Dividend Policy
Dr. Subrahmanya Kumar N
Associate Professor and Associate Head
Department of Commerce, Manipal Academy of Higher Education
WhatsApp: +91 9480 65 9896 Email: ns.kumar@manipal.edu
Dividend Policy
• On successful completion of the unit, students will
be able to
• Discuss different theories of dividend policy,
including dividend relevance, residual theory,
and dividend irrelevance (Modigliani and Miller).
• Syllabus
• The dividend decision; theories of dividend
policy – dividend relevance, residual theory, and
dividend irrelevance (Modigliani and Miller);
practical constraints/issues – practical
influences, dividend capacity; real world
dividend policies; share buyback schemes;
alternatives to cash dividend.
Dividend
• A dividend is a portion of a company's profits distributed to its shareholders as
a reward for their investment in the company.
• Dividends are typically paid in cash but can also be distributed in the form of
stocks
• The company’s board of directors decides the dividend amount and payment schedule,
which is usually approved by shareholders.
• Has impact on
• Retained earnings
• Cash
• Share price
• Importance - debatable
• Income to investors
• Signals financial health
• Attracts investors
Dividend
• Retained earnings or internally generated funds are an
important source of capital
• Long-term and short-term
• No issue cost
• Flexible - no need to apply for it or no repayment
requirements
• No dilution of control
• Immediately available – no lapse in time
• Use of retained earnings as a source of capital
• Direct impact on amount of dividend paid
• What is the impact on existing shareholders and share price
of the company?
Theories of Dividend Policy
• What will be the impact of a cut in the dividend on
a company and its shareholders?
• Dividend Irrelevance Theory of Modigliani and
Miller
• Residual Theory
• Dividend Relevance
Dividend Irrelevance Theory of
Modigliani and Miller
• Assumptions
• Perfect capital markets
• No transaction costs, taxes, or issuance costs exist.
• All investors have equal access to market information (symmetrical
information).
• There are no differences between the treatment of dividends and capital
gains in terms of taxation.
• Rational investor behaviour
• Argument
• In a perfect capital market, existing shareholders will only be concerned in
increasing their wealth, but will be indifferent as to whether that increase
comes in the form of dividend or capital gain
• Company can pay any dividend with shortfall of funds being met through new
issue of equity provided investments are made in positive NPV. Projects
• Obtaining outside finance would reduce the value of shares but the reduction
will be equal to the dividend paid
Dividend Irrelevance Theory of
Modigliani and Miller
• Practically inefficient – market imperfections
• Dividend signaling
• Managers often have better knowledge about the company’s true financial
situation than external investors
• Positive Signal:
• An increase in dividends is generally interpreted as a sign that the
company is confident about its future cash flows and profitability.
• It reassures investors of the company's financial strength and stability.
• Negative Signal:
• A reduction or omission of dividends can indicate financial trouble or
uncertainty about future earnings.
• It may lead investors to believe that the company’s earnings are declining
or unstable.
• Not all dividend changes are due to changes in earnings or confidence.
• Changes in dividend policy affect investors’ liquidity planning, tax planning
• Clientele – investors preferring a specific dividend policy – income vs
capital gain | tax treatment of dividend vs capital gain
Residual Theory
• It argues that dividends themselves are important but
the pattern of them is not
• The residual theory argues that provided the present
value of the dividend stream remains same, the timing of
the dividend payments is irrelevant
• Retentions should be used for project finance with
dividends as residual
• Only after all positive NPV projects are financed, if
there is residual fund, dividend be paid of the residual
funds
• Increases the potential for higher dividends in the
future
• Assumes no taxation and no market imperfections
Illustration
• A firm pays out a constant dividend of 10c in
perpetuity. Its cost of equity is 10%. A new
project opportunity has arisen, and the firm would
need to cancel the T1 dividend of 10c to pay for
it. Firm is likely to distribute additional
dividend in T2. Apply residual theory and prove
that the investors’ wealth is unchanged by the
change made to the dividend policy.
Dividend Relevance
• In a perfect capital market, it is difficult to challenge dividend irrelevance
• However, in real world these assumptions are relaxed
• Dividend Signaling
• Investors do not have perfect information concerning the future prospects of
the company
• Pattern of dividend payments will be used by investors to estimate future
performance
• Increase in dividend – greater confidence in future – higher price
• Sudden dividend cut – serious impact on share price
• Should the company adopt stable and rising dividend policy ?
