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Dividend Theories and Policy Notes
Dividend Theories and Policy Notes
Dividend Theories and Policy Notes
Introduction
When a corporation earns a profit or surplus, it can either re-invest it in the business
(called retained earnings) or it can distribute it to shareholders as dividends.
Dividend policy determines the division of earnings between payments to stock holder’s
ad re-investment in the firm.
Dividends Theories
Dividend theories are propositions put in place to explain the rationale and major
arguments relating to payment of dividends by firms.
Firms are often torn in between paying dividends or reinvesting their profits on the
business.
Even those firms which pay dividends do not appear to have a stable formula of
determining the dividend payout ratio.
At the heart of the dividend policy theories discussion there are two opposing schools of
thought:
One side holds that whether firms pay dividends or not is irrelevant in determining the
stock price and hence the market value of the firm and ultimately its weighted cost of
capital.
The opposing side holds that firms which pay periodic dividends eventually tend to have
higher stock prices, market values and cheaper weighted average cost of capital
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The main proponents of this view are Franco Modigliani and Merton Miller (1958,
1961). They argue that to investors, payment of dividends is irrelevant as investors can
always sell a portion of their equity if they need cash.
Therefore, two firms of the same industry and scale should have the same value even
when one of the firms pays dividends and the other one does not.
The Modigliani and Miller Approach & the residual theory of dividends are the main
theories supporting the dividend irrelevance notion.
This theory was advanced by Modigliani and Miller in 1961. The theory asserts that a
firm’s dividend policy has no effect on its market value and cost of capital.
They argued that the firm’s value is primarily determined by its ability to generate
earnings from investments and the level of business and financial risk.
According to MM dividend policy is a passive residue determined by the firm’s need for
investment funds. i.e if a firm is in need of investments then it should not pay dividends
but use the retained profits for investing.
It does not matter how the earnings are divided between dividend payment to
shareholders and retention and therefore an optimal dividend policy does not exist.
When a firm’s investment policy is known investors will need only this information to
make an investment decision.
The theory further explains that investors can indeed create their own cash inflows from
their stocks according to their cash needs regardless of whether the stocks they own pay
dividends or not. e.g though sale of some of their stocks
If an investor in a dividend paying stock doesn’t have a current use of the money availed
by a particular stock’s dividend, he will simply reinvest it in the stock.
Likewise, if an investor in a non-dividend paying stock needs more money than availed
by the dividend, he will simply sell part of his stock to meet his present cash need.
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i. The capital markets are perfect, i.e. investors behave rationally, information is freely
available to all investors, transaction and floatation costs associated with share
floatation costs do not exist, and no investor is large enough to influence the price of a
share.
ii. Taxes do not exist or there is no difference in the tax rates applicable to both
dividends and capital gains.
iii. The firm has a fixed investment policy which is independent of its dividend policy.
iv. No risk i.e. there is no uncertainty about the firm’s future prospects, and therefore all
investors are able to forecast future prices and dividends with certainty and one
discount rate is appropriate for all securities over all time periods.
The validity of the Modigliani and Miller theory is highly dependent on two critical assumptions,
which unfortunately are not tenable in the real world. The theory assumes a world in which
transaction costs and taxes are absent. In real sense, it is not possible to have an economy in
which these two aspects are absent.
The residual theory holds that dividends paid by firms are residual, after the firm has
retained cash for all available and desirable investment projects with a positive net
present value.
It assumes that retained earnings are the best source of long term capital since it is readily
available and cheap.
This is because no floatation cash are involved in use of retained earnings to finance new
investments.
Therefore, the first claim on earnings after tax and preference dividends will be a reserve
for financing investments.
Therefore this model supports that dividend payment is useless in determining the future
market value of the firm.
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Therefore firms should never forego desirable investment projects to pay dividends.
Investors who subscribe to this theory therefore do not care whether firms pay dividends
or not, what they are concerned with is the prospect of higher future cash flows which
might lead to capital appreciation of their stocks and higher dividends payouts.
Procedure for the Residual-Dividend Model
i. The first step in the residual dividend model to set a target dividend payout ratio (dps /
Mps) to determine the optimal capital budget.
ii. Then, management must determine the equity amount needed to finance the optimal
capital budget.
iii. This should be done primarily through retained earnings.
iv. The dividends then are paid out with the leftover, or residual, earnings. Given the use of
residual earnings, the model is known as the "residual-dividend model".
No need to raise debt or equity capital since there is high retention of earnings which
requires no floatation costs.
New equity issue would dilute ownership and control. This will be avoided if retention is
high. A high retention policy may enable financing of firms with rapid and high rate of
growth.
