Chapter Three: Dividend Decision/Policy

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Chapter Three

Dividend Decision/Policy
Topics in this Chapter
1. The Relationship Between Dividend Policy and
the Financing Decision
2. Dividend Policy: Theory (Theoretical
Approaches to the Dividend Decisions)
3. Dividend Policy: Practical Issues (Practical
Influences on Dividend Decisions)
4. Real World Dividend Policies
5. Alternatives to Cash Dividend Policies and
Share Buyback Schemes
The Relationship Between Dividend Policy and
the Financing Decision
• There is a clear link between financing decisions and the
wealth of a company's shareholders.
• Dividend policy plays a big part in a company's relations with
its equity shareholders, and a company must consider how the
stock market will view its results.
• Retained earnings is one and main Internal sources of finance.
• Retained earnings is surplus cash that has not been needed for
operating costs, interest payments, tax liabilities, asset
replacement or cash dividends. For many businesses, the cash
needed to finance investments will be available because the
earnings the business has made have been retained within the
business rather than paid out as dividends.
Cont…
• The interaction of investment, financing and
dividend policy is the most important issue facing
many businesses. 
• Note: A company may have substantial retained
profits in its statement of financial position but no
cash in the bank and will not therefore be able to
finance investment from retained earnings.
Cont…
• Advantages of using retained earnings
(a) Retained earnings are a flexible source of finance; companies
are not tied to specific amounts or specific repayment patterns.
(b) Using retained earnings does not involve a change in the
pattern of shareholdings and no dilution of control.
(c) Retained earnings have no issue costs.
• Disadvantages of using retained earnings
(a) Shareholders may be sensitive to the loss of dividends that
will result from retention for reinvestment, rather than paying
dividends.
(b) Not so much a disadvantage as a misconception, that
retaining profits is a cost-free method of obtaining funds. There
is an opportunity cost in that if dividends were paid, the cash
received could be invested by shareholders to earn a return.
Dividend Policy

• Dividend policy is a decision to pay out earnings


versus retaining and reinvesting them. Includes these
elements:
1. High or low payout?
2. Stable or irregular dividends?
3. How frequent?
4. Do we announce the policy?
Cont’d

• Retained earnings are the most important single source of


finance for companies, and financial managers should take
account of the proportion of earnings that are retained as
opposed to being paid as dividends.
• Companies generally smooth out dividend payments by
adjusting only gradually to changes in earnings: large
fluctuations might undermine investors' confidence.
• The dividends a company pays may be treated as a signal to
investors. A company needs to take account of different
clienteles of shareholders in deciding what dividends to pay.
• For any company, the amount of earnings retained within the
business has a direct impact on the amount of dividends. Profit
re-invested as retained earnings is profit that could have been
paid as a dividend.
Cont…
• A company must restrict its self-financing through
retained earnings because shareholders should be
paid a reasonable dividend, in line with realistic
expectations, even if the directors would rather keep
the funds for re-investing. At the same time, a
company that is looking for extra funds will not be
expected by investors (such as banks) to pay generous
dividends, nor over-generous salaries to owner-
directors.
• The dividend policy of a business affects the total
shareholder return and therefore shareholder
wealth.
Dividend payments
• Shareholders normally have the power to vote to
reduce the size of the dividend at the Annual
General Meeting, but not the power to increase the
dividend.
• The directors of the company are therefore in a
strong position, with regard to shareholders, when
it comes to determining dividend policy.
• For practical purposes, shareholders will usually be
obliged to accept the dividend policy that has been
decided on by the directors, or otherwise to sell
their shares.
Factors influencing dividend policy
• When deciding upon the dividends to pay out to shareholders, one of the
main considerations of the directors will be the amount of earnings they wish
to retain to meet financing needs.
• As well as future financing requirements, the decision on how much of a
company's profits should be retained, and how much paid out to shareholders,
will be influenced by:
(a) The need to remain profitable. Dividends are paid out of profits, and an
unprofitable company cannot go on indefinitely, paying dividends out of
retained profits made in the past.
(b) The law on distributable profits. Companies legislation may make
companies bound to pay dividends solely out of accumulated net realised
profits, as in the UK.
(c) The government may impose direct restrictions on the amount of
dividends that companies can pay. (For example, this happened in the UK in
the 1960s as part of a prices and income policy).
(d) Any dividend restraints that might be imposed by loan agreements and
covenants. A loan covenant may restrict the amount of dividends that the
company can pay, because this will provide protection for the lender.
Factors influencing dividend policy

