Dividend Policy

Dividend Policy
• For any company, the amount of earnings retained
have a direct impact on dividends paid.
• A company should restrict its financing through
retained earnings in order to pay reasonable
dividends to shareholders. This will avoid large
fluctuations in dividends payments which may
undermine investor’s confidence
• Directors usually determine the dividend policy in a
company. Shareholder have the power to vote to
reduce dividends payments but not to increase it.
 FACTORS INFLUENCING DIVIDEND
POLICY
• Profitability of the company: a company with high
profits is likely to pay high dividends than a loss making
company, ceteris paribus.
• Liquidity position of the company: where the company
is unable to generate sufficient working capital i.e. low
cash position, it will pay less amounts of dividends.
• Investment opportunities: where a company has many
investment opportunities available, it is likely to pay low
dividends since a large proportion of the earnings will be
directed to such investments.
• Contractual obligations/debt covenants: where the debt-
holders restrict the amount of dividends to be paid by the
company, shareholders of such a company will receive low
amounts of dividends.
• Industrial practice: Companies will operate within the
acceptable industrial norms. A company operating in an
industry paying high dividends will also pay high dividends
due to the effect of competition.
• Growth stage of the company: a well established company
is likely to pay high dividends since its earnings are high and
stable. A young growing company will pay low dividends
since it retains most of its earnings generated to investment
opportunities so that it can increase its level of operations.
• Capital structure of the company: a company will
aim to achieve an optimal capital structure. Where the
gearing level is high, the company will pay low
dividends to allow reserves to accumulate until an
optimal capital structure is restored.
• Legal rule:
– Undue retention of earnings rule- the law may prohibit companies
from retaining profits in order to avoid paying taxes now on the
dividends
– Capital impairment rule: prohibits the company from paying
dividends from capital. The company cannot sell its assets to pay
dividends. This is liquidating the firm.
– Insolvency rule: a company should not pay dividends when it is
insolvent. A company is insolvent if the assets are less than its
liabilities.
• Ownership structure: in a small company where the owners are
few and want to retain funds for expansion, the dividends paid
will be low. In a public quoted company, dividends are significant
since they reflect/send signals to the existing and potential
investors on the company’s performance.
• Shareholders expectation: The class of shareholders who invest
in the business with a motive to earn dividends are likely to
withdraw their investments if the company fails to pay them
dividends.
• Access to capital markets: large quoted cos. have access to
capital markets and therefore can afford to pay high dividends
since they can finance investments by funds accessed in the
markets. Small companies are less likely to access funds through
the capital market hence will retain more in the business and pay
less dividends.
 DIVIDENDS AS SIGNAL TO INVESTORS
• Management can use dividend policy to signal important
information to the market which is only known to them
• e.g. if management pays high dividends, it signals high
expected profit in the future to maintain the high
dividend level. This will increase the market price of the
share due to increased demand and the value of the firm.
• Investors look at the dividend policy to determine
whether or not to invest in a company since it reflects
the ability of the company to generate earnings.
• Signaling effect of a company’s dividend policy
may be used by management of a company
which faces a possible takeover.
• The dividend level might be increased as a
defense against takeover since investors will take
the increased dividend as signal of improved
future prospects, thus driving the share price
higher and making the company more expensive
for a potential bidder to take over.
 THEORIES OF DIVIDEND POLICY
Residual Theory
• In this policy, dividend is the residual amount, paid
only after all the positive NPV projects have been
undertaken.
• The limitation to this theory is variability of periodic
dividends leading to share price decline.
Traditional View
• This focuses on the effects of the share price. The price
of a share depends on a mix of dividends given
shareholder’s required rate of return, and growth.
 Irrelevancy Theory
• It was advanced by Modigliani and Miller (MM) in 1961.
MM’s theory states that in a perfect market, investors are
indifferent between dividends and capital gains.
• Provided a company is investing in positive NPV
projects, it will make no difference whether projects are
funded by a cut in dividends or obtaining additional funds
from outside sources.
• Obtaining finance from outside instead of using retained
earnings, would result to a fall in the share price.
However, MM argue that this reduction would equal the
amount of dividends paid, making shareholder’s wealth
unaffected.
• They further argued that for any corporate
decision to have value, a firm must do something
that shareholders cannot do for themselves.
• Shareholders can “manufacture” their own
dividends by selling part of their shareholding.
• Accordingly, investors would be indifferent
between dividends and capital gains and the
firm’s value would not be affected by the present
and future dividends decision of the firms.
Assumptions of dividend irrelevance
theory

• No personal or corporate taxes

• No floatation cost
• A firm has a given investment opportunity
which does not change
• Dividend policy has no effect on the firms cost
of equity
• All investors have free access to all relevant
information
• There is perfect certainty by every investor
regarding future investments.
 HOW TO PAY DIVIDENDS

Cash dividends
• Mostly companies pay dividends in form of cash. The
company should be in a sound liquid position to do so
since the dividends paid reduce the cash positions of the
company.
Bonus issue/ scrip dividends
• Under conditions of liquidity or financial constraints, the
company can pay dividends in form of bonus issue.
• This involves issue of additional shares for free instead of
cash dividends to the existing shareholders in their
shareholding proportion.
Stock Repurchase
• It occurs when the company buys back some of its
outstanding shares from the shareholders instead of paying
cash dividends. The shares repurchased are referred to as
treasury stock. The company refunds the amount of
capital that had been contributed by the shareholders.
• The company repurchases its stock if it is of the opinion
that such stock is undervalued. When it purchases it
increases the demand for its shares and in the process
causes the share price to appreciate after which the
company may dispose of the shares at the higher price
achieved