CHAPTER 16

DIVIDEND POLICY

1. The dividend decision

Retained earnings - a cheap source of finance

- no issue cost/flexible/no need for publicity- however, it is cheap at the expense of current

shareholders who do not get dividends

Key question:

If a company decides to fund new investments by a dividend cut what would be the impact on existing shareholders and on the share price?

What is the relevance of dividend policy?

2. Theories of dividend policy

1. Dividend irrelevancy theory

2. Residual theory

3. Dividend relevance

2. Theories of dividend policy

1. Dividend irrelevancy theory

Modigliani and Miller

- Shareholders care only about increasing their wealth but not the form of that increase (dividends or capital growth);

- If shareholders need money (to consume) they can sell shares;

- If shareholders prefer retentions they could buy additional shares with the dividend received.

2. Theories of dividend policy

1. Dividend irrelevancy theory

Modigliani and Miller

Theory Provided a company is investing in positive NPV projects, it will make no difference to the shareholders (and share price) whether the projects are funded via:

- a cut in dividends or - additional funds from outside sources

2. Theories of dividend policy

2. Residual Theory

Dividends are important but dividends pattern is not.

If raising new finance is costly, then retained earnings should be used to finance investment projects.

Theory - Provided that the present value of the dividend stream remains the same, the timing of the dividend payments is irrelevant.

Consequence - Only after the firm has invested in all positive NPV projects should a dividend be paid if any extra-funds are available. Hence dividends are residual.

2. Theories of dividend policy

3. Dividend relevance

Dividend irrelevance theory and residual theory are based on the assumption of perfect markets, no taxation etc

Allowing for imperfections yields a third theory:

Dividend policy does matter:- Reductions in dividends signal “bad news” to shareholders

(dividend signaling);- Reductions in dividend may conflict with investors’ liquidity

requirements;- Changes in dividend policy may upset investor tax planning

(the clientele effect).

2. Theories of dividend policy

Other practical constraints

Legal restrictions on dividends payments

- put a limit to the distributable profits;- debt arrangements may contain covenants that restrict dividend payments;

Liquidity- dividend distribution is constrained by cash availability – e.g. cash might be needed to fund working capital.

2. Theories of dividend policy

Alternatives to cash dividends

Share repurchase

- company may repurchase shares as a form of paying the shareholder a dividend

Scrip dividendsScrip dividend = the company allows its shareholders to get their dividends in the form of new shares not cash.

- shareholders increase their shareholding by avoiding transaction costs;

- firms save on cash but still “pay” dividends