Lecture 5:Dividend Policy

Dividends and earnings

• The dividend decision is closely linked to the financing

decision of a company.
• The dividend decision must take account of the views
and expectations of shareholders.
• Retained earnings are preferred as a source of
investment funds (pecking order theory).
• Dividend payments reduce the earnings available for
investment, increasing the need for external funds to
meet investment plans.
 Operational considerations
• Dividend is a distribution of after-tax profit made on a cash basis.
• Payment of dividend is usually done semi-annually (like in UK) or
quarterly (like in US).
• When a dividend is announced, a company’s share price will
change.
• This change will reflect the market’s attitude to the dividend that
has just been declared.
• The share price will then continue to be cum dividend for a short
period of time, meaning that anyone purchasing the share during
this period is entitled to receive the dividend when it is paid.
• When the share price goes ex dividend, anyone purchasing the
share on or after this date will not be entitled to the dividend
payment
Cum dividend and ex dividend share
prices

Figure 10.1 The relationship between the cum dividend and ex dividend share prices
Practical constraints
• Liquidity: 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.
• 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.
Practical constraints (Cont.)
• Investment opportunities:
• Retained earnings are a major source of finance for companies.
• 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.
• Factors affecting decision reducing dividend to finance project:
• 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.
Does Dividend policy matter?
• Generally accepted that:
• companies’ dividend policies are relevant to their share valuations.
• One reason: dividends are preferred to capital gains due to their certainty
(the bird in the hand argument).
• According to the argument bird in the hand : “Current dividends, on this analysis,
represent a more reliable return than future capital gains”.

• This means that:

