F3 – Financial Strategy CH7 – Dividend policy

Chapter 7
Dividend policy

Chapter learning objectives:

Lead Component Indicative syllabus content

B.4 Evaluate dividend Evaluate policy in the following areas: • Features and criteria
policy (a) Cash dividends • Impact on shareholder
(b) Scrip dividends value and entity value,
(c) Share repurchase programmes financial statements and
performance

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1. Dividend policy
One long-standing question in corporate finance is: is shareholder wealth affected by a
company’s dividend policy?
Key factors in relation to the payment of dividends are:
• Modigliani and Miller’s (M&M) dividend irrelevancy argument.
• The interests of shareholders (the clientele effect and the bird-in-the-hand argument).
• The signalling effect or information content of dividends.
• The cash needs of the entity.

Dividend irrelevancy - Modigliani and Miller (M&M)

• The pattern of dividend payout should be irrelevant.
• As long as the company continues to invest in positive NPV projects, the wealth of the
shareholders should increase, whether or not the company makes a dividend payment
this year.

M&M’s argument is built up as follows

• The return on a share is determined by the share’s systematic risk.
• The return itself is delivered to shareholders in two parts:
1) The dividend paid
2) The capital gain/loss in the share price
• The dividend decision that a company makes is a decision as to how the return is
delivered: how much of the annual earnings should be paid out as dividends and how
much should be retained and reinvested within the company so that it flows through to
shareholders in the form of a capital gain on the share price.
• As the dividend does not affect the risk of the shares, it does not affect their return. All
the dividend decision does is determine how the return is to be split up between dividends
and capital gains.
• Do shareholders mind how their returns are split between dividends and capital gains?
The answer according to M&M is: no, they do not if we assume:
- There are no taxes (there are no differences between dividends and capital gains)
- Shares can be bought and sold free of any transaction costs (such as stockbrokers’
commissions).
M&M argue that shareholders can manufacture the dividend policy irrespective of the
company policy.

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The assumptions that M&M make play a key role. Obviously, if dividends are taxed and capital
gains are tax-free, shareholders will mind how their return is delivered. They will strongly
prefer it to be delivered in the form of capital gains rather than dividends.
However, given that their assumptions hold good, M&M could claim that shareholders are
indifferent between dividends and capital gains, and so the dividend decision/the dividend
policy the company pursues is irrelevant.

The interests of shareholders

• It is critical that a business satisfies the needs of its shareholders with its dividend policy.
• If the shareholders do not feel that the business’ dividend policy meets their expectations,
they may sell their shares, perhaps causing the share price to fall.
Two important considerations of the interests of shareholders:

Clientele Effect
The interests of
shareholders
The bird-in-the-
hand argument

Clientele Effect: The bird-in-the-hand argument:

• In the real world, there are different tax • It puts forward a very simple argument.
treatments for dividends and capital gains.
• Some investors may find capital gains
• There are also transaction costs on share more tax-efficient than dividends.
dealings.
• Some investors will avoid transaction costs
• Shareholders are concerned as to how if their returns are delivered in the form of
their return is delivered to them by the capital gains rather than dividends.
company.
• Despite that, investors generally have a
• Thus, companies should follow a strong preference for dividends.
consistent dividend policy to ensure that
• The reason given is that a dividend is
they gather to them a clientele of
certain and investors prefer a certain
shareholders who like that particular
dividend now to the promise of uncertain
policy.
future dividends.
• The argument here is that the actual
dividend policy that a company follows is
unimportant but, having decided on a
particular policy, it should then keep to it.

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The signalling effect

• Signals are important for investors.
• Investors look for signals in the company’s dividend decision since they say much about
the company’s future performance.

Two very strong dividend signals:

1) A reduction in the dividend per share signals that the company is in financial difficulties.
2) A failure to pay out any dividend at all signals that the company is very close to
receivership.

Cash needs of the entity

It is important to consider the effect of investment and financing when considering dividend
policy. Different types of business will have different cash needs and will therefore have to
set their dividend, investment and financing policies accordingly.
Overall influences on dividend policy can be summarised as follows:
Impact of investment: Impact of financing:

• High level of investment may cause • Dividend payment may be restricted by

liquidity problems
• If capital gains tax is lower than tax on
dividends, an entity may reinvest to
increase the share price
debt covenants
• Shareholder expectations: e.g. consistent
dividend
• Attitude to debt: a company may not want
to use debt finance (need to use internal
funding)
• If the market reads increasing a divided as
a positive signal, this could lead to a rise in
the share price

2. Dividend policy in practice

Dividend
policy

Stable (fixed) Constant Residual

Zero payout
amount payout (%) approach

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Stable (fixed) dividend policy

Paying a constant or constantly growing dividend each year:
• Offers investors a predictable cash flow.
• Reduces management opportunities to divert funds to non-profitable activities.
• Works well for mature firms with stable cash flows.
However, there is the risk that reduced earnings would force a dividend cut, with all the
associated difficulties.