High-income shareholders prefer low dividends to reduce their tax burden on dividends
income. They prefer high retention of earnings which are reinvested, increase share value
and they can gain capital gains which are not taxable in Kenya.
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Supporters of this theory argue that proposers of the dividend irrelevance theory made
unrealistic assumptions in crafting their respective theories.
As such, they argue that if those assumptions, key of which are the absence of taxes and
transaction costs, are relaxed, the dividend irrelevance theories won’t be able to hold
water.
Their main argument is that in a real world, payment of periodic dividends will have a
positive impact on the stock price of a firm, its market value and its weighted average
cost of capital.
The ideals of this school of thought were solidified mainly by Gordon (1963), Lintner
(1962) and Walter (1963).
Other theories which support the notion of dividend relevance includes tax preference
theory, the Agency theory, the Signaling Hypothesis, and The Clientele Effect
Hypothesis,
This theory was advanced by John Litner (1962) and furthered by Myron Gordon (1963).
It argues that shareholders are risk averse and prefer certainty of being paid dividends
now.
Dividends paid now are more certain than future capital gains.
Therefore, one bird in hand (certain dividends) is better than two birds in the bush
(uncertain capital gains).
Therefore, a firm paying high dividends (certain) will have higher value since
shareholders will require to use lower discounting rate.
MM argued against the above proposition.
The bird-in-the-hand theory therefore states that dividends are relevant to determining of
the value of the firm.
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In a popular common stock valuation model developed by Gordon,
The determinants of the value of a firm’s cost of equity financing are the dividends the
firm is expected to pay to perpetuity, the expected annual growth rate of dividends and
the firm’s current stock price.
According to Gordon’s dividend capitalization model, the market value of a share (P0) is equal to
the present value of an infinite stream of dividends to be received by the share. Thus:
The above equation explicitly shows the relationship of current earnings (E,), dividend policy,
(b), internal profitability (r) and the all-equity firm’s cost of capital (k), in the determination of
the value of the share (P0).
Because the structural underpinnings and implication of the Bird-in-Hand and Walter’s theories
are similar, they can be jointly critiqued.
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Although these models provide a simple framework to explain the relationship between the
market value of the share and the dividend policy, they have some unrealistic assumptions.
1. The assumption of no external financing apart from retained earnings, for the firm make
further investments is not really followed in the real world.
2. The constant return (r) is not real as r decrease as more and more investments are made.
It’s assumed most profitable investments are made first and poorer investments made
later and the firm should therefore stop where r=ke .
3. Constant cost of capital (ke) – this is not possible in real world and changes directly with
the firm’s risk.
This theory argues that dividends are relevant because they have information value i.e.
management can use dividend policy to signal important information to the market which
is only known to them.
If e.g the management pays high dividends, it signals high expected profits in future to
maintain the high dividend level and this would increase the share price/value and vice
versa.
Managers who look after the firm usually possess information about its current and future
prospects that is not available to outsiders.
MM attacked this position and suggested that the change in share price following the
change in dividend amount is due to informational content of dividend policy rather than
dividend policy itself.
Therefore according to MM, dividends are irrelevant if information can be given to the
market to all players. This theory supports that dividend decisions are relevant in an
inefficient market and the higher the dividends, the higher the value of the firm.
Assumptions of Information signaling effect theory
1. The sending of signals by the management should be cost effective.
2. The signals should be correlated to observable events (common trend in the market).
3. No company can imitate its competitors in sending the signals.
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4. The managers can only send true signals even if they are bad signals. Sending untrue
signals is financially disastrous to the survival of the firm.
They argued that tax rate on dividends is higher than tax rate on capital gains.
Therefore, a firm that pays high dividends has lower value since shareholders pay more
tax on dividends. Investors in low tax brackets who rely on regular and steady income
will tend to be attracted to firms that pay high and stable dividends.
Some institutional investors with major periodic cash outflows also tend to be attracted to
high-dividend stocks.
On the other hand, investors in relatively high tax brackets might find it advantageous to
invest in companies that retain most of their income to obtain potential capital gains.
Some investors however, are indifferent between dividends and capital gains.
Dividend decisions are relevant and the lower the dividend the higher the value of the
firm and vice versa. In Kenya, dividends attract a withholding tax of 5% which is final
and capital gains are tax exempt.
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DIVIDENDS POLICIES
This is where the firm will pay a fixed dividend rate e.g. 40% of earnings.
The dividend per share would therefore fluctuate as the earnings per share changes.
Dividends are directly dependent on the firm’s earnings ability and if no profits are made
no dividend is paid.
This policy creates uncertainty to ordinary shareholders especially who rely on dividend
income and they might demand a higher required rate of return.
