Retained Earnings – -One of the most important sources of new equity funds for companies. The more funds retained, the less available for the payment of dividends and vice versa.
Prime Objective – To maximise the wealth of the shareholders.
Dilemma – Pay dividends now or retain earnings for future capital gain.
There are a number of practical considerations which a company must take into account in setting its particular dividend policy. Chief among these are:
- Taxation – Income Tax v Capital Gains Tax. If shareholders pay high marginal rates of Income Tax they may prefer low dividends. If subject to low tax rate or zero tax (e.g. pension fund) they may prefer high dividends.
- Investment Opportunities – “Residual Theory” => retain sufficient funds until all profitable investments (those with a positive NPV) have been funded. Balance to be paid as dividends. Drawback is that dividends may vary dramatically from year to year. Also, consider the timing of the cash flows from the investments as these will be required to pay future dividends.
- Availability of Finance – If the company is highly geared it may have little option but to retain. Retentions will build up the equity base, thus reducing gearing and assisting future borrowing. Certain types of company (e.g. small/unquoted/private) may not have access to external funds and may need to retain.
- Liquidity – Profits do not equal cash. Adequate cash must be available to pay dividends. Also, for growth companies sufficient liquidity must be available for reinvestment in fixed assets.
- Cost of New Finance – The costs associated with raising new equity/debt can be quite high. If debt is raised interest rates may be high at that particular point in time.
- Transaction Costs – Some shareholders may depend on dividends. If earnings are retained they can create “home-made” dividends by selling some shares (capital). However, this may be inconvenient and costly (brokerage fees etc.).
- Control – If high dividends are paid the company may subsequently require capital and this may be obtained by issuing shares to new shareholders. This may result in a dilution of control for existing shareholders.
- Inflation – In periods of high inflation companies may have to retain funds in order to maintain their existing operating capability. On the other hand, shareholders require increased dividends in order to maintain their purchasing power.
- Information Content – The declared dividend provides information to the market about the company’s current performance and expected future prospects. An increase or a reduction will be reflected in the share price.
- Existing Debt – Restrictive covenants in existing loan agreements may limit the dividend payout or prohibit the company from arranging further borrowing. Existing debt which may be due for repayment will require funds and may cause a reduction in the level of dividend.
- Legal Restrictions – Dividends can only be paid out of realised Past losses must first be made good.
- Perceived Risk – The earnings from retained dividends may be perceived as being a more risky return than actual cash dividends, thereby causing their perceived value to be lower (the “Bird in the Hand Theory”).
- Stable Dividends – Generally, shareholders require a stable dividend policy and hopefully, steady dividend growth.
Note: Some companies adopt a constant pay-out ratio, whereby a fixed percentage of earnings are paid out as dividends. This has the drawback that dividends will rise and fall with earnings. However, this may not be a problem for a company which is not subject to cyclical factors and whose earnings grow steadily.
There is unlikely to be a single dividend policy which will maximize the wealth of all shareholders. The company should try to ascertain the composition of its shareholders in order to pursue a dividend policy which is acceptable. Maybe, the best is to adopt a consistent policy and hope to attract a “clientele of shareholders” to whom it appeals.
A scrip dividend is where a company offers existing shareholders a choice of new shares in lieu of their cash dividend. This effectively converts reserves into issued share capital.
The advantage for the company is that it conserves cash and increases the capital base, thereby improving gearing. The shareholders can increase their holdings without incurring brokerage fees and stamp duty.
Some companies have offered enhanced scrip dividends, where the value of the shares offered is greater than the cash alternative. Thus the shareholder is enticed to choose the scrip dividends.
SHARE REPURCHASE (“SHARE BUYBACK”)
Share repurchases are a way for companies to distribute earnings to shareholders other than by a cash dividend. They are also a means of altering a target capital structure; supporting the share price during periods of weakness; and deterring unwelcome take-over bids. Companies typically repurchase shares either by making a tender offer for a block of shares, or by buying the shares in the open market.
In the absence of taxation and transactions costs, share repurchase and the payment of dividends should have the same effect on share value. However, the different treatment of taxation on dividends and capital gains in many countries may lead to a preference for share repurchases by investors. If the repurchase of shares is by means of a tender offer, this will often be at a price in excess of the current market value and may have a different effect on overall company value.
The use of share repurchases and the payment of dividends will be influenced by the amount of investment that the company undertakes. When a company does not have sufficient investments to fully utilise available cash flow, the payment of dividends or share repurchases are more likely. When a company buys back its shares it replaces equity with cheaper, taxdeductible debt and raises Earnings per Share (EPS) by reducing the number of shares outstanding. The practice is most often used by companies with surplus cash not needed for further investment or to cut debt.
Analysts are believed normally to consider an increase in dividends or share repurchases as good news, as they suggest that the company has more cash and possibly greater earnings potential than previously believed. Buybacks are usually followed by share price outperformance and evidence indicates that the market may be outperformed by an average of 20% immediately after the buyback. However, if this subsequently proves not to be so, share prices will adjust downwards. Share repurchases in themselves do not create value for the company, but the market may see the information or the signals that they provide as significant new information that will affect the share price.
These are the issue of additional shares at no cost to existing shareholders in proportion to their current holdings, but with lower par value. Share splits have no effect on corporate cash flows and, in theory, should not affect the value of the company. The share price, in theory, should reduce proportionately to the number of new shares that are issued.
Motives for share splits include:
- A company wishes to keep its share price within a given trading range. It is sometimes argued that investors might be deterred by a high share price and that lower share prices would ensure a broader spread of share ownership.
- Companies hope that the market will regard a share split as good news, and that the share price will increase (relative to the expected price) as a result of the announcement. Evidence suggests that even if such reaction occurs it is short-lived unless the company improves cash flows, increases dividends etc. in subsequent periods.