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Financial Management - DIVIDEND POLICIES

Implications for Corporate Policy - DIVIDEND POLICIES

   Posted On :  20.06.2018 06:25 am

Dividends have greater tax consequences than capital gains. Investors in high tax brackets may prefer capital gains, and thus a low payout ratio, to dividends.

Implications for Corporate Policy

1. Establish a policy that will maximize shareholder wealth.

2. Distribute excess funds to shareholders and stabilize the absolute amount of dividends if necessary (passive).

3. Payouts greater than excess funds should occur only in an environment that has a net preference for dividends.

4. There is a positive value associated with a modest dividend could be due to institutional restrictions or signaling effects.

5. Dividends in excess of the passive policy do not appear to lead to share price improvement because of taxes and flotation costs

Funding Needs of the Firm

 
1.    Liquidity
 
2.    Ability to Borrow
 
3.    Restrictions in Debt Contracts
 
4.    Control Other Issues to Consider
 

Other Issues to Consider

 

Dividend Stability

 
1. Stability - maintaining the position of the firm’s dividend payments in relation to a trend line.

2. Earnings per share Dividends per share
 
Information content -- management may be able to affect the expectations of investors through the informational content of dividends. A stable dividend suggests that the company expects stable or growing dividends in the future.
 
Current income desires -- some investors who desire a specific periodic income will prefer a company with stable dividends to one with unstable dividends.
 
Institutional considerations -- a stable dividend may permit certain institutional investors to buy the common stock as they meet the requirements to be placed on the organizations “approved list.”
 

Taxes Preference Theory

 
Dividends have greater tax consequences than capital gains. Investors in high tax brackets may prefer capital gains, and thus a low payout ratio, to dividends. Also, taxes on capital gains are paid only when the stock is sold, which means that they can be deferred indefinitely.
 

Clientele Effect

 
Different groups (clienteles) of stockholders prefer different dividend policies. This may be due to the tax treatment of dividends or because some investors are seeking cash income while others want growth. Changing the dividend policy may force some stockholders to sell their shares.

Market practice


The market practices with regard to dividend declaration or policy are:

They maintain their dividend rate as it is preferred by the shareholders and the government.

When earnings permit, they declare good dividends. They don’t have a policy to accumulate surplus and declare bonus share.

The main stake holder does not insist on any preferred dividend rate. It is entirely decided the company and its management

Dividend declaration is governed by commercial considerations and at times companies tend to exhibit conservative approach

Companies reward shareholders generously – both in dividends and bonus shares. They practice very high pay out

Sometimes companies skip dividend when performance is poor or liquidity is poor to maintain financial strength

Companies maintain a fixed rate of dividend and issue bonus shares when it is possible. The purpose is to ensure that the shareholders retain shares to enjoy capital gains

Some companies decide on the fair return to investors and maintain their dividend at these levels

Companies declare as high a dividend as they can. This will result in share price increase. The companies will then be in a position to raise more funds in the capital markets either by going in for fresh capital issue

Companies declare a consistent and reasonable return to the shareholders; this will enable them to plough back profits to take care of contingencies and to improve their capital base

Since the shareholder is the king, companies reward them through dividends; bonus and rights issue to get further investment / funds in future for their growth plans.

How do companies decide on dividend payments?

Mr John Lintner conducted a series of interaction with corporate leaders in the 1950s to find out their dividend policies. And he observed that the following four facts do impact the dividend payments

Firms have long run target dividend pay out ratio. Mature companies with stable earnings generally pay out a high proportion of earnings. Growth companies have low payouts, if they pay any dividends at all

Corporate leaders focus on dividend changes rather than absolute levels. For them paying 20% dividend is an important decision if they paid 10% dividend last year. And it is not a big issue if the dividend pay out last year was also 20%

Dividend changes follow shifts in long run, sustainable earnings. Leaders smoothen out dividend payments. Temporary changes in earnings level is unlikely to affect dividend pay outs

Leaders are reluctant to make dividend changes that may have to be reversed in the future years. They  would be concerned if they are to lower dividend pay out ratio.

