CHAPTER THREE

DIVIDEND THEORY & POLICY

Learning objectives
 After studying this chapter, you should have
achieved the following learning objectives:
 An understanding of the arguments put forward by the
‘dividend irrelevance’ school of thoughts;

 A general understanding of the arguments put forward

by those who believe that dividends are relevant to
share valuation.

 The ability to discuss the reasons why a financial

manager disregards the importance of the dividend
decision at his or her peril;
 An appreciation of the alternative dividend policies that
companies can operate and their significance to
investors;

 The ability of describe the factors that affect the

Introduction
 Traditionally, corporate finance was seen to involve
two distinct areas of decision making:
 the investment decision, where investment projects are
evaluated and suitable projects selected; and
 The finance decision, where finance is raised to
enable the selected projects to be implemented.

 The dividend decision, which considers the amount

of earnings to be retained by the company and the
amount to be distributed to shareholders, is
closely linked to both the investment and
financing decisions.
Con’t…

For example, a company with few suitable

projects should return unused earnings to
shareholders via increased dividends.

A company with several suitable projects that

maintains high dividends will have to find
finance from external sources.
Con’t…

 In recent years, the decision on the amount of earnings

to retain and the amount to pay out has become an

increasingly important decision in its own right to the
extent that it is now usual to talk about the three decision
areas of corporate finance, as you did in the previous
courses.

 Managers need to take into account the views and

expectations of shareholders and other providers of

capital when making dividend decisions.
Con’t…

The attitude of shareholders to changes in

the level of dividend paid must be balanced
against the availability and cost of internal
and external sources of finance.

Therefore;
Dividend policy involves the balancing of
the shareholders’ desire for current
dividends and the firm’s needs for funds
for growth.
 What is “dividend policy”?
Financial Managers must make decisions
regarding their dividend policy.
It’s the 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?
– The financial manager must take careful
decisions on how the profit should be
distributed among shareholders.
 Con’t…
 Dividend Decision is very important and crucial part of the

business concern, because these decisions are directly related with

the value of the business concern and shareholder’s wealth.

 Like financing decision and investment decision, dividend

decision is also a major part of the financial manager.

 When the business concerns decide dividend policy, they have to

consider certain factors such as retained earnings and the nature

of shareholder of the business concern.
 Con’t….

Therefore a company’s dividend policy is

important for the following reasons:
1. It bears upon investor attitudes:
 For example, stockholders look unfavorably upon the
corporation when dividends are cut, since they associate
the cutback with corporate financial problems.
 Further, in setting a dividend policy, management must
ascertain and fulfil the objectives of its owners.
Otherwise, the stockholders may sell their shares, which
in turn may bring down the market price of the stock.
 Stockholder dissatisfaction raises the possibility that
control of the company may be seized by an outside
group.
 Con’t…

2. It impacts the financing program and capital

budget of the firm.
3. It affects the firm’s cash flow position.
A company with a poor liquidity position may
be forced to restrict its dividend payments.
4. It lowers stockholders’ equity, since
dividends are paid from retained earnings, and
so results in a higher debt-to-equity ratio.
 Dividend Theories
Do investors prefer high or low payouts?
There are three theories:
On the relationship between dividend
policy and the value of the firm,
different theories have been advanced.
I. Dividends are irrelevant: Investors don’t
care about payout.
II. Bird in the hand: Investors prefer a high
payout.
III. 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.
The principal proponents of the dividend
irrelevance theory are Merton Miller
and Franco Modigliani (MM).

12
 Con’t….
They argued that the firm’s value is
determined only by its basic earning power
and its business risk.
 In other words, MM argued that the value of the firm
depends only on the income produced by its assets,
not on how this income is split between dividends
and retained earnings.
There is no relation between the dividend
rate and value of the firm. Dividend decision
is irrelevant of the value of the firm.
Modigliani and Miller contributed a major
approach to prove the irrelevance dividend
concept.
 Con’t….
According to MM, under a perfect market condition,
the dividend policy of the company is irrelevant
and it does not affect the value of the firm.

