TOPIC 4: <Dividend Policy>

COURSE CODE: <BAF 428>

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 TOPIC 4: <Dividend Policy>

TABLE OF CONTENTS

1. Topic overview 3

1. Introduction 3

2. Objectives 3

3. Learning Activities 3

4. Assignment 3

2. Main Content 4

4.1 When Should the Firm Pay Dividends? 4

4.2 How Much to Pay: Alternative Dividends Policies 4

4.3 How Should the Firm Pay Dividends 6

3. Summary 11

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 TOPIC 4: <Dividend Policy>

1. Topic overview

1. Introduction
Corporations can return cash to their shareholders by paying a dividend or by repurchasing shares. In this topic we explain
how financial managers decide on the amount and form of payout, and we discuss the controversial question of how payout
policy affects shareholder value

2. Objectives
By the end of this topic, you should be able to:

1. Explain the objectives of dividend policy in practice.

2. Understand the factors that influence a firm’s dividend policy.
3. Demonstrate how much should a company pay in dividends.
4. Discuss the significance and implications of bonus shares and stock splits and the share buyback.

3. Learning Activities
• Read and make short notes on Dividend policy- when- how-how-much
• Attempt the given Quiz 4.1
• Read

4. Assignment
Quiz 4.1

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 TOPIC 4: <Dividend Policy>

2. Main Content

Dividends are part of earnings which are distributed to the ordinary shareholders from their investment in the company dividend
decision are important to the company because: -

a) They provide the solution to the dividend puzzle. i.e., Thus, payment of dividend increases or reduces the value of the
firm.
b) It’s part of the company financing strategies- payment of high dividend means low retained earnings and hence need
for more debt capital in the company’s structure.

Dividend policy decisions include 4 critical issues, namely: -

a) When should the firm pay dividends:

b) How Much Should the Firm Pay Dividends?
c) How Should the firm Pay Dividends?
d) Why Should The firm Pay Dividends (Discussed in the next topic)

4.1 When Should the Firm Pay Dividends?

A company can pay dividend twice in the course of the year i.e., interim and final or it can pay dividends once in a year. I.e.,
final dividend. And it will depend on the company’s liquidity position, the expectation of the shareholders and the need for cash
for financing.

4.2 How Much to Pay: Alternative Dividends Policies

a) Add There are four different policies which influence the amount of dividends per share a company can pay. This
includes; -

i. Constant pay-out policy: - under this policy a company should pay a fixed proportion of its earnings attribute
to the ordinary shareholders as dividends. Since the earnings fluctuate aver time the earnings per share will
fluctuate over time, the total dividend payable and the dividend per share will also fluctuate over time. E.g.,
assume a company has a 40% dividend pay-out ratio and 100M issued and fully paid ordinary share. The
EPS and the DPS will then fluctuate as follows: -
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 TOPIC 4: <Dividend Policy>

This constant policy has the following limitation.

• It creates uncertainty as the amount of dividends income receivable by the shareholders.

• The shareholders may require a higher rate of return to compensate them for uncertainty.

ii. Constant/Fixed DPS Policy: -Under this policy the company will pay a fixed amount of dividend per share
irrespective of the level of earnings. Therefore, in this case the ordinary shareholders are treated like
preference shareholders because they receive fixed dividends. In this case the EPS may fluctuate over time
but the dividends per share remains constant.

This policy has the following implications:

• It creates certainty and it’s therefore preferable to the low-income shareholders who have high
preference for dividends instead of equivalent capital gains.

• The certainty reduces the shareholders required rate of return

• When the firm has high earnings more income will be retained for future financing needs.

iii. Low constant DPS plus Surplus/bonus.

Under this policy the dividend per share is set at a very low level and paid every year. However, a bonus or extra dividends are
paid in the years of super normal earnings. This extra dividend is paid in such a way that it’s not seen as a commitment to the
firm to contribute paying the extra dividends in the future. In this case the earnings per share will be fluctuating over time while
the dividends per share will remain constant with occasional bonus or surplus.

The implications of this policy include:

• Gives the company the flexibility to increase dividends when earnings are high.

• It gives the shareholders a chance to participate in super normal earnings of the firm.

• Its most appropriate to those company with volatility in earnings e.g., firms in the agricultural sector.

iv. Residual dividend policy.

In this case dividends are paid out of the earnings left after the investment opportunities have been financed. Therefore, out of
the earnings attributable to the owners the first allocation is towards the financing of all projects yielding NPVs. Dividends are
only paid if the earnings are not exhausted by the company’s financing needs.