Thus Lintner’s findings suggest that the dividend depends in part on the company’s current earnings and in part on the dividend for the previous year, which in turn depended on that year’s earnings and the dividend in the year before.

Check your progress (Answer at the end of Chapter)

The following are several observations about typical corporate dividend policies. Which are true and which are false?

Companies decide each year’s dividend by looking at their capital expenditure requirements and then distributing whatever cash is left over

Most companies have some idea of a target dividend distribution percentage

They set each year’s dividend equal to the target pay out ratio times that year’s earnings

Managers and investors seem more concerned when earnings are unexpectedly high for a year or two

Companies undertake substantial share repurchases usually finance them with an offsetting reduction in cash dividends

Answer the following question twice, once assuming current tax law and once assuming the same rate of tax on dividends and capital gains.

Suppose all investments offered the same expected return before tax. Consider two equally risk shares ABC Ltd and XYZ Ltd. ABC Ltd pay a generous dividend and offer low expected capital gains. XYZ Ltd pay low dividends and offer high expected capital gains. Which of the following investors would prefer the XYZ Ltd? What would prefer ABC Ltd? Which should not care? (Assume that any stock purchased will be sold after one year)

i. Pension fund

ii. An individual

iii. A corporation
 
iv. Acharitable endowment

v. A security dealer

To sum up…..

Dividends are earnings distributed to its share holders by a company

The (distribution) dividends expressed in percentage terms is called pay out ratio

Retention ratio is there fore 1 minus pay out ratio

A high pay out or a low retention ratio represents more dividends and therefore less funds for growth and expansion

A low pay out or a high retention ratio represents less dividends and therefore more funds for growth and expansion

Dividend policies affect the market value of the firm in the short run. However, whether such dividend increase value or not will depend on the profitable investment avenues available to the company

Walter considers that it depends on the profitability of the investment avenues available to company and the cost of capital. If the company has profitable avenues, its value will be very high and maximum when entire earnings are retained

Another view is that due to uncertainty of capital gains, investors will prefer dividends and more dividends. This implies that the value of shares in the market of a very high pay out and low retention company will command premium.

Miller and Modigliani do not subscribe to the view that dividends affect the market value of the shares.

According to them, a trade off takes place between cash dividends and issue of ordinary shares, if the investment policy of the company is firm and given.

They opine, the share price in the market will be adjusted by the amount of earnings distributed (or dividends distributed); and therefore the existing share holder is in the same platform when compared with the new investor – neither better off nor worse off.

Miller and Modigliani assume perfect capital markets, no transaction costs and no taxes.
 
However, in practical markets, transaction costs exist and taxes are levied. In such a scenario investors will prefer cash dividends.

Only  tax  exempt  investors  prefer  high  pay  out  companies. Investors in high tax brackets prefer high retention so that the share values could so high to assure them capital gains. Normally capital gains are taxed lower when compared with cash dividends.

In countries like India, the investors are not taxed for the dividends received by them. However capital gains are taxed for them. Hence there is a possibility that the Indian investor may prefer dividend distribution.

This reveals no clear picture or any consensus – whether dividend matters or not.

Therefore a number of factors will have to taken into account before deciding about the dividend policy.

Dividend can be distributed in cash or share form. Share form dividend is called bonus share.

Bonus share has a psychological appeal. They do not increase the value of the share. Stock splits have the same effect as the bonus shares.

Companies prefer to distribute cash dividends.

They prefer to finance their expansion and growth through issue of new shares and / or borrowing.

This is based on the assumption that shareholders and entitled to and they prefer period return on their investment.

Many companies move over to long term pay out ratios systematically planning and working for it.

While working out the dividends they consider past distribution and also current and future earnings. Thus dividends have information contents.

Companies would like to reward their shareholders through a stable dividend policy for reasons of certainty.

Stable dividend policy does not mean and result in constant pay out ratio. In this regard stable policy means predictable policy.

The company’s dividend policy would depend on its funds requirement for future growth, shareholder’s desire and cash or liquidity availability.

Shareholders expect that the company in the future will improve its performance and it will reckon the dividend rate to the increased capital.

In this hope, the share price may increase.

If the actual performance is poor and no increase in dividend distribution, the share price will decline.

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