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Dividend Decision
Dividend policy (Rwanda Tourism University College)
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DIVIDEND DECISION
Meaning of Dividend
Dividend refers to the business concerns net profits distributed among the shareholders. It
may also be termed as the part of the profit of a business concern, which is distributed
among its shareholders.
FORMS OF DIVIDEND
Dividend may be distributed among the shareholders in the form of cash or stock. Hence,
Dividends are classified into:
a) Cash dividend
b) Stock dividend
c) Bond dividend
d) Property dividend
Cash Dividend
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is
paid periodically out the business concerns EAIT (Earnings after interest and tax). Cash
dividends are common and popular types followed by majority of the business concerns.
Stock Dividend
Stock dividend is paid in the form of the company stock due to raising of more finance.
Under this type, cash is retained by the business concern. Stock dividend may be bonus
issue. This issue is given only to the existing shareholders of the business concern.
Bond Dividend
Bond dividend is also known as script dividend. If the company does not have sufficient
funds to pay cash dividend, the company promises to pay the shareholder at a future
specific date with the help of issue of bond or notes.
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Property Dividend
Property dividends are paid in the form of some assets other than cash. It will distributed
under the exceptional circumstance.
.
DIVIDEND POLICY
Dividend policy determines the division of earnings between payment to shareholders and
reinvestment in the firm. It therefore involves the following four aspects:
1. HOW MUCH TO PAY
It encompasses the 4 major alternative dividend policies.
a) Constant payout ratio
This is where the firm will pay a fixed dividend rate e.g. 40% of earnings.
Dividends will therefore fluctuate as the earnings change. Dividends are therefore
directly dependant on the firms earning ability. If no profits are made, no
dividends are paid. The policy creates uncertainty in ordinary shareholders
especially those who depend on dividend income thus they may demand a higher
required rate of return.
b) Constant amount per share/fixed dividend per share
The dividend per share is fixed in amount irrespective of the earnings level. This
creates uncertainty and is thus preferred by shareholders who have a reliance on
dividend income. It protects the firm from periods of low earnings by fixing
dividends per share at a low level. Thus policy treats all shareholders like
preference shareholders by giving a fixed return. Dividend per share could be
increased to a higher level if earnings appear relatively permanent and sustainable.
c) Constant amount plus extra
Here, a constant dividend per share is paid every year. However, extra dividends
are paid in years of supernormal earnings. This policy gives firms the flexibility
to increase dividends when earnings are high and shareholders are given a chance
to participate in the supernormal profits of the firm. The extra dividends are given
in such a way that it is not seen as a commitment to continue the extra in the
future. It is applied by firms whose earnings are highly volatile e.g. the
agricultural sector.
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d) Residual amount
Under this policy, dividend is paid out of earnings left over after investment
decisions have been financed. Dividends will therefore only be paid if there are no
profitable investment opportunities available. This policy is consistent with
shareholders wealth maximization.
2. WHEN TO PAY
Dividends can either be interim or final.
Interim dividends are paid in the middle of the financial year and are paid in cash.
Final dividends are paid at the year end and can be and can be in cash and stock form
(bonus issue).
3. WHY PAY
a) Residue dividend theory
Under this theory, a firm will pay dividends from residue earnings ie. Earnings
remaining after all suitable projects with a positive NPV have been financed. It
assumes that retained earnings are the best source of long term capital since it is
readily available and cheap. This is because no floatation costs are involved in the
use of retained earnings to finance new investments therefore the first claim on
profit after tax and preference dividend. There will be a reserve for financing
investments. Dividend policy is therefore irrelevant and treated as a passive
variable. It will hence not affect the value of the firm. However the investment
decision will.
Advantages of residual theory
1. Savings on floatation costs
2. There is no need to raise debt or equity capital since there is a high retention of
earnings which require no floatation costs.
3. Avoidance of dilution of ownership. A new equity issue will dilute ownership and
control. This will be avoided if retention is high.
