DIVIDEND POLICY

4.1 INTRODUCTION

Dividends are part of the earnings which are distributed to the ordinary shareholders for
investing in the company. The dividend decision is important to the company because
of two main reasons:-
1. It provides the solution to the dividend puzzle i.e. Does payment of dividend
increase or reduce the value of the firm?
2. It is part of the company’s financing strategy i.e. payment of high dividend
means low retained earnings and hence the need for more debt capital in the
company’s capital structure.
In this lesson we will seek to answer some critical questions surrounding the dividend
puzzle. These are:-
1. When should the firm pay dividend?
2. How much dividend should the company pay?
3. How should the firm pay dividends?
4. Why should the firm pay dividends?

Lecture outline
4.1 When to pay dividend
4.2 Dividend policy
4.3Different forms of dividends
4.4Dividend theories
4.5Normal practice in dividend payment

Learning outcomes
By the end of this chapter you should be able to
i. Explain why firms pay or not pay dividends
ii. Justify why a firm may not distribute all its earnings as dividends
iii. Explain the different forms of dividends
iv. Critique the dividend theories and relate them to the practice

4.2 When should the firm pay dividends

A company can pay dividends twice in the course of the year that is interim and final or
it can pay dividends once in a year that is final dividends.
The question on whether to pay interim and final or just the final dividend will depend
on:-
 The company’s liquidity position.
 The expectation of the shareholders.
 The need for cash for financing purposes.

4.3 How much dividend to pay

 There are four different dividend policies which influence the amount of dividend
per share a company can pay. These include:-
 Constant pay out policy
 Constant or fixed Dividend per share policy
 Low constant DPS plus bonus or surplus
 Residual dividend policy

4.3.1 Constant payout policy

Under this policy a company could pay a fixed proportion of its earnings attributable
to ordinary shareholders as dividends. Since the earnings fluctuate over time the
EPS and the total dividends payable and dividends per share will also fluctuate over
time.
This policy has the following implications:-
 It creates uncertainty as to the amount of dividend income receivable by the
shareholders.
 The shareholders may require a higher rate of return to compensate them
for the uncertainty.

4.3.2 Constant or fixed DPS policy

Under this policy the company could pay a fixed amount of DPS irrespective of the
levels of earnings. Therefore in this case the ordinary shareholders are treated as
preference shareholders because they receive fixed dividends. In this case the EPS may
fluctuate over time but the DPS remains constant. This policy has the following
implications:-


It creates certainty and its therefore preferable to the low income
shareholder’s who have a high preference for dividends instead of capital
gains.
 The certainty reduces the shareholders required rate of return.
 When the firm has high earnings more income will be retained for future
financing needs.
4.3.3 Low constant DPS plus bonus or surplus
Under this policy the DPS is set at a very low level and paid every year. However, a
bonus or extra dividend is paid in the years of supernormal earnings. This extra
dividend is paid in such a way that it’s not seen as a commitment for the firm to
continue paying it in the future. Therefore, the EPS will be fluctuating every time
while DPS will remain constant with occasional bonuses or surplus.
 Implications of this policy
a) It gives the company flexibility to increase dividends when the earnings
are high.
b) It gives shareholders a chance to participate in supernormal earnings of
the firm.
c) It’s most appropriate to those companies with high volatility in earnings
and business risk e.g. companies in the agricultural sector.

4.3.4. Residual dividend policy

In this case dividends are paid out of the earnings left after all the profitable
investment opportunities have been financed. Therefore, out of the earnings
attributable to the owners the first allocation is towards financing all projects
yielding a positive NPV.
Dividends are only paid if earnings are not exhausted by the company’s financing
needs. By first financing projects which yield positive NPV the policy attempts to
maximize the value of the firm and the shareholders wealth. This policy has the
following advantages.