Constant payout ratio

Paying out a constant proportion of equity earnings:
• Maintains a link between earnings, reinvestment rate and dividend flow, but
• Cash flow is unpredictable for the investor.
• Gives no indication of management intention or expectation.

Zero dividend policy

All surplus earnings are reinvested back into the business. Such a policy:
• Is common during the growth phase.
• Should be reflected in an increased share price.
When growth opportunities are exhausted:
• Cash will start to accumulate.
• A new distribution policy will be required.

Residual dividend policy

A dividend is paid only if no further positive NPV projects are available. This may be popular
for firms:
• In the growth phase.
• Without easy access to alternative sources of funds.
However,
• Cash flow is unpredictable for the investor.
• Gives constantly changing signals regarding management expectations.

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Ratchet Patterns

Most firms adopt a variant on the stable dividend policy – a Ratchet Pattern of payments.
This involves paying out a stable but rising dividend per share.
• Dividends lag behind earnings, but can then be maintained even when earnings fall below
the dividend level.
• Avoids bad news signals.
• Does not disturb the tax position of investors.

3. Scrip/bonus dividends and share repurchase

Scrip dividends
A scrip dividend is where shareholders are offered bonus shares free of charge as an
alternative to cash dividends.
• Useful where the company wishes to retain cash in the business or where shareholders
wish to reinvest dividends but avoid the brokerage costs of buying shares.
• There may also be tax advantages of receiving shares rather than cash in some
jurisdictions.
• If all shareholders opt for bonus shares, the scrip issue has the effect of capitalising
reserves; reserves reduce and share capital increases.

The disadvantages to shareholders:

• Unlike reserves, share capital is non-distributable in the future.

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• In addition, both share price and earnings per share are likely to fall due to the greater
number of shares in issue.
However, the overall value of each shareholders’ shares and shares in future earnings should,
theoretically, remain unchanged.
Advantage to the issuer:
• The most important advantage to the issuer is retaining cash in the business while still
achieving a distribution of reserves.

Share repurchase
This is used to return surplus cash to shareholders.
• Tends to be used when the company has no positive NPV projects to invest the cash in,
so it returns the cash to shareholders so that they can make better use of it rather than it
sitting idle in the company.
• Alternatively, a share repurchase can be used to privatise a listed company by buying
back its shares from a wide pool of investors. However, it is rare.

Shares repurchase vs one-off large dividends

• As an alternative, a company may decide to use a large one-off dividend to return surplus
cash to the shareholders.
• If all shareholders agree to repurchase, both a share repurchase and a large one-off
dividend will have the same impact on the cash and gearing of the company (they reduce
the value of the equity, so increasing the gearing and hence financial risk and cost of
equity).
• However, though the impact on shareholder value is the same for any individual
shareholder, the impact on the price per share will differ.
• A dividend results in a lower share price, as the number of shares remain the same, but
a share repurchase is unlikely to affect the individual share price, only the number of
shares in issue.
• A one-off dividend has the advantage of the certainty of an ultimate payout, but a share
repurchase has the following advantages:
- Investors can choose whether or not to sell their stock back.
- It avoids the risk of a false dividend signal: after a one-off large dividend, the
shareholders may be disappointed when the higher level of dividend is not maintained
in the future.

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4. The impact of scrip dividends and share repurchase on

financial ratios

Impact of scrip dividend

• Nil on shareholder wealth
• More shares in issue, but the overall shareholder value stays the same, so the share price
decreases
Impact on the entity’s performance measures/ratios:
• Total shareholder equity (in the statement of financial position) remains the same
• It does not change the capital structure and gearing ratios because the equity value stays
the same

Impact of share repurchase

• The impact of share repurchase on shareholder wealth is the same as the impact of the
cash dividend being paid.
• The impact of a share repurchase on the entity’s performance measures/ratios is different
from the impact of a cash dividend. After a share repurchase, there will be fewer shares
in issue, so the earnings per share of the entity will increase.

5. Chapter summary

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