Dividend policy is defined as the policy that a company uses to determine how much of its earnings
it will pay out to shareholders in dividends (Lee, 2009). In other words, it is the division of earnings
between payments to shareholders and reinvestment in the firm. Dividends can be divided into
many types. Cash dividends are the most common way; others include stock dividends, property
dividends, scrip dividends and liquidating dividends. As well, stock split and stock repurchase can
sometimes be regarded as two additional kinds of dividends.
Dividend policy really involves three key issues: (1) How much should be distributed? (2) Should the
distribution be as cash dividends, or should the cash be passed on to shareholders by buying back
some of the stock they hold? (3) How stable should the distribution be, that is, should the funds paid
out from year to year be stable and dependable, which stockholders would probably prefer, or be
allowed to vary with the firm’s cash flows and investment requirements, which would probably be
better from the firm’s standpoint?
Southeastern Steel Company will undergo an initial public offering, and as it is their first time in
offering their shares of stock to the public, they must present their company’s ability to generate
profit the best way possible; as that is every investors’ goal, to generate profit; to invest in a firm
that would maximize their wealth.
SCC should use the residual dividend policy, as they are a 5 year old company which uses a process
that they have developed on their own.
Companies that usually decided to pay dividend constantly growth are large, mature companies that
have predictable earnings growth. Dividends tend to be lower in industries that have many
profitable opportunities to invest their earnings. But, as a company matures and finds fewer
profitable investment opportunities, it generally pays out a greater portion of its earnings in
dividends.
Many companies are reluctant to cut dividends because the share price usually falls when a
reduction of dividends is announced. The investors tend to penalize companies that cut dividends.
Therefore, corporations tend to only raise their regular quarterly dividend when they are sure they
can keep it increased in the future
QUESTION 2:
Miller and Modigliani (1961) stated that dividend policy was irrelevant to firms’ equity value under a
fully efficient capital markets. No matter what the dividend policy was, it couldn’t affect firms’ share
price or investors’ investment return. In contrast to the dividend irrelevance theory, De Angelo
(1996) showed that dividend policy was relevant to firms’ equity value. Share prices and investors’
decisions were related to dividend policy because dividend policy contained some potential
information which made signals to capital markets and investors.
In their theory MM said that, investors are indifferent between dividends and capital gains, making
dividend policy irrelevant with regard to its effect on the value of the firm.
Modigliani-Miller has argued that firm’s dividend policy is irrelevant to the value of the firm.
According to this approach, the market price of a share is dependent on the earnings of the firm on
its investment and not on the dividend paid by it. Earnings of the firm which affect its value, further
depends upon the investment opportunities available to it.
The dividend irrelevance theory was proposed by Modiglian and Miller, but they had to make some
very restrictive assumptions to prove their arguments. The following are the assumptions regarding
the MM Dividend policy theory:
There are no taxes paid on dividend,
The stocks can be bought and sold with no flotation cost and transactions costs and
Perfect Capital Markets: The MM theory believes in the existence of perfect capital markets. It
assumes that all the investors are rational, everyone in the market, Investor and Manger they have
access to free information, they have same information regarding firm’s earnings meaning no large
investor to influence the market price of the share.
No Risk of Uncertainty: All the investors are certain about the future market prices and the
dividends.
Investor is indifferent between dividend income and capital gain income: It is assumed that investor
is indifferent between dividend income and capital gain income. It means if he requires total return
of US $. 500, he may get US $. 200 dividend income and US $. 300 as capital gain income or reverse,
in either of the case he gets equal satisfaction.
MM continue to argue that paying out a dollar per share of dividends reduces the growth rate in
earnings and dividends, because new stock will have to be sold to replace the capital paid out as
dividends. Under their assumptions, a dollar of dividends will reduce the stock price by exactly $1.
Therefore, according to Modiglian-Miller, shareholders should be indifferent between dividends and
capital gains.
ASSUMPTION
The assumptions of MM appear to be unrealistic and unpractical although theoretically it is
appealing, but in real world such perfect markets do not exist in the practical world.
QN 3:
Some investors may prefer high-dividend-paying stocks because when a company has high pay out
ratio its stock price would have a high value, and also because dividends are less risky than capital
gain.
And some investors may prefer low-paying dividend stocks because they would like to avoid
incurring transaction costs
Investors might also prefer low-payout firms or capital gains to dividends because they may want to
avoid transactions costs, having to reinvest the dividends and incurring brokerage costs, not to
mention taxes. The maximum tax rate on dividends is the same as it is for capital gains; however,
taxes on dividends are due in the year they are received, while taxes on capital gains are due
whenever the stock is sold. In addition, if an investor holds a stock until his/her death, the
beneficiaries can use the date of the death as the cost-basis date and escape all previously accrued
capital gains.
