Ch 7 Flashcards
Example Dividend Policies
Question: Is sh/h wealth affected by an org’s dividend policy?
POLICIES
(i) paying constant annual dividend
(ii) paying out constant proportion of annual earnings
(iii) increasing dividends in line with inflation etc.
(iv) paying out what’s left after financing all future investment - “residual policy”
Key Factors to Consider regarding divident payment
(1) Modigliani & Miller’s dividend irrelevancy argument
(2) Interest of shareholders - “clientele effect” and “bird-in-hand” argument
(3) signalling effect or information content of dividends
(4) entity’s cash needs
Summary - Modigliani & Miller’s Dividend Irrelevancy Theory
Pattern of dividend payment is irrelevant
As long as companies invest in +ve NPV projects, sh/h wealth should increase irrespective of dividend payments (or non-payments)
Breakdown of M&M’s dividend irrelevancy theory arguments
(1) return on a share is determined by share’s (systematic) risk
(2) return delivered to sh/h in two parts - dividend and capital gain/loss in sh price
(3) org’s dividend dec’n is about how return is delivered - how much as dividends vs how much reinvested w/in company (thus flowing to sh/h as share price increase)
(4) dividend decision does not affect share risk, thus does not affect return - it merely determines split between dividends and capital gains
(5) M&M believe sh/h don’t care how returns are split (div vs cap gains) - assuming no taxes and no tx costs to buy/sell shares
Key assumptions in M&M Dividend Irrelevancy Theory
(1) sh/h can “create” their own dividend policy - if holding shares for income and org withholds dividend, sh/h can sell some shares to replace lost income
(2) assumption of no taxes - whereas if dividends were taxes and capital gains were not, sh/h would prefer capital gains > dividend payments
(3) assumption of no tx costs - whereas if buy/sell decisions had costs, sh/h would prefer returns through dividends > capital gains
Dividend Policy - Sh/h Interests
policy must satisfy sh/h needs, otherwise sh/h will sell and price may fall
two important considerations are CLIENTELE EFFECT and BIRD IN HAND ARGUMENT
Clientele Effect
real world = tax differences in dividends vs capital gains, and tx costs on share dealings
thus, sh/h care about how company delivers return
thus, companies should be consistent in dividend policy to ensure they attract clientele who like that particular policy
consistency is thus more important than what policy the org chooses to adopt
Bird-in-the-hand argument
some investors will find capital gains more tax efficient than dividends
others will avoid tx costs if returns come as capital gains > dividends
despite this, investors tend to strongly prefer dividends
reason is preference for certain dividend now vs promise of uncertain future dividends (arising out of retaining and reinvesting earnings)
Dividend Policy - Signalling Effect
investors read “signals” from dividend decision that speak to future financial performance as much as past
e.g. mgmt will not reduce dividend if PY was poor, if they expect next year to be good
if this is correct, dividend decision is important and company must be careful not to send wrong signal
HOWEVER - signalling is not the only indicator to investors - other factors exist such as investment plans, strategy, mgmt quality, etc.
Signalling - two so-called very strong dividend signals
(1) reduction in dividend per share = company in financial difficulty
(2) failure to pay out dividend = company very close to receivership
suggestion is that dividend growth is 2-3 years behind market growth, suggesting that mgrs do not increase dividends until they are confident that they can maintain increased level into the future
HOWEVER - exceptions exist - e.g. Apple withheld dividends for many years to build the business - and the market responded strongly => + share price
Dividend Policy - Entity’s Cash Needs
Investment, financing, and dividend decisions are all inter-linked - thus important to consider impact of inv and fin when considering div policy
different types of org have different cash needs and need to set div/inv/fin policies accordingly, e.g.
small org / poor credit rating = struggle to raise finance externally, thus cash needs may dictate restriction of dividends
growing org = multiple potential investment opps = cash needs met by balancing dividend policy with external finance sources
well-established stable company = cash rich, thus able to pay large dividends without compromising internal cash reqs
Factors in determining dividend policy in the real world
like so much else in corp fin, mgr judgement based on a series of factors
PRIMARY FACTORS
what are sh/h expecting (clientele effect)?
what are org’s cash needs?
what was PY dividend (signalling impact)?
SECONDARY FACTORS
is it legal to pay a dividend?
is cash available to pay one?
do we have minimum gearing req’d to meet debt agreements?
what tax impact on sh/h of paying divs?
what investment opps does org face?
how difficult/costly to raise ext fin?
what inflation - thus what dividend increase to maintain sh/h purchasing power?
what capital gain/loss in share price over past year?
Four commonly adopted dividend policies
Stabled Dividend Policy
Constant Payout Ratio
Zero Dividend Policy
Residual Approach to Dividends
Stable Dividend Policy
paying a constant or constantly growing dividend each year
- predictable CF for investors
- reduced opps for mgmt to divert funds to non-profitable activities
- works well for mature firms with stable CF
risk that reduced earnings drives dividend cut (and related challenges)
Constant Payout Ratio
paying out constant proportion of equity earnings
- maintain link between earnings, reinvestment rate, and dividend flow
- however, CF is unpredictable to investor, and
- gives no indication of mgmt intention/expectation
Dividend Policy - ratchet patterns
most firms adopt RATCHET PATTERN of payments - variant on stable dividend policy:
- paying out a stable but rising dividend per share
- dividends lag behind earnings but can then be maintained even when earnings fall below dividend level
- avoids “bad news” signals
- does not disturb investor tax positions
