THE DIVIDEND POLICY DECISION NOTES

THE DIVIDEND POLICY DECISION

Dividends are part of the earnings which are distributed to the ordinary shareholders for investing in the company. Dividend decisions are important to the company because of two main reasons;

• They provide the solution to the dividend puzzle i.e. does payment of dividend increase or reduce the value of the firm?
• It is part of the company’s financing strategy i.e. payment of high dividend means low retained earnings and hence the need for more debt capital in the company’s capital structure.

The dividend decision policy includes the following four critical issues. These are;

• When should the firm pay dividend
• How much dividend should the company pay
• How should the firm pay dividend
• Why should the firm pay dividend

 

• When should the firm pay dividends

A company can pay dividends twice in the course of the year that is interim and final or it can pay dividends once in a year that is final dividends.

The question on whether to pay interim and final or just final dividend will depend on;

• The company’s liquidity position
• The expectation of the shareholders
• The need for cash for financing purposes

• How much dividend to pay

There are four different dividend policies which influence the amount of dividend per share a company can pay. These include;

• Constant pay out policy
• Constant or fixed Dividend per share policy
• Low constant DPS plus bonus or surplus
• Residual dividend policy

• Constant payout policy

Under this policy a company could pay a fixed proportion of its earnings attributable to ordinary shareholders as dividends. Since the earnings fluctuate over time the EPS and the total dividends payable and dividends per share will also fluctuate over time.

This policy has the following implications;

• It creates uncertainty as to the amount of dividend income receivable by the shareholders.
• The shareholders may require a higher rate of return to compensate them for the uncertainty.

 

• Constant or fixed DPS policy

Under this policy the company could pay a fixed amount of DPS irrespective of the levels of earnings. Therefore in this case the ordinary shareholders are treated as preference shareholders because they receive fixed dividends. In this case the EPS may fluctuate over time but the DPS remains constant.

This policy has the following implications;

• It creates uncertainty and it’s therefore preferable to the low income shareholders who have a high preference for dividends instead of capital gains.
• The certainty reduces the shareholders required rate of return
• When the firm has high earnings more income will be retained for future financing needs.
• Low constant DPS plus bonus or surplus

Under this policy the DPS is set at a very low level and paid every year. However, a bonus or extra dividend is paid in the years of supernormal earnings. This extra dividend is paid such a way that it’s not seen as a commitment for the firm to continue paying it in the future. Therefore, the EPS will be fluctuating every time while the DPS will remain constant with occasional bonuses or surplus.

Implications of this policy are;

• It gives the company flexibility to increase dividends when the earnings are high
• It gives shareholders a chance to participate in supernormal earnings of the firm
• It’s most appropriate to those companies with high volatility in earnings and business risk e.g. companies in agricultural sector

• Residual dividend policy

In this case dividends are paid out of the earnings left after all the profitable investment opportunities have been financed. Therefore, out of the earnings attributable to the owners the first allocation is towards financing all projects yielding a positive NPV.

Dividends are only paid if earnings are not exhausted by the company’s financing needs. By first financing projects which yield positive NPV the policy attempts to maximize the value of the firm and the shareholders wealth.

This policy has the following advantages;

• Savings on floatation costs

The use of internally generated funds (earnings) to finance new projects does not involve floatation cost as compared to when raising new securities.

• Avoidance of dilution of ownership

With no issue of additional shares there will be no dilution of ownership control and future dividends per share of the firm.

• Tax position of shareholders

The re-investment of earnings in projects with positive NPV will lead to the increase in market share per share and investors would realize capital gains which are not taxed in Kenya. This will reduce the tax burden of shareholders who have high incomes from other sources.

• How should the firm pay dividends

A company can pay dividends in different forms;

• In cash
• Bonus or scrip issue
• Stock split and reverse split
• Stock or share repurchase

• Payment of cash dividends

This is the most common mode of dividend payment. However the payment of cash dividend will depend on;

• The company’s liquidity position
• The financing need of the company

•  Bonus or scrip issue

This is also known as Dividend reinvestment scheme. It involves giving free shares to the existing shareholders instead of cash dividends. The shares will be given in proportion to the shareholders ownership. This method has the following advantages;

• There is conservation of cash since there is no cash outlay
• There is the tax advantage whereby the free shares can be sold to realize capital gains which are not taxable in Kenya.
• In case of an increase in future profits the bonus issue may be an indication of high future dividends to the existing shareholders.

            Stock split and reverse split

This is the process by which a company undertakes to reduce the par value of its shares and to increase the number of ordinary share by the same proposition. The major reason for a stock split is to make the shares attractive and more affordable than before.

The stock split has no effect on the net worth of the company. A reverse stock split is the opposite of a stock split and it involves the consolidation of the shares into bigger units or stocks. In this case the number of ordinary shares is reduced while the par value of the share is increased by the same proportion that has been used to reduce the number of the ordinary shares.