The Dividend per share is fixed in amount irrespective of the earnings level.
This creates certainty and is therefore preferred by shareholders who have a high reliance
on dividend income.
It protects the firm from periods of low earnings by fixing dividend per share at a low
level.
This policy treats all shareholders like preferred shareholders by giving a fixed return.
NB pref. div. (sh) = pref. dividend rate (%) * par value of pref. shares & hence is fixed
The dividend per share could be increased to a higher level if earnings appear relatively
permanent and sustainable.
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d) Residual dividend policy
Under this policy dividend is paid out of earnings left over after investment decisions
have been financed.
Dividend will only be paid if there are no profitable investment opportunities available.
The policy is consistent with shareholders wealth maximization.
NB Stability of Dividends
Stable dividend can be in form of constant dividend per share or constant percentage.
A stable dividend policy adopted by a company may result in a serious damage regarding the
financial standing of the company in the mind of investors
External factors
a) State of economy
Due to uncertain economic conditions, the firm may retain a large part of earning to build
up reserves to absorb future shocks. During periods of depression the management may
also retain a large part of its earnings to preserve the firm’s liquidity position. During
periods of economic boom the management may not retain earnings because of
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availability of larger profitable investment opportunities. During inflationary periods the
management may retain a large portion of earnings to finance replacement of outdated
machines.
If the capital market is favorable, the management may adopts a liberal dividends policy
otherwise they align to a conservative dividend policy.
c) Legal restriction
There are various restrictions that company’s act has laid down. It states that dividends
can only be only paid out of current or past profit of the company and Payment of
dividend out of capital and capital reserves is illegal. A company cannot declare
dividends unless:
ii. Certain percentage of profits has been transferred to the reserve of the
company
iii Past accumulated profits can be used for declaration of dividends only as
d) Contractual restrictions
Lenders sometimes may put restrictions on the payment of dividends to protect their
interests especially when the firm is experiencing liquidity problems.
e) Taxations policy
High taxation reduces the earnings of the companies and consequently the rate of
dividend is lowered down.
Internal factors
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a) Stability of earnings-
Industrial units having stability of earnings may formulate a more consistent dividend
policy than those having uneven flow of income because they can predict easily their
savings and earnings. Enterprises dealing with necessities suffer less from oscillating
earnings than those dealing with fancy goods and luxuries.
A newly established company may require much of its earnings for investment and
expansion programs and may therefore adopt a rigid dividend policy while order
companies can formulate a clear cut and a more consistent policy regarding dividends.
A dividend represent a cash flow, and the better the liquidity of the firm the more its able
to pay its dividends. if cash position is week stock dividends will be distributed and if
cash position is good cash dividends can be paid.
This affects divided decision in that a closely held company is likely to get an approval of
the shareholders to suspend dividend payments while a company with many shareholders
and majority in low income groups will finds it difficult to get such kind of an assent.
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f) Time for payment of dividends
Dividends mean outflow of cash. The most desirable time for distribution of dividends is
when the firm is least in need of cash management should plan the payment of dividends
in such a way that there is no cash outflow when the company is in need of urgent
finances.
g) Shareholder decisions
Though managers decide the rate of dividend, it is always at the interest of the
shareholders. The shareholders expect two types of returns i.e. capital gains (an increase
in the market value of shares) and dividends (regular returns on their investment).
Cautious investors look for dividends because they are certain, indicates the financial
strength of a company and due to the need for income.
PAYMENT OF DIVIDENDS
The firm can decide to pay both interim and final or choose to pay the final dividend.
1. Liquidity position of the company. If a firm is financially stable it should pay both
interim and final dividends but if it cannot finance both it should only pay the final
dividends.
2. The culture of the company - the culture of an organization lays out its practices. If a
company has been paying both interim and final dividends it should continue to do so to
avoid frustrating the shareholders.
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3. The need for cash for investments purpose-If the company is in need of cash to invest
it will pay fewer dividends so as to retain more for investment.
4. Expectations of the shareholders- companies should conduct research to be able to
know what kinds of dividends the shareholders are expecting to avoid frustrations
especially in a case where the shareholders are paid what they are not expecting.
Types of Dividends
a) Cash dividend
Normally dividend are paid in cash resulting in cash outflow for the firm. The firm
should ensure that there is sufficient cash to pay dividends and also secure adequate
funding for its project before choosing to pay cash dividends.
This is a situation where a company pays dividends in form of assets other than cash this
assets can be the assets that are not required by the company or the products of the
company.
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This is rare and can occur for variety of reason such as major litigation win, the sale of a
business or liquidation of the investment. They can take the form of cash, stock or
property dividend.
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