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 TOPIC 4: <Dividend Policy>

By first financing projects which yield positive NPV the policy attempts to maximize the value of the firm and the shareholders
wealth. This policy leads to residual theory which has the following advantages.

• Savings on the floatation cost: the use of internally generated funds (earnings) finance new projects
does not involve any floatation costs when compared with the issues of new securities.

• Avoidance of dilution in ownership; -with no issue of additional information there will be no dilution in
ownership control and future DPS.

• Tax position of Shareholders: - the pre-investment of earnings in project with positive NPV will lead
in increase in market price per share and investors will realize capital gains which is not taxed in
Kenya. This will reduce the tax burden of the shareholders who have high incomes from other
sources.

• Financing of rapid growth; - small companies without access of capital markets can decide to retain
most of their earnings for investment purposes since they cannot secure debt capital market.

4.3 How Should the Firm Pay Dividends

Add A company may pay dividend in the following forms:

i. Payment of Cash Dividends.

This is the most common of mode of dividend payment. However, payment of cash dividend will depend on company’s liquidity
position and financing needs of the company.

ii. Bonus issue/ Script Issue

This is also known as dividend re-investment scheme it involves giving free shares to existing shareholders instead of the cash
dividend. The shares in this case are given in proportion to the existing proportion of ownership by the shareholders. This method
offers the following advantages.

• There is conservation of cash in the company since there is no actual cash outflow.

• There is the tax advantage whereby the free shares can be sold by the shareholders to realize capital gains which are
not taxable in Kenya.

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• Increase in future profits. i.e., a bonus issue may be an indication of signals by the companies’ management that they
expect high profits in the future in order to maintain the EPS.

• Increase in future dividends. If the company follows a constant dividend per share policy before and after the bonus
issue.

iii. Stock Split and Reverse Split

A stock split is the process by which a company undertakes to reduce the par value of its shares and increase the rise of ordinary
by the same proportion it has reduced its par value. The major reasons for a stock split are to make the shares attractive and
more affordable than before. The stock split has no effect on the net worth of the company.

Reverse stock split is a reverse of the stock split and it involves the consolidation of shares into bigger units/stocks. In this case
number of ordinary shares is reduced while the par value of the no of shares is increased by the same proportion that has been
used to reduce the number of ordinary shares.

Advantages: -

• It enables the existing shareholders to sell their shares at affordable prices.

• If the company does not change its dividend policy, it will lead to increased dividend to the existing shareholders.

• As a result of a stock split some wealthy shareholders may sell their shares to outsiders who will join the company with
new constructive ideas.

• It may increase the shareholding of small and medium shareholders as the wealthy shareholders may leave the
company

Disadvantages:

• If the wealthy shareholders dispose of their shares, there may be dilution in ownership.

• The incoming shareholders may bring new ideas which may disrupt the operations of the company

• The company may incur some cost to undertake the stock split e.g. clerical costs

• The company will have to pay more dividends in the future because of the increase no of shares.

Difference between stocks split and stock dividend.

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Stock Split Stock Dividend/bonus issue

• It reduces the par value of the ordinary shares. • It has no effect on the par value of ordinary shares

• It has no effect on the retained earnings • It reduces the companies retained earnings

• Its objective is to make the share attractive and • It is declared to some the liquidity problems of the
affordable after the share prices has increased company and to capitalize the retained earnings
tremendously
• Its declared instead of cash dividends
• Its declared when the Market price of the
• It reduces the market price of share in the short run.
ordinary share has increased tremendously

• It reduces the market price of the share in long

run.

Similarities between stock splits and stock dividends

a) Both of them entail the distribution of extra shares to the company’s existing shareholders.

b) Both them are issued free of charge.

c) Both of them do not affect the net worth of the company.

d) Both of them reduce the market price in the stock exchange.

e) If both of them are sold by some of the existing shareholders they will lead to the dilution in ownership.

f) Both of them are issued in proportion to the existing shareholding.

g) Both of them are issued by the financing stable companies.

Differences between a stock split and rights issue.

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Stock Split Rights Issues

a) Issued free of charge a) Shareholders makes payments at a price slightly

below the existing market price per share (MPS)
b) Does not affect the net worth of the company.
b) It increases the net worth of the companies
c) It reduces the par value of the share.
c) It has no effect on the par value of the share
d) Its objectives are to reduce the par value of the
company’s share so as to make them attractive d) Its objective is to raise additional funds from the
and affordable. company’s existing shareholders

e) Its mandatory for all existing shareholders e) It’s optimal to the existing shareholders.

f) It reduces the market per share on the long run. f) It reduces the market price per share in the short
run.

