Chapter Three: Dividend Decision/Policy
Chapter Three: Dividend Decision/Policy
Chapter Three: Dividend Decision/Policy
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
(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
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