 7 Stocks and Bonds 287