Dividend Policy Flashcards
What is a dividend?
-A cash payment made to shareholders.
-A distribution of after-tax earnings.
-Usually paid semi-annually (twice per year)
Interim (mid-year) and Final (after year end)
Delay between announcement and payment of dividend:
- ex-div date: dividend will be paid to those holding the shares on this date.
- Cum-div: the price of the share between announcement and payment.
- Share price will fall on ex-dividend date as the shareholder who buys immediately after the xd date does not have the right to receive the dividend.
Maximisation of shareholder wealth
Primary objective of management:
- Maximise shareholder wealth
- Maximise company value/share price
Return to shareholder:
- Dividend (income)
- Increase in share price (capital growth)
Measuring dividends:
- For one company: Dividend Per Share (DPS)
- For multiple companies: Dividend Yield = DPS / Share Price
The dividend decision
Considers how much the company should retain to re-invest in the company and how much it should distribute to shareholders (dividends)
If the company has a positive NPV project in which to invest the money, should it retain the funds rather than having to raise funds externally?
How much can a dividend be?
-Dividends can only be paid out of distributable profits.
-Lenders will put constraints on dividend payments (restrictive covenants)
-Liquidity- dividend is cash so company has to have cash to make the payment.
-Investment opportunities:
retained earnings are a major source of finance
Dividend irrelevance
Modigiliani and Miller suggested:
- Share valuation is a function of earnings.
- Investment decisions, which deliver future profitability are the determinants of share price.
- Share valuation is independent of the level of dividend.
Optimal investment policy
- Invest in all projects with positive NPV.
- Surplus funds (no positive NPV projects left) can be paid out as dividends
- Dividend is a residual decision.
Dividend Relevance
Litner (1956) and Gordon (1959):
- Dividends are preferred due to their certainty.
- Current dividends provide a reliable return.
- Future profits are less attractive.
- This suggests that dividend policy is relevant to market value as investors will value those companies who pay out dividends more highly
Dividend Growth Model
The market value of the company is equal to the present value of its future dividends.
The higher the dividend the greater the market value.
Value of share= D1/ (r-g)
Dividends as signal
Asymmetry of information;
- Managers/directors know more about the company and its prospects than shareholders.
- Strong dividend seen as “good news”.
- Directors are confident of profit and cash flow.
- pDividend decrease is taken as a negative signal of future problems.
- A company considering cutting its dividend needs to explain clearly why they have taken this action.
- Company needs to manage shareholder expectations.
Clientele effect
- Some shareholders rely on dividends as income to meet liabilities.
- Other investors are looking for long term capital returns.
- Investors will cluster in the companies whose policies suit them.
- If the company changes its dividend policy the investors may sell their shares and look for others whose policy suits them.
- Tax considerations
Dividend Policies
Fixed percentage payout ratio:
- Easy to operate
- Clear signal to investors
- Does not consider cash constraints
- Not suitable for companies with volatile profits
- Ignores investment decision
Zero dividend policy:
- Easy to operate and clear
- Allows company to use all retained earnings to re-invest
- Particularly useful for new companies or for those requiring significant upfront investment
Constant dividend/Constant growth dividend:
- Real or nominal terms?
- Dividend kept in line with the long-term growth in earnings
- Used in mature companies with stable earnings
- Failure to make dividend sends a very negative signal to the market
- Limits opportunities for investment as dividends become the “first” decision rather than the residual
- Companies who undertake this policy keep growth very low so as not to disappoint shareholders in a bad year,
Alternatives to dividends
Scrip dividends:
- Give additional shares instead of dividends
- Allows company to retain cash
- May be tax efficient for investor
Share repurchases:
- Enhances value of each remaining share
- Can increase EPS
Non-cash benefits:
- Gift vouchers
- Discounts on services
Special dividends:
- Return surplus cash to shareholders as a “one of” payment
- Return cash to investors where company has no positive NPV projects in which to invest
