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UDC: 658.155.2 JEL: G35, G12 ID: 207708172

SCIENTIFIC REVIEW

Identification and Evaluation of Factors of Dividend Policy

Omerhodžić Sead1, Tuzla University, Faculty of Economy,
Tuzla, Bosnia and Herzegovina

ABSTRACT – Dividend policy determines the ratio between the earnings distributed to
shareholders and the earnings retained in the company. Even though retained earnings are one of the
most important funding sources used for financing corporate growth, the accrued dividends represent
stakeholders' cash flows. Should the cash be reinvested in business operations or should it be paid out
to investors in equity? The decision might seem simple, but it provokes a surprising number of
controversies. Despite thorough theoretical and empirical analyses aimed to explain their
omnipresence, dividends remain one of the biggest puzzles in corporate finances.
This paper starts by determining the term of dividend and stating the types of dividends. This is
followed by a discussion on dividend policy and optimal dividend policy and an analysis of factors that
managers should have in mind when forming dividend policy. Considerable attention is given to the
leading dividend theories which try to answer the question about the role of dividends in maximizing
the value of a corporation, as well as to practical instructions offered to managers in an attempt to
achieve this goal. Other related issues are also discussed, such as dividend reinvestment plans, stock
dividends, and share repurchase. Finally, two surveys are presented. The aim of conducting the
surveys was to determine the attitudes of managers on dividend policy and to identify factors which
the managers viewed as decisive when establishing a concrete dividend policy.

KEY WORDS: dividend, types of dividends, optimal dividend policy, share price, dividend
theories, stock dividends, share repurchase, surveys

Introduction

It is often emphasized in literature that the three main groups of decisions companies
make, more important than all others, are decisions about the choice of investment
alternatives and allocating capital to investment projects, decisions on the way of their
financing which, among other things, involves finding the optimal capital structure, and
decisions about dividends.
The dividend decision, determined by the company's dividend policy, affects the amount
of paid out earnings of the company compared to the amount of earnings that the company
retains and reinvests. When the company changes its payment of dividends, it can change
one of these remaining policies. By reducing the amount of distributed dividend, the
company can retain more funds for investment and avoid procuring funds from external

1 Univerzitetska 8, Tuzla, Bosnia and Herzegovina, e-mail: [email protected]

 Omerhodžić, S., Factors of Dividend Policy, EA (2014, Vol. 47, No. 1-2, 42-58) 43

funding sources. Also, the company can finance capital expenditures mostly by incurring
debt, which freesup cash for dividends.
The central principle of financial management is that managers make decisions that lead
to the maximal wealth of shareholders, which is reflected in the share price of the company.
The decision to pay out dividends compared to retaining earnings is often confusing because
it includes many opposing forces. Both professionals and corporate managers continue to
disagree on whether the value of a company is independent of its dividend policy. The
challenge faced by the board of directors and the management is to balance these forces in
order to maximize the contribution of their dividend policy to increasing the shareholders'
wealth.

Definitions and types of dividends

Dividends are the payments that the corporations make to their owners, shareholders.
Dividends have a tendency to be seen both by the management of the company and by the
shareholders who receive them as an equivalent to interest payments to creditors who
approved loans, as a compensation to shareholders for delaying consumption, etc.
Dividends are often vividly described as rewards to shareholders in the form of
distribution of profits from the previous or current year and as an important determinant of
the share price (McLaney, 1997). Some investors use the dividend yield as a risk measure and
as investment screen, investing in shares with a high dividend yield (Damodaran, 1999).
Dividends represent the only regular channel for transferring corporate assets to
shareholders. In that context, it can be stated that dividends represent proportional
distribution of corporate assets to shareholders within the framework of the current and
accumulated net earnings.
Corporations usually pay dividends in cash and thus the dividend refers to the money
paid from the earnings (Ross, Westerfield, Jordan, 2006). Also, corporations periodically pay
dividends in shares and some forms of assets. For example, the U.S. whiskey producers, in
addition to regular dividends, also distributed extra dividends in the forms of their products
to their shareholders. All dividends, with the exception of stock dividends, reduce the total
equity of the corporation.
Since the dividends are paid out from the net earnings, dividend per share is usually
lower than earnings per share. However, the shareholders do not receive only the yield
based on dividends. To them it is important that the company is doing well and that the
market price of its share is rising, because that is the way they generate yield on a different
basis, as a difference in share price. That other source of income for a shareholder is called
capital gain. However, one should keep in mind that when investors sell their shares, they
are paid by other investors and not by the corporation. Except when the corporation is
repurchasing its own shares (which is a form of dividend payout), only the corporation's
money paid to investors is the payment of dividend.
As we have mentioned already, dividends are usually paid in cash. Regular cash
dividends are paid on a quarterly basis, but a small number of companies declare them on a
monthly, semiannual and annual basis. The term “regular” indicates only that the company
44 Economic Analysis (2014, Vol. 47, No. 1-2, 42-58)