Advantages of a stock split

• It enables the existing shareholders to sell their shares at affordable prices
• If the company does not change its dividend policy it will lead to increased dividends to the existing shareholders
• As a result of a stock split some wealthy shareholders may sell their shares to the outsiders who will join the company with new constructive ideas
• It may increase the shareholding of small and medium income shareholders as the wealthy shareholders may leave the company.

 

Disadvantages of a stock split

• If the wealthy shareholders dispose off their shares this may lead to dilution of share ownership
• The incoming shareholders may bring new ideas which may disrupt the operations of the company
• The company may incur costs to undertake the stock split e.g. clerical costs
• The company will have to pay more dividends in the future because of the increased number of shares

Differences between a stock split and a stock dividend

Stock Split                                                                                                     Stock dividend / bonus issue

·        It reduces the par value of the ordinary share ·        It has no effect on the retained earnings of the company ·        Its objective is to make the shares attractive and more affordable ·        Its declared when the market price of the company’s ordinary shares has increased tremendously ·        It reduces the market price of the share in the long run	·        It has no effect on the par value of the ordinary share ·        It reduces the company’s retained earnings ·        Its declares to solve the liquidity problems of the company ·        Its declared instead of cash dividend     ·        It reduces the market price of the share in the short term.

 

 

Similarities between stock split and stock dividend

1. Both of them entail the distribution of extra shares to the company’s existing shareholders
2. Both of them are issued free of charge
3. Both of them do not affect the net worth of the company
4. Both of them reduce the company’s market price in the stock exchange
5. If both of them are sold by some of the existing shareholders this will lead to dilution of share ownership
6. Both of them are issued in proportion to the existing shareholding
7. Both of them are issued by financially stable companies

Similarities between stock splits and rights issue

1. Both of them are issued to the existing shareholders
2. Both of them reduce the MPS
3. Both of them increase the number of ordinary shares to the existing shareholders and to the company

Differences between stock split and rights issue

Stock Split                                                                                                     Rights Issue

·        They are issued free of charge     ·        It does not affect the net worth of the company ·        It reduces the par value of the share ·        Its objectives is to reduce the par value of the company’s shares so as to make them affordable and attractive ·        It is mandatory to all existing shareholders   ·        It will reduce the market price per share in the long run

·        The shareholder makes a payment at a price slightly below the existing market price per share ·        It increases the net worth of the company   ·        Has no effect on the par value of the share ·        Its objectives is to raise additional funds from the company’s existing shareholders   ·        Its optional and hence not mandatory to the existing shareholders ·        It reduces the MPS in the short run

 

• Stock or share repurchase

This is where the company buys back some of the shares it had previously issued using the cash that would have been paid out as dividends.

The shares that would have been bought back are called treasury stock or shares. The buying back of the shares would reduce the company’s shares in the stock exchange and assuming a constant demand the MPS would increase. The increase in MPS will result in capital gains which can be substitute for dividend income.

Advantages of a stock repurchase

1. It increases the market price of the share. This is because of the reduced supply of the company’s shares in the market
2. Increased dividend per share and earnings per share. This is because the number of ordinary shares in issue will reduce after the stock repurchase but the earnings are expected to remain constant.
3. It may be seen as a sign that shares of the company are undervalued especially if market price increases after stock repurchase. This is particularly so if the market is insufficient.
4. It is one of the methods of utilizing idle cash i.e. the stock repurchase is a preferable way of utilizing excess cash instead of investing it unwisely.
5. It is one of the methods of restructuring the debt equity mix in the capital structure.
6. A stock repurchase can be effected by the company buying back the shares of its disloyal shareholders who can easily sell the shares to a creditor company which can forcefully acquire the company.

 

Disadvantages of a stock repurchase

1. Market signaling: a stock repurchase using excess cash available may be interpreted as a signal that the firm does not have viable investment opportunities. This may be seen as failure on the part of management.
2. Loss of investment income: a stock repurchase does not generate extra income since it’s not an investment. Therefore, there is foregone interest income if the excess cash could have been invested in viable projects.
3. Payment of a higher price: a firm has to pay a premium above the existing MPS to the shareholders to agree to have their shares repurchased. If the price paid for the repurchase is too high this may be disadvantage to the remaining shareholders.

 

• Why should the firm pay dividends?

This question can be answered by the various dividend theories which attempt to explain whether the payment of dividends affects the value of the firm.

These include the following theories;

• THE AGENCY THEORY

The agency problem between shareholders and management can be solved through the payment of dividends. This can be explained as follows;

• If all earnings are paid out as dividends managers will require raising additional equity and debt finance future projects.
• This will expose the managers to the providers of capital in order to finance future projects.
• If the managers were to seek this through external borrowing they must engage in activities that maximize the shareholders wealth or the value of the firm and they must make full disclosure of their activities to providers of funds. (Disciplining effect of debt)
• Managers will thus become self regulated and hence there will be no need of incurring agency costs

In summary therefore the higher the dividend paid the higher the value of the firm and vice versa.

