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1 Deciding on a distribution and retention policy Dividend irrelevancy theory ( Modigliani and Miller ) Proposed their dividend irrelevancy

y theory, the key points of which are as follows: In an efficient market, dividend irrelevancy theory suggests that, provided all retained earnings are invested in positive NPV projects, existing shareholders will be indifferent about the pattern of dividend payouts. However, practical influences, including market imperfections, mean that changes in dividend policy, particularly reductions in dividends paid, can have an adverse effect on shareholder wealth: Reductions in dividend can convey bad news to shareholders (dividend signaling). Changes in dividend policy, particularly reductions, may conflict with investor liquidity requirements (selling shares to manufacture dividends is not a costless alternative to being paid the dividend) Changes in dividend policy may upset investor tax planning (e.g. income v capital gain if shares are sold). Companies may have attracted a certain clientle of shareholders precisely because of their preference between income and growth. As a result, most companies prefer to per-determine dividend policy.

Practical influences on dividend policy Before developing a particular dividend policy, a company must consider the following: legal position levels of profitability inflation growth

control tax liquidity/cash other sources of finance. Many of these limit the dividend capacity of the fir m. This can be simply defined as the ability at any given time of a firm to pay dividends to its shareholders. This will clearly have a direct impact on a companys ability to implement its dividend policy (i.e Can the company actually pay the dividend it would like to). Dividend policy in practice In practice, there are a number of commonly adopted dividend policies: stable dividend policy constant payout ratio zero dividend policy residual approach to dividends. stable dividend policy Stable dividend policy:Paying a constant or constantly growing dividend each year: It offers investors a predictable cash flow works well for mature firms with stable cash flows. reduces management opportunities to divert funds to nonprofitable activities However, there is a risk that reduced earnings would force a dividend cut with all the associated difficulties.

Constant payout ratio Paying out a constant proportion of equity earnings:

maintains a link between earnings, reinvestment rate and dividend flow but cash flow is unpredictable for the investor gives no indication of management intention or expectation. Zero dividend policy All surplus earnings are invested back into the business. Such a policy is common during the growth phase .It should be reflected in increased share price. When growth opportunities are exhausted (no further positive NPV projects are available) cash will start to accumulate and a new distribution policy will be required. Residual dividend policy A dividend is paid only if no further positive NPV projects available. This may be popular for firms: in the growth phase without easy access to alternative sources of funds. However: cash flow is unpredictable for the investor gives constantly changing signals regarding management expectations. Ratchet patterns Most firms adopt a variant on the stable dividend policy a ratchet pattern of payments. This involves paying out a stable, but rising dividend per share: Dividends lag behind earnings, but can then be maintained even when earnings fall below the dividend level. It avoids bad news signals. Does not disturb the tax position of investors.

Scrip dividends

A scrip dividend is where a company allows its shareholders to take their dividends in the form of new shares rather than cash. Do not confuse a scrip issue (which is a bonus issue) with a scrip dividend. The advantage to the shareholder of a scrip dividend is that he can painlessly increase his shareholding in the company without having to pay brokers commissions or stamp duty on a share purchase. The advantage to the company is that it does not have to find the cash to pay a dividend and in certain circumstances it can save tax. Some companies give shareholders the choice between cash and scrip dividends. In such cases the terms of the choice are usually designed so that the shareholder who chooses the scrip sees their wealth increase with a fall in wealth if cash is chosen. Such an arrangement is called an enhanced script.

Share repurchase schemes If a company wishes to return a large sum of cash to its shareholders, then it might consider a share repurchase rather than a one off special dividend. These are schemes through which a company buys back its shares from shareholders and cancels them. The companys Articles of Association must allow it. It often occurs when the company: has no positive NPV projects wants to increase the share price [cosmetic exercise]

wants to reduce the cost of capital by increasing its gearing. Advantages for the company might include: Giving flexibility where a firms excess cash flows are thought to be only temporary. Management can make the distribution in the form of a share repurchase rather than paying higher cash dividends that cannot be maintained. Increasing EPS through a reduction in the number of shares in issue. Buying out dissident shareholders. Altering capital structure to reduce the cost of capital. Effective use of surplus funds where growth of business is poor, outlook is poor (i.e. adjusting the equity base to a more appropriate level). Creation of a market where no active market exist for its shares (e.g. if the company is unquoted). Reducing likelihood of a takeover. For the shareholders, advantages might include: Giving a choice, as they can sell or not sell. With cash dividend shareholders must accept the payment and pay the taxes. Saving transaction costs. But constraints might include: Getting approval by general meeting (arguments about the price at which repurchase is to take place) The company may pay too high a price for the shares. Premiums paid are set first against share premium and then against distributable profits (if against distributable profits, this will reduce future dividend capacity) Might be seen as a failure of the current management/company to make better use of the funds through reinvesting them in the business.

The shareholders may feel they have received too small a price for their shares. Shareholders may not be indifferent between dividends and capital gains due to their tax circumstances .