Chapter 18: Dividend policy

Chapter learning objectives

Upon completion of this chapter you will be able to:

• explain the impact that the issue of dividends may have on a company's share price
• explain the theory of dividend irrelevance
• discuss the influence of shareholder expectations on the dividend decision
• discuss the influence of legal constraints on the dividend decision
• discuss the influence of liquidity constraints on the dividend decision
• define and distinguish between bonus issues and scrip dividends.

1 The dividend decision

We've already seen in the chapter on sources of finance thatretained earnings are an important source of finance for both long andshort-term purposes. They have no issue costs, they are flexible (theydon't need to be applied for or repaid) and they don't result in adilution of control.

However, for any company, the decision to use retained earnings as asource of finance will have a direct impact on the amount of dividendsit will pay to shareholders.

The key question is if a company chooses to fund a new investmentby a cut in the dividend what will the impact be on existingshareholders and the share price of the company?

2 Theories of dividend policy

There are three main theories concerning what impact a cut in the dividend will have on a company and its shareholders.

Dividend irrelevancy theory

The dividend irrelevancy theory put forward by Modigliani &Miller (M&M) argues that in a perfect capital market (no taxation,no transaction costs, no market imperfections), existing shareholderswill only be concerned about increasing their wealth, but will beindifferent as to whether that increase comes in the form of a dividendor through capital growth.

As a result, a company can pay any level of dividend, with anyfunds shortfall being met through a new equity issue, provided it isinvesting in all available positive NPV projects.

Any investor requiring a dividend could "manufacture" their own byselling part of their shareholding. Equally, any shareholder wantingretentions when a dividend is paid can buy more shares with the dividendreceived.

Most of the criticism of M&M's theory surrounding the assumption of a perfect capital market.

Dividend irrelevancy theory

M&M's theory states that provided a company is investing inpositive NPV projects, it will make no difference to the shareholder(and share price) whether the projects are funded via a cut in dividendsor by obtaining additional funds from outside sources.

As a result of obtaining outside finance instead of using retainedearnings, there would be a reduction in the value of each share.However, M&M argued that this reduction would equal the amount ofthe dividend paid, thereby meaning shareholder wealth was unaffected bythe financing decision.

Residual theory

This theory is closely related to M&Ms but recognises the costs involved in raising new finance.

It argues that dividends themselves are important but the pattern of them is not.

We saw in the cost of capital chapter that the market value of ashare will equal the present value of the future cash flows. Theresidual theory argues that provided the present value of the dividendstream remains the same, the timing of the dividend payments isirrelevant.

It follows that only after a firm has invested in all positive NPVprojects should a dividend be paid if there are any funds remaining.Retentions should be used for project finance with dividends as aresidual.

However, this theory still takes some assumptions that may not bedeemed realistic. This includes no taxation and no market imperfections.

Residual theory

A firm pays out a constant dividend of 10c in perpetuity. Its cost of equity is 10%.

The value of the dividend stream to an investor is:

• They would need to cancel the T1 dividend of 10c to pay for it.
• The project should earn 10% return, i.e. the 10c would be worth 10 × 1.1 = 11c the following year.

Provided the firm then distributed the additional 11c, the shareholder would have:

So in theory, provided the firm invests the withheld dividend inprojects that at least earn the shareholders' required return, theinvestors' wealth is unchanged and they will not object.

• Dividends become a residual – firms only pay a dividend if there are earnings remaining after all positive NPV projects have been financed.

Dividend relevance

Practical influences, including market imperfections, mean thatchanges in dividend policy, particularly reductions in dividends paid,can have an adverse effect on shareholder wealth:

• reductions in dividend can convey 'bad news' to shareholders (dividend signalling)
• changes in dividend policy, particularly reductions, may conflict with investor liquidity requirements
• changes in dividend policy may upset investor tax planning (clientele effect).

As a result companies tend to adopt a stable dividend policy and keep shareholders informed of any changes.

Dividend relevance

In theory the level of dividend is irrelevant and in a perfectcapital market it is difficult to challenge the dividend irrelevancyposition. However, once these assumptions are relaxed, certain practicalinfluences emerge and the arguments need further review.

Dividend signalling

In reality, investors do not have perfect information concerningthe future prospects of the company. Many authorities claim, therefore,that the pattern of dividend payments is a key consideration on the partof investors when estimating future performance.

For example, an increase in dividends would signal greaterconfidence in the future by managers and would lead investors toincrease their estimate of future earnings and cause a rise in the shareprice. A sudden dividend cut on the other hand could have a seriousimpact upon equity value.

This argument implies that dividend policy is relevant. Firmsshould attempt to adopt a stable (and rising) dividend payout tomaintain investors' confidence.

Preference for current income

Many investors require cash dividends to finance currentconsumption. This does not only apply to individual investors needingcash to live on but also to institutional investors, e.g. pension fundsand insurance companies, who require regular cash inflows to meetday-to-day outgoings such as pension payments and insurance claims. Thisimplies that many shareholders will prefer companies who pay regularcash dividends and will therefore value the shares of such a companymore highly.

The proponents of the dividend irrelevancy theory challenge thisargument and claim that investors requiring cash can generate 'homemadedividends' by selling shares. This argument has some attractions but itdoes ignore transaction costs. The sale of shares involves brokeragecosts and can therefore be unattractive to many investors.

Taxation

In many situations, income in the form of dividends is taxed in adifferent way from income in the form of capital gains. This distortionin the personal tax system can have an impact on investors' preferences.

From the corporate point of view this further complicates thedividend decision as different groups of shareholders are likely toprefer different payout patterns.

One suggestion is that companies are likely to attract a clienteleof investors who favour their dividend policy (for tax and otherreasons) e.g. higher rate tax payers may prefer capital gains todividend income as they can choose the timing of the gain to minimisethe tax burden. In this case companies should be very cautious in makingsignificant changes to dividend policy as it could upset theirinvestors.

Research in the US tends to confirm this 'clientele effect' withhigh dividend payout firms attracting low income tax bracket investorsand low dividend payout firms attracting high income tax bracketinvestors.

3 Other practical constraints

Legal restrictions on dividend payments

• Rules as to distributable profits that prevent excess cash distributions.
• Bond and loan agreements may contain covenants that restrict the amount of dividends a firm can pay.

Such limitations protect creditors by restricting a firm's abilityto transfer wealth from bondholders to shareholders by paying excessivedividends.

Liquidity

Consider availability of cash, not just to fund the dividend butalso cash needed for the continuing working capital requirements of thecompany.

4 Alternatives to cash dividends

Share repurchase

• consider using cash to buy back shares as an alternative to a dividend, particularly if surplus cash available would distort normal dividend policy.
• alternative is to pay one-off surplus as a 'special dividend'.

Scrip dividends

A scrip dividend is where a company allows its shareholders to take their dividends in the form of new shares rather than cash.

• The advantage to the shareholder of a scrip dividend is that he can painlessly increase his shareholding in the company without having to pay broker's commissions or stamp duty on a share purchase.
• The advantage to the company is that it does not have to find the cash to pay a dividend and in certain circumstances it can save tax.

Do not confuse a scrip issue (which is a bonus issue) with a scrip dividend.

A bonus (scrip) issueis a method of altering the share capital without raising cash. It isdone by changing the company's reserves into share capital.

The rate of a bonus issue is normally expressed in terms of thenumber of new shares issued for each existing share held, e.g. one fortwo (one new share for each two shares currently held).

5 Chapter summary

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