• Preference for current income
• Cash dividends for current consumption
• Individual and institutional investors
• Companies issuing regular and known level of dividend will carry higher value
• Home made dividend involves cost
Dividend Relevance
• Taxation
• Income from dividend vs capital gain
• Dividend – at individual’s applicable tax slab rate (0% to 30%)
• STCG – at 15% if STT is paid
• LTCG – at 10% for gains exceeding INR 1 Lakh if STT is paid
• Different groups of shareholders are likely to prefer
different pay-out patterns
• If a company fixes a dividend policy, they are likely to
attract a clientele of investors who prefer their dividend
policy
• Investors at higher tax slab – prefer capital gain over dividend
• Companies should be careful while making significant changes
in dividend policy
• Bird in hand theory
• Income in the form of dividend is more secure than the income
in the form of capital gain that may or may not arise in the
future
• Investors may place higher value on high pay-out
shares/company
Practical Issues
•
Legal position
• Some countries impose restrictions on dividend payments by companies to ensure financial
stability, protect creditors, and maintain corporate solvency. These restrictions can vary widely
based on the legal, regulatory, and economic frameworks of the country.
•
Profitability
• Stable profits
•
Inflation
• In periods of inflation larger retention may be required for maintaining operating capacity of
the company due to increasing costs
•
Growth
• Rapidly growing companies pay low dividends to use retained earnings for financing expansion
•
Control
• Use of internally generated funds will avoid dilution of ownership and alteration in gearing
level
•
Liquidity
• Availability of liquid funds (cash) to pay dividend
•
Taxation
• Tax position of investors/shareholders
•
Access to sources of finance and their cost
• Is the company having ready access to alternative sources of finance and at what cost
Dividend Capacity
• Different factors identified under practical issues
limit the dividend capacity of the firm/company
• Firm’s ability to pay dividends to its shareholders
at any given time is the firm’s dividend capacity
• It has a direct impact on its ability to implement
its dividend policy
• Legally dividend capacity is determined by the
amount of accumulated distributable profits
• Practically dividend capacity is calculated as Free
Cash Flow to Equity – cash available is the main
driver
• FCFE = Net Income + Depreciation and Amortization −
Capital Expenditures − Change in Working Capital +
Net Borrowing
Real world dividend policies
• Stable dividend policy
• Constant or constantly growing dividend each year
• Predictable cash flow
• Managers cannot divert funds
• Suitable for firms with stable cash flows
• Risk – if earnings reduce dividend cut will result in
associated difficulties
• Constant pay-out ratio
• Constant proportion of equity earnings
• Maintains link between earnings, reinvestment rate and
dividend flow
• Cash flow is not predictable to the investor
• Gives no indication of management’s intention or
expectation
Real world dividend policies
• Zero dividend policy
• All surplus earnings are retained and reinvested
• Common during growth phase
• Should be reflected in increased share price
• When growth opportunities are exhausted
• Cash will start accumulating
• A new dividend policy will be required
• Residual dividend policy
• Dividend paid only after positive NPV projects are financed
• Growth phase
• Without easy access to alternative sources of funds
• Cash flow is not predictable to the investor
• Gives constantly changing signals of management’s expectations
Rachet patterns
• A rachet pattern of
dividend payments is
variant of stable dividend
policy
• Paying out stable but
rising divided per share
• Dividends lag earnings but
are maintained even when
earnings fall below the
dividend level
• Avoids bad signal
• Does not disturb tax
position of investors
Scrip Dividend
• Company allows shareholders to take their dividends in the form
of new shares
• Increase in shareholding without paying transaction cost
• No cash payment by company
• What is the tax implication ?
• Company may give choice between scrip dividend and cash dividend
• Converts retained profits to permanent capital
• Cash is preserved for re-investment
• May not dilute share price, unless significant
• Less gearing, more borrowing capacity
• If tax has to be paid, shareholders receive no cash !!
Share buyback scheme
• If company wants to return a large sum of cash to
shareholders it might consider share buyback rather than
a one-off special dividend
• Company buys back its shares from shareholders and
cancels them.
• Company’s Articles of Association must allow it
• When
• Has no positive NPV projects
• Wants to increase share price
• Wants to reduce cost of capital by increasing gearing
• Wants to give a positive signal to the market –
signal to investors that the shares currently
represent good value for money/undervaluation
Advantages of share buyback
• Company
• When there is excess cash flows that are temporary higher cash
dividends are not sustainable
• Increase in EPS due to reduction in number of shares outstanding
• Effective use of surplus funds where growth of business is poor
• Adjusting equity base to a. more appropriate level
• Buying out dissident shareholders
• Creation of market where no active market exist for its shares
• Altering capital structure to reduce cost of capital
• Reducing likelihood of takeover
• Shareholders
• Get a choice to sell or not to sell. Cash dividend does not give a
choice.
• Saving transaction cost
Disadvantages/constraints of
share buyback
• Getting approval by general meeting – arguments about
price at which repurchase is to take place
• The company may pay too high price for the shares
• Shareholders may feel they have received too small a
price for their shares
• Premium paid are set first against share premium then
against distributable profits – reduction in future
dividend capacity
• Might be seen as a failure of the management to make
better use of funds through reinvestment
• Capital gain vs dividend argument due to taxation