(e) The effect of inflation, and the need to retain some profit within the
business just to maintain its operating capability unchanged.
(f) The company's gearing level. If the company wants extra finance, the
sources of funds used should strike a balance between equity and
debt finance.
(g) The company's liquidity position. Dividends are a cash payment, and
a company must have enough cash to pay the dividends it declares.
(h) The need to repay debt in the near future.
(i) The ease with which the company could raise extra finance from
sources other than retained earnings. Small companies which find it
hard to raise finance might have to rely more heavily on retained
earnings than large companies.
(j) The signalling effect of dividends to shareholders and the financial
markets in general – see below.
Do investors prefer high or low payouts? There
are three theories:
1. Dividends are irrelevant: Investors don’t care
about payout.
2. Bird in the hand: Investors prefer a high
payout.
3. Tax preference: Investors prefer a low
payout, hence growth.
Dividend Irrelevance Theory

• Investors are indifferent between dividends and


retention-generated capital gains. If they want cash,
they can sell stock. If they don’t want cash, they can
use dividends to buy stock.
• Modigliani-Miller support irrelevance.
• Theory is based on unrealistic assumptions (no taxes
or brokerage costs), hence may not be true. Need
empirical test.
Bird-in-the-Hand Theory

• Investors think dividends are less risky than potential


future capital gains, hence they like dividends.
• If so, investors would value high payout firms more
highly, i.e., a high payout would result in a high P0.
Tax Preference Theory

• Retained earnings lead to long-term capital gains,


which are taxed at lower rates than dividends: 20%
vs. up to 39.6%. Capital gains taxes are also
deferred.
• This could cause investors to prefer firms with low
payouts, i.e., a high payout results in a low P0.
Which theory is most correct?

• Empirical testing has not been able to


determine which theory, if any, is correct.
Thus, managers use judgment when setting
policy. Analysis is used, but it must be applied
with judgment.
Dividends as a signal to investors

• The ultimate objective in any financial management


decisions is to maximize shareholders' wealth. This
wealth is basically represented by the current market
value of the company, which should largely be
determined by the cash flows arising from the
investment decisions taken by management.
• Although the market would like to value shares on the
basis of underlying cash flows on the company's projects,
such information is not readily available to investors. But
the directors do have this information. The dividend
declared can be interpreted as a signal from directors to
shareholders about the strength of underlying project
cash flows.
Dividends as a signal to investors
• Investors usually expect a consistent dividend
policy from the company, with stable dividends
each year or, even better, steady dividend growth.
A large rise or fall in dividends in any year can have
a marked effect on the company's share price.
Stable dividends or steady dividend growth are
usually needed for share price stability. A cut in
dividends may be treated by investors as signalling
that the future prospects of the company are
weak. Thus, the dividend which is paid acts,
possibly without justification, as a signal of the
future prospects of the company.
Cont…

• The signalling effect of a company's dividend policy


may also be used by management of a company
which faces a possible takeover. The dividend level
might be increased as a defence against the
takeover: investors may take the increased dividend
as a signal of improved future prospects, thus driving
the share price higher and making the company
more expensive for a potential bidder to take over.
Theories of dividend policy

Residual theory
• A 'residual' theory of dividend policy can be summarized as follows.
– If a company can identify projects with positive NPVs, it should
invest in them.
– Only when these investment opportunities are exhausted should
dividends be paid.
• Dividends should therefore be the amount of after-tax profits left
over (the ‘residual’ amount) after setting aside money to invest all
viable business opportunities. According to this theory dividend
payout ration can be calculated by using the following formula:
Cont’d

