Dividend Policy

Lecturer: Adrian Euler

Dividends and earnings• The dividend decision is closely linked to the

financing decision of a company.• The dividend decision must take account of the

views and expectations of shareholders.• Retained earnings are preferred as a source of

investment funds (pecking order theory).• Dividend payments reduce the earnings

available for investment, increasing the need for external funds to meet investment plans.

Operational issues

• Dividend is a distribution of after-tax profit made on a cash basis.

• Interim and final dividends = total dividend.• Shareholders must approve final dividend.• When dividend is announced the share price

goes ‘cum div’, meaning the buyer of share also buys right to receive next dividend payment.

• When share price goes ‘ex div’, the buyer no longer gains the right to receive next dividend.

Cum div and ex div share prices

to t1 t2

Dividend announced

Share goes ex-dividend

Dividend paid

Share is cum-dividend

Share is ex-dividend

Share price changes to reflect information content of dividend

Share price changes to reflect change in intrinsic

wealth

Share price

0 Time ex ex ex ex

Long-term shareprice

trend

Cum div and ex div share prices

Practical issuesLegal constraints:

• Dividend can only be paid from accumulated net realised profits (distributable profits).

• Regulations such as accounting standards define the meaning of distributable profits.

• Governments may impose restrictions on dividend payments.

• Restrictions may be imposed on dividend payments by loan agreements or covenants.

Liquidity:

• Dividends are cash payments so managers need to consider the effect on liquidity of proposed dividend payments.

• High levels of profit may not mean large dividends, as profit is not the same as cash.

Interest payment obligations

• Funds available for dividend payments will be reduced if gearing is at a high level.

Practical issues

Investment opportunities:

• Whether dividends are cut to provide funds for investment depends on the– attitude of shareholders and markets to a cut in

dividends.– availability and cost of external finance.– amount of funds required compared with

amount of distributable profits.

Practical issues

Dividend irrelevance

Modigliani and Miller 1961:• Share value depends on corporate

earnings.• Corporate earnings reflect investment policy

of company.• Share value depends only on investment

decisions, not on dividend and financing decisions.

• Share value is independent of the level of dividend paid.

M&M assumed capital markets are perfect:• No taxes or transaction costs• Free entry and exit• Many buyers and sellers• Participants are utility maximisers• Information is costless and freely availableM&M also assumed that companies are

financed only by equity (ordinary shares).

Dividend irrelevance

M&M pointed out that:

• Rational investors are indifferent between capital gains and dividends.

• The optimal investment policy is to invest in all projects with a positive NPV.

• The market value of the company increases to reflect expected future dividends.

• The market value of the company does not depend on its dividend policy.

Dividend irrelevance

• M&M argued that shareholders were indifferent to the timing of dividends.

• As future dividends are reflected in the share price, shareholders wanting dividends could sell shares (home-made dividends).

• For M&M the investment decision is divorced from the dividend decision, which is seen as part of the financing decision.

Dividend irrelevance

Internalrate ofreturn(%)

Amount of funds

Optimal investment policyOptimal investment policy

Internalrate ofreturn(%)

Amount of funds

1122

33

4455

66IRRIRR

Optimal investment policyOptimal investment policy

Internalrate ofreturn(%)

Amount of funds

1122

33

4455

66IRRIRR

Cost of equityCost of equity

Optimal investment policyOptimal investment policy

Internalrate ofreturn(%)

Amount of funds

1122

33

4455

66IRRIRR

Cost of equityCost of equity

OO

OA is needed for

investment purposes

AA

Optimal investment policyOptimal investment policy

Dividend irrelevance• If cash is needed for optimum investment

policy (OA), company can issue new shares.

• Company can pay any dividend and it will not influence its market value.

• If funds are needed to pay the dividend, the firm can issue new shares.

• This is possible because investors have perfect information about the firm and its future cash flows.

• Lintner and Gordon believed that dividends were preferred to capital gains due to lower risk and increased certainty.

• This is the ‘bird in the hand’ argument.

• If this is true, shares of companies paying higher dividends will be more valuable than shares of companies paying lower dividends.

• Hence dividend policy is seen as a key factor in determining the share price.

Dividend relevance

Signalling properties of dividends:• Asymmetry of information means dividend

decisions may contain (signal) information that is new for shareholders.

• The information content depends on:– direction of the dividend change.– difference between the actual dividend and the

dividend expected by the market.

• Information asymmetry arises as capital markets are not perfect.

Dividend relevance

Clientele effect:• Shareholders are not homogeneous and have

differing needs and preferences.• Some shareholders need regular income and

so prefer dividends to capital gains.• Shareholders may have differing dividend or

capital gain preferences depending on their personal tax circumstances.

• Clienteles will form as shareholders select companies that meet their preferences.

Dividend relevance

Dividend growth model suggests that dividends determine company’s share price.