4. Tax position of shareholders. High income shareholders prefer low dividends to
reduce their tax burden from dividend income. They prefer high retention of
earnings which are reinvested. This increase the share value and they make capital
gains which are not taxable.
b) MM dividends irrelevance theory.
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This was proposed by Modigliani and Muller .This theory asserts that a firms divided
policy has no effect on its market value and cost of capital .They argued that the firm
value is primarily determined by .
(i) Ability to generate earnings from investments .
(ii) Level of business and financial risk .
According to MM dividend policy is a passive residue determined by the firms needs for
investment funds. It does not matter how earnings are divided between divided and
retention therefore divided policy does not exist . When investment decisions are made
dividend decision is a mere detail without any effect on the value opf the firm
C)
The main dividend theories are:
i.
ii.
iii.
iv.
v.
vi.
vii.
Residual dividend theory
MM dividend irrelevance theory
Bird in hand theory
Information signaling effect theory
Tax differential theory
Clientele effect theory
Agency theory
4. HOW TO PAY DIVIDENDS/ MODE OF PAYING DIVIDENDS
a) Cash or Bonus issue
Ideally, a firm should pay cash dividends, for such a company it must ensure that it
that it has enough liquid funds to make payment. Under conditions of liquidity and
financial constraints, a firm can pay stock dividends (bonus issue ) Bonus issue
involves an issue of additional shares in addition to or instead of cash to the existing
shareholders prorate to their share holding in the company. A stock dividend / bonus
issue involves capitalization of retained earnings therefore does not increase the wealth
of the shareholders. This is because retained earnings are converted into share capital.
Advantages of a bonus issue
i.
ii.
iii.
iv.
To indicates that the form plans to retain a portion of earnings permanently in
the business.
To continue dividend distribution s without disbursing cash needed for
operation.
T o increase the trading of shares in the market.
Tax advantage. Shareholders can sale the new shares to generate cash in the
form of capital gains which are tax exempt unlike cash dividends which attract a
5% withholding tax which is final.
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v.
Indication of higher profits in the future of the company. A bonus issue is
inefficient market survey is important information that the firm expects high
profits in future to offset additional outstanding share so that the earnings per
share is not diluted.
b) Stock Splits and reverse split.
A stock split is a change in the number of shares outstanding accompanied by an
offsetting change in the par or stated value per share.
The primary purpose of a stock split is to increase the market activity of the stock.
Example
A company has 1000 ordinary shares of sh.20 each and a share split has been
announced of 1:4. The effect on ordinary share capital is a s follows;
New par value = 20/4
=sh.5
Ordinary shares outstanding = 1000×4
=4000
The ordinary share capital remains the same (4000×5=sh. 20,000)
A reverse split is the opposite of a stock split as it involves consolidation of shares
into bigger units thereby increasing the par value of the shares .It is meant to attract
high income clientele.
Example
In the case of 20,000 shares at sh.20 par value, they can be considered into 10,000
shares at par value of sh.40 par value.
Example
Company Z has the following capital structure,
sh.000
Ordinary shares (Sh.20 par)
8000
Share premium
3600
Retained earnings
2400
14000
The company shares have been selling in the market for sh.60. The management has
declared a share split of 4 share for every one share held. Assume that the shares are
expected to sell at sh17 after the stock split.
Required,
i. Prepare the capital structure of the company after the company’s stock split.
ii. Compute the capital gain for a shareholder who held 40,000 shares before the split.
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Solution
i)
Number of shares before split
Number of shares after split
sh.8000,000÷20
400,000×4
New par value
20/4
Capital structure
Ordinary shares (Sh.5 par)
Share premium
Retained earnings
shares
400,000
1,600,000
sh.5
sh.000
8,000
3,600
2,400
14,000
ii)
Shares before split
Share after split
Capital gain
40,000×60
40,000×4×17
2750 -2400
sh.000
2400
2750
320
c) Stocks repurchase.
The company can also buy back some of its outstanding shares instead of paying cash
dividends. This is known as a stocks repurchase and the share bought back are known
as treasury stock. If some outstanding shares are repurchased, fewer share s would
remain outstanding .Assuming a repurchase does not adversely affect the firm’s
earnings , EPS would increase .This would result in an increase in the market price per
share so that a capital gain is substituted for dividends.