i. Savings on floatation costs

The use of internally generated funds (earnings) to finance new
projects does not involve floatation cost as compared to when
raising new securities.
ii. Avoidance of dilution of ownership
With no issue of additional shares there will be no dilution of
ownership control and future dividends per share of the firm.
iii. Tax position of shareholders
The re-investment of earnings in projects with positive NPV
will lead to the increase in market share per share and
investors would realize capital gains which are not taxed in
most countries. This will reduce the tax burden of
shareholders who have high incomes from other sources.
4.4 HOW SHOULD THE FIRM PAY DIVIDENDS (TYPES OF DIVIDENDS)
A company can pay dividends in different forms
 In cash
 Bonus or scrip issue
 Stock split and reverse split
 Stock or share repurchase

4.4.1 Payment of cash dividends

This is the most common mode of dividend payment. However the payment of
cash dividend will depend on:-
 The company’s liquidity position.
 The financing needs of the company.

4.4.2 Bonus or scrip issue

This is also known as a dividend reinvestment scheme. It involves giving free
shares to the existing shareholders instead of cash dividends. The shares will be
given in proportion to the shareholders ownership. This method has the
following advantages:-
 There is conservation of cash since there is no actual cash outlay.
 There is the tax advantage whereby the free shares can be sold to realize
capital gains which are not taxable in most countries.
 Incase of an increase in future profits the bonus issue may be an
indication of high future dividends to the existing shareholders.

4.4.3 Stock split and reverse split

This is the process by which a company undertakes to reduce the par value of its
shares and to increase the number of ordinary shares by the same proportion. The
major reason for a stock split is to make the shares attractive and more affordable
than before.
The stock split has no effect on the net worth of the company. A reverse stock
split is the opposite of a stock split and it involves the consolidation of the shares
into bigger units or stocks. In this case the number of ordinary shares is reduced
while the par value of the share is increased by the same proportion that has been
used to reduce the number of the ordinary shares.
 4.4 WHY SHOULD THE FIRM PAY DIVIDENDS?
( THE DIVIDEND THEORIES)
This question can be answered by the various dividend theories which attempt to
explain whether the payment of dividends affects the value of the firm. These include
the following theories:-
4.1 Dividend irrelevance argument (Modigliani and Miller)
Professors Merton H. Miller and Franco Modigliani (MM) have advanced the Dividend
Irrelevance theory, which posits that in perfect capital markets, the dividend payout ratio is
irrelevant. They argue that a firm’s value is determined solely by the earning power and risk of
its assets (investments) and that the manner in which the firm splits its earnings stream between
dividends and internally retained, and reinvested, funds does not affect this value. They assert
that, given the investment decision of the firm, the dividend decision does not in any way affect
the wealth of shareholders. MM hypothesis of irrelevance is based on the following critical
assumptions:

1. There exists perfect capital markets in which all investors are rational, information is
available to all at no cost, securities are infinitely divisible and no investor is large enough to
affect the market price of a security.
2. Taxes do not exist, or there are no differences in a tax rates applicable to capital gains and
dividend. Thus, investors are indifferent between dividend and capital gains.
3. A firm has a fixed or given investment policy that is not subject to change.
4. Transactions can take place instantaneously and at no cost. Similarly, securities can be issued
by a firm without the incurrence of issue costs.
5. Investors are perfectly certain as to the future investments and profits of the firm. Because of
this assurance, there is, among other things, no need to distinguish between stocks and bonds
as sources of funds. The analysis, therefore, assumes an all equity firm.

According to MM, the effect of dividend payment on shareholder wealth is exactly offset by
other means of financing. If the firm’s investment decision is already made, the firm must decide
whether to retain its earnings or to pay dividends and, say, sell new stock in the amount of these
dividends in order to finance its investments. MM suggest that the market value of the firm’s
stock before the financing and dividend payment remains unaffected regardless of the decision
taken. The shareholder is, therefore, indifferent between dividends and retention of earnings and
subsequent capital gains.

