The Dividend Decision

Retained earnings are an important source of finance for both long and short-term purposes. They have no issue costs, they are flexible (they don't need to be applied for or repaid) and they don't result in a dilution of control.

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

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

Or put another way, does dividend policy affect shareholder wealth?

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 shareholders will only be concerned about increasing their wealth, but will be indifferent as to whether that increase comes in the form of a dividend or through capital growth.

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

If they need cash, then any investor requiring a dividend could "manufacture" their own by selling part of their shareholding. Equally, any shareholder wanting retentions when a dividend is paid can buy more shares with the dividend received.

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

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.

The market value of a share will equal the present value of the future cash flows. The residual theory argues that provided the present value of the dividend stream remains the same, the timing of the dividend payments is irrelevant.

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

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

Dividend relevance

Practical influences, including market imperfections, mean that changes 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 (selling shares to 'manufacture dividends' is not a costless alternative to being paid the dividend).
• Changes in dividend policy may upset investor tax planning (e.g. income v capital gain if shares are sold). Companies may have attracted a certain clientele of shareholders precisely because of their preference between income and growth

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

Practical influences on dividend policy

Before developing a particular dividend policy, a company must consider the following:

Legal position

Many countries will place legal restrictions on the amount of dividend that can be paid out relative to a company's earnings.

In addition, governments have operated policies of dividend restraint over various periods.

Profitability

Profit is obviously an essential requirement for dividends. All other things being equal, the more stable the profit the greater the proportion that can be safely paid out as dividends. If profits are volatile it is unwise to commit the firm to a higher dividend payout ratio.

Inflation

In periods of inflation, paying out dividends based on historic cost profits can lead to erosion of the operating capacity of the business. For example, insufficient funds may be retained for future asset replacement. Current cost accounting recalculates profit taking into consideration inflation, asset values and capital maintenance. Firms would then ensure that the dividend is limited to the CCA profit.

Growth

Rapidly growing companies commonly pay very low dividends, the bulk of earnings being retained to finance expansion.

Control

The use of internally generated funds does not alter ownership or control. This can be advantageous particularly in family owned firms.

Liquidity

Sufficient liquid funds need to be available to pay the dividend.

Tax

The personal tax position of investors may put them in a position of preferring either dividend income or capital gains though growing share prices. If the clientele of investors in the company have a clear preference for one or the other, the company should be wary of altering dividend policy and upsetting investors.

Other sources of finance

If a firm has limited access to other sources of funds, retained earnings become a very important source of finance. Dividends will therefore tend to be small. This situation is commonly experienced by unquoted companies that have very limited access to external finance

These factors limit the 'dividend capacity' of the firm.

Dividend capacity

This can be simply defined as the ability at any given time of a firm's ability to pay dividends to its shareholders. This will clearly have a direct impact on a company's ability to implement its dividend policy (i.e. can the company actually pay the dividend it would like to).

Legally, the firm's dividend capacity is determined by the amount of accumulated distributable profits.

However, more practically, the dividend capacity can be calculated as the Free Cash Flow to Equity (after reinvestment), since in practice, the level of cash available will be the main driver of how much the firm can afford to pay out.

Dividend policy in practice

In practice, there are a number of commonly adopted dividend policies:

• stable dividend policy
• constant payout ratio
• zero dividend policy
• residual approach to dividends.

Stable dividend policy

Paying a constant or constantly growing dividend each year:

• 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.

However, there is a risk that reduced earnings would force a dividend cut with all the associated difficulties.

Constant payout ratio

Paying out a constant proportion of equity earnings:

• maintains a link between earnings, reinvestment rate and dividend flow but
• cash flow is unpredictable for the investor
• gives no indication of management intention or expectation.

Zero dividend policy

All surplus earnings are invested back into the business. Such a policy:

• is common during the growth phase
• should be reflected in increased share price.

When growth opportunities are exhausted (no further positive NPV projects are available):

• cash will start to accumulate
• a new distribution policy will be required.

Residual dividend policy

A dividend is paid only if no further positive NPV projects available. This may be popular for firms:

• in the growth phase
• without easy access to alternative sources of funds.

However:

• cash flow is unpredictable for the investor
• gives constantly changing signals regarding management expectations.

Ratchet patterns

Most firms adopt a variant on the stable dividend policy - a ratchet pattern of payments. This involves paying out a stable, but rising dividend per share:

• Dividends lag behind earnings, but can then be maintained even when earnings fall below the dividend level.
• Avoids 'bad news' signals.
• Does not disturb the tax position of investors.

Further complications relating to dividend policy include the following:

• If the company has insufficient cash, then it may choose to give shareholders shares instead of a conventional cash dividend. This is known as a "scrip dividend"
• If the company has an excess of cash , then it might choose to buy back shares, rather than pay a large one-off dividend. International companies
• face additional complications when setting their dividend policies.

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