Advantages of stock repurchase.
1. Utilization of idle funds.
Companies which have accumulated cash balances in excess of future investments
might find a share re-investment scheme a fair method of returning cash to
shareholders .Continuing to carry excess cash may prompt management to invest
unwisely as a means of using excess cash e.g. a firm may invest in a tendency for
more mature firms to continue in investment plans even when the expected return is
lower than the cost of capital.
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2. Enhanced dividends and EPS.
Following a stock repurchase, the number of shares issued would decrease therefore
in normal circumstances , both DPS and EPS would increase in future . However the
increase in EPS is a book-keeping increase since total earnings remain constant.
3. Enhanced share price.
Companies that undertake a stock repurchase experience an increase in the market
price of the share.
4. Capital structure.
A company’s managers may use a share buy-back or repurchase as a means of
correcting what they perceive to be an unbalanced capital structure .If shares are
repurchased from cash reserves, equity would be reduced and gearing increased ,
assuming debt exists in the capital structural term natively , a company may raise
debt to finance a repurchase . Replacing equity with debt can reduce the overall cost
of capital.
5. Reducing takeover threat.
A share repurchase reduces the number of shares in operation and also the number of
weak shareholders i.e. shareholders with no strong loyalty to the company since a
repurchase would induce them to sell .This helps to reduce the threat of as hostile
takeover as it makes it difficult for a predator company to gain control .This is also
referred to as a poison pill i.e. a company’s value is reduced because of huge cash
outflow or borrowing huge long-term debt to increase gearing.
Disadvantages of a stock repurchase.
1. High price.
A company may find it difficult to repurchase\se at their current value or the price
paid maybe too high to the detriment of the remaining shareholders.
2. Market signaling.
Despite directors efforts at trying to convince markets otherwise, a share repurchase
may be taken as a signal that the company lacks suitable investment opportunities
.This may be interpreted as a sign of management failure.
3. Loss of investment income.
The interest that could have been earned from investment of excess cash is lost.
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FIRMS DIVIDEND POLICY AND FACTORS INFLUENCING DIVIDEND
POLICIES
The various types of dividend policies are discussed as follows:
1. Regular Dividend Policy
In this type of dividend policy the investors get dividend at usual rate. Here the
investors are generally retired persons or weaker section of the society who want to
get regular income. This type of dividend payment can be maintained only if the
company has regular earning.
Payment of dividend at the usual rate is termed as regular dividend.
Advantages of regular dividend policy:
i) It establishes a profitable record of the company.
ii) It creates confidence amongst the shareholders.
iii) It aids in long-term financing and renders financing easier.
iv) It stabilizes the market value of shares.
v) The ordinary shareholders view dividends as a source of funds to meet their day-today living expenses.
vi) If profits are not-distributed regularly and are retained, the shareholders may have to
pay a higher rate of tax in the year when accumulated profits are distributed. However,
it must be remembered that regular dividends can be maintained only by companies of
long standing and stable earnings.
2. Stable Dividend Policy
The term 'stability of dividends' means consistency in the stream of dividend payments. In
more precise terms, it means payment of certain minimum amount of dividend regularly. A
stable dividend policy may be established in any of the following three forms:
a) Constant payout ratio
This is where the firm will pay a fixed dividend rate e.g. 40% of earnings. The DPS would
therefore fluctuate as the earnings per share changes.
Dividends are directly dependent on the firm’s earnings ability and if no profits are made no
dividend are paid.
This policy creates uncertainty to ordinary shareholders especially who rely on dividend
income and they might demand a higher required rate of return.
b) Constant amount per share (fixed D.P.S.)
The DPS is fixed in amount irrespective of the earnings level. This creates certainty and is
therefore preferred by shareholders who have a high reliance on dividend income.
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It protects the firm from periods of low earnings by fixing DPS at a low level.
