Dividend Policy
Dividend policy
Investors purchase equity shares in
the hope of receiving an annual or
bi-annual dividend.
Dividend policy is ‘the determination
of the proportion of profits to be paid
out to shareholders’.
When?
UK quoted companies usually pay
out dividends every 6 months (an
interim and a final payment). Our US
counterparts such as IBM will often
pay quarterly dividends.
Where does the money come from?
Dividends may only be paid out of
accumulated profits and not out of
capital.
A loss making company can still pay
dividends out of prior year profits,
i.e. accumulated profit
Dividend is not compulsory
Firms do not have to pay a dividend.
Hence in difficult trading periods the
shareholder may receive no
dividend.
This is part of the risk that equity
holders take, and part of the reason
why Ke>Kd
But does it matter?
Of course..
Ke = d/MV and MV = d/Ke
Hence the extent of the divi affects
both the cost of capital and the
market price of the share.
Shareholders will react !
If the firm issues poor dividends the
shareholder may sell out and take
his funds elsewhere.
Also, Ke might rise, and it becomes
difficult to raise new funds.
Dividend policy
So
the question of how much
dividend to pay out, i.e. what
proportion of distributable profit
to pay, is one of the big
questions in corporate finance?
Shareholder wealth
The point of the question is this…
Is there a dividend policy, a pattern
of dividends or a payout ratio, which
maximises shareholder wealth?
If there is, then it is the duty of
directors to follow that policy.
Constant payout
In this policy the firm pays out a constant proportion
of accounting profits as a dividend, say 40% of
accounting profits.
Since accounting profits will differ from year to year,
this will make dividend payments volatile and
unpredictable. Many investors are looking for a
steady level of dividend payout. For example, retired
people who invest for a regular and predictable
income stream would avoid such companies.
Regular dividend
A company makes regular
dividend payments, irrespective of
the level of accounting profits.
For example, the firm may pay a
dividend of 50p per year every year.
This is the most common policy in
practice.
Institutional shareholders
Also tend to favour the regular dividend.
For example, a pension fund has to pay
pensions, and so requires a regular and
predictable income stream.
Multiple increases
Similar to the previous policy except that the firm
makes frequent small dividend increases, rather
than making larger increases at longer intervals.
The objective is to gain the benefits of the
previous policy, whilst using the frequent
dividend increase announcements as a way of
keeping investors aware of the firm.
An announcement of a dividend increase is free
advertising for the firm to the investment
community. It is not clear that sophisticated
investors will be Influenced by such a strategy.
Special dividends
Sometimes a firm will find itself with a lot of
spare cash. If it cannot find any good projects
(with positive NPV) it should return the cash to
the shareholders. Many firms do this.
Shareholders like such a policy since it shows
that the managers are acting in their best
interests, i.e. they are returning extra cash to the
shareholders rather than wasting it on private
corporate jets, luxurious offices, or a negative
NPV project such as a badly thought out
acquisition
Residual dividend policy
Over the long term the firm will have a variety of
cash needs, e.g. initiating, implementing and
running the firm's capital projects, and for
servicing debt. Over the long term, there may be
a cash surplus. What should be done with this
residual cash? There is really only one thing that
can be done. If the cash really is residual there
are no more positive NPV projects for the firm to
invest in. So, the only thing the firm can do is to
give the cash to its shareholders by paying
dividends.
So which policy do we follow?
The most common choice is to follow the
regular dividend policy of paying out the
long-term residual cash.
There are various theoretical reasons
which justify this approach
However…….
There is also a theory which
suggests that traditional dividend
policy is irrelevant, i.e. there is no
best policy which enriches
shareholders.
Sound familiar?
Enter Modigliani & Miller
Dividend Irrelevancy Hypothesis
According to their paper written in 1961, if
a few assumptions can be made, dividend
policy is irrelevant to share value.
The determination of value is the
availability of projects with positive NPV's
and the patterns of dividends makes no
difference to the acceptance of these.
Conditions….
There are no taxes.
There are no transactions costs e.g..
investors face no buying or selling
costs and companies can issue
shares at no cost.
All investors can lend and borrow
at the same interest rate.
Investors have free access to all
information.
The case for the defence…
If the company chooses not to issue a
dividend, the shareholders would simply sell
a proportion of their shares to generate some
cash (these are known as homemade
dividends). Since there are no transaction
costs they receive the cash tax free so the
investor is neutral as to whether the
company pays a dividend or not.
