Dividend Policy

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B1 – FINANCIAL

MANAGEMENT

TOPIC: DIVIDEND POLICY

JOHN MWITA, CPA(T), ATEC II, B. A&


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TOPIC: DIVIDEND POLICY

DIVIDEND
Is the distribution of after-tax distributable earning to equity shareholders. From definition
• Dividend comes the distributable earning (Business performance)
• Dividend is the distribution to equity shareholders
Dividend decision policy relates with other important decision policies of the business
includes;
A. Financial policy decision
One of the forms of finance is internal financing through related earning and this
depends ondividend decision
B. Investment decision
Decision on allocation of funds whether to give back to equity shareholder or reinvest
again.
PAYOUT RATIO
Is the proportion of earning paid to equity shareholders.

Payout ratio = ‫ܦ‬i‫ݒ‬i݀݁݊݀


× 100%
‫݊ݎܽܧ‬i݊g (‫ܦ‬i‫ݎݐݏ‬iܾ‫)݈ܾ݁ܽݐݑ‬

Retention ratio =1-Payout ratio

FORMS OF DIVIDEND POLICIES


Dividend policy can take different forms which includes
 Constant amount of dividend policy
 Constant payout ratio
 Zero dividend payout policy
 Residual dividend policy

Explanation:
i. Constant dividend amount Policy
Under this policy a constant amount is paid to equity shareholders throughout a year. The
payout ratio may be changing overtime but the dividend amount remains the same.
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Given the following years and their respective earning
Year 1990 1991 1992 1993 1994

Earning 1,000 1,500 1,900 800 350

Payout ratio 20%

In 1990 the firm adopted constant amount dividend policy and used it throughout all coming
years
Required to compute payout ratio for year 1991 up to 1994
Year 1991 1992 1993 1994
Earning 1,500 1,900 800 350
Dividend 200 200 200 200

Payout ratio 13% 10.5% 25% 57.1%

ii. Constant Payout Ratio


Under this policy the firm pays a constant payout ratio to its shareholders throughout years.
Therefore, the amount may be changing overtime but payout is constant
Example
Assume in the year 1990 the firm adopted constant payout ratio calculate dividend for year
1991 to 1994
Year 1991 1992 1993 1994

Earning 1,500 1,900 800 350

Payout ratio 20% 20% 20% 20%


Dividend 300 380 160 70

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iii. Zero dividend policy
Under this policy no dividend is paid to equity shareholders. All of the distributable earnings
are retained back in the business
• Payout ratio 0%
• Retention ratio 100%
iv. Residual Dividend Policy
Under this policy dividends are paid at last after all fund requirements have been met. From
distributable earning earned in the business, the first step is to look on investment
opportunities, it should finance these investment opportunities and the remainder is
distributable to equity shareholder
Example
Given the firm has identified investment opportunities cost 10millions. The earning made
from business operation is 12millions. If the firm debt to equity ratio is 1 and the firm needs
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to maintain the same ratio under residual dividend policy, which amount will remain as
dividend?
FACTOR AFFECTING DIVIDEND POLICY
i. Company financial requirement.
The higher the financial requirement the lower the dividend since a lot of earning will be
retained back in the business.
ii. Company financial performance.
Financial performance =Earning of the company,
The better the performance the higher the dividend
iii. Legal fund regulatory Issue
E.g., Dividend has been limited to be paid out of distributable earning only.
• If earning =1milions
• Dividend cannot exceed 1million
iv. Liquidity of the company
Dividend (cash dividend) is paid out of cash of the company, if the Coy faces liquidity
problems there will be no dividends to be paid.
• Earning = 1 million

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• Cash balance 0millions
Earning have been made but the company faces liquidity problems
v. Interest payment obligation
The company has obligation of paying interest on debt finance where the interest is
higher due to the higher level of debt finance, it reduces earning to equity shareholders
vi. Shareholders expectation
Shareholders tend to have different expectation from the company these may be affected
by different factors includes;
• Age
Junior –lower payout ratio
Senior- Higher payout ratio
• Earning Position
Employed/ entrepreneur – lower /zero payout ratio
• Tax brackets
Lower tax brackets - High payout ratio
Higher tax brackets – Lower payout ratio
DIVIDEND AND PRICE OF SHARE
Present value is the present value of all expected future cash flows
Price = D
(Firm pays part of its earning and the other part in retained)
Ke