Different groups of investors, or clienteles, prefer different dividend policies. The dividend clientele
effect states that high-tax bracket investors (like individuals) prefer low dividend payouts and low
tax bracket investors (like corporations and pension funds) prefer high dividend payouts.
QN4:
Announcement of a dividend increase often results in an increase in the stock price, while an
announcement of a dividend cut typically causes the stock price to fall. One could argue that this
observation supports the premise that investors prefer dividends to capital gains.
MM argued that dividend announcements are signals through which management conveys
information to investors. Information asymmetries exist—managers know more about their firms’
prospects than do investors. Further, managers tend to raise dividends only when they believe that
future earnings can comfortably support a higher dividend level, and they cut dividends only as a last
resort. Therefore, (1) a larger-than-normal dividend increase ―signals‖ that management believes
the future is bright, (2) a smaller-than-expected increase, or a dividend cut, is a negative signal, and
(3) if dividends are increased by a―normal‖ amount, this is a neutral signal.
The information content, dividend signalling hypothesis implies that dividends contain information
that can be used to signal the market about a firm’s future prospects, namely its earnings. This
theory about the ‘information content of dividends’ was first presented by Miller and Modigliani
(1961).
Dividend signalling is a theory that suggests that a company's announcement of an increase in
dividend payouts is an indication of positive future prospects.
Dividend signaling posits that dividend increases are an indication of positive future results for a
firm, and that only managers overseeing positive potential will provide such a signal.
Increasing a company's dividend payout may predict favorable performance of the company's stock
in the future.
The dividend signaling theory suggests that companies that pay the highest dividends are, or should
be, more profitable than those paying smaller dividends.
The information content of dividends theory says that a high dividend indicates that the company is
strong and a good investment. The idea is that if a company pays out a high dividend, it is because it
is financially sound and will earn a lot in the future.
There are two distinct views about this theory: one according to which dividends contain signals
about future earnings and another in which changes in the dividend policy contain no such insight on
future prospects. Among the first group of scholars, Lintner (1956) showed that changes in earnings
impact the dividend policy. Fama and Babiak (1968) achieved similar results, attesting that dividend
changes contained lagged changes in earnings. On the opposite side, it was argued that firms do not
want to decrease dividends because such a movement is negatively viewed by the market and tends
to cause a decrease in share prices (Eades, 1982; Damodaran, 2006).
A number of past studies found evidence that managers use changes in dividends as a way to signal
information about future earnings of a firm. Bhattacharya (1979), John and Williams (1985), Miller
and Rock (1985), Kao and Wu (1994), Fama and French (1998) and more recently Harada and
Nguyen (2005) and Baker et al. (2006) suggest that changes in dividends are a tool that managers
frequently use to convey data about unexpected shocks in earnings.
Earlier studies (Brickley, 1983; Healy and Palepu, 1988) found that an increase in dividends tends to
lead to the increase in future earnings
2:
Different groups, or clienteles, of stockholders prefer different dividend payout policies. The
dividend clientele effect states that high-tax bracket investors (like individuals) prefer low dividend
payouts and low tax bracket investors (like corporations and pension funds) prefer high dividend
payouts.
If a firm retains and reinvests income rather than paying dividends, those stockholders who need
current income will be disadvantaged. The value of their stock might increase, but they will be
forced to go to the trouble and expense of selling off some of their shares to obtain cash. On the
other hand, stockholders who are saving rather than spending dividends favor the low-dividend
policy: The less the firm pays out in dividends, the less these stockholders have to pay in current
taxes and the less trouble and expense they must go through to reinvest their after-tax dividends. All
of this suggests that a clientele effect exists, which means that firms have different clienteles and
that the clienteles have different preferences—hence, that a change in dividend policy might upset
the majority clientele and have a negative effect on the stock’s price. This suggests that a company
should follow a stable, dependable dividend policy so as to avoid upsetting its clientele.
