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

Share is cum-dividend to Dividend announced t1 Share goes ex-dividend Share is ex-dividend t2 Dividend paid

Share price changes to reflect information content of dividend

Share price changes to reflect change in intrinsic wealth

Cum div and ex div share prices

Long-term share price trend
Share price

ex

ex

ex

ex

Time

Practical issues
Legal 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.

Practical issues
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.

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.

Dividend irrelevance
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 available M&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.

Optimal investment policy

Internal rate of return (%)

Amount of funds

Optimal investment policy

Internal rate of return (%) 1

2
3

4
5 6 IRR

Amount of funds

Optimal investment policy

Internal rate of return (%) 1

2
3 Cost of equity

4
5 6 IRR

Amount of funds

Optimal investment policy

Internal rate of return (%) 1 OA is needed for investment purposes

2
3 Cost of equity

4
5 6 IRR

Amount of funds

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.

Dividend relevance
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 companys 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)

Relevance or irrelevance?
Some of the assumptions made by Miller and Modigliani are clearly unrealistic: Transaction costs are not zero, so homemade 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.

Relevance or irrelevance?
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.

Dividend policies
(1) Fixed percentage pay-out ratio: Advantages: Easy to operate Sends signals to investors on company performance Disadvantages: Dividends fluctuate with earnings Inflexible in terms of retained earnings

Dividend policies
Dividend policy of Tesco plc:
1999 2000 2001 2002 2003 2004 2005 Dividend (p) 4.12 4.48 4.98 5.60 6.20 6.80 7.56 EPS (p) 9.37 10.2 11.3 12.14 13.98 16.31 18.3 Payout (%) 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

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.

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 investors Disadvantages: Shareholders expect increasing dividends that companies may not be able to afford May limit companies ability to invest Most 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
1998 1999 2000 2001 Dividend (p) 39.8 43 45 45 EPS (p) 95 92.4 92.8 61 Payout (%) 41.9% 46.5% 48.5% 73.8% 2002 45.9 63.2 72.6% 2003 2004 2005 45.9 47 48.5 58.1 61.4 55.6 79.0% 76.5% 87.2%

Above: Dividend policy of Severn Trent plc

Alternatives to cash dividends

Scrip dividends Offer of additional shares as an alternative to 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

Alternatives to cash dividends

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 way of 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 to be 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

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.