Chapter 11 Dividend Policy

1. 1.1 Objectives Identify and discuss internal sources of finance, including: (a) retained earnings; (b) increasing working capital management efficiency. E plain t!e impact t!at t!e issue of di"idends may !a"e on a company#s s!are price. E plain t!e t!eory of di"idend irrele"ance. &iscuss t!e influence of s!are!older e pectations on t!e di"idend decision. &iscuss t!e influence of li(uidity constraints on t!e di"idend decision. &efine and distinguis! between bonus issues and scrip di"idends. &iscuss t!e implications of s!are repurc!ase.
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Internal Sources of Finance Internal sources of finance include retained earnings and increasing or!ing capital "anage"ent efficiency. &etained earnings +etained earnings is surplus cas! t!at !as not been needed for operating costs, interest payments, ta liabilities, asset replacement or cas! di"idends. .or many businesses, t!e cas! needed to finance in"estments will be a"ailable because t!e earnings t!e business !as made !a"e been retained wit!in t!e
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business rat!er t!an paid out as di"idends. It is important not to confuse retained earnings ith the accounting ter" 'retained profit( from t!e income statement and statement of financial position. 4+etained profit5 in t!e accounting statements is not necessarily cas! and does not represent funds t!at can be in"ested. +etained earnings in finance is t!e cash generated from retention of earnings w!ic! can be used for financing purposes. 2 company may !a"e substantial retained profits in its statement of financial position but no cas! in t!e bank and will not t!erefore be able to finance in"estment from retained earnings. 2d"antages and disad"antages $dvantages +etentions are a fle ible source of finance; &oes not in"ol"e a c!ange in t!e pattern of s!are!oldings and no dilution of control; 6a"e no issue costs. Disadvantages -!are!olders may be sensiti"e to t!e loss of di"idends t!at will result from retention for re7 in"estment, rat!er t!an paying di"idends. 1!ere is an opportunity cost in t!at if di"idends were paid, t!e cas! recei"ed could be in"ested by s!are!olders to earn a return.

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Increasing or!ing capital "anage"ent efficiency It is important not to forget t!at an internal source of finance is t!e savings t!at can be generated from more efficient management of trade recei"ables, in"entory, cas! and trade payables. Efficient working capital management can reduce bank o"erdraft and interest c!arges as well as increasing cas! reser"es. Dividend Policy Shareholders normally !a"e to po er to vote to reduce the si+e of t!e di"idend at t!e 289, but not the po er to increase the dividend . 1!e directors of t!e company are t!erefore in a strong position, wit! regard to s!are!olders, w!en it comes to determining di"idend policy. .or practical purposes, s!are!olders will usually be obliged to accept t!e di"idend policy
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t!at !as been decided on by t!e directors, or ot!erwise to sell t!eir s!ares. #$% $.2 Factors influencing dividend policy ;!en deciding upon t!e di"idends to pay out to s!are!olders, one of t!e main considerations of t!e directors will be t!e amount of earnings t!ey wis! to retain to meet financing needs. 2s well as future financing re(uirements, t!e decision on !ow muc! of a company#s profit s!ould be retained, and !ow muc! paid out to s!are!olders, will be influenced by: (a) 1!e need to re"ain profitable < di"idends are paid out of profits, and an unprofitable company cannot for e"er go on paying di"idends out of retained profits made in t!e past. (b) 1!e la on distributable profits < a ,ompany 2ct may make companies bound to pay di"idends solely out of accu"ulated net reali+ed profits as in t!e =>. (c) 1!e go"ernment w!ic! may impose direct restrictions on t!e amount of di"idends companies can pay. .or e ample, in t!e => in t!e 1:)?#s as part of a prices and income policy. (d) 2ny dividend restraints t!at mig!t be imposed by loan agree"ents. (e) 1!e effect of inflation, and t!e need to retain some profit wit!in t!e business @ust to maintain its operating capability unc!anged. (f) 1!e company#s gearing level < if t!e company wants e tra finance, t!e sources of funds used s!ould strike a balance between e(uity and debt finance. (g) 1!e company#s li,uidity position < di"idends are a cas! payment, and a company must !a"e enoug! cas! to pay t!e di"idends it declares. (!) 1!e need to repay debt in t!e near future. (i) 1!e ease wit! w!ic! t!e company could raise e-tra finance from sources ot!er t!an retained earnings < small companies w!ic! find it !ard to raise finance mig!t !a"e to rely more !ea"ily on retained earnings t!an large companies. (i) 1!e signaling effect of di"idends to s!are!olders and t!e financial markets in general. Dividends as a signal to investors 2lt!oug! t!e market would like to "alue s!ares on t!e basis of underlying
