Lecture 10- Dividend Policy

DIVIDEND POLICY
 Internal sources of finance
 Retained Earnings
 Increasing working capital efficiency

 Dividend policy
 Traditional Theory
 Residual Theory
 Irrelevancy Theory (M&M)
 Scrip Dividend
 Share Repurchase

 Homework

Retained Earnings

Retained earnings = profits not paid out as dividend or tax

Retained earnings ≠ cash available for investment because the cash might have
been invested already, for example in non-current assets

Retained earnings are classified as shareholders' equity

1) Advantages of Retained Earnings

No issue costs
No change in share ownership or control
No repayment or servicing of capital needed
No increase in gearing
Quick and easy for directors to use as opposed to raising external finance

2) Disadvantages of Retained Earnings

There might not be enough to finance company plans – especially as retained
earnings ≠ cash available.

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 Shareholders might prefer larger dividends so financing operations from retained
earnings would not be popular. This may lead to borrowing to pay a dividend
They are not cost-free: opportunity cost – if paid to shareholders, they cannot be
invested to earn income

3) Increasing Working Capital Efficiency

Cash available for investment can be increased if:
Receivable collection period is reduced.
Inventory is reduced.
Payables period is increased.

4) Traditional Theory on Dividend Policies are as follows:

Stability- Volatile dividends undermine shareholder confidence. Directors like to
deliver steady dividend growth. This implies that directors are managing the
company well

Clientele- Shareholders buy shares that suit them: the clientele effect. Changing
dividend policy irritates them. NB- If the same dividend policy results in
fluctuating dividends, they accept that. E.g., if the dividend policy is to prioritise
investment over payment of dividends and this results in fluctuating dividends,
this is acceptable.

Signalling- Dividends signal what directors think about future prospects. If profits
fall and dividends are maintained, the fall in profits is temporary. If profits fall and
dividends are cut, the fall in profits is likely to be sustained.

 Traditional theory focuses on the effects of dividends and dividend expectation on

share price.
 The price of a share depends on both current dividends and expectations of future
dividend growth, given shareholder’s required rate of return.

5) Apart from the Traditional theory (stability, clientele, signalling) on dividend

policy,
There are two other theories:
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 Residual theory
Irrelevancy theory (Modigliani and Miller)

6) Residual theory
The best use of earnings is to invest in projects with a positive NPV.
A positive NPV means that a project makes the shareholder richer, so investing
in the project is a good use of cash that would otherwise be paid as a dividend.
Only when all suitable investments are made should earnings be paid out.

(i) Residual Dividend Policy- Dividends move up and down erratically

Company makes varying dividend payments over a number of years say 5
years

(ii) Smooth Dividend Policy

Company makes the same dividend payments each year for the same 5
years above

7) Irrelevancy theory of A Dividend Policy (Modigliani and Miller)- A Perfect Market

Shareholders are indifferent between dividends and capital gains. It means they
have NO preference for either.

Dividends can be manufactured from capital gains by selling some shares.

Dividends not paid now will be invested.

Provided the investment NPV is positive, this will produce gains or larger future
dividends to compensate for the current loss of income.

So, whether dividends are paid now or not is irrelevant: value simply swaps
between share price and cash with shareholders.

8) Irrelevancy theory of Dividend Policy – problems

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 Different rates of income tax and capital gains tax will mean that gains and
income are not perfectly interchangeable.

Dividend retention will often be preferred by companies in a period of capital

rationing. So dividend policy is not IRRELEVANT

If dividends are cut, shareholders who need income can sell some of their more
valuable shares instead. That’s good, but there are transaction costs every time a
share is sold. Shareholder bears that cost.

It is not so easy to sell a share when a shareholder wishes. We operate in an

Imperfect Market.

Risk: a dividend now is better that the promise of gains or larger dividends in the
future. Time value of money!

9) Scrip Dividend
A scrip dividend is a dividend paid by the issue of additional company shares,
rather than by cash.
Dr Reserves Cr Share capital

Each investor is offered a choice of a normal cash dividend or a scrip dividend.

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

10) Advantages of a Scrip Dividend

They preserve a company's cash position if a large number of shareholders take
up the share option. This is useful when liquidity is a problem, or when cash is
needed to meet capital investment or other financing needs.

Investors can increase their holding without incurring the transaction costs of
buying more shares.

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 A small scrip dividend issue will not dilute the share price significantly.

It will lead to a decrease in gearing because of the increase in issued shares.

This decrease in gearing will increase debt capacity.

11) Disadvantages of a Scrip Dividend

Where shareholders opt for receiving scrip dividends, it means when dividends
are actually paid out in cash, it will be sizeable, because of the increased share
capital

Scrip dividends may be seen as a negative signal by the market ie the company
is experiencing cash flow issues.

12) 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, often including:

The company must have sufficient distributable reserves before it can purchase
its own shares.

The company has to maintain its capital in accordance with legislation.

13) Advantages of Share repurchase

A use for surplus cash. Larger dividends could be paid but managers usually aim
for a stable dividend policy.

Increase in EPS (earnings are divided over fewer shares)

To prevent a takeover as it can allow a quoted company to withdraw from the

market: the company buys the shares rather than an external purchaser.

14) Disadvantages
For unquoted shares it is difficult to determine a price that is fair to both the
vendors and to any shareholders who are not selling shares to the company.
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A repurchase of shares could be seen as an admission that the company cannot
make better use of the funds than the shareholders.