• If shareholders require a return of 17%, the last dividend per share was 24p per share and dividends are expected to grow by 6% per year, the dividend growth model gives:

P0 = Do (1 + g) = 24 × (1 + 0.06) = £2.31 (r - g) (0.17 - 0.06)

Dividend relevance

Relevance or irrelevance?

Some of the assumptions made by Miller and Modigliani are clearly unrealistic:

• Transaction costs are not zero, so home-made dividends come at a cost.

• Taxation exists in the real world.

• Issuing securities does incur costs.

• Information is not necessarily freely available to all investors.

• In practice, dividend decisions are taken with market expectations in mind.

• Increased institutional shareholding has increased the need for dividend payments.

• Listed companies maintain dividends if possible, even if profits are low.

• Both managers and investors behave as if dividend policy is important.

Relevance or irrelevance?

Dividend policies

(1) Fixed percentage pay-out ratio:Advantages:• Easy to operate• Sends signals to investors on company

performanceDisadvantages:• Dividends fluctuate with earnings• Inflexible in terms of retained earnings

Dividend policy of Tesco plc:

• It appears that Tesco, up to 2001, aimed for a fixed percentage pay-out ratio of 44%.

• From 2002, EPS increased steeply but pay-out ratio declined after the 2002 peak.

1999 2000 2001 2002 2003 2004 2005Dividend (p) 4.12 4.48 4.98 5.60 6.20 6.80 7.56EPS (p) 9.37 10.2 11.3 12.14 13.98 16.31 18.3Payout (%) 44.0% 43.9% 44.1% 46.1% 44.3% 41.7% 41.3%% growth 8.738 11.16 12.45 10.71 9.677 11.18

Dividend policies

(2) Zero dividend payment

Advantages:

• Desirable for investors wanting capital gains

• Cheap and easy to operate

• Allows company to re-invest earnings

Disadvantages:

• Unacceptable to most investor groups

Dividend policies

• In the past it has been the company's practice to conserve cash resources to fund the Group's expansion. Accordingly, the company has not previously distributed any dividends. No dividend will be paid for the 1999 financial year. Furthermore, it is anticipated that no dividends will be paid for the next 2 or 3 years. It is Energy Solutions International's intention to create ‘Shareholder Value’ by growing the future earnings potential and by that way increase the share price.

Energy Solutions, Annual Report: 1999

Dividend policies

(3) Constant or steadily increasing dividend Advantages:• Acceptable to majority of investorsDisadvantages:• Shareholders expect increasing dividends

that companies may not be able to afford• May limit companies’ ability to investMost commonly pursued dividend policy

Dividend policies

• ‘The company continues to be committed to increasing the dividend paid to shareholders at a rate exceeding UK price inflation.’

Pearson Annual Report: 1999

Above: Dividend policy of Severn Trent plc

1998 1999 2000 2001 2002 2003 2004 2005Dividend (p) 39.8 43 45 45 45.9 45.9 47 48.5EPS (p) 95 92.4 92.8 61 63.2 58.1 61.4 55.6Payout (%) 41.9% 46.5% 48.5% 73.8% 72.6% 79.0% 76.5% 87.2%

Dividend policies

Alternatives to cash dividends

Scrip dividends

• Offer of additional shares as an alternativeto a cash dividend

• Scrip dividends taxed as income

• Cash flow advantages to company

• Small decrease in gearing

• If the capital markets are efficient, share price unchanged

Share repurchases

• Way of returning value to shareholders

• Cash should be returned if shareholders can use it more effectively than the firm

• Value of remaining shares will be enhanced while ROCE, EPS and gearing will increase

• On balance, market value of company should increase following share repurchases

Alternatives to cash dividends

Special dividends

• An alternative to share repurchases as a wayof returning surplus funds to shareholders.

• National Grid gave £770m to shareholders in 1998, equivalent to 44.7p per share or 15% of its market capitalisation, because it did not expect any major expansion opportunities tobe completed in the next year or two.

Alternatives to cash dividends

Non-pecuniary benefits • For example, discounts or special offers on

company products to shareholders: – Fullers plc (all shareholders) 15% off beer prices– Thistle Hotels (minimum 440 shares held) 20% of published hotel price– Thorntons (minimum 200 shares held) £34 discount voucher

Alternatives to cash dividends

Empirical evidence

Empirical evidence is far from clear cut:

• Traditionally, research (Lintner 1956 and Gordon 1959) supports dividend relevance.

• While M&M have not been totally discredited, there is substantial evidence for tax clienteles and the signalling effect of dividends, again lending support to dividend relevance.

Dividend policy: a conclusion

• At a theoretical level, according to Miller and Modigliani, dividend policy is irrelevant to company value.

• In practice, if shareholders behave as though dividend policy is important, then it is.

• However, excessive focus on dividend decisions by institutional investors can have a detrimental effect on shareholder value.