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cas! flows on t!e company#s pro@ects, suc! information is not readily available to investors. 0ut t!e directors do !a"e t!is information. 1!e di"idend declared can be interpreted as a signal from directors to s!are!olders about t!e strength of underlying project cash flo s. In"estors usually e pect a consistent dividend policy from t!e company, wit! stable di"idends eac! year or, e"en better, steady dividend gro th. 2 large rise or fall in di"idends in any year can !a"e a marked effect on t!e company#s s!are price. -table di"idends or steady di"idend growt! are usually needed for s!are price stability. 2 cut in dividends may be treated by in"estors as signaling t!at t!e future prospects of the co"pany are ea!. 1!e signaling effect of a company#s di"idend policy may also be used by management of a company w!ic! faces a possible ta!eover. 1!e dividend level mig!t be increased as a defence against the ta!eover < in"estors may take t!e increased dividend as a signal of i"proved future prospects , t!us dri"ing t!e s!are price !ig!er and making t!e company more e pensi"e for a potential bidder to take o"er. /heories of Dividend Policy &esidual theory 2 residual t!eory of di"idend policy can be summariAed as follows. (a) If a company can identify pro@ects wit! positi"e B/Cs, it s!ould in"est in t!em (b) Only hen t!ese invest"ent opportunities are e-hausted s!ould dividends be paid. Irrelevancy theory 0odigliani and 0iller (9D9) proposed t!at in a ta-1free orld, shareholders are indifferent bet een dividends and capital gains , and t!e value of a co"pany is deter"ined solely by t!e earning po er of its assets and in"estments. 9D9 argues t!at if a company wit! in"estment opportunities decides to pay a di"idend, so t!at retained earnings are insufficient to finance all its in"estments, t!e s!ortfall in funds will be made up by obtaining additional funds fro" outside sources. 2s a result of obtaining outside finance instead
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of using retained earnings: 2oss of value in e-isting shares 3 $"ount of dividend paid #C% %.% /raditional vie 1!e traditional "iew of di"idend policy, implicit in our earlier discussion, is to focus on t!e effects on s!are price. 1!e price of a s!are depends upon t!e mi of di"idends, gi"en s!are!olders# re(uired rate of return, and growt!. Signaling effect Dividend signaling < as mentioned in $.*, an increase in di"idends would signal greater confidence in t!e future by managers and would lead in"estors to increase t!eir estimate of future earnings and cause a rise in t!e s!are price. 1!is argument implies t!at di"idend policy is rele"ant. .irms s!ould attempt to adopt a stable (and rising) di"idend payout to maintain in"estors# confidence. Preference for current income (bird in the hand) 9any in"estors re(uire cas! di"idends to finance current consumption. 1!is does not only apply to indi"idual in"estors needing cas! to li"e on but also to institutional in"estors, e.g. pension funds and insurance companies, w!o re(uire regular cas! inflows to meet day7to7day outgoings suc! as pension payments and insurance claims. 1!is implies t!at many s!are!olders will prefer companies w!o pay regular cas! di"idends and will t!erefore "alue t!e s!ares of suc! a company more !ig!ly. Clientele effect () In many situations, income in t!e form of dividends is ta-ed in a different way from income in t!e form of capital gains. 1!is distortion in t!e personal ta system can !a"e an i"pact on investors4 preferences. .rom t!e corporate point of "iew t!is furt!er complicates t!e di"idend decision as different groups of s!are!olders are likely to prefer different payout patterns. Ene suggestion is t!at companies are likely to attract a clientele of in"estors
