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CHAPTER 9:

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:

1. How much to pay

It encompasses the 4 major alternative dividend policies.


a) Constant pay out ratio

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

The dividend per share is fixed in amount irrespective of the earnings


level. This creates uncertainty and is thus preferred by shareholders who
have a reliance on dividend income. It protects the firm from periods of
low earnings by fixing dividends per share at a low level. Thus policy
treats all shareholders like preference shareholders by giving a fixed
return. Dividend per share could be increased to a higher level if
earnings appear relatively permanent and sustainable.
c) Constant amount plus extra

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

Dividends can either be interim or final.


Interim dividends are paid in the middle of the financial year and are paid in cash.
Final dividends are paid at the year end and can be and can be in cash and stock form
(bonus issue).
3. Why pay

a) Residue dividend theory

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 .]

Advantages of residual theory


1. Savings on floatation costs .

2. There is no need to raise debt or equity capital since there is a high retention of
earnings which require no floatation costs.

3. Avoidance of dilution of ownership. A new equity issue will dilute ownership


and control. This will be avoided if retention is high.

4. Tax position of shareholders. High income shareholders prefer low dividends


to reduce their tax burden from dividend income. They prefer high retention of
earnings which are reinvested. This increase the share value and they make
capital gains which are not taxable.

b) MM dividends irrelevance theory.

This was proposed by Modigliani and Muller .This theory asserts


that a firms divided policy has no effect on its market value and cost
of capital .They argued that the firm value is primarily determined
by .
i. Ability to generate earnings from investments .

ii. Level of business andfinancial risk .

According to MM dividend policy is a passive residue


determined by the firms needs for investment funds.It does
not matter how earnings are divided between divided and
retention therefor divided policy does not exist . When
investment decisions are made dvident decision is a mere
detail without any effect on the value opf the firm
C)

The main dividend theories are:


i. Residual dividend theory

ii. MM dividend irrelevance theory

iii. Bird in hand theory

iv. Information signaling effect theory

v. Tax differential theory

vi. Clientele effect theory

vii. Agency theory

4. How to pay dividends/ mode of paying dividends

a) Cash or Bonus issue


Ideally, a firm should pay cash dividends, for such a company it must ensure that
it that it has enough liquid funds to make payment . Under conditions of liquidity
and financial constraints , a firm can pay stock dividends (bonus issue ) Bonus issue
involves an issue of additional shares in addition to or instead of cadsh to the
exixsting shareholders prorate to their share holding in the company. Astock
dividend / bonus issue involves capitalization of retaoined earnings therefore does
not increasew the wealth of the shareholders. This is because retained earnings is
converted into share capital.

Adnvantages of a bonus issue


i. To indicaes that the foirm plans to retain a portion of earnings permanenbtly
in the business.

ii. To continue dividend distribution s without disbursing cash needed for


operation.

iii. T o increase the trading of shares in the market.

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.

v. Indication of higher profits in the future of the company. A bonus issue is


an inefficient market survey b importsant information that the firm expects
high profits in future to offset additional outstanding share so that the
earnings per share is not diluted.

b) Stock Splits and reverse split.

A stock split is a change in the number of shares outstanding accompanied by an


offsetting change in the par or stated value per share.
The primary purpose of a stock split is to increase the market activity of the stock.
Example
A company has 1000 ordinary shares of sh.20 each and a share split has been
announced of 1:4. The effects on ordinary share capital is a s follows;
New par value = 20/4
=sh.5
Ordinary shares outstanding = 1000×4
=4000
The ordinary share capital remains the same(4000×5=sh. 20,000)

A reverse split is the opposite of a stock split as it involves consolidation of shares


into bigger units thereby increasing the par value of the shares .It is meant to attract
high income clientel.
Example
In the case of 20,000 shares at sh.20 par value, they can be considered into 10,000
shares at par value of sh.40 par value.
Example
Company Z has the following capital structure,
sh.000
Ordinary shares (Sh.20
par) 8000
Share premium 3600
Retained earnings 2400
14000
The company shares have been selling in the market for sh.60. The management
has declared a share split of 4 share for every one share held. Assume that the
shares are expected to sell at sh17 after the stock split.

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

New par value 20/4 sh.5

Capital structure sh.000


Ordinary shares (Sh.5 par) 8,000
Share premium 3,600
Retained earnings 2,400
14,000

ii)
sh.000
Shares before split 40,000×60 2400
Share after split 40,000×4×17 2750

Capital gain 2750 -2400 320

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.

1. Utilization of idle funds.


Companies which have accumulated cash ba,lance s in excess of future investments
might find a share re-invest\ment scheme a fair mewthod of returning cash to
sshareholders .Continuing to csrry excess cash may prompt managementto invest
unwiselyas a meanssof using excess cash e.g. a firm may invest in a tendency for more
mature firms to continue in investment plans even when the expected return is lower
than the cost of capital.
2. Enhanced dividends and EPS.

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.

Companies that undertake a stock repurchase experience an increase in the market


price of the share.
4. Capital structure.

A company’s managers may use a shae buy-back or repurchase as a meansof


correctingwhat they perceive to be an unbalanced capital structure .If shares are
repurchased from cash reserves, equity would be reduced and gearing increased ,
assuming debt exists in the capital structureal termnatively , a company may raise debt
to finance a repurchase . Replacing equity with debt can reduce the overall cost of
capital.
5. Reducing take over threat.

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.

Disadvantages of a stock repurchase.


1. High price.
A company may find it difficult to repurchase\se at thei current value or the
price pid maybe too high to the detriment of the remaining shareholders.
2. Market signaling.

Despite directors efforts at trying to convince markets otherwise, a share


repurchase may be taken as a signal that the company lacks suitable investment
opportunities .This may bre interpreted as a sign of management failure.
3. Loss of investment income.

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.

2. Profitability and liquidity.


A company’s capacity to pay dividends will be determined primarily by it’s ability to
generate adequate and stable profits and cashflows. If the company has liquidity
problems ,it may be unable to pay cash dividends and resort to paying stock dividends.

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.

4. Tax position of share holder


Dividend payment is influenced by the tax regime of a country e.g. in Kenya cash dividends
are taxed at source, while capital gains are tax exempt. The effect of tax differential is to
discourage shareholders from wanting high dividends.

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.

8. Owners hip structure.

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.

9. Access to capital markets.

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.

10. Shareholders expectation.


Shareholder s that have become accustomed to receiving stable and increasing dividends will
expect a similar pattern to continue in to the future .Any sudden reduction or reversal of such
a policy is likely to dissatisfy shareholders and the results in falling share prices.

11. Contractual obligations on debt covenants.

This limits the flexibility and amount of dividends to pay e.g. the cashflow based covenants.

Important ratios on dividends.

Dividend pay-out ratio.

This ratio reflects a company's dividend policy. It indicates the proportion of


earnings per share paid out to ordinary shareholders as divided. It is computed as
follows:

Dividend pay-out ratio = Dividends per ordinary share / Earnings per share

Where ordinary dividends per share = Ordinary dividends/ Number of ordinary shares

Dividend Yield Ratio

This shows the dividend return being provided by the share. It is given by

Dividend yield = Dividends per share / Market price per share

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