This policy treats all shareholders like preferred shareholders by giving a fixed return. The
DPS could be increased to a higher level if earnings appear relatively permanent and
sustainable.
c) Constant DPS plus Extra/Surplus
Under this policy a constant DPS is paid every year. However extra dividends are paid in
years of supernormal earnings.
It gives the firm flexibility to increase dividends when earnings are high and the
shareholders are given a chance to participate in super normal earnings
The extra dividend is given in such a way that it is not perceived as a commitment by the
firm to continue the extra dividend in the future. It is applied by the firms whose earnings
are highly volatile e.g agricultural sector.
d) Residual dividend policy
Under this policy dividend is paid out of earnings left over after investment decisions have
been financed. Dividend will only be paid if there are no profitable investment
opportunities available. The policy is consistent with shareholders wealth maximization.
Advantages of Stable Dividend Policy
(i) It is sign of continued normal operations of the company.
(ii) It stabilizes the market value of shares
(iii) It creates confidence among the investors, improves credit standing and makes
financing easier.
(iv) It provides a source of livelihood to those investors who view dividends as a source of
fund to meet day-to-day expenses.
(v) It meets the requirements of institutional investors who prefer companies with stable
divide.
3. Irregular Dividend Policy
In this policy the firm doesn’t pay fixed dividend regularly and it changes from year to year
according to changes in earnings level. This is followed by the companies which have
unstable earning
Some companies follow irregular dividend payments on account of the following:
(i) Uncertainty of earnings
(ii) Unsuccessful business operations
(iii) Lack of liquid resources
4. No Dividend Policy
A company can follow a policy of paying no dividends presently because of its unfavorable
working capital position or on account of requirements of funds for future expansion and
growth.
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FACTORS INFLUENCING DIVIDEND POLICIES
1. Legal rules:
a) Net profit rule- This states that the dividends may be paid from company profits,
either past or present.
b) Capital impairment rule- This prohibits payment of dividends from capital i.e.
from the sale of assets. This would be liquidating the firm.
c) Insolvency rule- This prohibits payment of dividends when a company is
insolvent .An insolvent company is one where assets are less than liabilities .In
such a case all earnings and assets belong to debt holders and no dividends are
paid.
2. Profitability and liquidity.
A company’s capacity to pay dividends will be determined primarily by its ability to
generate adequate and stable profits and cashflows. If the company has liquidity
problems, it may be unable to pay cash dividends and resort to paying stock dividends.
3. Investment opportunity.
Lack of appropriate investment opportunities i.e. those with positive returns may
encourage a firm to increase its dividend distribution. If a firm has many investments
opportunities it will pay low dividends and have high retention.
4. Tax position of share holder
Dividend payment is influenced by the tax regime of a country e.g. in Kenya cash
dividends are taxed at source, while capital gains are tax exempt. The effect of tax
differential is to discourage shareholders from wanting high dividends.
5. Capital structure.
A company’s management may wish to achieve or restore an optimal capital structure.
E.g. If they consider gearing to be too high they may pay low dividends and allow
reserves to accumulate until a more optimal capital structure is achieved or restored.
6. Industrial practice
Companies will be resistant to deviate from accepted dividend or payment norms in the
industry.
7. Growth stage.
Dividend policy is likely to be influenced by the firms growth stage, e.g. a young
rapidly growing firm is likely to have high demand for developing funds therefore may
pay low dividends or differ dividend payment till the company reaches maturity. It will
therefore retain high amounts.
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8. Owners hip structure.
A dividend policy may be driven by the ownership structure in affirm e.g. in small firms
where the owners and managers are the same, dividend payout is usually low. However, in
large quoted public companies, dividends are significant since the owners are not the
managers. The value and preferences of a small group of owner managers would exert more
direct influence on the dividend policy.
9. Access to capital markets.
Large well established firms have access to capital markets hence can get funds easily.
They therefore pay high dividends unlike small firms which pay low dividends due to the
limited borrowing capacity.
10. Shareholders expectation.
Shareholder s that have become accustomed to receiving stable and increasing dividends
will expect a similar pattern to continue in to the future .Any sudden reduction or reversal
of such a policy is likely to dissatisfy shareholders and the results in falling share prices.