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w!o fa"our t!eir di"idend policy. .or e ample, !ig!er rate ta payers may prefer capital gains to di"idend income as t!ey can c!oose t!e timing of t!e gain to minimiAe t!e ta burden. In t!is case companies s!ould be "ery cautious in making significant c!anges to di"idend policy as it could upset t!eir in"estors. +esearc! in t!e =- tends to confirm t!is clientele effect wit! !ig! di"idend payout firms attracting low income ta bracket in"estors and low di"idend payout firms attracting !ig! income ta bracket in"estors. $lternative to Cash Dividends Scrip dividends 2 scrip di"idend is a dividend paid by the issue of additional co"pany shares, rat!er t!an by cas!. ;!en t!e directors of a company would prefer to retain funds wit!in t!e business but consider t!at t!ey must at least a certain amount of di"idend, t!ey mig!t offer e(uity s!are!olders t!e c!oice of a cas! di"idend or a scrip di"idend. 2d"antages of scrip di"idends (a) 1!ey can preserve a company#s cash position if a substantial number of s!are!olders take up t!e s!are option. (b) In"estors may be able to obtain ta- advantages if di"idends are in t!e term of s!ares. (c) In"estors looking to e-pand their holding can do so ithout incurring the transaction costs of buying more s!ares. (d) 2 small scrip di"idend issue will not dilute the share price significantly. If !owe"er cas! is not offered as an alternati"e, empirical e"idence suggests t!at t!e s!are price will tend to fall. (e) 2 s!are issue will decrease t!e company#s gearing, and may t!erefore enhance its borro ing capacity. Stoc! split 2 stock spilt occurs w!ere, for e ample, eac! ordinary s!are of F1 eac! is spilt into two s!ares of '?c eac!, t!us creating c!eaper s!ares wit! greater marketability. 1!ere is possibly an added psyc!ological ad"antage, in t!at in"estors may e pect a company w!ic! splits its s!ares in t!is way to be
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planning for substantial earnings growt! and di"idend growt! in t!e future. 2s a conse(uence, t!e "ar!et price of shares "ay benefit. .or e ample, if one e isting s!are of F1 !as a market "alue of F), and is t!en split into two s!ares of '?c eac!, t!e market "alue of t!e new s!ares mig!t settle at, say, F$.1? instead of t!e e pected F$, in anticipation of strong future growt! in earnings and di"idends. 1!e difference bet een a stoc! split and a scrip issue is t!at a scrip issue coverts e,uity reserves into share capital , w!ereas a stock split lea"es reser"es unaffected. Share repurchase /urc!ase by a company of its own s!ares can take place for "arious reasons and must be in accordance wit! any re(uirements of legislation. .or a smaller company wit! few s!are!olders, t!e reason for buying back t!e company#s own s!ares may be t!at t!ere is no immediate willing purc!aser at a time w!en a s!are!older wis!es to sell s!ares. .or a public company, s!are repurc!ase could pro"ide a way of wit!drawing from t!e s!are market and going private. 0enefits of a s!are repurc!ase sc!eme (a) .inding a use of surplus cash, w!ic! may be a dead asset. (b) Increase in earning per share t!roug! a reduction in t!e number of s!ares in issue. 1!is s!ould lead to a !ig!er s!are price t!an would ot!erwise be t!e case, and t!e company s!ould be able to increase di"idend payments on t!e remaining s!ares in issue. (c) Increase in gearing. +epurc!ase of a company#s own s!ares allows debt to be substituted for e(uity, so raising gearing. 1!is will be of interest to a company wanting to increase its gearing wit!out increasing its total long7term funding. (d) &eadjust"ent of the co"pany4s e,uity base to more appropriate le"els, for a company w!ose business is in decline. (e) /ossibly preventing a ta!eover or enabling a (uoted company to wit!draw from t!e stock market. Dra bac!s of a s!are repurc!ase sc!eme (a) It can be hard to arrive at a price t!at will be fair bot! to t!e "endors and to any s!are!olders w!o are not selling s!ares to t!e company. (b) 2 repurc!ase of s!ares could be seen as an ad"ission t!at t!e company cannot "a!e better use of the funds t!an t!e s!are!olders.
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-ome s!are!olders may suffer from being ta-ed on a capital gain following t!e purc!ase of t!eir s!ares rat!er t!an recei"ing di"idend income.

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