Traditional view
• The 'traditional' view of dividend policy, implicit in
our earlier discussion, is to focus on the effects of
dividends and dividend expectations on share price.
The price of a share depends on both current
dividends and expectations of future dividend growth,
given shareholders' required rate of return.
Theories of dividend policy
Irrelevancy theory
• In contrast to the traditional view, Modigliani and Miller
(MM) proposed that in a perfect capital market,
shareholders are indifferent between dividends and
capital gains, and the value of a company is determined
solely by the 'earning power' of its assets and investments.
• MM argued that if a company with investment
opportunities decides to pay a dividend, so that retained
earnings are insufficient to finance all its investments, the
shortfall in funds will be made up by obtaining additional
funds from outside sources. As a result of obtaining
outside finance instead of using retained earnings:
• Loss of value in existing shares (due to increment of cost of
capital) = Amount of dividend paid
Cont’d

• In short the dividend irrelevance theory


indicates that a company’s declaration and
payment of dividends should have little to no
impact on the stock price. If this theory holds
true, it would mean that dividends do not add
value to a company’s stock price.
Assumptions of the dividend irrelevance
theory
The dividend irrelevance policy assumes the following:
1. The capital markets are perfect
2. There are neither flotation nor transaction costs
3. There are no taxes
4. The capital structure does not affect cost, i.e., cost of
capital is constant at any proportion of debt and equity
5. Both management of companies and investors have equal
access to all public and private information, i.e., there is no
arbitrage opportunity
6. The cost of equity is constant at any dividend payout rate
7. The dividend policy does not affect capital budgeting
Theories of dividend policy
The case in favour of the relevance of dividend policy (and
against MM's views)
• There are strong arguments against MM's view that dividend
policy is irrelevant as a means of affecting shareholder's wealth.
(a) Differing rates of taxation on dividends and capital gains
can create a preference among investors for either a high
dividend or high earnings retention (for capital growth).
(b) Dividend retention should be preferred by companies in a
period of capital rationing.
(c) Due to imperfect markets and the possible difficulties of
selling shares easily at a fair price, shareholders might need
high dividends in order to have funds to invest in
opportunities outside the company.
Cont…
(d) Markets are not perfect. Because of transaction costs on
the sale of shares, investors who want some cash from
their investments will prefer to receive dividends rather
than to sell some of their shares to get the cash they want.
(e) Information available to shareholders is imperfect, and
they are not aware of the future investment plans and
expected profits of their company. Even if management
were to provide them with profit forecasts, these forecasts
would not necessarily be accurate or believable.
(f) Perhaps the strongest argument against the MM view is
that shareholders will tend to prefer a current dividend to
future capital gains (or deferred dividends) because the
future is more uncertain.
Scrip dividends
• A scrip dividend is a dividend paid by the issue of additional
company shares, rather than by cash.
• When the directors of a company would prefer to retain funds within
the business but consider that they must pay at least a certain amount
of dividend, they might offer equity shareholders the choice of a cash
dividend or a scrip dividend. Each shareholder would decide
separately which to take.
• With enhanced scrip dividends, the value of the shares offered is
much greater than the cash alternative, giving investors an incentive
to choose the shares.
Advantages of scrip dividends
(a) They can preserve a company's cash position if a substantial
number of shareholders take up the share option.
(b) Investors may be able to obtain tax advantages if dividends are
in the form of shares.
(c) Investors looking to expand their holding can do so without
incurring the transaction costs of buying more shares.
Cont’d
(d) A small scrip dividend issue will not dilute the
share price significantly. If however cash is not
offered as an alternative, empirical evidence suggests
that the share price will tend to fall.
(e) A share issue will decrease the company's gearing,
and may therefore enhance its borrowing capacity.
Disadvantages of scrip dividends
(a) Assuming that dividend per share is maintained or
increased, the total cash paid as a dividend will
increase.
(b) Scrip dividends may be seen as a negative signal by
the market ie the company is experiencing cash flow
issues.
Share repurchase
• Purchase by a company of its own shares can take place
for various reasons and must be in accordance with any
requirements of legislation.
• In many countries companies have the right to buy back
shares from shareholders who are willing to sell them,
subject to certain conditions.
• For a smaller company with few shareholders, the reason
for buying back the company's own shares may be that
there is no immediate willing purchaser at a time when a
shareholder wishes to sell shares.
• For a public company, share repurchase could provide a
way of withdrawing from the share market and 'going
private'.
Cont…
• Public companies with a large amount of surplus
cash may offer to repurchase (and then cancel)
some shares from its shareholders. A reason for
this is to find a way of offering cash returns to
investors without increasing dividend payments.
Higher dividend payments would affect investor
expectations about future dividends and dividend
growth; whereas share buy-backs would not affect
dividend expectations at all. In addition, by
reducing the number of shares in issue, the
company should be able to increase the earnings
per share (EPS) for the remaining shares.
Cont…
Benefits of a share repurchase scheme
(a) Finding a use for surplus cash, which may be a 'dead asset'.
(b) Increase in earnings per share through a reduction in the
number of shares in issue. This should lead to a higher share
price than would otherwise be the case, and the company
should be able to increase dividend payments on the remaining
shares in issue.
(c) Increase in gearing. Repurchase of a company's own shares
allows debt to be substituted for equity, so raising gearing. This
will be of interest to a company wanting to increase its gearing
without increasing its total long-term funding.
(d) Readjustment of the company's equity base to more
appropriate levels, for a company whose business is in decline.
(e) Possibly preventing a takeover (by increasing EPS) or enabling
a quoted company to withdraw from the stock market.
Cont…
Drawbacks of a share repurchase scheme
(a) It can be hard to arrive at a price that will be
fair both to the vendors and to any shareholders
who are not selling shares to the company.
(b) A repurchase of shares could be seen as an
admission that the company cannot make better
use of the funds than the shareholders.
(c) Some shareholders may suffer from being
taxed on a capital gain following the purchase of
their shares rather than receiving dividend
income.
Stock Split

