DIVIDEND THEORIES AND DIVIDEND POLICIES

Dividend policy is the policy used by a company to decide how much it will pay out to shareholders in dividends. Part of the profits are kept in the company as retained earnings and the other part is distributed as dividends to shareholders.
From the share valuation model, the value of a share depends very much on the amount of dividend distributed to shareholders. Dividends are usually distributed in the form of cash (cash dividends) or shares (share dividends). When a company distributes a cash dividend, it must have sufficient cash to do so. This creates a cash flow issue. Profit generated may not be in the form of cash. A company may have profit of $450 million but the cash only increased by $190 million in a financial year. This is a concern to the management as insufficient cash may mean the company is unable to distribute a dividend. Investors earn returns from their shares in the form of capital gains and dividend yield. Dividend yield is an important ratio in evaluating investment. The ratio of the actual distribution or dividend, and the total distributable profits, is called dividend payout ratio.

There are other factors in addition to profit and cash flow that may influence the dividend payout ratio.

a)      In some countries, dividends are taxable. The higher the dividend, the higher the tax an investor needs to pay. In such cases, high dividends are not desirable. In Kenya dividends are taxed at 15% being final tax.

b)      If a company is expanding, it needs to keep sufficient cash for its plans rather than having to go to the equity or debt market to raise additional finance.

c)      Government policies may require companies to distribute a certain minimum percentage of profit to shareholders. This would be necessary for government to earn money through divided withholding tax.

Dividend policy is based on the answers to several important questions.

a)      How much dividend should a company distribute to shareholders?

b)      What will the impact of the dividend policy be on the company’s share price?

c)      What will happen if the amount of dividend changes from year to year?

Common dividend policies are:

a)      Stable dividend policy or fixed dividend per share

b)      constant payout ratio

c)      residual dividend policy and

d)      low constant dividend per share plus surplus or bonus

Let us look at each of these policies in details

a)      Stable/Fixed dividend per share

In the stable dividend policy, management maintains a fixed dividend per share each year. The impact on share pricing can be seen from the share valuation formula P0 = D1/(r-g) where P0 is the current price, D1 is the dividend in the coming year, r is the required equity return and g is the dividend growth rate. If there is no growth in dividend, g=0, and P0 = D1/r. After one year P1 = D1/r but D1 = D2. Thus P1 = P2 and there is no growth in the share price.

Here, the company pays a fixed amount of dividend per share irrespective of earnings made during the year. In this case, the shareholders are treated as if they were preference shareholders. Because of the stability of dividend per share, the share price increases.

This policy is appropriate when the company is making constant or growing profits and cash flow of the company is strong.

b)     Constant payout ratio

In the constant payout ratio situation, management maintains a fixed percentage dividend payout ratio irrespective of profits made during the year. For example if a company payout ratio is 80% it means that, it distributes 80% of its earnings as dividends. Since the earnings of the company fluctuate over time, the dividend per share is also expected to fluctuate over time. Due to this uncertainty in dividends per share, the share price also fluctuates over time.

This policy is necessary  when the company want to maintain a constant part of the earnings for more investment and growing the company.

c)      Residual dividend policy

In a residual dividend policy, profits are used to fund new projects with the residual or remaining profit distributed as dividends. If a company has a profit of $100 million and is going to fund a new development project costing $60 million, the remaining $40 million will be distributed as dividends. Dividends are only paid when earnings are not exhausted by the company financial requirements and there are no profitable investment projects to invest in.

This is policy is necessary when the company wants to invest more in order to grow future profits.

d)     Low constant  dividend per share plus surplus or bonus

Dividend per share is set at very low level and is paid for each period. Extra dividend will be paid during periods of high earnings. This extra dividend is paid in such a away that is not seen as commitment on the part of the company to continue paying the extra dividend in the future.

This is necessary when the company’s profits fluctuate to a large extent.

Investors prefer steady growth of dividends each year and avoid investment to companies with fluctuating dividend policy. Some companies reduced their dividends during weak economic times but others are still able to maintain the same dividend per share. Dividend theory includes an argument called dividend irrelevance which was proposed by two Noble Laureates, Modigliani and Miller. They argued that if a company distributed high dividends now it may reduce its dividends later and thus the total effect is zero in time value. For example, a company may distribute a dividend of $1.1 per share and investors may expect it can maintain this payment for some time. Eventually the company reduces its dividend to $0.89 per share and the ultimate time value result is the same.

A sudden increase in dividend may not be a good sign. In an efficient market, investors are able to distinguish between a genuine dividend increase and an artificial dividend increase. Companies try to maintain a stable dividend because if they reduce their dividend payments, investors may suspect that company has cash flow problem. A company must not cut a positive NPV project by paying dividends. Otherwise, dividends cannot be maintained. It must not reduce its dividend as this may imply there are cash flow problems. A company should try to pay dividends but at the same time maintain sufficient retained earnings to avoid having to raise new finance. A company must never allow the distribution of high dividend to be funded by borrowing money and worsening its debt-equity ratio. Finally, the company should set a target dividend payout ratio which is constructive but which also depends on the stability and prospects of the business.

