DIVIDEND POLICY

Internal sources of finance include retained earnings and increasing working capital
efficiency.

1. Retained Earnings

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.

Retained earnings belong to shareholders and are classified as equity financing.

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.

Advantages of using Retained Earnings

(a) Retained earnings are a flexible source of finance; companies are not tied to specific
amounts or specific repayment patterns.
(b) Using retained earnings does not involve a change in the pattern of shareholdings and
no dilution of control.
(c) Retained earnings have no issue costs.

Disadvantages of using Retained Earnings

(a) Shareholders may be sensitive to the loss of dividends that will result from retention
for re-investment, rather than paying dividends.
(b) Not so much a disadvantage as a misconception, that retaining profits is a cost-free
method of obtaining funds. There is an opportunity cost in that if dividends were paid,
the cash received could be invested by shareholders to earn a return.

2. Increasing Working Capital Management Efficiency

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.

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Dividend Policy

Retained earnings are the most important single source of finance for companies, and
financial managers should take account of the proportion of earnings that are retained as
opposed to being paid as dividends. Companies generally smooth out dividend payments by
adjusting only gradually to changes in earnings: large fluctuations might undermine
investors’ confidence.

The dividends a company pays may be treated as a signal to investors. A company needs to
take account of different clienteles of shareholders in deciding what dividends to pay.

For any company, the amount of earnings retained within the business has a direct impact on
the amount of dividends. Profit re-invested as retained earnings is profit that could have been
paid as dividends.

A company must restrict its financing through retained earnings because shareholders should
be paid a reasonable dividend, in line with realistic expectations, even if the directors would
rather keep the funds for re-investment. At the same time, a company that is looking for extra
funds will not be expected by investors (such as banks) to pay generous dividends, nor over-
generous salaries to owner-directors.

The dividend policy of a business affects the total shareholder return and therefore
shareholder wealth.

Dividend Payment

Shareholders normally have the 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.

Factors influencing Dividend Policy

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.

As well as future financing requirements, the decision on how much of a company’s profits
should be retained, and how much paid out to shareholders, will be influenced by:

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 (a) The need to remain profitable. Dividends are paid out of profits, and an unprofitable
company cannot go on indefinitely, paying dividends out of retained profits made in
the past.
(b) The law on distributable profits. Companies’ legislation may make companies bound
to pay dividends solely out of accumulated net realised profits.
(c) The government may impose direct restrictions on the amount of dividends that
companies can pay.
(d) Any dividend restraints that might be imposed by loan agreements and covenants. A
loan covenant may restrict the amount of dividends that the company can pay,
because this will provide protection for the lender.
(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 cash enough to pay the dividends it declares.
(h) The need to pay 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.
(j) The signalling effect of dividends to shareholders and the financial markets in general
(discussed below).

Dividends as a Signal to Investors

The ultimate objective in any financial management decisions is to maximise shareholders’

wealth. This wealth is basically represented by the current market value of the company,
which should largely be determined by the cash flows arising from the investment decisions
taken by management.

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.

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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. Stable dividends or
steady dividend growth are usually needed for share price stability. A cut in dividends may be
treated by investors as signalling that the future prospects of the company are weak. Thus, the
dividend which is paid acts, possibly without justification, as a signal of the future prospects
of the company.

The signalling effect of the 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.

Theories of Dividend Policy

1. Residual Theory

A residual theory of dividend policy can be summarised as follows:

 If a company can identify projects with positive NPVs, it should invest in them.
 Only when these investment opportunities are exhausted should dividends be paid.

Dividends should therefore be the amount of after-tax profits left over (the residual amount)
after setting aside money to invest in all viable business opportunities.

Under the residual theory, dividends are determined as:

Dividends = Net Income – (Target Equity Ratio X Capital Needed)

Example:
Suppose a firm has a target equity ratio of 60% and needs to spend K50m on new projects.
The firm needs 0.6 X K50m = K30m in equity.
If its net income is K100m, its dividend will be:
100 – (0.6 X 50) = K70m

If capital requirements were K200m, the firm would not pay any dividend.