• A stock split is an accounting decision to


change the number of shares outstanding
without selling any more to the public.
• When a company declares a stock split, the
number of shares of that company increases,
but the market cap remains the same. Existing
shares split, but the underlying value remains
the same. As the number of shares increases,
price per share goes down.
Cont’d

• Let's assume XYZ Corp, which has two million


shares outstanding, is trading for $30. In this case,
the firm's total market value, or market
capitalization, is $60 million (2 million x
$30/share). After a two-for-one stock split, the firm's
number of shares will double to four million, while
the value of those shares will be cut in half to $15.
However, the company's total market capitalization
will remain the same at just $60 million (4 million*
$15/share).
Motives for stock split

• If the net effect to current shareholders is zero, then


why do companies choose to split their stock?
Typically, a firm's board of directors decides to split
its stock in an effort to reduce its share price. After all,
high prices can act as a deterrent to prospective buyers
-- particularly smaller ones. A stock split will reduce a
company's share price to a level that is hopefully seen
as more affordable to a broader range of investors.
• Therefore, the primary motivation for a stock split is
usually a desire to reduce the share price.
Chapter End Question: Dividend policy
• Ochre is a company that is still managed by the two individuals
who set it up 12 years ago. In the current year the company was
launched on the stock market. Previously, all of the shares had
been owned by its two founders and certain employees. Now,
40% of the shares are in the hands of the investing public. The
company's profit growth and dividend policy are set out below.
Will a continuation of the same dividend policy as in the past be
suitable now that the company is quoted on the stock market?
Year Profits Dividend Shares in issue
$'000 $'000
4 years ago 176 88 800,000
3 years ago 200 104 800,000
2 years ago 240 120 1,000,000
1 year ago 290 150 1,000,000
Current year 444 222 (proposed) 1,500,000
Answer to the Chapter End Question
Year Dividend per share cents Dividend as %of profit
4 years ago 11.0 50%
3 years ago 13.0 52%
2 years ago 12.0 50%
1 year ago 15.0 52%
Current year 14.8 50%
 
• The company appears to have pursued a dividend policy of paying out half
of after-tax profits in dividend. This policy is only suitable when a company
achieves a stable EPS or steady EPS growth. Investors do not like a fall in
dividend from one year to the next, and the fall in dividend per share in the
current year is likely to be unpopular, and to result in a fall in the share
price. 
• The company would probably serve its shareholders better by paying a
dividend of at least 15c per share, possibly more, in the current year, even
though the dividend as a percentage of profit would then be higher.
Individual Assignment III (accounts for 15%). Submission
date: May 30/2012 E.C.

Instruction: Review the following article with


maximum of 5 pages.

Does Dividend Policy Follow the Capital


Structure Theory?

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