11. Contractual obligations on debt covenants.
This limits the flexibility and amount of dividends to pay e.g. the cashflow based covenants.
Important ratios on dividends
Dividend pay-out ratio
This ratio reflects a company's dividend policy. It indicates the proportion of
earnings per share paid out to ordinary shareholders as divided. It is computed
as follows:
Dividekd payout ratio =
Dividekds per ordikary sℎare
Earkikgs per sℎare
Wℎere ordikary dividekds per sℎare =
Ordinary dividends
Number of ordinary shares
Dividend Yield Ratio
This shows the dividend return being provided by the share. It is given by
Dividekd yield =
Dividekds per sℎare
Market price per sℎare
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DIVIDEND RELEVANCE THEORIES
The main dividends theories are:
1. Residual dividend theory
Under this theory, a firm will pay dividends from residual earnings i.e. earnings remaining
after all suitable projects with positive NPV has been financed.
It assumes that retained earnings are the best source of long term capital since it is readily
available and cheap. This is because no floatation cash are involved in use of retained
earnings to finance new investments.
Therefore, the first claim on earnings after tax and preference dividends will be a reserve
for financing investments.
Dividend policy is irrelevant and treated as passive variable. It will not affect the value of
the firm. However, investment decisions will.
Advantages of Residual Theory
1. Saving on floatation costs
No need to raise debt or equity capital since there is high retention of earnings which
requires no floatation costs.
2. Avoidance of dilution of ownership
New equity issue would dilute ownership and control. This will be avoided if
retention is high.
A high retention policy may enable financing of firms with rapid and high rate of
growth.
3. Tax position of shareholders
High-income shareholders prefer low dividends to reduce their tax burden on
dividends income.
They prefer high retention of earnings which are reinvested, increase share value and
they can gain capital gains which are not taxable in Kenya.
2. MM Dividend Irrelevance Theory
This is the theory that a firm’s dividend policy has no effect in either its value or its cost of
capital. MM argued that a firm’s value is determined only its basic earning power and its
business risk. They argued that the value of the firm depends only on the income produced
by its assets, not on how this income is split between dividends and retained earnings.
MM noted that any shareholder can in theory construct his/her own dividend policy e.g. if
a firm does not pay dividends, shareholder who wants a 5% dividend can “create” it by
selling 5% of his/her stock. Conversely, if a company pays a higher dividend than an
investor desires, the investor can use the unwanted dividends to buy additional shares of the
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company’s stock. If investors could buy and sell shares and thus create their own dividend
policy without incurring cost, then the firm’s dividend policy would truly be irrelevant.
However, it should be noted that investors who want additional dividends must incur
brokerage costs to sell shares and investors who do not want dividends must first pay taxes
on the unwanted dividends and then incur brokerage costs to purchase shares with the aftertax dividends. Since taxes and brokerage costs to purchase shares with the after-tax
dividends. Since taxes and brokerage costs certainly exist, dividend policy may well be
relevant.
Was advanced by Modigliani and Miller in 1961. The theory asserts that a firm’s dividend
policy has no effect on its market value and cost of capital.
They argued that the firm’s value is primarily determined by:
 Ability to generate earnings from investments
 Level of business and financial risk
According to MM dividend policy is a passive residue determined by the firm’s need for
investment funds.
It does not matter how the earnings are divided between dividend payment to shareholders
and retention. Therefore, optimal dividend policy does not exist. Since when investment
decisions of the firms are given, dividend decision is a mere detail without any effect on
the value of the firm.
They base on their arguments on the following assumptions:
1. No corporate or personal kites
2. No transaction cost associated with share floatation
3. A firm has an investment policy which is independent of its dividend policy (a fixed
investment policy)
4. Efficient market – all investors have same set of information regarding the future of
the firm
5. No uncertainty – all investors make decisions using the same discounting rate at all
time i.e required rate of return (r) = cost of capital (k).
3. Bird-in-hand theory
Advanced by John Litner (1962) and furthered by Myron Gordon (1963).