Price = Do(1+g) (Firm pays part of its earning and the other is retained)
Ke−g

DIVIDEND RELEVANCE
Dividend relevance is determining the price of a share. Dividend is relevant in shareholder value
maximization.
Models under Relevance dividend;
i. Gordon Growth Model
Based on Gordon
Do(1+g)
P0 ==
Ke−g

The higher the dividend the higher the price

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ii. Walter’s Approaches model
Based on Walter’s
r
D+ (E−D)
Ke
P0 =
Ke

Whereby
D = Dividends
r = rate of return from investment
Ke = Cost of equity
ASSUMPTIONS ARE:
i. Dividend is paid forever
ii. Going concern and r and Ke are constant
When: r>Ke – Growing firm
r<Ke –Declining firm
r= k- Stable firm
Example;
Given earning is TZS 8milions and dividend paid out is 3millions. If the cost of equity and return
on investment are given as
a) r =10% Ke =8% (Pay less dividend to increase value)
b) r =10% Ke =15% (Pay more dividend)
c) r =10% Ke =10% (Dividend has no effect)
DIVIDEND IRRELEVANCE:
Dividend is not relevant on calculating value of the firm. This is under Miller and Modigliani
Model
(i) According to MM, the prevailing market price Po is determined as follows

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(ii) If there is no external financing, the value of firm is equal to the number of times the
Price of the share given by

(iii) If the firm was to finance all investment proposals, then the amount to be raised through
new shares is given by

Under this model price share is affected by other part from dividend
Other factors includes
• Earning
• Cost of equity etc.

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ALTERNATIVE TO CASH DIVIDEND POLICY
These are alternatives to cash dividend policy.

They include thefollowing below;


A. STOCK DIVIDENDS
This may be also be called bonus share or script dividend.
It is an alternative to cash dividends policy whereby the company offer additional shares
to its equity shareholders
NOTE: additional share will depend on amount of earning since it is stock Dividend
Advantage of stock Dividends
To the company
1. Retain liquidity of the company (No cash is paid)
2. Help to reduce gearing ratio (Since increases level of equity)
3. Complies with legal and regulatory requirement like cash dividend.
To the Shareholders
1. Advantage on tax since the company does not need to issue new share to get
cash
2. No dilution of ownership since the company does not need to issue newer share
to get cash.
Disadvantages of stock dividends
1. No cash is paid to shareholders
2. Administration cost and challenges when making follow up of stock dividend
B. SHARE REPURCHASE
This happens when the firm has excess cash hence determined to pay it back to shareholders
through repurchase back of the share.

No of shares outstanding x Market price


Purchase price =
No of share outstanding−No of share repurchased

Share purchased leads to increase in the market price per share for the remained share
Advantages of share repurchased
1. Increase in earnings per share
2. Save the constraints of paying cash dividend out of only earning

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3. Increase the market price per share
Disadvantages of share repurchased
1. The company can execute share purchase if and only if has excess cash
2. Share repurchased has signalizing effect
SIGNALIZING EFFECT
• Can be good: When the market has positively taken the action of the company
• Can be bad: When market has negatively taken the action of the company
• Excess cash =No investment opportunities and ideas to invest in.
Share repurchased can be done in three forms
1. Open market share repurchase
Share repurchased is done in an open market through the broking house. The price will be
determined by the market
2. Fixed price tender offer
This is when the price and number of shares to be purchased is done and fixed by the
company
Only the specified number will be repurchased at stated price
3. Dutch auction tender offer
Company declares the minimum and maximum price; shareholders submit no of shares
they are willing to sell. Based on these calculations are made to determine price to be used
for repurchase and No. of shares

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