Module 8

Company Dividend Policy

 Dividend Irrelevancy I
• There is a set of arguments that says that the dividend decision of a
company is unimportant; that nothing the company does in the way
of paying or not paying a dividend has any effect upon the wealth
of its shareholders. See Simple corporation on page 8/2.
• Higher cash dividends mean lower market value to existing
shareholders, and lower cash dividends mean higher market value
to existing shareholders. This is common to all dividend policy
changes when other financial decisions are to be held the same.
• If existing shareholder dividends are reduced, their claim upon
future dividends, and thus current market value, is higher because
less new equity is raised. If existing shareholder dividends are
increased, their claim upon future dividends, and thus current
market value, is lower because more new shares must be sold.
• Link between dividend policy and investment decision.
 Dividend Irrelevancy I
• In summary, the notion of dividend irrelevancy argues
as follows: leaving other financial decisions intact,
higher dividends require more new shares to be sold,
lower dividends require fewer. As long as the new
shareholders insist upon receiving full value for the
cash they contribute, and company share value in total
is unchanged (because other decisions are intact),
existing shareholder wealth is unaffected by the
dividend decision. Any change in the cash portion of
current shareholder wealth (due to changes in cash
dividends) will be exactly offset by changes in the value
of their shareholdings (due to changes in the amounts
of new shares issued by the company).
 Dividends and Market Frictions
• Taxes, transaction costs and flotation costs.
• Taxation of Dividends
• When a company pays a dividend, the cash thus distributed must
make its way through whatever tax system exists in the economy
before the dividend is useful to the shareholder. From the
shareholder’s perspective, it is after tax (both company and
personal) dividends that are of interest. It is generally the case,
however, that dividends are more heavily taxed than capital gains.
In countries where the amounts of cash available to pay dividends
are net of company taxes, and the dividends paid are taxed again at
the shareholder level, dividend payment to taxable shareholders is
expensive. Those shareholders would likely be better off receiving
their wealth in the form of share price increases that are either not
taxed or taxed at lower rates than the dividends.
• See table 8.2.
 Dividends and Market Frictions
• Transaction Costs of Dividend Payments
• In real markets, shareholders cannot shift costlessly
between shares and cash. There are usually brokerage
fees to be paid when such transactions take place.
(And there may be the forced ‘realisation’ of capital
gains and the taxes thereby due.) So shareholders may
prefer one dividend policy to another depending upon
their preferences for consuming wealth across time
and the costs they would pay to achieve the desired
consumption pattern, given a particular dividend policy
by the company.
 Dividends and Market Frictions
• Flotation Costs
• Companies themselves incur costs in raising
money from capital markets when they pay
dividends so high as to require new shares to be
sold. These are called flotation costs, and they
can be significant for the issuance of new shares,
depending upon the mechanism of sale. If
intermediaries such as investment bankers are
used, the costs can be as high as 5 to 25 per cent
of the total value of issued shares.
• Residual Dividend Policy
 Dividend Clienteles: Irrelevancy II
• It is important to recognise that shareholders are not all alike in the
exposure they have to dividend and capital gains taxation and that
preferences for consumption of wealth across time differ. One type
of shareholder, say those in high personal tax brackets, would
prefer one kind of dividend policy (low cash payout), whereas
another kind of shareholder in a low tax bracket might well prefer
high cash payout.
• Such different kinds of shareholders have come to be called
clienteles in finance. The interpretation is that they comprise
groups that would be willing to pay extra to get the type of
dividend policy that is best suited to their own tax and consumption
preferences. In other words, they may have probably been
attracted to the shares of a company that pursues a policy that to
them is attractive.
 Dividend Clienteles: Irrelevancy II
• There are not just a few companies providing wealth
disbursements to shareholders; there are many. And
those companies provide a wide range of dividend
strategies to the market. Given the number and types
of dividend payout patterns available, we can raise
questions as to whether anything a particular company
can do to change its dividend policy is likely to give its
shareholders something that they could not acquire
elsewhere. This idea is one of the underpinnings of
current thinking about company dividend policy, and it
brings us back to the original ‘irrelevancy’ conclusion,
even in realistic financial markets.
 Dividends and Signalling
• One of the empirical findings about company
dividends is that these cash payouts seem to be
more stable in monetary terms across time than
any particular residual or clientele hypothesis for
dividend policy can explain. Company financial
managers seem to be loath to pay a dividend
unless they think it can be sustained for some
period of time by the expected cash flows of the
firm. One explanation for the ‘smoothing’ across
time of company dividends that seems more
reasonable is the signalling value of dividends.
 Dividends and Share Repurchase
• Reasons given for repurchase
1) undertaken so as to have shares for various uses (merger
and acquisition purposes, employee stock option exercise,
and so forth);
2) very often the company will announce that it considers its
shares ‘underpriced’ and thus a good investment, and is
therefore investing in itself.
• Real reason: Share repurchases are nothing more than a
cash dividend to shareholders. If all shareholders sell back
to the company the same proportion of their holdings, it is
easy to see that the net effect is to shift cash from the
company to shareholders, leaving undisturbed the
proportional claim of each shareholder.