THEORIES OF DIVIDEND POLICY

Definition:
• Dividend policy is A firm's decisions on how to
distribute (or not distribute) their earnings to
their shareholders.
• In other words, it is a company's stance on
whether it will pay out profits as dividends or
keep them as retained earnings.
• If the company decides to issue dividends, the
policy will outline whether or not the dividends
will be issued on an ongoing basis, or if the
dividend payout will be infrequent.
 Why is it important?
• Dividend policy is concerned with financial policies
regarding paying cash dividend in the present or paying
an increased dividend at a later stage.
• Whether to issue dividends and what amount, is
determined mainly on the basis of the company's
inappropriate profit (excess cash) and influenced by
the company's long-term earning power.
• When cash surplus exists and is not needed by the
firm, then management is expected to pay out some or
all of those surplus earnings in the form of cash
dividends or to repurchase the company's stock
through a share buyback program.
Dividend Theories Outline
 Dividend Irrelevance Theory
• Much like their work on the capital-structure
irrelevance proposition, Modigliani and Miller also
theorized that, with no taxes or bankruptcy costs,
dividend policy is also irrelevant.
• This is known as the "dividend-irrelevance theory",
indicating that there is no effect from dividends on a
company's capital structure or stock price.
Cont...
• MM's dividend-irrelevance theory says that investors
can affect their return on a stock regardless of the
stock's dividend.
• For example, suppose, from an investor's
perspective, that a company's dividend is too big.
• That investor could then buy more stock with the
dividend that is over the investor's expectations.
Cont...

• Likewise, if, from an investor's perspective, a

company's dividend is too small, an investor could
sell some of the company's stock to replicate the
cash flow he or she expected.
• As such, the dividend is irrelevant to investors,
meaning investors care little about a company's
dividend policy since they can simulate their own.
Cont...

• Modigliani and Miller's dividend irrelevance theory

argues that the value of a company is determined by
the NPV of the investments undertaken by the
company, and not by any distribution policy.
• MM showed that changes in the value of a firm's
shares are not dependent on the actual pattern of
dividends paid (you do not need to know the
workings of proof for this theory).
Cont...
• They argue that if a company issues a dividend from
retained earnings, and then needs to raise cash for
an investment, the loss on shares of the additional
finance is exactly equal to the dividend paid, and a
company should therefore be indifferent as to its
dividend policy.
• Moreover, whilst accepting the existence of the
clientele effect, MM state that the type of clientele a
firm has will have no effect on a firm's value.
 Assumptions
• This argument assumes perfect capital markets and
rational investors, and these assumptions are the
basis of the criticisms of MM's model:
• (a) It assumes that share issue costs are zero, and
ignores the potential problems of capital rationing.
Cont...
• (b) There is no taxation. In reality:
• The timings of Tax payments discourage high dividend
payouts by companies.
• Taxpayers may have a slight preference for capital gains.
• Some taxpayers will be indifferent between capital gains
and dividends.
• (c)Shareholders receive all relevant information about
the company's reinvestment plans.
• This ignores competition and different perceptions of
risk.
 Relavance Theories
• According to relevance theory dividend
decisions affects value of firm thus it is called
relevance theory.
• Walter’s Model
• Gordon’s Model
Cont...
This model is based on
• 1.Return on investment OR Internal rate of return
• 2.Cost of Capital OR Required rate of return

The model divides the firm into three groups.

• 1.Growth firms
• 2.Normal firms
• 3.Declining firms
 Assumptions
• 1.Internal Financing: the firm finances all its investments through
retained earnings; debt or new equity is not issued.
• 2.Constant return and cost of capital: the firms’ rate of return (r)
and its cost of capital (k) are constant.
• 3.100% payout or retention: all earnings are either distributed as
dividends or reinvested internally immediately
• 4.Constant EPS and DPS: beginning earnings and dividends never
change. The values of the EPS and DPS may be changed in the
model to determine results but are assumed to remain unchanged
in determining a given value.
• 5.Infinite time: the firm has a very long or infinite life.
Three Scenarios and Dividend Decision
• 1.Growth firm: there are several investment opportunities
(r>k) and the firm can reinvest earnings at a higher rate r
than that which is expected by shareholders (k). Thus they
will maximize value per share if they reinvest all earnings.
• 2.Normal firm; There aren’t any investments available for
the firm that are yielding higher rates of return (r=k) thus
the dividend policy has no effect on market price.
• 3.Declining firm: There aren’t any profitable investments
for the firm to reinvest its earnings, i.e. any investments
would earn the firm a rate less than its cost of capital (r<k).
The firm will therefore maximize its value per share if it
pays out all its earnings as dividend.
 GORDON’S MODEL
According to this model a firm share price is dependent on
dividend payout ratio.

