Chapter 11 Dividend Policy
1.1 Identify and discuss internal sources of finance, including:
(a) retained earnings;
(b) increasing working capital management efficiency.
1.2 Explain the impact that the issue of dividends may have on a company’s share price.
1.3 Explain the theory of dividend irrelevance.
1.4 Discuss the influence of shareholder expectations on the dividend decision.
1.5 Discuss the influence of liquidity constraints on the dividend decision.
1.6 Define and distinguish between bonus issues and scrip dividends.
1.7 Discuss the implications of share repurchase.
2. Internal Sources of Finance
2.1 Internal sources of finance include retained earnings and increasing working capital management efficiency.
(A) Retained earnings
2.2 Retained earnings is surplus cash that has not been needed for operating costs, interest payments, tax liabilities, asset replacement or cash dividends. For many businesses, the cash needed to finance investments will be available because the earnings the business has made have been retained within the business rather than paid out as dividends.
2.3 It is important not to confuse retained earnings with the accounting term “retained profit” from the income statement and statement of financial position. “Retained profit” in the accounting statements is not necessarily cash and does not represent funds that can be invested. Retained earnings in finance is the cash generated from retention of earnings which can be used for financing purposes.
2.4 A company may have substantial retained profits in its statement of financial position but no cash in the bank and will not therefore be able to finance investment from retained earnings.
2.5 Advantages and disadvantages
(B) Increasing working capital management efficiency
2.6 It is important not to forget that an internal source of finance is the savings that can be generated from more efficient management of trade receivables, inventory, cash and trade payables. Efficient working capital management can reduce bank overdraft and interest charges as well as increasing cash reserves.
3. Dividend Policy
3.1 Shareholders normally have to power to vote to reduce the size of the dividend at the AGM, but not the power to increase the dividend. The directors of the company are therefore in a strong position, with regard to shareholders, when it comes to determining dividend policy. For practical purposes, shareholders will usually be obliged to accept the dividend policy that has been decided on by the directors, or otherwise to sell their shares.
(A) Factors influencing dividend policy
3.2 When deciding upon the dividends to pay out to shareholders, one of the main considerations of the directors will be the amount of earnings they wish to retain to meet financing needs.
3.3 As well as future financing requirements, the decision on how much of a company’s profit should be retained, and how much paid out to shareholders, will be influenced by:
(a) The need to remain profitable – dividends are paid out of profits, and an unprofitable company cannot for ever go on paying dividends out of retained profits made in the past.
(b) The law on distributable profits – a Company Act may make companies bound to pay dividends solely out of accumulated net realized profits as in the UK.
(c) The government which may impose direct restrictions on the amount of dividends companies can pay. For example, in the UK in the 1960’s as part of a prices and income policy.
(d) Any dividend restraints that might be imposed by loan agreements.
(e) The effect of inflation, and the need to retain some profit within the business just to maintain its operating capability unchanged.
(f) The company’s gearing level – if the company wants extra finance, the sources of funds used should strike a balance between equity and debt finance.
(g) The company’s liquidity position – dividends are a cash payment, and a company must have enough cash to pay the dividends it declares.
(h) The need to repay debt in the near future.
(i) The ease with which the company could raise extra finance from sources other than retained earnings – small companies which find it hard to raise finance might have to rely more heavily on retained earnings than large companies.
(i) The signaling effect of dividends to shareholders and the financial markets in general.
(B) Dividends as a signal to investors
3.4 Although the market would like to value shares on the basis of underlying cash flows on the company’s projects, such information is not readily available to investors. But the directors do have this information. The dividend declared can be interpreted as a signal from directors to shareholders about the strength of underlying project cash flows.
3.5 Investors usually expect a consistent dividend policy from the company, with stable dividends each year or, even better, steady dividend growth. A large rise or fall in dividends in any year can have a marked effect on the company’s share price.
3.6 Stable dividends or steady dividend growth are usually needed for share price stability. A cut in dividends may be treated by investors as signaling that the future prospects of the company are weak.
3.7 The signaling effect of a company’s dividend policy may also be used by management of a company which faces a possible takeover. The dividend level might be increased as a defence against the takeover – investors may take the increased dividend as a signal of improved future prospects, thus driving the share price higher and making the company more expensive for a potential bidder to take over.
4. Theories of Dividend Policy
(A) Residual theory
4.1 A residual theory of dividend policy can be summarized as follows.
(a) If a company can identify projects with positive NPVs, it should invest in them
(b) Only when these investment opportunities are exhausted should dividends be paid.
(B) Irrelevancy theory
4.2 Modigliani and Miller (M&M) proposed that in a tax-free world, shareholders are indifferent between dividends and capital gains, and the value of a company is determined solely by the earning power of its assets and investments.
