Normally, a firm would be using its dividend policy to pursue its objective of maximizing its shareholders’ return so that the value of their investment is maximized.
Issues in dividend policy
Normally, a firm would be using
its dividend policy to pursue its objective of maximizing its shareholders’
return so that the value of their investment is maximized. Shareholders return
consists of dividends and capital gains. Dividend policy directly influences
these two components of return. Even if dividends are not declared but retained
in the firm, the shareholders’ wealth or return would go up.
We shall examine various ratios
which impact our firm’s dividend policy:
1. Pay out ratio
It is defined as dividend as a
percentage of earnings. It is an important concept in the dividend policy. A
firm may decide to distribute almost its entire earnings. Another firm may
decide to distribute only a portion of its earnings. Initially it may appear,
the former firm declares maximum dividends. However in the long run, the latter
firm which declares only a portion of its earnings may overtake our former high
pay out firm.
Let us now look at this with an
Firms X and Y have equity capital of Rs.100. Let us
assume both the firms generate 25% earnings every year. Let us assume that Firm
X declares 50% dividend every year and firm Y declares only 25% dividend every
If you look at the returns* to the investors of firms
X and Y at the end of 15 years, the following position will emerge on Rs.100
invested in each firm
overlooking the interest on the dividend received by
way of cash.
In the case of low dividend pay
out company, in fact from the year 14 onwards, the quantum of dividend paid has
actually overtaken the high dividend pay out company. If you look at the market value,
a low pay out firm will result in a higher share price in the market because it
increases earnings growth. Uncertainty surrounding future
company profitability leads certain investors to prefer the certainty of
current dividends. Investors prefer “large” dividends. Investors do not like to
manufacture “homemade” dividends, but prefer the company to distribute them
directly. Capital gains taxes are deferred
until the actual sale of stock. This creates a timing option. Capital gains are
preferred to dividends, everything else equal. Thus, high dividend yielding
stocks should sell at a discount to generate a higher before-tax rate of
return. Certain institutional investors pay no tax. Dividends are taxed more heavily
than capital gains, so before-tax returns should be higher for high dividend -
paying firms. Empirical results are mixed -- recently the evidence is largely
consistent with dividend neutrality.
2. Retention ratio If x is pay out ratio, then the
retention ratio is 100 minus x. That is retention ratio is just the reverse of
the pay out ratio. As we have seen above, a low pay out (and hence a high
retention) policy will produce a possible higher dividend announcement (and
thereby higher share price in the secondary market leading to huge capital
gains) because it increases earnings growth.
3. Capital gains Investors of growth companies
will realize their return mostly in the form of capital gains. Normally such
growth companies will have increasing earnings year after year but their pay
out ratio may not be very high. Their retention ratio will therefore be higher.
Investors in such companies will reap capital gains in the later years.
However, the impact of dividend policy (high or low pay out with low or high
retention ratio) is not very simple. Such capital gains will result in the distant
future and hence many investors may consider them as uncertain.
4. Dividend yield The dividend yield is the
dividends per share divided by the market value per share. The dividend yield
furnishes the shareholders’ return in relation to the market value of the
Tags : Financial Management - DIVIDEND POLICIES
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