And conversely…..
If a company follows a high dividend pay
out policy and the investor does not wish
to receive a dividend he will simply use
the cash to buy more shares. This puts
them in exactly the same position as if the
company did not pay a dividend.
Example
White plc has net assets whose net
present value is £5.0m. This includes
cash of £1m which could be used to pay a
dividend.
Assuming that White plc is financed
entirely by 1m of ordinary shares and that
no dividend is paid what would be the
value of each ordinary share?
With no dividend…
NPV of firm
£5m
£5m / 1m shares
MV = £5 per share
With dividend
If White PLC wanted to pay the dividend what
would the price be of each ordinary share?
NPV of firm
£5m
Less dividend
£1m
Net assets
£4m
Value of share £4
Dividend
£1
Shareholder wealth
£5
And so…..
In this hypothetical world the pattern of
dividends makes no difference to shareholders
wealth.
Since shareholders do not care about their firm's
dividend policy, the firm's dividend policy will
not have any affect on the share price.
Therefore, in the text book world where markets
are perfect and complete and where there are no
taxes, the firm's dividend policy cannot affect the
value of the firm.
Convinced?
Like the capital structure theory this
is based upon a textbook world, and
so is unlikely to apply in practice.
Information asymmetry and signaling
theory
In the text book world everyone has
perfect information since there are no
information costs. In the real world we
have information asymmetry. This means
that in the real world the managers of the
firm have a lot more information about the
firm than outside investors.
Actions speak louder than words.
If a firm that follows the regular dividend
policy announces a dividend increase this
will signal to investors that the managers
believe that the future prospects of the
firm are so good that this increase will be
maintained in the future. Now, if the
managers were just to say that the firm
has good prospects no one will believe
them.
So a dividend increase….
An announcement of a dividend increase
is a believable signal that the firm's
prospects are good. Empirical research
shows that announcements of dividend
increases are nearly always followed by
an increase in the share price.
Conversely…
For the same reasons, an
announcement of a dividend
decrease nearly always results in a fall in
the share price. This is because the
announcement signals to investors that
the managers are not optimistic about the
firm's future prospects.
(They are bearish)
Agency theory
We know that in theory, the managers
should act to maximize the wealth of the
firm's shareholders. However, what is to
stop managers from wasting the firm's
cash by paying themselves huge salaries
and spending on nonproductive assets,
expensive cars and lunches, whilst idling
away their time on the golf course?
Audit
Firstly, the accounts of firms are audited
by independent accountants. This gives
shareholders the opportunity to assess
the performance of managers.
Shareholder activism.
Secondly, the shareholders are the
ultimate owners of the firm, and can in
theory sack the board of directors. This
does happen in practice, especially in the
US, but it is costly and time consuming.
It is also complicated by the dominance of
the institutional shareholders
Takeover
Thirdly, an under performing firm is
likely to be the target of a takeover.
Goal congruency
Finally, compensation packages can be
designed so that managers are rewarded
for actions that benefit shareholders.
Incentive schemes such as profit related
pay and awarding share options are very
popular.
These compensation packages motivate
managers to act to maximize the wealth of
the firm's shareholders.
The agency problem…
These four factors focus managers'
attention on shareholder value. The costs
associated with controlling managers'
actions, such as audit fees, and profit
related bonuses are known as agency
costs, and the problem of motivating
managers to act in the interests of
shareholders is known as the agency
problem.
And this is why…
The agency problem gives an explanation
why dividends are so popular with
shareholders. If cash is paid out to
shareholders managers cannot spend it
on activities that do not maximize
shareholder wealth. Paying dividends
reduces agency costs.
And further…
It means that if the directors want capital
sums for any purpose, they have to come
and ask the shareholders for it, often
through a rights issue.
Hence demanding dividends is a way of
keeping the directors under control.
Summary
As we have seen there are so many
factors influencing dividend policy
that is difficult to imagine a
universally applicable model which
allows firms to identify the optimum
payout ratio.
And so..
Firms in different circumstances are likely
to exhibit different payout ratios. Those
with plentiful investment opportunities
will in general opt for relatively low
dividend rate when compared with those
with few opportunities. Each type of
company will tend to attract the type of
clientele favouring it’s dividend policy.