The big question is why a firm should pay dividends. This can be answered be answered by the various dividend theories which attempt to explain whether payment of dividends affect the value of the firm. These theories include:

a)      The agency theory

b)      The bird in hand theoryModel

c)      James walter

d)      The information signaling theory

e)      The clientele effect theory and

f)        Modigliani and Miller approach

Explained under:

a)      The agency theory

Agency costs are differences between the interests of stockholders and the interests of management. Higher dividend payments are argued to require more acquisition of external capital and subject management to greater scrutiny by the market, reducing agency costs. This however exposes the firm to high risk due to borrowing. The management therefore need engage in activities that will maximize the shareholders wealth and make full disclosures of their activities to the providers of funds. The theory concludes that dividends are relevant since they affect the value of the firm

b)     James Walter Model

This is similar to Gordon’s dividend valuation model which is given by:

P_{0 =} D₁

      K_e-g where P0 is current price per share, D₁ dividend per share and _g is expected growth rate

James Walter model is given by:

P0 = D + r/x [E-D]

              x

Where E is Earnings per share, r is return on investment and x is market capitalization rate.

According to Walter, the optimal dividend is determined by changing the dividend per share until market price per share is maximized. Walter concludes as follows:

i)        Optimal dividend payout ratio will be equal to 0% if return on investment is greater than market capitalization rate i.e. r>x

ii)       The optimal dividend payout ratio will be 100% if return on investment is less than market capitalization i.e. r<x

iii)     If return on investment = market capitalization rate i.e. r=x, then the share price will be insensitive to dividend  payout ratio

The model generally implies that the optimal dividend payout ratio should be determined mainly by the profitability of investment available.

c)      The bird in hand theory.

This theory was developed by Myron Gordon and John Litner. It is based on certainty of income obtained from shares in form of dividends and capital gains. The theory argues that if dividend are not paid then they are used to finance profitable projects  which will lead to an increase in share price thus the realization of capital gains in the future instead of the immediate dividends. The theory implies the following:

i)        All investors are risk averse; they prefer certainty of income

ii)       Dividend income is immediate and more certain (a bird in hand) compared to capital gains which are uncertain and will be received in the future (two birds in the bush).

iii)     Given that investors prefer income certainty, a  company that pays dividend will have a higher value compared to another company of similar nature that does not pay dividends.

d)     Information signaling theory

This theory was developed by Stephen Ross in 1977. He argued that if stock markets stock are efficient then the management can use the dividend policy to signal some important information to investors. Therefore, if a company pays high dividends, it shows that the company is profitable and will be able to maintain high dividends in the future. Most theoretical models assume that information is freely available to all. It has been suggested that in reality access to information varies. Management may have access to inside information, causing an "information asymmetry" between management and stockholders. Signaling refers to the use of dividends and dividend changes to convey information to investors. Similar to the clientele effect, it is not the absolute but rather the relative level of dividends that is important. Under this argument, management will avoid increasing dividends unless it is highly likely that the higher level of dividends can be maintained. This implies that a dividend increase is a signal that the firm has reached a new level of profitability, and is a positive signal. A dividend decrease, on the other hand, indicates that profitability has decreased and the former dividend level cannot be supported, a negative signal. Note that under the residual argument, however, a dividend increase (decrease) signals a lack (abundance) of attractive projects and decreased (increased) future firm growth. Because of the potential for false signals, more costly signaling is considered more reliable.

This will lead to increase in the value of the firm. The theory confirms that dividend policy is relevant since it affects the value of the firm.

e)     The clientele effect theory

The clientele effect indicates that investors will tend to hold stocks whose dividend policy fits their needs. That is, investors preferring more certain dividends over uncertain future earnings, or having a preference for current income over capital gains, will tend to hold stocks with relatively high dividend payout, and vice versa (i.e., a stock will have a clientele attracted by its dividend policy). Under these conditions, it is not the dividend policy itself that is relevant, but the stability of the policy. The theory was developed by Richard Petit in 1977.

The theory concludes that:

i)        A group of shareholders with high income will prefer low or no dividends to reduce tax burden. They therefore prefer high capital gains that come in the future.

ii)       Low income shareholders will prefer high dividends in order to supplement their low income. They will therefore shift from low dividend company to high dividend company.

iii)     As investors shift from one company to another in search of companies with dividend policies of their choice, the market price of shares will change due to demand and supply in the market. However, at equilibrium, the dividend policy will be irrelevant since it will be consistent with the requirement of the shareholders.