• Companies that pay out low dividends may experience a fall in share price as
investors exchange their shares for those of a different company with a more
generous dividend policy.
Argument supporting the importance of
dividend policy
• Dividends are signals to investors:
• Shareholders see dividend decisions as conveying new information about the company and its
prospects.
• A dividend increase is usually seen by the market as conveying good news , while a dividend
decrease is usually seen as bad news, indicating a gloomy future for the company.
• However it could also mean:
• A dividend increase could be due to a shortage of attractive investments, implying that
growth prospects for the company and its dividends are poor.
• A dividend decrease may be a positive sign for investors, indicating an abundance of
attractive projects and hence good prospects for growth in future dividend payments.
• Markets not perfect in interpreting the dividend changes (even when a company
explains the reasons of the change):
• E.g. A company wanting to cut its dividend for reasons of financial prudence often faces a
significant decrease in its share price (e.g. British steel company in 1991).
Dividend relevance (Cont.)
Clientele effect:
• Shareholders are not homogenous and have differing needs and preferences.
• Some shareholders need regular income and so prefer dividends to capital gains
(this is true for small shareholders such as pensioners and institutional investors).
• Preferences for dividend or capital gains may arise due to their different tax
treatment.
• Clienteles will form as shareholders select companies that meet their
preferences.
• Investors will be attracted to companies whose dividend policies meet their requirements.
• The implication for a company: is that a significant change in its dividend policy could give
rise to dissatisfaction among its shareholders, resulting in downward pressure on its share
price.
Dividend relevance (Cont.)
• Relevance of dividend is supported by the dividend growth model.
• Dividend growth model suggests dividends determine company’s share
price.
P0 = D0 (1 + g) = D1
(r  g) (r  g)
• If shareholders require a return of 17%, the last dividend per share was 24p
per share and dividends are expected to grow by 6% per year, the dividend
growth model gives:
P0 = D0 (1 + g) = 24 × (1 + 0.06) = £2.31
(r  g) (0.17  0.06)
Dividend policies
(1) Fixed percentage payout ratio policy
Advantages:
• Easy to operate
• Sends signals to investors on company’s performance
Disadvantages:
• Dividends fluctuate with earnings
• Inflexible in terms of retained earnings
Dividend policies (Cont.)
(2) Zero dividend policy
Advantages:
• Desirable for investors wanting capital gains
• Cheap and easy to operate
• Allows company to reinvest earnings
Disadvantages:
• Unacceptable to most investor groups (Given that the majority of
ordinary shareholders are institutional investors who rely on dividend
payments for income)
Dividend policies (Cont.)
(3) Constant or steadily increasing dividend
Advantages:
• Acceptable to majority of investors
Disadvantages:
• Shareholders expect increasing dividends that companies may not be able to afford
• Cuts in dividends, however well signalled or justified to the markets, are usually
taken to mean financial weakness and result in downward pressure on a company’s
share price
• May limit companies’ ability to invest
• Because of the reaction of the market to a dividend cut, companies experiencing
increases in profit tend to be cautious about a dividend increase.
Dividend policy (Cont.): Reason for low
payout:
Why might a low payout be desirable?
• Individuals in upper income tax brackets might prefer lower dividend
payouts, with their immediate tax consequences, in favor of higher
capital gains.
• Flotation costs – low payouts can decrease the amount of capital that
needs to be raised, thereby lowering flotation costs
• Dividend restrictions – debt contracts might limit the percentage of
income that can be paid out as dividends
Dividend policy (Cont.): Reason for high
payout:
Why might a high payout be desirable?
• Desire for current income
• Individuals in low tax brackets
• Groups that are prohibited from spending principal (trusts and
endowments)
• Uncertainty resolution – no guarantee that the higher future
dividends will materialize
• Taxes
• Tax-exempt investors don’t have to worry about differential treatment
between dividends and capital gains
Dividend policies in practice
• The dividend policies adopted by companies tend in practice to be
influenced by two readily identifiable factors.
• The first factor is the industry or commercial sector within which a company
operates.
• Companies operating in industries that require large amounts of long-term reinvestment are
usually found to have lower payout ratios in order to facilitate higher levels of reinvestment.
• Companies operating in industries associated with high business risk, or industries susceptible
to large cyclical swings in profit, tend to pay lower dividends and have lower payout ratios to
avoid the risk of having to reduce dividend payments in the future.
• The second factor that affects companies’ dividend policies is the nature of the
company and its individual characteristics.
• For example, a company which has reached the mature stage of its life cycle may choose to
adopt a high payout ratio owing to its minimal reinvestment requirement.
• A company which has a high level of bank borrowings relative to the rest of the companies in
its sector may, in response to an increase in interest rates, choose to decrease its level of
dividend payout in order to meet its interest commitments.
Compromise Dividend Policy
• Goals, ranked in order of importance:
• Avoid cutting back on positive NPV projects to pay a dividend
• Avoid dividend cuts
• Avoid the need to issue equity
• Maintain a target debt/equity ratio
• Maintain a target dividend payout ratio
• Companies want to accept positive NPV projects while avoiding
negative signals
Alternatives to cash dividends
Share repurchases:
• Way of returning value to shareholders
• Cash should be returned if shareholders can use it more effectively then the
firm
• Value of remaining shares will be enhanced while ROCE, EPS and gearing will
increase
• On balance, market value of company should increase following share
repurchases
Alternatives to cash dividends (Cont.)
Stock Dividends
• Distribute additional shares of stock instead of cash
• E.g. If you own 100 shares and the company declared a 10% stock dividend,
you would receive an additional 10 shares
• Possible advantages:
• The major advantage with paying a stock dividend is that it allows a company
to keep the cash that would have been paid out in cash dividends.
• Another possible advantage associated with paying a stock dividend is that it
allows a company to decrease its gearing ratio slightly
Alternatives to cash dividends (Cont.)
Stock splits – essentially the same as a stock dividend except expressed
as a ratio
• For example, a 2-for-1 stock split is the same as a 100% stock dividend
• Stock price is reduced when the stock splits
• Common explanation for split is to return price to a “more desirable
trading range”
Alternatives to cash dividends (Cont.)
Non-pecuniary benefits (shareholder perks):
• For example, discounts or special offers on company products to
shareholders:
• Inchcape (min 100 shares) 15% discount on service, parts and accessories and
£100 off the retail price of new and used cars
• Mulberry Group (min 250 shares) 20% discount in a number of their high-
street stores
• Next (min 100 shares) Voucher that entitles holders to a 25% discount on
purchases
Dividend policy (Empirical evidence):
• There is substantial evidence for tax clienteles and the signalling
effect of dividends.
• Excessive focus on dividend decisions by institutional investors can
have a detrimental effect on shareholder value.