expects to be able to maintain payments in the future. If the company does not want to give
that kind of promise, it usually declares both regular and extra dividend. Investors
understand that extra dividend might not be repeated. Another type of dividend is
liquidating dividend, which refers to any kind of dividend not based on the earnings.
Liquidating dividends imply returning the investment to shareholders, not the earnings. For
example, liquidating dividends can be a consequence of selling the entire company or only
one of its parts and distributing assets. Finally, the term special dividend is mostly reserved
for payments that are not likely to be repeated.
The amount of dividend can be shown as: (a) dividend per share – the sum of monetary
units per share, (b) dividend yield – the rate compared to the share market price, and (c)
dividend payout ratio – paid dividends (in monetary units) compared to the net profit.
Dividend payout ratio usually refers to the percentage of net profit paid to shareholders
in cash. This indicator is calculated by dividing the total amount of paid dividends (in
monetary units) by net profit, and it is also often seen as the indicator of the generosity of the
company's dividend policy or the lack of one (Gallagher, Andrew, 1997).
Dividend payout ratio of 30%, for example, tells us that the corporation pays out
dividends. However, caution is advised. By focusing on the presented earnings and the
dividend payout ratio, we ignore the key for the payout of dividends. That key is cash. When
a company makes profit, that usually results in money that flows into in the company.
However, profit and cash flows do not necessarily happen at the same time. The Table 1
illustrates these time differences.

Table 1. Selected financial data for the corporation X for the current year
Sales (all on credit payment due in next year) KM 2.000.000
Total expenses 800.000
Net profit 1.200.000
Cash received this year KM 0

Table 1 shows that the corporation X showed earnings in the amount of 1.200.000 KM this
year, but that it did not receive any cash. The corporation would not be able to pay out
dividends, except by using the money from previous earnings.
If the corporation thinks that a certain dividend payout is crucial for preserving its value,
it can even choose to incur debt to obtain cash needed to pay out dividends. It sometimes
happens that corporations incur debt to obtain cash for dividend payout when it is expected
that the dividend payout is of vital importance for regular shareholders.

Dividend policy

Dividend policy is an important theme in corporate financing since dividends represent a

large cash expense for many corporations. At first sight it can seem obvious that a company
always wants to return as much as possible to their shareholders by paying out dividends.
However, it can seem equally obvious that a company can always invest money for its
shareholders instead of paying it out. That is the reason why dividend policy is needed. That
 Omerhodžić, S., Factors of Dividend Policy, EA (2014, Vol. 47, No. 1-2, 42-58) 45

is the area in which the shareholders are very much interested, but at the same time it is the
area used by the corporate management to preserve the interests of the company by taking
account of the possible connection between dividends and the company's market value.
Dividend policy refers to the payment policy used by the management when
determining the amount and patterns of distribution to shareholders over a period of time
(Baker, Powell, 2005). It is considered that dividend policy includes three questions
(Brigham, Houston, 2004): (a) Which part of the earnings should be distributed? (b) Should
the distribution be in the form of cash dividends or share repurchase? and (c) Should the
company maintain a steady, stable growth rate of dividends?
We can safely say that the central question of dividend policy is whether the available
earnings will earn more money for the shareholders if the company stays in business with
the aim of financing growth, or if the earnings are distributed to them as a cash dividend or
share repurchase. Dividends are important because the timing and the sum of expected
dividend payments of the company determines the value of its share. What is less clear is
whether or not the time patterns of dividends (more now compared to more later) are a
contentious question. This is the question of dividend policy and it is not easy to give a
definitive answer to it.
It should be kept in mind that a direct dividend payout benefits the shareholders, but
that it also influences the ability of the company to retain the earnings in order to use the
possibility of growth. Dividend policy provides guidelines for balancing the opposed forces
that surround the decision whether or not to pay out a dividend or retain the earnings.
Even though the total income of the company, after taxes, belongs to its shareholders, the
corporations usually distribute only one part as cash dividends, if they are able to do so, and
they reinvest the remaining income in the additional assets. When a company retains the
earnings, such earnings appear as retained earnings in the equity section in the balance sheet.
We would like to also add here that the retained earnings as a source of funds has a few
advantages, the most important of which are the following (Bradley, 1978): (a) a cheap
source, (b) does not have the right to vote, (c) does not impose restrictive regulations on the
management, (d) the company has an unlimited use of funds, (e) the issuer does not pay a
fixed yield, as would be the case with bond issue, and (f) collateral is not needed.
Furthermore, when deciding about the amount of money that should be distributed to
shareholders, financial managers have to have in mind that the company's goal is to
maximize value for shareholders. Consequently, the target dividend payout ratio should to a
large extent be based on whether investors prefer dividends compared to the capital gain.
This preference can be considered in relation to the model of the valuation of ordinary
shares which assumes that dividends per share will grow by a constant growth rate in every
period never expecting it to change. The constant growth model is also known as Gordon
Growth Model, named after the financial economist Gordon who developed it and made it
widely known. According to this model, the price of an ordinary share is determined in the
following way: P0 = D1/(ks – g). It is obvious that the price of an ordinary share according to
the given formula depends on three factors: (a) the expected dividend in the following
period, D1, (b) requested rates of return, ks i (c) rates of growth of the company's dividends, g.
Along with other constant factors, if the company decides to increase the cash dividend, D1,
the share price of the company should increase. Still, by increasing its dividend, the company
46 Economic Analysis (2014, Vol. 47, No. 1-2, 42-58)

reduces its growth rate (g), which tends to lower the price of the company's share. The
reduction of the growth rate happens because retaining a smaller amount of earnings
reduces the available cash for obtaining additional assets. Since the increase in the asset base
is crucial for the growth of the company, having a reduced amount of retained earnings
reduces the expected growth rate, g, and lowers the price of the share, P0. Therefore, changes
in dividends result in opposing the forces which can increase or reduce the value of the
ordinary share of the company. We can draw a conclusion that the optimal dividend policy
establishes balance between the current dividends and the future growth which maximizes
the price of the ordinary share of the company (Brigham, 1991).
We will also mention that companies need a strategic policy for dividend payouts
because market participants (current and potential shareholders) mostly do not like
surprises. Unregulated dividend policy means that those shareholders who liked the
previous dividend cannot be sure whether they will like the next one. This insecurity can
lead to the fall of the price of company's shares. When shareholders do not get what they
expect, they often express their dissatisfaction by selling their shares. One well planned
policy applied to the corporation and its business strategy can prevent unpleasant surprises
for market participants and protect the share price.