 MM approach is based on the following

Unrealistic assumptions:
 There are no transactions costs associated with
converting shares into cash by selling them;
 Firms can issue shares without incurring flotation
or transactions costs;
 There are no taxes at either a corporate or a
personal level;
 Con’t…
 Capital markets are perfectly efficient: the
firm operates in perfect capital market where
investor’s behave rationally, information is freely
available to all, transaction and flotation costs don’t
exist.
 Perfect capital market also imply that no investor is
large enough to affect the market price of a share.
 Investor’s are rational (i.e. they always make
the choice that maximizes their wealth)
 No risk: risk of uncertainty does not exist. That is,
investors are able to forecast future prices and
dividends with certainty.
 its dividend policy may have no influence on the market
price of shares”.
 Criticism of MM approach
The following are the major criticisms of MM approach.
i. MM approach assumes that tax does not exist. It is not
applicable in the practical life of the firm.
 Taxation does exist in the real world, at both a

corporate and a personal level,

ii. MM approach assumes that, there is no risk and uncertain of the

investment. It is also not applicable in present day business life.
iii. MM approach does not consider floatation cost and transaction
cost. It leads to affect the value of the firm.
iv. MM approach assumes that, investor behaves rationally. But we
cannot give assurance that all the investors will behave rationally.
 Dividend Preference: Bird-in-the-Hand
 Investors might thinkTheory
dividends (i.e., the-bird-in-
the-hand) 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 and would require a lower
return to induce them to buy its stock.

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 Tax Preference Theory
Retained earnings lead to capital gains, which
are taxed at lower rates than dividends: 28%
maximum 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.

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 Possible Stock Price Effects

Stock Price ($)

Bird-in-Hand
40

30 Irrelevance

20
Tax preference
10

0 50% 100% Payout

 Possible Cost of Equity Effects

Cost of equity (%)

Tax Preference
20

15 Irrelevance

10 Bird-in-Hand

0 50% 100% Payout

Implications of the 3 Theories for
Managers

Theory Implication
Irrelevance Any payout OK
Bird-in-the-hand Set high payout
Tax preference Set low payout

But which, if any, is

correct?
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 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.

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Factors Influencing Dividend
Policy

 So far we have discussed only the theoretical aspects

of dividend policy.
 Yet there are a number of practical constraints that
companies must consider when paying dividends to
shareholders. These are described below.
1. Liquidity: Since dividends and their associated
tax liabilities are cash transactions, managers need
to consider carefully the effect on the company’s
liquidity position of any proposed dividends.
 A common misconception is that a company with
high levels of profits can afford to pay high
dividends.
Con’t…
 Profit is not the same as the cash available to the
company and so the amount of dividends paid must
reflect not just the company’s profits but also its
ability to pay dividends.

2. Interest payment obligations: Dividends are paid

out of profits remaining after interest and taxation
liabilities have been accounted for.
 A company’s level of gearing and its interest
commitments are therefore a major constraint on its
dividend policy.
Con’t….

 A highly geared company with high interest

payments will have lower profits from which to
pay dividends than a company with low gearing and
similar overall profit levels.
o However, if a highly geared company has fewer issued shares
than a low-geared company with similar overall profits, the highly
geared company may actually pay a higher dividend per share.

3. Tax Policy:
 Tax policy of the government also affects the

dividend policy of the firm.

 When the government gives tax incentives, the

company pays more dividend.

Con’t….

4. Investment opportunities: Retained earnings

are a major source of finance for companies. Hence,
when companies are faced with a number of
attractive projects, there is pressure to reduce
dividends in order to finance such projects as
much as possible from retained earnings.
Whether a company will choose to reduce dividend
payments to finance new projects will depend on a
number of factors. These will include:
• the attitude of shareholders and capital markets to a reduction
in dividends;
• the availability and cost of external sources of finance;
• the amount of funds required relative to the available
distributable profits.
End Of Chapter!