4.5.2 The agency theory

The agency problem between shareholders and management can be solved through
the payment of dividends. This can be explained as follows:-
 If all earnings are paid out as dividends managers will require to raise additional
equity and debt finance to finance future projects.
 This will expose the managers to the providers of capital in order to finance
future projects.
  If the managers were to seek this through external borrowing they must engage in
activities that maximize the shareholders wealth or the value of the firm and they
must make full disclosure of their activities to providers of funds. ( disciplining
effect of debt)
 Managers will thus become self regulated and hence there will be no need of
incurring agency costs.
In summary therefore the higher the dividend paid the higher the value of the
firm and vice versa.
4.5.3 Bird in hand theory (Gordon and Lintner) 1963
This theory is based on the certainty of dividends over capital gain. The theory argues
that if dividends are not paid they are used to finance projects with a positive NPV
which leads to an increase in the MPS leading to realization of capital gains in the
future. The theory can be summarized as follows:-
 Investors who are risk averse will prefer dividends to capital gains.
 Dividend income is immediate and more certain ( a bird in hand) compared to
capital gains that are receivable in the future and are highly uncertain (two) birds
in the bush)
 Given that most investors prefer certain income they will prefer dividend income
to capital gains.
Therefore a company that pays high dividends will have a higher value and
vice versa.
In response MM argued that investors are indifferent between dividend yield and
capital gain. Hence the cost of capital (equity) is not affected by dividend policy. MM
argued that many if not most investors would re invest their dividend in the same or
similar firm if they do not need current income. MM referred to Gordon and Lintner’s
model as the bird in hand fallacy.
4.5.4 Clientele theory (Petit 1977)
Clientele is the tendency of a firm to attract investors who like or prefer its dividend
policy. Different groups of stock holders prefer different payout policies e.g. retired
individuals prefer current income and would like to invest in companies with high
payout ratios. However, investors in their peak earning years may have no need of
current investment income and would simply re-invest any dividend received after
paying the relevant taxes.
MM however argued that one clientele is as good as any other. The existence of
clientele effect does not suggest that one policy is better than the other.

4.5.5 Tax differential theory (Linzenberger and Ramiswamy 1979)

This theory argues that capital gains tax is generally lower than the tax on ordinary
income including dividends. Investors also pay taxes on dividends in the same year
when the dividends are received whereas the capital gain tax is only payable when the
gain is actually realized, that is the shares are sold.
From the taxation point of view investors may therefore prefer capital gains to
dividend income in order to minimize their tax burden.

4.5.6 The information signaling theory (Stephen Ross – 1977)

Ross observed from empirical studies that firms that increase significantly dividend
payments had a corresponding increase in share prices whereas those firms that omitted
or reduced significantly dividend payments had a corresponding decline in share prices.
This in his opinion suggested that investors prefer dividends to capital gains.
In response MM however argued that a higher than normal dividend increase is a signal
to investors that the firm’s management forecast good future earnings. On the contrary a
dividend reduction is a signal that management forecast poor future earnings.
MM further argued that the investor’s reaction to changes in dividend policy does not
necessarily show that investors prefer dividend to capital gain. Rather the fact that price
change follows a dividend action simply indicates that there is important information or
signaling content in dividend announcements.
According to Solomon Ezzra 1963, a dividend action may offer tangible evidence of
the firm’s ability to generate cash flows. As a result a dividend action may affect share
prices. He states ‘ In this uncertain world in which verbal statements may be mis-
interpreted, a dividend action provides a clear cut means of making a statement
that speaks louder than a thousand words.’

Over the years, various models have been developed that establish the relationship
between dividends and stock prices. The most important of them is the Walter Model:

4.5.7 Walter Model

Prof James E. Walter devised an easy and simple formula to show how dividend can be
used to maximize the wealth position of shareholders. He considers dividend as one of
the important factors determining the market valuation. According to Walter, in the long
run, share prices reflect the present value of future stream of dividends. Retained
earnings influence stock prices only through their effect on further dividends.