                                       

a)      Modigliani and Miller (M&M) approach

Franco Modigliani was awarded Nobel prize in 1985 and Merton Miller in 1990 (along with Markowitz and Sharpe). M&M have theorised on the irrelevance of the capital structure, and a corollary, irrelevance of the dividend payout ratio to the value of the firm. Like several financial theories, M&M hypothesis is based on the argument of efficient capital markets. In addition, we believe that a firm has two options:

i)  It retains earnings and finances its new investment plans with such retained earnings;

ii) It distributes dividends, and finances its new investment plans by issuing new shares.

The intuitive background of the M&M approach is extremely simple, and in fact, almost self-explanatory.

It is based on the following propositions:

i)        Why would a company retain earnings? Only tenable reason is that the company has investment opportunities. If the company does not retain earnings, where would it finance investment opportunities from? We may assume a debt issuance, but then as M&M otherwise propounded irrelevance of the capital structure (I will write on M&M Capital Structure in another article), they see a parity between debt and equity, and hence, it does not make a difference whether the new investments are funded by equity or debt. So, let us assume that the new growth plans are funded by equity.

ii)       Shareholders price the equity shares of the company to take into account the earnings and the retentions of the company. If the company distributes dividends, the shareholders take into account that fact in pricing of the shares; if the company does not distribute dividends, that is also reflected in the pricing of the shares.

iii)     If dividends are distributed, the financing needs of the company will be funded by issuing new shares. The issue price of these shares will compensate for the fact that the dividends have been distributed. That is to say, the market price of the share will remain unaffected by whether the dividends have been distributed or not.

M & M criticized other theories as follows:

i)        Bird in hand theory – they argued that the required rate of return of shareholders is independent of the company dividend policy. They argued that if investors were indifferent between dividend income and capital gains, then this theory is irrelevant.

ii)       Information signaling theory –  M & M argued that the changes in price after announcement of dividends is due to information content of the dividend policy and not because of dividend policy itself. They concluded that the information provided in dividend policy could be obtained from other sources.

The nature of assumption of M & M dividend irrelevant theory includes:

i)        That there are not transaction cost associated with floatation of shares

ii)       There are no corporate and personal taxes

iii)     That the company investment policy is independent of its dividend policy

iv)     That the stock market are efficient

v)      There is no uncertainty in the market

Based on the above assumptions, M&M proved the dividend irrelevant theory as follows:

We use the following notations:

Po : Price of the equity share at point 0

P1 : Price of the equity share at point 1, that is, end of period 1

D1 : Dividend per share being paid in period 1

n : existing number of issued shares

m : new shares to be issued

I : Investment needs of the company in year 1

X : Profits of the firm year in 1

The relation between the price at the beginning of the year (Po), and that at the end of the year

(P1) is the simple question of discounted value at the shareholders’ expected rate of return (KE).

Hence,

Po = (P1 +D1) / (1+(KE) Equation (1)

Equation (1) is quite easy to understand. Shareholders have got a cash return equal to D1 at the end of Year 1, and the share is still worth P1. Hence, discounted at the cost of equity KE, the discounted value is the price at the beginning of the period. Alternatively, it may also be stated that the

P1 = (P0 ) (1+(KE) - D1 Equation (2)

That is to say, if the company declares dividends, the price at the end of year 1 comes down to the effect of the distribution.

Equation (1) can be manipulated multiplying both sides by n, and adding a self-cancelling number m, we may write Equation (3) as follows:

nPo = [(n+m)P1 -mP1 +nD1)]/(1+(KE) Equation (3)

Note that we have multiplied both sides by n, and the added number m along with m is cancelled by deducting the same outside the brackets. mP1 represents the new share capital raised by the company to finance its investment needs. How much share capital would the company need to raise? Given the investment needs I and profits X, the new capital issued will be given by the following:

mP1 = I – (X - nD1) Equation (4)

Again, this is not difficult to understand, as the total amount of profit of the company is X, and the total amount distributed as dividends is nD1. Hence, the company is left with a funding gap as shown by equation (4)

If the value of mP1 is substituted in Equation (3), we have the following:

nPo = [(n+m)P1 – {I – (X - nD1)}+nD1)]/(1+(KE) Equation (5)

As nD1 would cancel out, we will be left with the following:

nPo = [(n+m)P1 – I + X] /(1+(KE) Equation (6)

Since nPo is total value of the stock at point 0, it is seen from Equation (6) that dividend is not a factor in that valuation at all.

The above equations may be quite tricky for people with less or no knowledge of capital structure of the firm.

Look out for Capital Structure of The Firm in the next post

Godfrey Chege

Senior Accountant, Dreamcatcher Productions Limited

CPA, BBM (Moi University, Finance and Banking)