Dividend Policy

Chapter 7

Dividend policy:

One long-standing question in corporate finance is: Is shareholders'

wealth affected by a company's dividend policy?

Examples of such policies may include:

a) paying a constant annual dividend;

b) paying out a constant proportion of annual earnings;
c) increasing dividends in line with the annual rate of inflation,
etc;
d) paying out what's left after financing all future investment –
the residual policy.

Key factors to consider in relation to payment of dividends are=

M and M’s Dividend irrelevancy theory=

The return on a share is determined by the shares systematic risk.

Return is delivered in 2 parts, the actual dividend and capital

gain/loss on the share price.

Dividend decision that a company makes is a decision as to how the

return is delivered, whether to pay the dividend or to re-invest the
funds into the business and deliver a gain on share price.

As the dividend decision does not affect the “risk” of the shares it
should not affect their “return”.
Shareholders do not mind how they get their return if we assume
that there are no taxes and shares can be bought and sold free of
any transaction costs.

Wealth of the shareholder must increase whether or not the

company makes a dividend payment this year. So the dividend
policy the firm pursues is irrelevant.

M & M argue that shareholders can 'manufacture' a dividend policy

irrespective of the company policy. For instance, if a person is
holding shares for income but the company withholds a dividend,
the shareholder can sell some of the shares to replace the lost
income.

The assumptions that M & M make play a key role. Obviously, if

dividends were taxed and capital gains were tax free, shareholders
would mind how their return was delivered – they would strongly
prefer it to be delivered in the form of capital gains rather than
dividends.

Similarly, investors who were holding shares for the income they
generated would mind how their return was delivered if they had to
incur transaction costs when realising their capital gains so as to
turn them into income – such investors would strongly prefer if the
return were delivered in the form of dividends, rather than capital
gains.
The interests of shareholders=

Business must satisfy the needs of the shareholders with its

dividend policy otherwise they will sell their shares and invest
elsewhere. 2 important considerations=

a) Clientele effect= Shareholders are concerned as to how

their return is delivered to them because of capital gain
taxes and differential dividend treatments. Thus,
company must follow a consistent policy and ensure a
clientele of shareholders that like that particular policy.
Argument here is that actual dividend policy does not
matter, but after one is chosen it should be followed
consistently.

b) Bird in hand argument= Investors generally have a

strong preference for dividends. Reason for this is that
dividends are certain and investors prefer a certain
dividend now against a promise of future uncertain
dividends.
The signaling effect=

The investors read signals into the company’s performance and

these signals say as much as about the company’s future
performances they do about its past performances. Becomes
important for the company not to give wrong signals.

2 very strong signals=

a) A reduction in dividend per share signals that company is

in financial trouble.

b) A failure to pay out any dividend at all signals that the

company is very close to receivership.

Litner discovered that dividend growth lagged 2 to 3 years behind

earnings growth. This can be interpreted as meaning that the
managers are reluctant to increase dividend per share until they are
confident that they will be able to maintain a new level of dividend.

Exception of Apple. Where they paid no dividend and still share

price increased because there was growth.
Cash needs of an entity=

Different types of businesses will have different needs for cash and
thus will set their dividend and financing policies accordingly.

For example:

A small company, or a company with a poor credit rating, will often

struggle to raise finance from external sources, so its cash needs
might have to be met by restricting the number of dividends it pays
out.

A growing company will have many potential investment

opportunities. The cash needs for these new investments will have
to be met by balancing dividend policy alongside external finance
sources.
Dividend policy in practice=

A) Stable dividend policy=

Offers investors a predictable cash flow, reduces

management opportunities to divert funds to non-profitable
activities, works well for mature firms with stable cash flows.
Risk is that reduced earning will force a dividend cut.

B) Constant payout ratio=

Link between earnings, re-investment rate and dividend

flow, cash flow is unpredictable for the investor an gives no
indication of management intention or expectation.

C) Zero dividend policy=

Increased share price must be reflecting this, and popular

during a growth phase. When growth opportunities are
exhausted cash will start to accumulate and this will lead to
a new distribution policy.