Factors affecting dividend policy

There are several factors which affect dividend policy, the most important of which are
the following: (a) legal rules, (b) liquidity position, (c) the need to pay off debt, (d)
restrictions in debt contract, (e) rate of expansion of assets, (f) profit rate, (g) stability of
earnings, (h) access to capital markets, (i) control, and (j) tax position of shareholders. Details
about these factors will be presented in the following section.
One of the factors that determine the extent to which the company will pay out dividends
instead of retaining earnings are legal rules. This rules state that dividends must be paid out
from the earnings (profit) – whether from current earnings or from the earnings from
previous years, which is shown on the balance sheet in “retained earnings”.
State laws emphasize three rules; (a) the net profit rule, (b) capital impairment rule and
(c) insolvency rule. The net profit rule states that dividends can be paid out from past and
current earnings. Capital impairment rule protects the creditors by forbidding dividend
payout from the capital. Dividend payout from capital would mean distributing the
investment in the company, not the earnings, and such dividend is called liquidating
dividend. The insolvency rule states that corporations cannot pay out dividends as long as
they are insolvent, i.e. as long as their liabilities exceed the value of their assets. Dividend
payout under such circumstances would mean giving the funds to the shareholders which
rightfully belong to the creditors.
One of the factors affecting dividend policy of companies is its liquidity position. Profits
that are kept in retained earnings, which appears on the right side of the balance sheet, are
usually invested in the assets needed for work. Retained earnings from past years are
already invested in facilities and equipment, supplies and other assets, meaning that they are
not being retained as cash. Therefore, even if the company has record earnings it may not be
able to pay out cash dividend due to its liquidity position. Growing companies, of course,
 Omerhodžić, S., Factors of Dividend Policy, EA (2014, Vol. 47, No. 1-2, 42-58) 47

even those very profitable ones, usually have an urgent need for funds. In such situation, the
company can choose not to pay out cash dividends.
The need to pay off debt also determines the company's dividend policy. When the
company sells its debt as a way of financing expansion or using it as a replacement for other
forms of financing, it faces two alternatives. It can return the debt on the maturity day by
replacing it with another form of securities. However, the decision to retire a debt will
mostly require retaining the earnings.
Dividend policy is also affected by restriction in debt contract. Debt contracts, especially
when a long-term debt is involved, frequently restrict the ability of the company to pay cash
dividends. Such restrictions, designed to protect the position of a lender, usually state that
(a) future dividends can be paid out only if the earnings were made after signing the loan
contract (i.e. they cannot be paid out from past retained earnings) and that (b) dividends
cannot be paid out when the net working capital (working capital minus short-term
liabilities) or the indicator of current liquidity (working capital, cash being one of its parts,
divided by short-term liabilities) are below a certain level.
Company's dividend policy also depends on the rate of expansion of assets. The bigger
the need for assets, the bigger the possibility that the company will retain earnings rather
than paying them out. If the company wants to obtain assets from external sources, a natural
source for that lies in current shareholders who already know the company. But, if the
earnings are paid out as dividends and are subjected to a high tax rate of personal income
tax, only part of them will be available for reinvestment.
Profit rate also affects dividend policy. The expected rate of return on assets determines
the relative attractiveness of paying out earnings to shareholders in the form of dividends
(who will use them elsewhere) or of using them in this (current) company.
Stability of earnings is also one of the factors which affects dividend policy. The company
that has relatively stable earnings is often able to make a rough assessment of its future
earnings. It is therefore more likely that such company will pay out a larger percentage of its
earnings than the company with variable earnings. An unstable company is not sure whether
the earnings they hope for will be achieved in the years to come and it is more likely that
they will retain a part of current earnings. It will be easier to maintain a lower dividend if
earnings decrease in the future.
Access to capital markets also determines dividend policy. Understandably, an easier
access to capital markets and a wider range of alternative sources of financing make the
pursuit of dividend policy easier. Possible restrictions face the management with a serious
dilemma: whether to give up on profitable projects and jeopardize the future cash flow and
future gain or to reduce or completely give up on dividends and face the effects of
unfavorable information signaling. It should be mentioned that large, affirmed companies
with the record profitability and stability of earnings have an easy access to capital markets
and other forms of external financing. On the other hand, potential investors see small or
new companies as more risky. Their ability to increase capital or debt funds from capital
market is limited and they have to retain more earnings for financing their business
operations. Affirmed companies will therefore probably have a higher rate of dividend
payment than new or small companies.
48 Economic Analysis (2014, Vol. 47, No. 1-2, 42-58)