Similarities between the stock split & right issue;

i. Both of them are issued to existing shareholders.

ii. Both of them reduce the market price per share.

iii. Both of them increase the number of ordinary shares to the existing shareholders of the company.

b) Stock/Share Repurchase

This is where the company buys back some of its shares previously issued using the cash that would have been paid out as
dividends. The shares that are bought back are called the treasury stock/shares. The buying back of the share will reduce the
company shares in the stock exchange and given a constant demand then the market price per share will increase since the
remaining shares will be less.

The increase in market price per share will results in capital gains which are substituted for dividend income.

Advantages of Stock/share repurchase;

a) It increases the market price of the share; this is because of the reduced supply of the shares in the stock exchange
and increase in earnings per share.

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b) Increased dividend per share and EPS. This is because the issued and fully paid ordinary share will reduce after the
stock repurchase. This is particularly so if the stock market is inefficient.

c) It’s one of the methods of utilizing the idle cash i.e. stock repurchase is a preferable way of utilizing the excess cash
instead of investing it unwisely.

d) It’s one of the method of restructuring debt and equity in the capital structure. Assuming a company has debt capital
stock repurchase may be seen as mechanism of correcting unbalancing capital structure e.g. if a company utilizes
retained earnings to buy back its share the equity capital will be reduced and its gearing will increase. Alternatively a
firm may issue debentures in order to raise debt capital and use the cash to repurchase the share since interest on
debt capital is tax allowable expense and replacing equity with debt may reduce the company weighted Average cost
capital.

e) Reduced threat of takeover. A share repurchase can be affected by the company buying back the shares of its disloyal
shareholders who can easily sell the shares to a predictor or a company that forcefully want to acquire our own
company.

Disadvantages of stock repurchase;

a) Market signalling, stock repurchase using excess stock cash available maybe interpreted as a signal that a firm does
not have viable investment opportunities. This is seen as failure by management.

b) Loss of investment income. A stock repurchase does not generate extra income since it’s not an investment therefore
there is foregone interest income if the excess cash should have invested in viable projects.

c) Payment of high price a firm has to pay a premium above the existing market price per share to the shareholders who
gave agree there shares to be repurchased. If the price paid for the repurchase is too high this may be to the remaining
shareholders. Notes

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 TOPIC 4: <Dividend Policy>

Concept Check

a) In relation to the financing of a firm, differentiate the following terms:

i) Financial structure from capital structure. (5 marks)

ii) Business risk from financial risk. (5 marks)

b) What is meant by gearing as used in the capital structure of Limited Liability Company? (2 marks)

The following information is on a company in the power generation business:

Shs.
10% preference shares (Sh.10 400,000
par)
Ordinary share capital (Sh.10 par) 400,000
800,000
Retained profits 700,000
1,500,000
15% debentures 1,200,000
2,700,000

Required

i) Calculate the gearing ratio for the above company. (2 marks)

ii) If the company’s net profit (before interest and tax) is Sh.2,000,000,000 and assuming a dividend payout ratio of 60% of the
earnings, compute the dividend per share (DPS). (6 marks)

iii) If the market price per share now is Sh.80, compute the dividend yield. (2 marks)

3. Summary

• Dividends may take two forms: cash dividend and bonus shares (stock dividend). Bonus shares are shares issued to
the existing shareholders without any cost.
• Bonus shares have a psychological appeal. They do not increase the value of shares.
• Companies generally prefer to pay cash dividends. They finance their expansion and growth by issuing new shares or
borrowing. This behavior is based on the belief that shareholders are entitled to some return on their investment.
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• Most companies have long-term payment ratio targets. But they do not apply target payout ratios to each year’s
earnings. They try to stabilize dividend payments by moving slowly towards the target payout each year.
• Companies also consider past dividends and current as well as future earnings in determining dividend payment.
Investors recognize this. Any extreme changes are read as signals of management’s expectations about the company’s
performance in future. Thus, dividends have information contents.
• Companies like to follow a stable dividend policy since investors generally prefer such a policy for the reason of
certainty.
• A stable dividend policy does not mean constant dividend per share. It means reasonably predictable dividend policy.
Companies determine dividend per share or dividend rate keeping in mind their long-term payout ratio

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