(FINM7312)

LU3: Dividend Policy

 Learning Objectives:

After completing this section, you should be able to:

• Explain cash dividend payment procedures in South Africa;
• Evaluate dividends from accounting, shareholder and company points of view;
• Explain share splits and share repurchases and the firm’s motivation for undertaking
each of them.
• Calculate the dividends payable and the impact thereof under various dividend
policies;
• Calculate the impact of share splits and share buy backs.
 Overview:

• Once a company turns a profit, management face the decision on what to do

with the profits. These profits could be retained by the company, or- the
profits may be paid out to owners and shareholders as dividends. A dividend
policy formalises the decision about what to do with profits.
• In this learning unit, we will examine the cash dividend payment procedures
in South Africa, evaluate dividends from the point of view of accounting,
shareholders and the company and explain share repurchases and share splits
in relation to the company’s motivation for undertaking each of them.
 Introduction:

• A dividend is:
• A distribution of profits to the holders of equity investments in proportion to their
holdings of a particular class of capital.

• Dividends are generally paid out of retained earnings.

• Internally generated funds are often thought to be a “free” form of finance.
Internally generated funds do have a cost – an opportunity cost (assumed
to be the cost of equity).
Objective:
 Cash dividend payment procedures:

❑Declaration date : Date on which the board of directors passes a resolution

to pay a dividend
❑Ex dividend date : The date after which purchase of the shares does not
entitle the buyer to receive a dividend
❑Record date/Last day to register: Date on which holders of the shares are
designated to receive a dividend
❑Date of payment: Date on which dividend cheques are mailed
Cash dividend payment procedures:
 Dividend policy theories
• Retained earnings / accumulated profits are earnings not distributed as dividends; a
form of internal financing. The dividend decision can significantly affect the firm’s
external financing requirements. The greater that amount of the dividend paid the
greater the external financing requirement
• Residual theory of dividends, --a theory that the dividend paid by a firm should be
the amount left over after all acceptable investment opportunities have been
undertaken. If a company can identify projects with positive net present values, then
it should invest in them.
• Finally, the theory indicates that dividend policies are irrelevant and not value-
creating activities.
 Dividend policy theories
• Dividends irrelevance theory, -- A theory put forth by Miller and Modigliani that, in a
perfect world, the value of a firm is unaffected by the distribution of dividends and is
determined solely by the earning power and risk of its assets
• Studies have shown that large dividend changes affect share prices in the same direction.
• In response M&M argue that these effects are not attributable to the dividend itself but
rather to the informational content of dividends with respect to future earnings
• (Informational Content – The information provided by the dividends of a firm with respect
to future earnings, which causes owners to bid up or down the price of a firm’s share)
• This basically means that investors view the movements in dividends as a signal of
management’s expectations of the firm’s future earnings
 Dividends irrelevance theories contin..
• M&M argue that the value of a firm is unaffected by dividend policy for three
reasons:
❑The firm’s value is determined solely by the earning power and risk of its assets
❑If dividends do not affect value, they do so solely because of their informational
content, which signals management’s earnings expectations
❑A clientele effect exists that causes a firm’s shareholders to receive the dividends
they expect
• (Clientele effect – The argument that a firm attracts shareholders whose preferences
with respect to the payment and stability of dividends correspond to the payment
pattern and stability of the firm itself)
 Dividends relevance theory

• The theory, attributed to Gordon and Linter, that there is a direct

relationship between a firm’s dividend policy and its market value
• The “bird in the hand argument” – The belief, in support of dividend
relevance theory, that current dividend payments (‘a bird in the hand) reduce
investor uncertainty and result in a higher value for the firm’s share price
 Contin…

• The clientele effect is the principle that not all investors are the same. Some
may prefer a high dividend payout, whereas others expect the company to
reinvest the funds for growth.
• When a dividend is declared, a signal is sent to the market about the
company. The market can regard the signal as either positive or negative. The
signal that a dividend declaration sends to the market is referred to as
information content.
 Factors affecting dividend policy