Argues that shareholders are risk averse and prefer certainty. Dividends payments are
more certain than capital gains which rely on demand and supply forces to determine share
prices.
Therefore, one bird in hand (certain dividends) is better than two birds in the bush
(uncertain capital gains).
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Therefore, a firm paying high dividends (certain) will have higher value since shareholders
will require to use lower discounting rate.
MM argued against the above proposition. They argued that the required rate of return is
independent of dividend policy. They maintained that an investor can realize capital gains
generated by reinvestment of retained earnings, if they sell shares.
If this is possible, investors would be indifferent between cash dividends and capital gains.
Gordon & Lintner argued that K decreases as the dividend pay-out is increased because
investors are less certain of receiving the capital gains that are supposed to result from
retaining earnings than they are of receiving dividend payments.
Gordon & Linter argued in effect that investors value a dollar or shilling of expected
dividend more highly than a dollar / shilling of expected capital gains.
Ks = D1 + g
Po
The bird-in-hand theory is based on the logic that what is available at present is preferable
to what may be available in the future. Basing their model on this argument, Gordon and
Lintner argued that the future is uncertain and the more distant the future is, the more
uncertain it is likely to be. Therefore, investors would be inclined to pay a higher price for
shares on which current dividends are paid.
4. Information signaling effect theory
Advanced by Stephen Ross in 1977, he argued that in an inefficient market, management
can use dividend policy to signal important information to the market which is only
known to them.
Example – If the management pays high dividends, it signals high expected profits in
future to maintain the high dividend level. This would increase the share price/value and
vice versa.
MM attacked this position and suggested that the change in share price following the
change in dividend amount is due to informational content of dividend policy rather than
dividend policy itself. Therefore, dividends are irrelevant if information can be given to the
market to all players.
Dividend decisions are relevant in an inefficient market and the higher the dividends, the
higher the value of the firm. The theory is based on the following four assumptions:
1. The sending of signals by the management should be cost effective.
2. The signals should be correlated to observable events (common trend in the market).
3. No company can imitate its competitors in sending the signals.
4. The managers can only send true signals even if they are bad signals. Sending untrue
signals is financially disastrous to the survival of the firm.
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5. Tax differential theory
Advanced by Litzenberger and Ramaswamy in 1979
They argued that tax rate on dividends is higher than tax rate on capital gains.
Therefore, a firm that pays high dividends have lower value since shareholders
pay more tax on dividends.
Dividend decisions are relevant and the lower the dividend the higher the value
of the firm and vice versa.
Note
In Kenya, dividends attract a withholding tax of 5% which is final and capital
gains are tax exempt.
6. Clientele effect theory
Advance by Richardson Petit in 1977
It stated that different groups of shareholders (clientele) have different
preferences for dividends depending on their level of income from other
sources.
Low income earners prefer high dividends to meet their daily consumption
while high income earners prefer low dividends to avoid payment of more tax.
Therefore, when a firm sets a dividend policy, there’ll be shifting of investors
into and out of the firm until an equilibrium is achieved. Low, income
shareholders will shift to firms paying high dividends and high income
shareholders to firms paying low dividends.
At equilibrium, dividend policy will be consistent with clientele of shareholders
a firm has. Dividend decision at equilibrium is irrelevant since they cannot
cause any shifting of investors.
7. Agency theory
The agency problem between shareholders and managers can be resolved by
paying high dividends. If retention is low, managers are required to raise
additional equity capital to finance investment. Each fresh equity issue will
expose the managers financing decision to providers of capital e.g bankers,
investors, suppliers etc. Managers will thus engage in activities that are
consistent with maximization of shareholders wealth by making full disclosure
of their activities.
This is because they know the firm will be exposed to external parties through
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external borrowing. Consequently, Agency costs will be reduced since the firm
becomes self- regulating.
Dividend policy will have a beneficial effect on the value of the firm. This is
because dividend policy can be used to reduce agency problem by reducing
agency costs. The theory implies that firms adopting high dividend payout ratio
will have a higher value due to reduced agency costs.
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