One of the important variables that affect dividend policy is the effect of alternative
sources of financing on the control situation in a company. If the company practices the
policy of larger dividend payouts, it is to be expected that it will reach for external sources of
financing, either because it needs additional capital for new investment or to finance
dividends themselves. The consequence of this activity can be control dilution in the
situations when shareholders from the control group do not subscribe a sufficient number of
new shares. Relying on internal financing with the aim of maintaining control reduces the
dividend payout.
And finally, the tax position of shareholders greatly affects the desire for dividends. In
relation to that, it should be mentioned that there can sometimes be a conflict of interests in
large corporations between shareholders in high tax grades and those in low tax grades. The
former can prefer low dividend payout and high rate of retaining earnings hoping for the
appreciation of the company's equity. The latter can prefer a relatively high dividend payout.
Dividend policy in such companies can be a compromise between a low and high payout –
medium payout ratio. If one group comes to dominate the company and sets, for example,
the low payment policy, the shareholders who want an income will probably send their
shares with time and find higher yielding shares. In that way, to a certain extent at least, the
company's dividend policy is determined by the type of shareholders that company has –
and the other way around. This is called the clientele effect on dividend policy.

Leading dividend theories

As we have already asserted, corporations take a large number of various factors into
account when deciding about the character of their dividend policy. Financial experts are
trying to combine these factors into dividend theories about the way in which dividend
policy affects the company's value. Leading dividend theories, which help the pursuit of
dividend policy, are the following: (a) residual theory of dividends, (b) stable dividend
theory, (c) dividend clientele theory, (d) signaling dividend theory, (e) “bird in the hand”
theory, (f) tax preference theory, and (g) dividend irrelevance theory.
Residual theory of dividends is widely known. This theory is based on a hypothesis that the
amount of dividends should not be the company's focus. Instead, the primary subject of
discussion should be the determining of the amount of retained earnings for investing within
a company. Since dividends come from the “residue”, or leftover earnings, the theory is
called residual theory. According to this theory, corporate companies follow four steps when
deciding on the rate of dividend payout (Brigham, 1991): (a) determine the optimal capital
budget, (b) determine the amount of equity needed for financing that budget, (c) to the
extent possible, use the retained earnings to supply the equity, and (d) pay out dividends
only if the available earnings are higher than needed to support the optimal capital budget.
If the company strictly follows the residual dividend policy, then the dividends paid put
in any year can be expressed in the following way (Brigham, Houston, 2004):

Dividends = Net income – Retained earnings required to help finance new investments
= Net income – [(Target equity ratio)(Total capital budget)].
 Omerhodžić, S., Factors of Dividend Policy, EA (2014, Vol. 47, No. 1-2, 42-58) 49

Determining the amount of dividends, according to the theory of residual dividends, will
be shown by using one example. Let us assume that the corporation Y needs 10 million KM
for financing its eligible projects of capital budgeting (Table 2).

Table 2. The application of the residual theory of dividends on the example of corporation Y
Investment needed for new projects 10.000.000 KM
Optimal capital structure 30% Debt – 70% Equity
Needed equity funds 70% × 10.000.000 KM = 7.000.000 KM
Available earnings 12.000.000 KM
Residual earnings 12.000.000 KM – 7.000.000 KM = 5.000.000 KM
Amount for dividend payout 5.000.000 KM

The corporation Y has earnings in the amount of 12 million KM. It needs equity funds in
the amount of 70 percent out of 10 million KM or 7 million KM, so that what is left is leftover
earnings in the amount of 5 million KM for dividends.
If available earnings were 20 million KM instead of 12 million KM, then the dividend
payout would be 13 million KM (20 million KM – 7 million KM). However, if the available
earnings were 6 million KM instead of 12 million KM, then dividends would not be paid out.
As a matter of fact, additional financing by equity in the amount of 1 million KM should be
increased by issuing new ordinary shares.
Theory of residual dividends focuses on the optimal using of earnings generated from the
perspective of the company. This dividend theory, therefore, ignores the shareholders'
preference concerning the regularity and the amount of dividend payout. If the company
applies the theory of residual dividends, when the earnings are high and the eligible projects
of capital budgeting are small and few, dividends will be high. In contrast, when the
earnings are high and there are many big eligible projects waiting to be financed, dividends
cannot be paid out if the theory of residual dividends is applied. Dividend payouts would
not be regular and the amounts would not be predictable.
Stable dividend theory is the theory which requires the payout of the same amount of
dividends per share in a series of consecutive accounting periods. As we have already
asserted, the essence of the residual approach is that dividends are paid out only after all
other profitable investment opportunities have been used up. Naturally, a strictly residual
approach can lead to a very unstable dividend policy. If the investment opportunities are
rather high in one period, dividend will be either low or zero. Conversely, dividend can be
high in the following period if it is considered that investment opportunities are not
promising. The company can choose between at least two types of dividend policies. First,
each quarterly dividend can be a fixed part of the earnings in that quarter. In this case,
dividends will vary during the entire year. This is a cyclical dividend policy. Second, each
quarterly dividend can be a fixed part of annual earnings, which implies that all dividend
payouts will be equal. This is a stable dividend policy. Corporate officers generally agree that
stable dividend policy is in the interest of the company and its shareholders and the stable
dividend policy will thus be more frequent.
50 Economic Analysis (2014, Vol. 47, No. 1-2, 42-58)