• BIRD IN HAND THEORY (GORDON AND LINTNER) 1963

This theory is based on the certainty of dividends and capital gains. The theory argues that if dividends are not paid they are used to finance projects with a positive NPV which leads to an increase in the MPS leading to realization of capital gains in the future.

The theory can be summarized as follows;

• Investors who are risk averse will prefer dividends to capital gains
• Dividend income is immediate and more certain ( a bird in hand) compared to capital gains that are receivable in the future and are highly uncertain .(two birds in the bush)
• Given that most investors prefer certain income they will dividend income to capital gains

Therefore, a company that pays high dividends will have a higher value and vice versa.

In response MM argued that investors are indifferent between dividend yield and capital gain. Hence the cost of capital (equity) is not affected by dividend policy. MM argued that many if not most investors would re-invest their dividend in the same or similar firm if they dos o not need current income. MM referred to Gordon and Lintner’s model as the bird in hand fallacy.

• CLIENTELE THEORY (PETIT 1977)

Clientele is the tendency of a firm to attract investors who like or prefer its dividend policy. Different groups of stock holders prefer different payout policies e.g. retired individuals prefer current income and would like to invest in company with high payout ratios. However, investors in their peak earning days may have no need of current investment income and would simply re-invest any dividend received after paying the relevant taxes.

MM however argued that one clientele is as good as any other. The existence of clientele effect does not suggest that one policy is better than the other.

• TAX DIFFERENTIAL THEORY (LINZENBERG AND RAMINSWAMY 1979)

This theory argues that capital gains tax is generally lower than the tax on ordinary income including dividends. Investors also pay taxes on dividends in the same year when the dividends are received whereas the capital gain tax is only payable when the gain is actually realized that is the shares are sold

From the taxation point of view investors may therefore prefer capital gains to dividend income in order to minimize their tax burden.

• THE INFORMATION SIGNALING THEORY ( STEPHEN ROSS 1977)

Ross observed from empirical studies that firms that increase significantly dividend payments had a corresponding increase in share prices whereas those firms that omitted or reduced significantly dividend payments had a corresponding decline in share prices. This in his opinion suggested that investors prefer dividends to capital gains.

In response MM however argued that a higher than normal dividend increase is a signal to investors that the firm’s management forecast good future earnings. On the contrary a dividend reduction is a signal that management’s forecast poor future earnings.

 

MM further argued that the investor’s reaction to changes in dividend policy does not necessarily show that investors prefer dividend to capital gain. Rather the fact that price change follows a dividend action simply indicates that there is important information or signaling content in dividend announcements.

According to Solomon Ezra 1963, a dividend action may offer tangible evidence of the firm’s ability to generate cash flows. As a result a dividend action may affect share prices. He states ‘in this uncertain world in which verbal statements may be miss-interpreted, a dividend action provides a clear cut means making a statement that speaks louder than a thousand words’

• MODIGLIANI AND MILLER (MM) DIVIDEND IRRELEVANCY POLICY (1961)

In a theoretical article on dividend policy, MM argued that dividend policy has no effect on either the price of the firm’s stock or its cost of capital. They stated that the dividend policy is therefore irrelevant. They argued that the firm’s value is determined by its basic earnings power or cash flows and its risk class.

Dividend policy has therefore no effect on either the manner the earnings are split between dividends and additions to retained earnings. They based their theories on the following assumptions;

• There are no transaction costs associated with the floatation of shares
• There are no taxes on corporate and personal income ( dividends and capital gains)
• The company’s investment policy is independent of its dividend policy
• The information known to managers is also known to shareholders
• The stock markets are efficient

Factors that influence the dividend policies in practice

• Investment opportunities available to the firm

Firms which have good investment opportunities often attempt to conserve their cash flows. They will therefore only pay a dividend if all the profitable investment opportunities have been exploited.

• Alternative sources of finance

If a firm is able to raise capital easily and cheaply from external sources it can distribute more dividends since it will not rely heavily on retained earnings

• Loan covenants

A firm may be restricted by debt covenants from paying dividends unless the retained earnings exceed certain levels.

• Legal requirements

According to the Company’s Act dividends are paid out of the current or previous period profits after providing for capital allowances. However, when it is for public interest the company may be forced to pay dividends before providing for capital allowances.

• Profit stability

Companies with a stable pattern of profits are in a better position to pay high dividends than firms with variable profits.

• Control

Low dividend policy hence high profit retention can help a firm to avoid the need of issuing new shares implying that the control of the shareholders is not diluted.

• Preferred stock restriction

Common dividends cannot be paid if the company has obtained payment of preference dividends. All the preference dividend areas must be settled before any common dividends can be paid.

• The impairment of capital rule

Common dividends cannot legally exceed the retained earnings. This legal restriction is designed to protect the creditors. Without this rule a firm in financial difficulties may distribute most of its assets to the shareholders as dividends.