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Under the residual dividend model, the better the firm’s investment opportunities, the lower
the dividend paid.

Following the residual dividend policy rigidly would lead to fluctuating dividends, something
investors don’t like.

To satisfy shareholders’ taste for stable dividends, firms should:

i) Estimate earnings and investment opportunities, on average over the next five to ten
years;
ii) Use this information to find out the average residual payout ratio;
iii) Set a target payout ratio.

2. Traditional View

The traditional view of dividend policy, implicit in our earlier discussion, is to focus on the
effects of dividends and dividend expectations on share price. The price of a share depends
on both current dividends and expectations of future dividend growth, given shareholders’
required rate of return.

3. Irrelevancy Theory

In contrast to the traditional view, Modigliani and Miller (MM) proposed that in a perfect
capital market, 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.

MM argued 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

In answer to criticism that certain shareholders will show a preference either for high
dividends or for capital gains, MM argued that if a company pursues a consistent dividend
policy, each corporation would tend to attract to itself a clientele consisting of those
preferring its particular payout ratio, but one clientele would be entirely as good as another in
terms of the valuation it would imply for the firm.

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The case in favour of the Relevance of Dividend Policy (and against MM’s views)

There are strong arguments against MM’s view that dividend policy is irrelevant as a means
of affecting shareholders’ wealth:

(a) Differing rates of taxation on dividends and capital gains can create a preference
among investors for either a high dividend or high earnings retention (for capital
growth).
(b) Dividend retention should be preferred by companies in a period of capital rationing.
(c) Due to imperfect markets and the possible difficulties of selling shares easily at a fair
price, shareholders might need high dividends in order to have funds to invest in
opportunities outside the company.
(d) Markets are not perfect. Because of transactions costs on the sale of shares, investors
who want some cash from their investments will prefer to receive dividends rather
than to sell some of their shares to get the cash they want.
(e) Information available to shareholders is imperfect, and they are not aware of the
future investment plans and expected profits of their company. Even if management
were to provide them with profit forecasts, these forecasts would not necessarily be
accurate or believable.
(f) Perhaps the strongest argument against the MM view is that shareholders will tend to
prefer a current dividend to future capital gains (or deferred dividends) because the
future is more uncertain.

Scrip Dividends

A scrip dividend is a dividend paid by the issue of additional company shares, rather than by
cash.

When the directors of a company would prefer to retain funds within the business but
consider that they must pay at least a certain amount of dividend, they might offer equity
shareholders the choice of a cash dividend or a scrip dividend. Each shareholder would
decide separately which to take.

With enhanced scrip dividends, the value of the shares offered is much greater than the cash
alternative, giving investors an incentive to choose the shares.

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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 form 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. 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.

Disadvantages of scrip dividends

(a) Assuming the dividend per share is maintained or increased, the total cash paid as a
dividend will increase.
(b) Scrip dividends may be seen as a negative signal by the market i.e. the company is
experiencing cash flow issues.

Share Repurchase

Purchase by a company of its own shares can take place for various reasons and must be
in accordance with any requirements of legislation.

In many countries companies have the right to buy back shares from shareholders who are
willing to sell them, subject to certain conditions.

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’.

Public companies with a large amount of surplus cash may offer to repurchase some
shares from its shareholders. A reason for this is to find a way of offering cash returns to
investors without increasing dividend payments. Higher dividend payments would affect

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 investor expectations about future dividends and dividend growth; whereas share buy-
backs would not affect dividend expectations at all. In addition, by reducing the number
of shares in issue, the company should be able to increase the earnings per share (EPS)
for the remaining shares.

Benefits of a Share Repurchase Scheme

(a) Finding a use for surplus cash, which may be a ‘dead asset’.
(b) Increase in earnings 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, thus 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.

Drawbacks of a Share Repurchase

(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.