3
Dividend policy changes should not be taken lightly, as it might upset a firm’s clientele, as some may
prefer low-dividend policy and others a high-dividend policy, a firm may have a hard time trying to
figure out which clientele they have or which kind of clientele is more, so a drastic change in
dividend policy will hurt a firm. Dividend policy should be changed slowly, rather than abruptly, in
order to give stockholders time to adjust. We need to know that, There are also costs (taxes and
brokerage) to stockholders who would be forced to switch from one stock to another if a firm
changes its dividend policy. Therefore, we cannot say whether a dividend policy change to appeal to
one particular clientele or another would lower or raise a firm’s cost of equity. MM argued that one
clientele is as good as another, so in their view the existence of clienteles does not imply that one
dividend policy is better than another. Still, no one has offered convincing proof that firms can
disregard clientele effects. We know that stockholder shifts will occur if dividend policy is changed,
and since such shifts result in transactions costs and capital gains taxes, dividend policy changes
should not be taken lightly. Further, dividend policy should be changed slowly, rather than abruptly,
in order to give stockholders time to adjust.
5
Firms establish dividend policy within the framework of their overall financial plans.
The firm forecasts its annual capital budget and its annual sales, along with its working capital needs.
The target capital structure, one that minimizes the WACC while retaining sufficient reserve
borrowing capacity to provide “financing flexibility,” will also be established.
With its capital structure and investment requirements in mind, the firm can estimate the
approximate amount of debt and equity financing required during each year over the planning
horizon.
A long-term target payout ratio is then determined, based on the residual model concept. Because
of flotation costs and potential negative signalling, the firm will not want to issue common stock
unless this is absolutely necessary. At the same time, due to the clientele effect, the firm will move
cautiously from its past dividend policy, if a new policy appears to be warranted, and it will move
toward any new policy gradually rather than in one giant step
1The firm forecasts its annual capital budget and its annual sales, along with its working capital
needs, for a relatively long-term planning horizon, often 5 years.
2The target capital structure, presumably the one that minimizes the WACC while retaining
sufficient reserve borrowing capacity to provide ―financing flexibility,‖ will also be established.
3. With its capital structure and investment requirements in mind, the firm can estimate the
approximate amount of debt and equity financing required during each year over the planning
horizon.
4. A long-term target payout ratio is then determined, based on the residual model concept.
Because of flotation costs and potential negative signaling, the firm will not want to issue common
stock unless this is absolutely necessary. At the same time, due to the clientele effect, the firm will
move cautiously from its past dividend policy, if a new policy appears to be warranted, and it will
move toward any new policy gradually rather than in one giant step.
5. An actual dollar dividend, say $2 per year, will be decided upon. The size of this dividend will
reflect (1) the long-run target payout ratio and (2) the probability that the dividend, once set, will
have to be lowered, or, worse yet, omitted. If there is a great deal of uncertainty about cash flows
and capital needs, then a relatively low initial dollar dividend will be set, for this will minimize the
probability that the firm will have to either reduce the dividend or sell new common stock. The firm
will run its corporate planning model so that management can see what is likely to happen with
different initial dividends and projected growth rates under different economic scenarios.
QN
The share repurchase price that is offered to shareholders is generally at a premium to the current
market price, which incentivizes shareholders to take part in the process. This process is especially
useful when management feels that the company’s share price is undervalued and wants to push
the price upward. Buybacks also allow the company to transfer surplus cash sitting idle on the
balance sheet to its shareholders.
The repurchased shares are absorbed by the company, reducing the number of outstanding shares
on the market.
There are two ways that companies conduct a buyback: A tender offer or through the open market:
Tender Offer: Corporate shareholders receive a tender offer that requests them to submit, or
tender, a portion or all of their shares within a certain time frame. The offer states the number of
shares the company wants to repurchase along with a price range for the shares. Investors who
accept state how many shares they want to tender along with the price they are willing to accept.
Once the company receives all the offers, it finds the right mix to buy the shares at the lowest cost.
Open Market: A company can also buy its shares on the open market at the market price, which is
often the case. But the announcement of a buyback causes the share price to shoot up because the
market perceives it as a positive signal.
The following are the advantages of Stock repurchase:
i.
Stock repurchase prevents a decline in the value of a stock by reducing the supply of the
stock.
ii.
Stocks repurchase helps to creating shareholder’s wealth because company use its idle cash
to purchase its own shares from shareholders.
iii.
Share repurchase is more tax-efficient way to return the earnings of the business to
shareholders, relative to dividends, which are taxable to those who receive them. There’s a
tax benefit for the shareholders upon the share repurchase. If the company has more cash in
hand or bank, they can either issue dividends or go for share repurchase. The tax on
dividends is computed on income tax slab rates, whereas the tax on share repurchase will be
entitled as capital gain tax. So, if the shareholders opt for share repurchase, they’ll be in the
lower tax bracket.
iv.
With the reduction in outstanding shares during share repurchase, the Earnings per Share
(EPS) of the company improve. This is a good indication of the company’s profitability and
may boost its share price in the long run.