Most companies that pay dividends try to follow the policy of stable dividend per share
for four reasons (Baker, Powell, 2005): (a) many managers think that stable dollar dividend
policy leads to higher share prices, (b) shareholders frequently rely on dividends to provide
a stable source of income to supplement their current consumption, (c) stable dividend
policy gives less chance of transmitting false information content, and (d) legal listing of
shares requires dividend stability in many countries.
We will also mention that instead of absolute stability, both corporations and
shareholders rather opt for the policy of relative stability which assumes gradual changes in
dividend payouts (generally in the ascending line) in relation to the trend line of net income,
while trying to avoid short-term net income fluctuations of the amount of dividends. Choices
of this kind are primarily motivated by the fact that dividend stability attracts investors and
it is therefore believed that this kind of policy leads to the increase in the market price of
shares.
Dividend clientele theory is based on the attitude that investors find certain companies
attractive in part due to their dividend policy. Dividend policy should therefore reflect the
clientele effect as well. For example, young investors might want the value of their portfolios
to grow from capital gains and not from dividends so they search for companies that retain
earnings instead of paying out dividends. In relation to that, it should be mentioned that
share prices have a tendency to increase when the earnings are retained and the resulting
capital gains are not taxable until the shares are sold.
If there really is a clientele effect, it means that at least some percentage of the company's
shareholders acquired shares because they like the company's dividend policy. If the
company is inconsistent in its dividend policy, many shareholders will sell shares, because
they do not know whether the level of dividends will suit their preferences or not. The lack
of popularity of shares would have a negative effect on share price and thus the cost of
capital as well. Even if a certain company was rather consistent in its dividend policy, but
then initiated a big change, some of its investors who particularly liked the previous
dividend policy (that may be the case with all shareholders) would probably want to switch
to shares of the company with dividend policy that they find more acceptable. Even though
it might be the case that new clientele finds the dividend policy attractive, the friction caused
by one group of investors selling to a new group of investors would have a negative effect on
shareholders.
Signaling dividend theory is based on the premise that the management of the company
knows more about its future financial prospects than shareholders. According to this theory,
if a company declares a dividend higher than the one predicted by the market, this will be
interpreted as a signal that future financial prospects are brighter than expected. Investors
assume that the management would not have raised the dividend if they did not think that
they could maintain it. As a result of this signal of good future prospects, investors buy more
shares, causing the share price to increase. In contrast, if the company lowers its dividend,
the market sees this as a signal that the management expects bad earnings and does not think
they can maintain the current dividend. If raising the dividend should act as a signal, it
seems reasonable to ask ourselves why the management does not only issue a declaration.
Surely a declaration would be much less ambiguous then the increase of dividend. Maybe
managements think that actions speak louder than words (McLaney, 1997).
 Omerhodžić, S., Factors of Dividend Policy, EA (2014, Vol. 47, No. 1-2, 42-58) 51

The “bird in the hand” theory claims that shareholders prefer to receive dividends instead
of the earnings being reinvested in the company on their behalf. According to this theory, the
value of the company will be maximized by a high dividend payout ratio because investors
think that current dividends are less risky than potential capital gains. Even though investors
should expect to benefit from retaining and reinvesting earnings in their company since the
future share prices will increase, there is uncertainty about whether that benefit will actually
be realized. In other words, “a bird in the hand is worth two in the bush” (Gallagher,
Andrew, 1997).
Tax preference theory states that, since capital gains are subject to lower tax burden than
dividends, investors prefer to own the retained earnings of the company than to be paid
dividends. Hence, increasing the dividends, according to this theory, would result in the fall
of share price and the growth of requested rate of return on equity.
There are three tax-related reasons that support the opinion that investors would prefer
low dividend payouts to high dividend payouts. Those reasons are the following (Brigham,
Houston, 2004): (a) Long-term capital gains are generally taxed at a rate of 20 percent,
whereas the income from dividends is taxed at effective rates that can reach as much as 38,6
percent. (b) Income taxes are not paid as long as shares are not sold. Due to the effect of time
value, a dollar of paid taxes in the future has a lower actual cost than a dollar paid today. (c)
If the shares are owned by someone until that person's death, there is no tax on all capital
gains – beneficiaries who receive the shares can use the value of shares on the day of death as
their purchase value and thus completely avoid capital gains tax.
Dividend irrelevance theory considers that a company's dividend policy does not have an
effect on the company's value or on its cost of capital. According to this theory, there is no
optimal dividend policy. One dividend policy is as good as any other. The notion that
dividends are irrelevant originates from the pioneer work of M. Miller and F. Modigliani
(M&M) entitled Dividend Policy, Growth, and the Valuation of Shares, published in 1961. In that
work, M&M claim that the value of a company is determined only by its earnings power and
its business risk. In other words, M&M claim that the value of the company depends only on
the earnings produced by its assets and not on whether those earnings are distributed in
dividends or retained. It should be kept in mind that M&M put their analysis in the context
of contemporary capital market with rational investors. The key assumptions of this ideal
version of capital market are the following: (a) no flotation, transaction, and agency costs, (b)
no taxes, (c) equal and free access to information – investors are symmetrically informed, (d)
rationality of investors, and (e) investors cannot influence the price of securities. Therefore,
under very restrictive assumptions, M&M provide a generally accepted argument for
dividend irrelevance. The theory by Miller and Modigliani and the messages to corporate
practitioners about the importance of dividend payouts are completely clear and as it seems,
correct in the context of set limitations.
What we cannot afford to miss is that the problem with most of the existing dividend
theories is that they neglect the consideration of the potentially complex interactions between
different elements. Another problem is that every theory usually assumes the “one size fits
all” approach when testing in order to generalize findings. Hence, dividend decisions, like
investment decisions and financing decisions, require a compromise (Damodaran, 1999).
52 Economic Analysis (2014, Vol. 47, No. 1-2, 42-58)

However, unlike with the latter decisions, it seems that little agreement exists on where to
find the compromises that are supposed to lead us to the “right” dividend policy.
Having all of this in mind, we can conclude that dividend policy clearly represents a
dynamic process with a number of interconnected affects that make the existence of a general
model that would lead to the optimal dividend policy for any occasion practically
impossible. This fact forces us to make a difficult conclusion that dividend decisions
represent an area where the ability to make good judgment calls still plays a big part.