▪ Profitability- in order to be in a position to declare dividends, companies must be

profitable. Payment of a dividend in excess of a company’s cumulative retained
earnings is not sustainable and is potentially illegal.
▪ Growth outlook- The firm’s financial requirements are directly related to the
anticipated degree of asset expansion
▪ Legal constraints :the Companies Act lays down the circumstances under which a
company may declare dividends in terms of their source. In addition to Company
Act requirements or limitations there are also aspects of dividend policy covered in
the Income Tax Act
 Contin….

▪ Contractual constraints- Often a firm’s ability to pay dividends is constrained

by restrictive provisions in a loan agreement
▪ Liquidity- The firm’s ability to pay cash dividends is often constrained by the
amount of cash available rather than the level of accumulated profit.
▪ Owner consideration- In establishing a dividend policy, the firm’s primary
concern should be to maximise owner wealth. Although it is impossible to
establish a policy that maximises each owners wealth, the firm must establish
a policy that has a favourable effect on the wealth of the majority of owners.
 Contin….

▪ Market considerations- An awareness of the markets probable response to

certain types of policies is helpful in formulating a suitable dividend policy.
▪ Taxation- Dividends are taxed at 20%. Shareholders are subject to capital
gains tax on any gains arising on the disposal of shares. Capital gains are
taxable at an inclusion rate of 40%.
▪ For companies holding shares as an investment. Taxable gains are included in
this taxpayer's taxable income at an inclusion rate of 80%
 Types of dividend policies
▪ Dividend Policy – The firm’s plan of action to be followed whenever a dividend
decision must be made
▪ Dividend payout ratio - indicate the % of each Rand that is distributed to owners in
the form of cash. Calculated by dividing the firm’s cash dividend per share by its
earnings per share.
1. Constant Pay-out Ratio Dividend Policy
• A dividend policy based on the payment of a certain percentage of earnings to
owners in each dividend period
• This policy is not recommended
 Types of dividend policies

2. Stable dividend amount/Regular dividend policy

• A dividend policy based on the payment of a fixed rand dividend in each
period.
3. Stable dividend plus bonus
• A company pays a low fixed rand amount regularly and supplements this
fixed dividend amount with an additional “bonus’ dividend when earnings
increase to higher level.
 Non- cash dividends

There are three other ways of compensating the shareholder without a

dividend payout in cash, namely:
• Dividend paid in shares
• Share splits
• Share buy-backs
 Share Dividend

• Issue dividends in the form of shares instead of cash

• The company would issue more shares to shareholders
• Advantages:
▪ No tax consequences
▪ Tax will only be paid when shares are sold for profit
 Share buy-backs

• Also known as share repurchase

• A company communicates that there is no better investment than the
company itself
• Company buys its own shares
• If a company buys back shares, that would reduce the number of shares
outstanding
• Normally occurs when shares are undervalued
 Share Splits

• When shares are overvalued – too expensive

• For instance, a 2-1 share split:
▪ For every share you own, that specific share will be divided into 2
▪ You will have double the number of shares you had before
▪ The share price will also halve (making shares more popular, creating a
higher demand)
 Reverse Share Split
• Also known as consolidation.
• When shares are undervalued or if the company wants to increase the
price per share to avoid being delisted
• For instance, a 2-1 reverse share split:
▪ For every share you own, that specific share will be multiplied by 2
▪ You will have halve the number of shares you had before
▪ The share price will also double (increasing the share price to a more
respectable level)
 Conclusion

• A company has various options available when deciding on what it should do

with its net earnings. These include:
▪ Maintaining current operations
▪ Paying outstanding debts
▪ Expanding the company through profitable investments
▪ Repurchasing shares
▪ Paying dividends.
 Home Work…..

• In the prescribed textbook:

• Question 3.2
• Question 3.3
• Revision Questions 3