Implications for Corporate Policy
1. Establish a policy that will maximize shareholder
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
2. Ability to Borrow
in Debt Contracts
Other Issues to Consider
Other Issues to Consider
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.
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.
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
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.