Assumptions

1. The company is a going concern with perpetual life span.

2. The only source of finance is retained earnings. i.e. no other alternative means
of financing.
3. The cost of capital and return on investment are constant throughout the life of
the company.
According to Walter Model,
 P=
1
K (
D+ ( E−D )
ROI
K )
P= Market price per share E= Earnings per share
D = Dividend per share, K= Cost of Capital (Capitalization rate)
ROI = Return on Investment (also called return on internal retention)

The model considers internal rate of return (IRR), market Capitalization rate (K) and
dividend payout ratio in determination of share prices. However, it ignores various
other factors determining the share prices. It fails to appropriately calculate prices of
companies that resort to external sources of finance. Further, the assumption of
constant cost of capital and constant return are unrealistic. If the internal rate of
return from retained earnings (RoI) is higher than the market capitalization rate, the
value of ordinary shares would be high even if the dividends are low. However, if the
ROI of the business is lower than what market expects, the value of shares would be
low. In such cases, the shareholders would expect a higher dividend.

If ROI > Kc, Price would be high even if Dividends are low

Walter model explains why market prices of shares of growth companies are high
even if dividend payout is low. It also explains why the market prices of shares of
certain companies which pay higher dividend and retain low profits are high.

Illustration 4.2
A Ltd. paid a dividend of Ksh 5 per share for 2010-11. The company follows a fixed
dividend payout ratio of 30% and earns a return of 18% on its investments. Cost of
capital is 12%. The expected market price of the shares of A Ltd. using Walter
Model would be calculated as follows;

30% = sh 5

100%= sh ? = EPS

100
xsh5=sh 16 . 67
=30 = EPS

0R

EPS = Dividend / payout Ratio = 5 / 0.30 = Ksh.16.67

According to Walter Model,

P=
1
K (
D+ ( E−D )
ROI
K )
 Where P is stock price, k is the cost of capital, E = EPS, D =DPS, ROI= Return on
equity

P=
1
(
0 . 12
5+ ( 16. 67−5 ) )
0. 18
0 .12
=187 .5

4.6 FACTORS INFLUENCING DIVIDEND POLICY

4.6.1 Contractual Constraints

Often, the firm’s ability to pay dividends may be constrained by certain restrictive covenants in
loan agreements or preference share agreements. These covenants generally protect creditors
from losses due to insolvency on the part of the firm. They may prohibit the firm from paying
cash dividends from earnings generated before signing the loan agreement; or until a certain
profit level is achieved. Alternatively, they may limit the dividends paid to a certain amount or
percentage of earnings. Similarly, preference dividends must be paid before cash dividends are
paid to ordinary shareholders.

4.6.2 Firm’s Financial Requirements

Financial requirements of a firm are directly related to the level of asset expansion envisaged in
the coming period. Over the life cycle of a firm, the growth stage is characterized by rapid
expansion and therefore greater need to finance capital expenditures. Similarly, high growth
firms are typically in need of funds to maintain and improve their assets. Such firms typically
require funds for expansion and are likely to depend heavily on internal financing through
retained earnings to take advantage of emerging profitable opportunities; they are likely to pay
only a small proportion of their profits as dividends. On the other hand, firms in the maturity
stage that have been around for long normally have access to new capital from external sources
and may not need to rely to a large extent on retained earnings for survival.

4.6.3 Liquidity Position

Dividends are paid out in the form of cash and, hence, the greater the firm’s cash position and
overall liquidity, the greater its dividend payment capacity. A firm may be very profitable but not
liquid enough because retained profits will have been invested in assets required for the conduct
of business such as plant and equipment and inventories. At the same time, firms may be
desirous of maintaining some liquidity cushion and, as such, reluctant to jeopardize this position
by paying a large dividend.

4.6.4 Legal Constraints

Legal rules governing cash dividend payment may be very complicated. They vary from one
country to another. Generally speaking, the essential nature of these rules may be captured under
three related provisions:

1) Capital Investment Restrictions: These prohibit firms from paying cash dividends from
any portion of their ‘legal capital,’ which may at times be defined to include both the par
value of stock and any capital paid in excess of par (also called share premium). Such
rules are designed to protect creditors’ claims by ensuring that a sufficient equity base is
maintained.
2) Insolvency Rules: These generally provide that firms cannot pay cash dividends
while insolvent. Insolvency is usually defined in the financial distress sense to mean
excess of liabilities over assets.
3) Net Profits Rule: This states that cash dividends can be paid only from past and present
earnings.
Legal rules are important in that they provide a framework within which dividend policies
may be formulated.