Guidelines for establishing dividend policy

The aim of dividend policy is to maximize its contribution to increasing the shareholders'
wealth. The task that the board of directors and the management face is the decision about
who can make the better use of money – the company or its owners. Practical instructions
available to companies which try to achieve this aim are reflected in the following (Baker,
Powell, 2005):
• The company should consider its investment opportunities and avoid further
reductions on profitable projects in order to pay out dividends. The point of the
analysis is to determine whether the company's opportunities are better than the
ones available to investors. If the expected return from the available discretionary
projects exceeds the opportunity cost of capital, the company should have a lower
dividend payout. If it cannot put the retained earnings to good purpose, the
company should distribute more to its shareholders. A higher target payment is
not an acknowledgment of failure.
• Companies should rely heavily on retained earnings as the source of equity.
Companies should avoid issuing new equity unless it is needed for financing
profitable investments. The sale of new shares includes the costs of flotation costs
and a negative market reaction to such sale.
• If the company is paying out dividends, it should consider paying them on a
regular basis from the available cash flow. Consistency, where possible, is
important because a large number of investors depend on dividends. When a
company establishes dividends, it has an implicit responsibility to maintain them
through a regular business cycle. Incurring debt in order to maintain a regular
dividend can be accepted if it is within reasonable bounds and if the management
expects the earnings to increase.
• Companies should avoid reducing or omitting dividends unless the current
dividend level is unsustainable in the long run. One of rare aspects of dividend
policy, on which a widespread agreement exists, is that the management should
not accidentally reduce a once established dividend rate.

Dividend reinvestment plans

Many corporations offer a dividend reinvestment plan based on which the shareholders
reinvest their dividends instead of receiving them in cash. Dividend reinvested plans are
popular because they provide shareholders with an opportunity to buy additional shares
 Omerhodžić, S., Factors of Dividend Policy, EA (2014, Vol. 47, No. 1-2, 42-58) 53

without creating provision costs that accompany regular purchases that shareholders make
through a stockbroker. To companies, dividend reinvestment plans represent a way to
increase the rate of retaining earnings without voting and declaring the lowering of dividend
payouts.
Dividend reinvestment plans have various characteristics. There are plans of reinvesting
in the existing and new shares. Plans also differ according to investment limits, according to
determining the price of reinvestment and according to the way of managing dividend
reinvestment plans (Orsag, 2003).

Stock dividends

In addition to cash dividends, the distribution of value to shareholders can be done by

distributing dividends in the form of shares (stock dividends). Stock dividends are not real
dividends because they are not paid in cash. The effect of stock dividends is the increase in
the number of shares owned by every shareholder. Since there are more outstanding shares,
each share is simply worth less.
Stock dividends are usually expressed in percentages. To take an example, a 20 percent
stock dividend means that the shareholder gets one new share for every five shares s/he
currently owns (increase by 20 percent). Since every shareholder gets a 20 percent increase in
shares, the total number of outstanding shares is increased by 20 percent. As we will see,
every share is worth around 20 percent less at one point.
A typical financial manager is aware of the many complexities of the real world and thus
the decision on stock dividends is not treated lightly in practice. Usually, in addition to using
the distribution of stock dividends to retain earnings in the company, distribution of stock
dividends can also be an indicator of higher future profit. The reason for that is the fact that
earnings would have to be retained only if it is possible to invest them profitably. If,
however, the profitability of the company does not increase, dilution of earnings will occur.
Therefore, the management that proposes the issuing of stock dividends should be
committed to achieving a higher profitability.
A stock dividend is very similar to stock splits. Specifically, the process of stock splitting,
as well as the process of distributing stock dividends, leads to the actual increase of the
number of shares (in inverse proportion to the reduction of their nominal value) while the
fixed capital remains unchanged. Even tough at first sight it might seem that the effects of
the two actions are the same or similar, it has to be emphasized that there is a significant
difference between them from a financial and accounting point of view. In support of the
process of stock splitting, it is stated that the market price of shares falls at a slower rate than
the proportion in which their splitting was done (Petty, Keown, Scott, Martin, 1993).

Repurchase of own shares

As an alternative to cash dividend payouts, corporations can choose to pay the earnings
to the owners by repurchasing ordinary shares outstanding. When repurchasing shares, the
company exchanges the assets for some part of its outstanding shares. Ordinary shares
acquired by the company issuer become treasury shares. Such shares have no voting rights,
54 Economic Analysis (2014, Vol. 47, No. 1-2, 42-58)