The following example below shows the impact on Earning Per Share (EPS) if a company buys back
20% of its shares, for example, reduction of shares from 100,000 to 80,000:
Pre-Buyback
Post-Buyback
Profit available to shareholders
Tzs. 1,000,000
Tzs. 1,000,000
No. of Outstanding Shares
100,000
80,000
Earnings Per Share
Tzs. 10.00
Tzs. 12.50
v.
Share repurchase is used as a strategy by management to show its confidence in the
company and to send a message that the stock is undervalued. For example, if a stock is
trading at Tzs. 120 and the company announces a buyback at Tzs. 150, it will instantly create
value for its shareholders and price will tend to move upward.
vi.
It helps the company use excess cash lying idle from a lack of opportunities. Idle cash earns
no additional income for the company.
vii.
Dividends return cash to all shareholders while a share buyback returns cash to self-selected
shareholders only. So when a company pays a dividend, everyone receives cash according to
the proportion of their shareholding whether they need cash or not. However, in case of a
share buyback, investors decide whether they want to take part in the process or not. This
also gives them the option of changing their shareholding pattern.
viii.
A higher EPS would lower the P/E ratio, which is looked at positively in the stock market.
Thus, a higher EPS coupled with a lower P/E ratio and higher ROA should have an overall
positive impact on the stock price.
ix.
The buyback also provides liquidity opportunities for a thinly traded stock.
Apart of the above advantages of share repurchase, the following are the disadvantages of share
repurchase.
i.
Share repurchase may indicate that the company doesn’t have any profitable opportunities
to invest in, which may send a bad signal to long term investors looking for capital
appreciation.
ii.
It may also give a negative signal about the company’s confidence in itself and promoters
may decide to sell their stake.
iii.
The buyback process is time-consuming and requires disclosures to stock exchanges and
approvals from regulatory bodies. It also involves hiring investment bankers, which becomes
an expensive affair for the company.
Cash Dividend means dividend which is paid to shareholders in Cash or Bank. But when a company
doesn’t have cash for payment of dividends, it gives dividends in the form of equity or we can say
that additional shares of the Company are allotted to the shareholder. This term is called Stock
Dividend.
There are some downsides of stock dividends as well. While the stock dividend strategy offers
advantages, it may also be disadvantageous in the following ways:
i.
The market may perceive the declaration of stock dividends as an acute shortage of cash or
distress in the company. Such a pessimistic assumption may give rise to a selling spree of the
stock, and the price may start spiraling down.
ii.
As investors who are not privy to the company’s internal management, it may not be easy to
judge the true intentions of the top management. They remain at the mercy of the company and
shall never know whether the company’s decision was genuine or just a way to hoard cash.
iii.
A company may actually be better off paying cash dividends rather than diverting the precious
funds to a risky project, the returns of which are uncertain.
Also, firms distribute value to shareholders through five major ways: regular cash dividend, open
market repurchases intra-firm tender offers, targeted repurchases and special dividends (Barklay
and Smith 1988). Dividend is therefore one of them and the most puzzling (Black, 1976).
As argued by Lintner (1956), changing of the dividend policy illustrates changes in the firms’
earnings. Firms with the stable dividend policy are more preferred by investors and managers. On
the other hand, as omitting the dividends can be a negative signal to the market which conveys
information about the firms’ financial distress; the managers are usually unwilling to omit or reduce
the dividends as stated by DeAngelo and De Angelo (1990).
According to the study of dividend changes, Brav et al (2005) reported that keeping the level of
dividends constant is a main concern for investment decisions. In contrast with Lintner’s findings,
managers are reluctant to increase dividend payment at the same time with any rise in earnings,
because they no longer consider dividends as the main decision variable (Brav, Graham, Harvey,&
Michaely, 2005).
In the 1960’s, Miller and Modigliani explained that, the dividend payment is irrelevant to the value
of the company based on certain conditions of perfect capital market and rational behavior (Miller &
Modigliani, 1961).
Based on the Modigliani and Miller (1961) model, in a perfect market the share price of a firm and
shareholder’s wealth is not affected by the dividend policy since they believe the value of the firm is
determined by its investment decisions. In other words, the value of firms is independent of how
they set their dividend policy.
To summarize, in the perfect capital market, the only determinant of firm’s value is the future cash
flow from investment decisions.
Market imperfections such as asymmetric information, agency costs, transaction costs and taxes
should be considered in dividend relevancy (Lease, et al., 2000).
Over years of researches, four main theories of dividends relevancy have been offered: The bird-inhand theory, signaling theory, tax preference theory and agency cost theory.