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DIVIDEND POLICY
Dividend policy determines the division of earnings between payment to shareholders and
reinvestment in the firm. It therefore involves the following four aspects:
This is where the firm will pay a fixed dividend rate e.g. 40%of
earnings. Dividends will therefore fluctuate as the earnings change.
Dividends are therefore directly dependant on the firms earning ability.
If no profits are made, no dividends are paid. The policy creates
uncertainty in ordinary shareholders especially those who depend on
dividend income thus they may demand a higher required rate of return.
b) Constant amount per share/fixed dividend per share
Here, a constant dividend per share is paid every year. However, extra
dividends are paid in years of supernormal earnings. This policy gives
firms the flexibility to increase dividends when earnings are high and
shareholders are given a chance to participate in the supernormal profits
of the firm. The extra dividends are given in such a way that it is not
seen as a commitment to continue the extra in the future. It is applied
by firms whose earnings are highly volatile e.g. the agricultural sector.
d) Residual amount
Under this policy, dividend is paid out of earnings left over after
investment decisions have been financed. Dividends will therefore only
be paid if there are no profitable investment opportunities available.
This policy is consistent with shareholders wealth maximization.
2. When to pay
Under this theory, a firm will pay dividends from residue earnings
ie. Earnings remaining after all suitable projects with a positive
NPV have been financed. It assumes that retained earnings is the
best source of long term capital since it is readily available and
cheap. This is because no floatation costs are involved in the use of
retained earnings to finance new investments therefore the first
claim on profit after tax and preference dividend. There will be a
reserve for financing investments. Dividend policy is therefore
irrelevant and treated as a passive variable. It will hence not affect
the value of the firm. However the investment decision will .]
2. There is no need to raise debt or equity capital since there is a high retention of
earnings which require no floatation costs.
iv. Tax advantage. Shareholders can sale the new shares to generatae cash in
the form of capital gains which are tax exempt unlike cash dividends
whiccjh attract a 5% withholding tax which is final.
Required,
i. Prepare the capital structure of the company after the company’s stock split.
ii. Compute the capital gain for a shareholder who held 40,000 shares before
the split.
Solution
i)
shares
Number of shares before
split sh.8000,000÷20 400,000
Number of shares after split 400,000×4 1,600,000
ii)
sh.000
Shares before split 40,000×60 2400
Share after split 40,000×4×17 2750
c) Stocks repurchase.
The company can also buy back some of its outstanding shares instead of paying
cash dividends. This is known as a stocks repurchase and the share bought back are
known as treasury stock.If some outstanding shares are repurchased , fewer share s
would remain outstanding .Assuming a repurchase does not adversely affect the
firm’s earnings , EPS would increase .This would result in an increase in the market
price per share so that a capital gain is substituted for dividends.
Advantages of stock repurchase.
Following a stock repurchase, the numer of shares issued would decrease therefore in
ni\ormal circumstances , both DPS and EPS would increase in future . However the
increase in EPS is a book-keeping increase since total earnings remain constant.
3. Enhanced share price.
A share repurchase reduces the number of shares in operation and also the number of
weak shareholders i.e. shareholders with no strong loyalty to the company since a
repurchase would induce them to sell .Ths helps to reduce the threat of as host\ile take
over as it makes it difficultfor a predator company to gain control .This is also refered
to as a poison pill i.e. a company’s value is reduced because of huge cash outflow or
borrowing huge long-term dept to increase gearing.
The interest that could have been earned from investment of excess cash is lost.
Factors that would affect dividend policy.
1. Legal rules:
a. Net profit rule- This states that the dividends may be paid from company profits,
either past or present.
b. Capital impairment rule- This prohibits payment of dividends from capital i.e.
from the sale of assets. This would be liquidating the firm.
c. Insolvency rule- This prohibits payment of dividends when a company is
insolvent .An insolvent company is one where assets are less than liabilities .In
such a case all earnings and assets belong to debt holders and no dividends are
paid.
3. Investment opportunity.
Lack of appropriate investment opportunities i.e. those with positive returns may encourage
a firm to increase its dividend distribution. If a firm has many investments opportunities it
will pay low dividends and have high retention.
5. Capital structure.
A company’s management may wish to achieve or restore an optimal capital structure. E.g.
If they consider gearing to be too high they may pay low dividends and allow reserves to
accumulate until a more optimal capital structure is achieved or restored.
6. Industrial practice
Companies will be resistant to deviate from accepted dividend or payment norms in the
industry.
7.Growth stage.
Dividend policy is likely to be influenced by the firms growth stage, e.g. a young rapidly
growing firm is likely to have high demand for developing funds therefore may pay low
dividends or differ dividend payment till the company reaches maturity. It will therefore
retain high amounts.
A dividend policy may be driven by the ownership structure in affirm e.g. in small firms where
the owners and managers are the same, dividend pay out is usually low. However, in large
quoted public companies, dividends are significant since the owners are not the managers. The
value and preferences of a small group of owner managers would exert more direct influence
on the dividend policy.
Large well established firms have access to capital markets hence can get funds easily. They
therefore pay high dividends unlike small firms which pay low dividends due to the limited
borrowing capacity.
This limits the flexibility and amount of dividends to pay e.g. the cashflow based covenants.
Dividend pay-out ratio = Dividends per ordinary share / Earnings per share
Where ordinary dividends per share = Ordinary dividends/ Number of ordinary shares
This shows the dividend return being provided by the share. It is given by