4.3 M&M argues that if a company with investment opportunities decides to pay a dividend, so that retained earnings are insufficient to finance all its investments, the shortfall in funds will be made up by obtaining additional funds from outside sources. As a result of obtaining outside finance instead of using retained earnings:
Loss of value in existing shares = Amount of dividend paid
(C) Traditional view
4.4 The traditional view of dividend policy, implicit in our earlier discussion, is to focus on the effects on share price. The price of a share depends upon the mix of dividends, given shareholders’ required rate of return, and growth.
(a) Signaling effect
4.5 Dividend signaling – as mentioned in 3.7, an increase in dividends would signal greater confidence in the future by managers and would lead investors to increase their estimate of future earnings and cause a rise in the share price.
4.6 This argument implies that dividend policy is relevant. Firms should attempt to adopt a stable (and rising) dividend payout to maintain investors’ confidence.
(b) Preference for current income (bird in the hand)
4.7 Many investors require cash dividends to finance current consumption. This does not only apply to individual investors needing cash to live on but also to institutional investors, e.g. pension funds and insurance companies, who require regular cash inflows to meet day-to-day outgoings such as pension payments and insurance claims. This implies that many shareholders will prefer companies who pay regular cash dividends and will therefore value the shares of such a company more highly.
(c) Clientele effect (顧客效應)
4.8 In many situations, income in the form of dividends is taxed in a different way from income in the form of capital gains. This distortion in the personal tax system can have an impact on investors’ preferences.
4.9 From the corporate point of view this further complicates the dividend decision as different groups of shareholders are likely to prefer different payout patterns.
4.10 One suggestion is that companies are likely to attract a clientele of investors who favour their dividend policy. For example, higher rate tax payers may prefer capital gains to dividend income as they can choose the timing of the gain to minimize the tax burden. In this case companies should be very cautious in making significant changes to dividend policy as it could upset their investors.
4.11 Research in the US tends to confirm this clientele effect with high dividend payout firms attracting low income tax bracket investors and low dividend payout firms attracting high income tax bracket investors.
5. Alternative to Cash Dividends
(A) Scrip dividends
5.1 A scrip dividend is a dividend paid by the issue of additional company shares, rather than by cash.
5.2 When the directors of a company would prefer to retain funds within the business but consider that they must at least a certain amount of dividend, they might offer equity shareholders the choice of a cash dividend or a scrip dividend.
5.3 Advantages of scrip dividends
(a) They can preserve a company’s cash position if a substantial number of shareholders take up the share option.
(b) Investors may be able to obtain tax advantages if dividends are in the term of shares.
(c) Investors looking to expand their holding can do so without incurring the transaction costs of buying more shares.
(d) A small scrip dividend issue will not dilute the share price significantly. If however cash is not offered as an alternative, empirical evidence suggests that the share price will tend to fall.
(e) A share issue will decrease the company’s gearing, and may therefore enhance its borrowing capacity.
(B) Stock split
5.4 A stock spilt occurs where, for example, each ordinary share of $1 each is spilt into two shares of 50c each, thus creating cheaper shares with greater marketability. There is possibly an added psychological advantage, in that investors may expect a company which splits its shares in this way to be planning for substantial earnings growth and dividend growth in the future.
5.5 As a consequence, the market price of shares may benefit. For example, if one existing share of $1 has a market value of $6, and is then split into two shares of 50c each, the market value of the new shares might settle at, say, $3.10 instead of the expected $3, in anticipation of strong future growth in earnings and dividends.
5.6 The difference between a stock split and a scrip issue is that a scrip issue coverts equity reserves into share capital, whereas a stock split leaves reserves unaffected.
(C) Share repurchase
5.7 Purchase by a company of its own shares can take place for various reasons and must be in accordance with any requirements of legislation.
5.8 For a smaller company with few shareholders, the reason for buying back the company’s own shares may be that there is no immediate willing purchaser at a time when a shareholder wishes to sell shares. For a public company, share repurchase could provide a way of withdrawing from the share market and going private.
5.9 Benefits of a share repurchase scheme
(a) Finding a use of surplus cash, which may be a dead asset.
(b) Increase in earning per share through a reduction in the number of shares in issue. This should lead to a higher share price than would otherwise be the case, and the company should be able to increase dividend payments on the remaining shares in issue.
(c) Increase in gearing. Repurchase of a company’s own shares allows debt to be substituted for equity, so raising gearing. This will be of interest to a company wanting to increase its gearing without increasing its total long-term funding.
(d) Readjustment of the company’s equity base to more appropriate levels, for a company whose business is in decline.
(e) Possibly preventing a takeover or enabling a quoted company to withdraw from the stock market.
5.10 Drawbacks of a share repurchase scheme
(a) It can be hard to arrive at a price that will be fair both to the vendors and to any shareholders who are not selling shares to the company.
(b) A repurchase of shares could be seen as an admission that the company cannot make better use of the funds than the shareholders.
(c) Some shareholders may suffer from being taxed on a capital gain following the purchase of their shares rather than receiving dividend income.
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