4.6.5 Control

A company may make it a policy that all expansion projects are financed using retained earnings
only. Such a policy may be defended on the grounds that the firm fears the dilution of control
that may result in the event that existing shareholders are unable to subscribe for additional
shares if new shares are floated to raise capital for expansion. Firms with such a policy in place
will be forced to adopt a low dividend payout. Managers of companies in danger of acquisitions
from an external group may, however, go for a high payout as a way of convincing the
shareholders that they are doing their best to maximize their (shareholders’) wealth.

4.6.6 Market Considerations

Managers should formulate a suitable dividend policy after a careful evaluation of probable
market responses. For instance, if shareholders prefer a stable dividend payout and the company
adopts a fluctuating payout policy, they (shareholders) may use a higher rate of return to discount
the firm’s earnings. Shareholders are likely to use a lower discounting rate if the frequency and
magnitude of dividends can be easily predicted. This should result in an increase in the market
value of stock and therefore, shareholders’ wealth.

The information content of a dividend is another aspect that must be judged carefully by a
company. If a firm skips dividend payment in a given period, say due to a loss or very low
earnings, investors are likely to interpret this as a negative signal. This creates uncertainty about
the firm’s future and may drive down the value of its stock.

4.6.7 Owner Considerations

The firm must give consideration to investment opportunities available to owners Firms should
not retain funds for investment in projects yielding lower returns than the owners could obtain
from external investment of equal risk. The firm should evaluate the returns expected on it’s own
investment opportunities and determine whether greater returns are obtainable from external
investments such as government securities or other corporate stocks. If it appears that
shareholders would have better opportunities externally, the firm should pay out a higher
percentage of its earnings. A lower payout would be justifiable if the firm’s investment
opportunities are at least as good as external investments of a similar risk.

The tax position of shareholders is another important consideration. The primary objective of
financial management is shareholder wealth maximization. The dividend policy adopted by a
firm should therefore be the one that can help in attaining this objective. Where a firm is closely-
held, the body of shareholders is small and homogeneous and their expectations can be easily
known to management. The dividend policy adopted in this case will be the one that meets those
expectations.

Where a firm is widely-held however, it is a formidable task to ascertain the shareholders’

preferences and the policy adopted should be the one that has a favorable effect on the wealth of
the majority of them. Shareholders of a widely-held firm may be divided into four distinct groups

1) Small Shareholders: These hold a small number of shares in a few companies without a
definite investment policy. However, they are likely to belong in the low income tax
bracket and as such might prefer a high dividend payout. This preference may not
influence the company’s dividend policy because small shareholders rarely prove to be
the dominating group in the shareholders’ body.
2) Retirees: These use their pension funds or savings to invest in shares with the main aim
of getting a regular income. As such, they will, generally, be interested in a high
dividend payout.
3) Wealthy Investors: These are people in high income tax brackets who are concerned
about maximizing their wealth as they minimize the amount of taxes they pay. If they
happen to be the dominating group of shareholders, the firm may be forced to adopt a
low dividend payout policy.
4) Institutional Investors: Unlike wealthy investors, these are concerned not with personal
income taxes but with profitable investments. Most institutional investors seek
diversification in their investment portfolios and favor a policy of regular dividend
payout.

4.7 Summary

In this topic we have covered one of the key decision areas in finance and know you can justify
when to pay a dividend, how to pay it and even why to pay it. We have looked at the dividend
theories and the debate revolves around whether to pay dividends or not. Modigliani and miller
disagree with these theorists and say payment or nonpayment of dividend does not the value of
the firm or wealth of the shareholder.
We have further seen, payment of dividend is influenced by the company’s circumstances at that
given time.