are not included in the calculation of earnings per share and do not meet the requirements
for dividend payout. Even though the primary source of funds used for financing the
repurchase is the available amount of funds, companies sometimes use debt and other
sources. There are two main types of the repurchase of shares: (a) the situation in which the
company has money available for distribution to its shareholders and it distributes that
money by repurchasing shares and not by paying cash dividends, and (b) the situation in
which the company concludes that its capital structure is overburdened by equity and it sells
its debt and uses the funds to repurchase its shares.
There are certain benefits as well as weaknesses to the repurchase of own shares. The
advantages of the repurchase of own shares can be summed up in the following (Brigham,
1991):
• Announcement of repurchase is often seen by investors as a positive signal
because repurchase is often motivated by the management's conviction that the
shares of the company are underrated.
• Shareholders have a choice when the company is repurchasing shares – to sell
them or not to sell them. However, shareholders have to accept the dividend
payout and pay the tax. Therefore, those shareholders who need cash can sell
some of their shares, whereas those who do not need additional cash can simply
keep their shares. From a tax point of view, both types of shareholders get what
they want.
• The third advantage is that repurchase can remove a large block of shares
looming over the market and keeping the share price low.
• Dividends are “sticky” in the short run which is the reason why the management
is hesitant to increase the dividend if the increase cannot be maintained in the
future – managerial aversion towards the reduction of cash dividends. Therefore,
if the surplus of cash flow is seen as being only temporary, the management can
prefer to choose a distribution in the form of share repurchase and not to declare
an increased cash dividend which cannot be maintained.
• Repurchase can be used for making big changes in the structure of capital.
Weaknesses of the repurchase of own shares include the following (Brigham, 1991):
• Shareholders may not be indifferent between dividends and capital gains, and the
price of shares can benefit more from cash dividends than from repurchase. Cash
dividends are mostly reliable, repurchases are not. Furthermore, if many
companies announced regular, reliable repurchase programs, improper
accumulation of taxes could become a threat.
• Shareholders who are selling their shares cannot be completely aware of all the
implications of the repurchase or they cannot have all relevant information about
the present and future activities of the corporation. However, companies mostly
announce repurchase programs before they engage in them in order to avoid
potential lawsuits by shareholders.
• Corporation can pay a high price for repurchased shares at the expense of the
remaining shareholders. If its shares are not used for active trade and if the
corporation wants to acquire a relatively large amount of its shares, then the
 Omerhodžić, S., Factors of Dividend Policy, EA (2014, Vol. 47, No. 1-2, 42-58) 55

offered price can be above its equilibrium level, and then start declining after the
corporation suspends its repurchase operations.

Survey results

Since there are certain reasons for and against dividend payouts and since there is a lack
of consensus about the effects of dividends on value, it is necessary to determine the factors
which managers take into account the most when making the dividend decision. Baker,
Farrelly and Edelman conducted a survey among managers in 1985 about their attitudes on
dividend policy and showed their level of agreement with a series of statements. Their
findings are summarized in Table 3 (Baker, Farrelly, Edelman, 1985).

Table 3. Management beliefs about dividend policy

No
Statements of management beliefs Agree Disagree
opinion
1. A firm’s dividend payout ratio affects the price of the
share. 61% 33% 6%
2. Dividend payouts provide a signaling device of
future prospects. 52% 41% 7%
3. The market uses dividend announcements as
information for assessing firm value. 43% 51% 6%
4. Investors have different perceptions of the relative
riskiness of dividends and retained earnings. 56% 42% 2%
5. Investors are basically indifferent with regard to
returns from dividends and capital gains. 6% 30% 64%
6. A shareholders are attracted to firms that have
dividend policies appropriate to the
stockholder’s tax environment. 44% 49% 7%
7. Management should be responsive to its
shareholders' regarding dividends. 41% 49% 10%

This research clearly shows that, whether they are right or wrong, managers think that
their dividend payout ratio affects the company's value and act as a signal of future
prospects. They also work under the assumption that investors choose companies with
dividend policies that suit their wishes and that the management should respond to their
needs.
We will also show the findings of the research conducted in big companies in Split-
Dalmatia County which is also related to the attitudes of managers on dividend policy. The
findings of that research are presented in Table 4 (Vidučić, 2004).
56 Economic Analysis (2014, Vol. 47, No. 1-2, 42-58)

Table 4. Attitudes of managers on dividend policy in large companies of Split-Dalmatia County

Attitudes on dividends Rating grade

Shareholders should be informed about the changes in dividend policy 1
It is necessary to define the target rate of dividend payout 2
When assessing securities, investors use information about dividends 3
Payment of dividends is a signal of the company's success 4

This research showed that financial managers think that shareholders should be
informed about the changes in dividend policy. Furthermore, they think that it is necessary
to determine an optimal dividend payout ratio. According to managers' attitudes, this
indicator ranges from 20 to 70%. Likewise, managers think that investors use information
about dividends to assess the value of shares and that the payout of dividends is a signal of
company's success. It can be assumed that the clientele effect also plays an important role,
while the tax effect can be described as marginal. This is understandable if we keep in mind
the fact that individuals do not pay tax on dividends, whereas tax on dividends and capital
gains of the corporate sector is taxable at the same rate.

