Chapter 5 - Dividend Policy Flashcards
Dividend policy & senior management:
- Senior management may have to decide on a suitable pay-out policy that reflects the expectations and preferences of shareholders.
- Focus should be on the primary objectives of the organisation = if shareholders expect dividend to be paid, senior management must balance dividend payment, retention policies and ensuring sufficient funds are available to finance profitable investment opportunities.
Influences on dividend policy:
- Investment and financing issues
* Cash needs of entity
Investment and financing issues (RELATE):
- Restrictive covenants (financing)
- Expectations of shareholders (financing)
- Liquidity (investment)
- Attitude to debt (financing)
- Tax (investment)
- Evaluation by the market (financing)
Restrictive covenants:
- Dividend payments may be restricted by covenants
* Ordinary dividends cannot be paid until any arrears on outstanding preference dividends are settled
Expectations of shareholders:
- Clientele effect = particular companies attract a particular type of shareholder based on their dividend policy – a change in policy may cause these shareholders to sell their shares and the share price to fall
- Shareholders in private ltd companies may prefer a cash dividend because of the difficulty in selling their shares
Liquidity:
- High levels of investment may cause liquidity problems
Attitude to debt:
If company is not willing to use debt finance, then internal funds are more likely to be used
Tax:
- If capital gains tax is lower than tax on dividends, entity may reinvest to increase the share price
Evaluation by the market:
- If the market interprets an increase in the dividend as a positive signal then this can lead to a rise in the share price (signalling effect)
- Signalling effect = the dividend policy is used to indicate the future prospects of a company
Cash needs of entity:
- Small company = may struggle to raise external finance therefore dividends may be restricted
- Growing company = require cash for investment opportunities, dividend policy may depend on its ability to raise external finance
- Mature company = can afford to pay out a dividend without compromising its internal cash requirements
Practical dividend policies:
- Constant pay-out ratio
* Constant % of earnings is paid out each year
* Logical, but could cause volatile dividend movements - Stable growth
* Dividend payment that increases at a constant rate each year (constant growth)
* Rate is set at a level that signals the growth prospects of the company - Residual policy
* Dividend payments come out of the residual or leftover equity after investment opportunities has been exhausted - Zero dividend policy
* No dividends are paid
* Profits are re-invested in the business
* Common in high growth technology companies
Life Cycle Issues:
- Young companies follow a residual policy
* Investments offer high returns
* Often prefer to avoid debt finance (unstable cash flows) - Mature companies follow a stable growth or constant pay-out policy
* Investments offer lower returns
* More likely to use debt finance (stable cash flows)
Dividend irrelevance theory (Modigliani & Miller):
- In a tax-free world, shareholders are indifferent between dividends and capital gains
- Value of the company is solely determined by the earning power of its assets and investments
M & M Theory - Company pays a dividend
- If company decides to cut the dividend it does not matter to shareholders because if shareholders do require cash, they can manufacture dividends by selling shares
- Shares will rise in value because of the investments & increase in value of the shares compensates for the loss of dividend
M & M Theory - Company does not pay a dividend
- If the company decides to pay a dividend, the shortfall in funds will be made up by obtaining additional funds from outside sources
- There will be a loss in the value of the firm to the original shareholders due to external funds being raised – the loss in value will be equal to the amount of dividend paid so the shareholders will not have lost overall.
Assumptions of M&M dividend irrelevance theory
- No taxes exist (corporate or personal)
- Capital markets are perfectly efficient = funds will always be made available to finance attractive investments
- No transaction costs = issuing new shares, taking out a bank loan or selling shares
- All info is fully & freely available to shareholders
Criticisms of M&M dividend irrelevance theory
- Impact of taxation = differing rates can create a preference for high dividends or high earnings retention which is one of the key reasons for the clientele effect.
- Capital markets are not perfectly efficient = funds may not always be available to fund financially attractive investments
* Where capital rationing is a issue, dividend retention may be preferred - Impact of transaction costs = investors who want some cash would prefer to receive a dividend rather than sell their shares for the cash required
- Imperfect information = if markets do not price shares accurately, based on all info available, the investors may find it difficult to sell their shares easily at a fair price
* Therefore, shareholders might require high dividends to fund other investments
* Shareholders are also not always fully aware of the future investment plans and expected profits for their company
* Even if management were to provide them with profit forecasts, it would not always be accurate unless backed up with a signal of confidence in the form of a rising dividend
* Shareholders may therefore prefer a current dividend rather than future capital gain because the future is so uncertain (bird in hand theory)
Alternatives to cash dividends:
- Scrip dividends
* Share repurchase
Scrip dividends
- Scrip dividend = dividend paid by the issue of additional shares at no cost rather than by cash.
- Allows shareholders the choice of building their equity stake or taking cash.
- Has the effect of capitalising reserves, = reserves reduce and share capital increases (DR retained earnings, CR Share Capital with nominal value of shares)
- Enhanced scrip dividend = giving the shareholder the choice between taking cash or shares but offering a generous number of shares so that it is likely that the shareholders will take the share issue instead of cash
Advantages of scrip dividends:
- Preserving the cash position
* Decreasing the gearing which enhances its borrowing capacity
Disadvantages of scrip dividends:
- Higher future dividend payments if dividend per share is maintained
- Indication that the company may have cash flow issues
- Disadvantage to shareholders = EPS & share price is likely to fall due to greater number of shares in issue, although overall value of each shareholders shares should theoretically remain unchanged.
Share repurchase:
- Used to return surplus cash to shareholders when the company has no positive NPV projects to invest the cash in – returns cash to shareholders so they can make better use of it
Advantages of share repurchase:
- Finds a use for surplus cash, which may be a dead asset
* Increases EPS through reduction in the number of shares
Disadvantages of share repurchase:
- Difficulty in arriving at a price that will be fair both to the vendors and to any shareholders who are not selling their shares
- Indication that company cannot make better use of the funds than shareholders