D) Residual dividend policy=

Gives constantly changing indications to the investor,

common during the growth phase and when there is no easy
access to alternative sources of funds. A dividend is only paid
if no further positive NPV projects are available.
 E) Ratchet patterns=

Variant on the stable dividend policy= involves paying out a

stable but rising dividend per share. Dividends lag behind
earning but can then be maintained even if earnings fall
below a certain level. Avoids bad news signals. Does not
disturb the tax position of investors.

Scrip dividends:

A scrip dividend (or bonus/scrip issue) is where shareholders are

offered bonus shares free of charge as an alternative to a cash
dividend.

They are useful where the company wishes to retain cash in the
business or where shareholders wish to reinvest dividends in the
company but avoid brokerage costs of buying shares. There may also
be tax advantages of receiving shares rather than cash in some
jurisdictions.

If all shareholders opt for bonus shares, the scrip issue has the effect
of capitalising reserves. Reserves reduce and share capital increases.

The disadvantage to shareholders is that, unlike reserves, share

capital is non-distributable in the future. In addition, both share price
and earnings per share are likely to fall due to the greater number of
shares in issue, although the overall value of each shareholder’s
shares and share in future earnings should, theoretically, remain
unchanged.

However, it has the important advantage to the issuer of retaining

cash in the business while still achieving a distribution of reserves.
Example:

A recent issue by Santander bank in February 2011 was set up in a

similar manner to a rights issue except that the rights were issued
without charge.

Shareholders were given rights to receive additional Santander

shares and three options for their allotment of rights:

a) Sell the rights off market to Santander and receive a fixed

cash amount.
b) Sell the rights on market and receive cash.
c) Hold the rights and receive new Santander shares, 1 share for
every 65 rights held.

Share re-purchase=

A share repurchase can be used to return surplus cash to

shareholders.

It tends to be used when the company has no positive NPV projects

to invest the cash in, so it returns the cash to shareholders so that
they can make better use of it rather than it sitting idle (in cash
investments) in the company.

Alternatively, a share repurchase can be used to privatise a company,

by buying back a listed company's shares from a wide pool of
investors. However, this is rare.
Share repurchase v one-off large dividend:

As an alternative to a share repurchase, a company may decide to

use a one-off large dividend to return surplus cash to shareholders.

If all shareholders agree to the repurchase, both a share repurchase

and a one-off large dividend have the same impact on the cash, and
the gearing of the company (they reduce the value of equity, so
increase the gearing and hence financial risk and cost of equity).

Although the impact on shareholder value is the same for any

individual shareholder, the impact on the price per share will differ.

A dividend results in a lower share price as the number of shares

remains the same, but a share repurchase is unlikely to affect the
individual share price but only the number of shares in issue.

The one-off dividend has the advantage of certainty of ultimate pay-

out.

However, a share repurchase has the following advantages:

a) investors can choose whether or not to sell their shares back

(they may prefer to keep the shares if they feel that future
returns will be high)

b) it avoids the risk of a false dividend signal – after a one-off

large dividend, the shareholders may be disappointed when
the higher level of dividend is not maintained in the future
Scrip dividends:

The impact of a scrip dividend on shareholder wealth is nil. There are

more shares in issue but the overall shareholder value stays the
same, hence the share price decreases.

For example, if price per share is $11 and if a shareholder has 100
shares, then after the issue of a 10% scrip dividend, the number of
shares increases to 110.

Hence, price per share will decrease to $1100/110 = $10.

The impact of a scrip dividend on the entity's performance

measures ratios is:

a) total shareholder’s equity (in the statement of financial

position) remains the same

b) it doesn’t change the capital structure (and gearing ratio)

because the equity value stays the same.

Share repurchase:

The impact of a share repurchase on shareholder wealth is the same

as the impact of a cash dividend being paid.

The impact of a share repurchase on the entity's performance

measures / ratios is different from the impact of a cash dividend
though. After a share repurchase there will be fewer shares in issue,
so the earnings per share of the entity will increase.
(Source: Kaplan F3 Textbook)