Conclusion

All corporate companies have to face the problem of finding a suitable dividend policy
which can be summarized in simple terms as deciding which part of the earnings to retain in
a company for the purpose of reinvesting and which part of the earnings to distribute to
shareholders through dividends. The main problem is the need for finding the optimal
dividend policy which would maximize the market value of a company.
We can safely state that dividend policy is one of the most controversial areas of financial
management. A number of reasons can be found for the payout of high dividends and an
equal number against dividend payout. Legal rules are important because they provide a
framework for the formulation of dividend policy. However, within its boundaries, financial
and economic sector have the biggest influence on dividend policy. Financial experts are
trying to combine these factors into dividend theories about the impact of dividend policy on
the price of an ordinary share. On the one hand, some argue that because of the tax
advantages related to the reception of dividends, in relation to price appreciation, some
companies should reduce or even stop dividend payouts and consider alternative ways of
returning money to shareholders. On the other hand, many claim that increasing the
dividend acts as a positive financial signal and that there are investors who prefer dividends,
regardless of tax disadvantages. Finally, there is a school of thought which claims that
dividend policy does not affect the value of an ordinary share. In short, there is some truth in
all of these points of view and it is possible to reach a consensus on the points on which they
agree. The reality is that dividend policy requires a compromise between additional tax
liability which can be created for some investors and potential signaling and benefits from
free cash flows. In some cases, a company can decide not to increase or not to start paying
dividends because its shareholders are in high tax grades and are particularly averse
towards dividends. In other cases, increase in dividends may occur.
 Omerhodžić, S., Factors of Dividend Policy, EA (2014, Vol. 47, No. 1-2, 42-58) 57

A key question, does the dividend policy affect the owner's wealth and if it does, does the
dividend payout increase it or not, does not have a single answer. Various theories of
dividend policy have to be considered in order to formulate a concrete dividend policy out
of their recommendations. Therefore, decision to pay or not to pay dividends as well as
decision on their hight depends on the specificity of each company and is in no way simple.
The “magic formula” does not exist. The optimal or ideal dividend policy is unusually
complicated and is in the final analysis determined to a large extent by the management's
ability to make the right call.

References

Baker, H.K., Farrelly, G.E. & Edelman, R.B. (1985). “A Survey of Management Views on
Dividend Policy”, Financial Management, Vol. 14(3).
Baker, H.K., Powell, G.E. (2005). Understanding Financial Management: A Practical Guide,
Blackwell Publishing Ltd, Oxford.
Bradley, J.F. (1978). Administrative Financial Management, fourth edition, The Dryden Press,
Hinsdale, Illinois.
Brigham, E.F. (1991). Fundamentals of Financial Management, sixth edition, The Dryden Press,
Orlando.
Brigham, E.F. & Houston, J.F. (2004). Fundamentals of Financial Management, tenth edition,
Thomson, South-Western, Ohio.
Damodaran, A. (1999). Applied corporate finance: a user′s manual, John Wiley & Sons, Inc.
Gallagher, T.J. & Andrew, Jr., J.D. (1997). Financial Management: Principles and Practice,
Prentice-Hall International, Inc., New Jersey.
McLaney, E.J. (1997). Business Finance: Theory and Practice, fourth edition, Pitman Publishing,
London.
Orsag, S. (2003). Vrijednosni papiri, Revicon, Sarajevo.
Petty, J.W., Keown, A.J, Scott D.F. & Martin, J.D. (1993). Basic Financial Management,
Prentice-Hall, inc., Englewood Cliffs, New Jersey.
Ross, S.A., Westerfield, R.W. & Jordan, B.D. (2006). Corporate Finance Fundamentals, seventh
edition, McGraw-Hill, International edition.
Vidučić, Lj. (2004). “Kontroverze politike dividendi”, Zbornik radova Sveučilišta u Rijeci,
Ekonomski fakultet.
Weston, J.F. & Copenland T.E. (1986). Managerial Finance, CBS College Publishing, New
York.

Identifikacija i evaluacija faktora politike dividendi

REZIME – Politikom dividendi se određuje omjer između zarade distribuirane dioničarima i

zadržane u firmi. Iako su zadržane zarade jedan od najvažnijih izvora sredstava koji se koristi u
finansiranju korporativnog rasta, obračunate dividende predstavljaju tokove gotovine za dioničare.
Treba li gotovinu reinvestirati u poslovanje ili je treba isplatiti investitorima u dionički kapital?
58 Economic Analysis (2014, Vol. 47, No. 1-2, 42-58)

Odluka se može činiti jednostavnom, ali izaziva iznenađujuću količinu kontroverze. Uprkos iscrpnim
teorijskim i empirijskim analizama da se objasni njihovo sveprožimajuće prisustvo, dividende su i dalje
jedna od najvećih zagonetki u korporativnim finansijama.
U ovom radu se najprije određuje pojam dividende i navode oblici dividendi. Nakon toga se
raspravlja o politici dividendi i optimalnoj dividendnoj politici, te analiziraju faktori koje menadžeri
trebaju imati u vidu kod oblikovanja politike dividendi. Znatna pažnja se posvećuje vodećim
dividendnim teorijama, koje nastoje da daju odgovor na pitanje kakva je uloga dividendi u
maksimiranju vrijednosti korporacije, te praktičnim uputstvima koja stoje na raspolaganju
menadžerima u pokušaju da postignu ovaj cilj. Takođe, raspravlja se i o drugim povezanim pitanjima,
kao što su planovi reinvestiranja dividendi, dividende u obliku dionica i otkup dionica. Konačno,
predstavljaju se i nalazi dva anketna istraživanja čiji je cilj bio utvrđivanje stavova menadžera o
politici dividendi, odnosno identifikuju se faktori koji su u najvećoj mjeri opredjeljivali menadžere pri
uspostavljanju konkretne dividendne politike.

KLJUČNE RIJEČI: dividenda, oblici dividendi, optimalna politika dividendi, cijena dionice,
dividendne teorije, dividende u obliku dionica, otkup dionica, anketna istraživanja

Article history: Received: 24 September 2013

Accepted: 10 October 2013