Lecture Notes - Dividend Policy

DEFINING DIVIDEND POLICY

Brealey et al defined dividend policy as “ the trade off between retaining earnings on the one hand and paying out cash and issuing new shares on the other.” Brealey et al (1986:417)

DIVIDEND CONTROVERSY

Over the last century, three schools of thought have emerged over dividend policy.

•      One faction sees dividends as attractive and as a positive influence on stock prices.

•      A second bloc believes that stock prices are not related to dividend payout levels.

•      The third group of theories maintains that firm dividend policy is irrelevant in stock price valuation.

The question is If dividends are so irrelevant as is being purported by Modigliani and Miller "Why do corporations pay dividends?" and also, "Why do investors pay attention to dividends?" Black [1976]

Theories of Dividend Policy

Irrelevance Theory

Modigliani and Miller researched and produced a paper stating that dividends were irrelevant to share value. They were of the view that the determinants of value of a share are the availability of projects with positive NPV’s rather than pattern of dividends paid out by a company to its shareholders

According to them under ideal conditions, the value of the firm is unaffected by dividend policy

Argument against MM preposition

1. If dividends are so irrelevant "Why do corporations pay dividends?" and also, "Why do investors pay attention to dividends?" Black [1976]

Argument for MM preposition

1. Dividend policy makes no difference because it has no effect on either stock prices or the cost of equity - Black and Scholes (1974),

Bird-in-hand theory

This theory states that dividends are more predictable than capital gains because managers can stabilize dividends, but cannot control stock price.

Therefore, dividend payments are safe cash in hand while the alternative capital gains are at best cash in the bush.

Tax Preference Theory

The theory argued taxes are paid on dividends in the year they are received while taxes on capital gains do not have to be paid until the stock is sold. Again taxes on capital gains may be less than on dividends, which are considered ordinary income. Thus depending on the tax situation of the investor, investors will prefer that companies retain the earnings and promote capital appreciation

THE CLIENTELE EFFECT

—  Some shareholders may prefer stocks that do not pay dividends.

—  Other shareholders may prefer stocks that pay a regular dividend.

—  Investors will form their well-diversified portfolios of stocks to have the desired dividend policy.

—  All clienteles would prefer not to be constantly rebalancing their portfolios as firm switch policies. Rebalancing is expensive due to transactions costs.

Main Factors Determining Dividend Policy

Dividend turn to be lower when there are more investment opportunities as the theory suggests. However, many businesses tend to base their dividend on the profit or earnings of the most recent year

How dividends are paid

Cash dividend

These are payment of cash by the firm to share holders

Stock dividends

This is the distribution of additional shares to share holders e.g., right issues

Dividend payout ratio:  this is the fraction of earnings paid out as dividends

Legal limitations on dividend

State laws- help to protect creditors against excessive payment of dividend

placing of limits on dividend payments

Stock repurchases

Some firms buys back from its share holders

Ex-dividend date – This is the date that determines whether a shareholder is entitled to dividend payment

   Example

The key dates of Wal-Matt’s quarterly dividends

March 8                 March 19           March 22   March 22       April Declaration  With – dividend       Ex-dividend        Record date         Payment

       date                 date              date                                             date

Scrip Dividend

This is when a company allows it share holders to take their dividend in the form of new shares rather than cash