ASSUMPTION:
• 1.The firm is all equity firm.
• 2.All investment projects are financed by exclusively
retained earnings
• 3.The rate of return firms is constant
• 4.The cost of capital remains constant
• 5.The firm has perpetual life
• 6.There are no corporate taxes.
 Conclusion of Gorden's Model
• The conclusion of Gordon’s model are similar to
Walter’s model due to the fact that their sets of
assumptions are similar.
• The market value of P0 increases with retention
ration b, for firms with growth opportunities, i.e.
when r>k.
• The market value of the share P0 increases with
payout ratio (1-b), for declining firms with r<k
• The market value is not affected by the dividend
policy where r =k
 Bird-in-the-Hand Theory
• The bird-in-the-hand theory, however, states that
dividends are relevant.
• Remember that total return (k) is equal to dividend
yield plus capital gains.
• Myron Gordon and John Lintner (Gordon/Litner) took
this equation and assumed that k would decrease as a
company's payout increased.
• As such, as a company increases its payout ratio,
investors become concerned that the company's future
capital gains will dissipate since the retained earnings
that the company reinvests into the business will be
less.
Cont...

• Gordon and Lintner argued that investors

value dividends more than capital gains when
making decisions related to stocks.
• The bird-in-the-hand may sound familiar as it
is taken from an old saying: "a bird in the hand
is worth two in the bush."
• In this theory "the bird in the hand' is referring
to dividends and "the bush" is referring to
capital gains.
 Signalling Theory
• The Concept reflects that in an efficient market
management can use dividend payment to signal
important information to the market which is only
known to them.
• If the management increases the dividend it signals
expected high profit and therefore stock prices will
increase.
• Investors can also infer information about the firm's
future earnings through the signal coming from the
dividend announcments
 Agency Cost Theory

• It claims that the payment of dividends is one of the

measures available to managers for controlling agency
behavior.
• It suggests that dividend policy is determined by
agency costs arising from the divergence of ownership
and control.
• Managers may not always adopt a dividend policy that
is value maximizing for shareholders but would choose
a dividend policy that maximized their own private
benefits.
• Making dividend payouts which reduces the free cash
flows available to the managers would thus ensure that
managers would thus ensure that manager maximize
shareholders wealth rather than using the funds for
their private benefit.
 Tax-Preference Theory
• Taxes are important considerations for investors.
Remember capital gains are taxed at a lower rate than
dividends. As such, investors may prefer capital gains to
dividends. This is known as the "tax Preference theory".
• Additionally, capital gains are not paid until an investment
is actually sold. Investors can control when capital gains are
realized, but, they can't control dividend payments, over
which the related company has control.
• Capital gains are also not realized in an estate situation. For
example, suppose an investor purchased a stock in a
company 50 years ago. The investor held the stock until his
or her death, when it is passed on to an heir. That heir does
not have to pay taxes on that stock's appreciation.
 The Dividend-Irrelevance Theory and
Company Valuation
• In the determination of the value of a
company, dividends is often used. However,
MM's dividend-irrelevance theory indicates
that there is no effect from dividends on a
company's capital structure or stock price.
• MM's dividend-irrelevance theory says that
investors can affect their return on a stock
regardless of the stock's dividend.
Cont...
• For example, suppose, from an investor's perspective,
that a company's dividend is too big.
• That investor
• could then buy more stock with the dividend that is
over his or her expectations. Likewise, if, from an
• investor's perspective, a company's dividend is too
small, an investor could sell some of the company's
• stock to replicate the cash flow he or she expected. As
such, the dividend is irrelevant to investors,
• meaning investors care little about a company's
dividend policy since they can simulate their own.
 The Principal Conclusion for Dividend
Policy
• The dividend-irrelevance theory, recall, with
no taxes or bankruptcy costs, assumes that a
company‘s dividend policy is irrelevant.
• The dividend-irrelevance theory indicates that
there is no effect from dividends on a
company's capital structure or stock price.
Cont...
• MM's dividend-irrelevance theory assumes
that investors can affect their return on a
stock regardless of the stock's dividend.
• As such, the dividend is irrelevant to an
investor, meaning investors care little about a
company's dividend policy when making their
purchasing decision since they can simulate
their own dividend policy.
 How Any Shareholder Can Construct
His or Her Own Dividend Policy?
• Recall that the MM's dividend-irrelevance theory says that
investors can affect their return on a stock regardless of the
stock's dividend. As a result, a stockholder can construct his
or her own dividend policy.
• Suppose, from an investor's perspective, that a company's
dividend is too big. That investor could then buy more stock
with the dividend that is over the investor's expectations.
• Likewise, if, from an investor's perspective, a company‘s
dividend is too small, an investor can sell some of the
company's stock to replicate the cash flow the investor
expected.
 Fundamental Theory of Share Values
• This model, also known as the traditional model, states
that the level of dividends paid is Important.
• The fundamental theory of share values (which
assumes that the market value of the company
depends on the size and growth rate of dividends paid,
and the rate of return required by shareholders) values
the company using the dividend growth model.
• The implications of this theory are that shareholders
will want management to pursue a
distribution/retention policy which will maximize the
level of, and growth in, dividends.
 Clientele Effect
• There may not, however, be an optimal
distribution/retention policy that the firm can adopt to
meet the needs of all shareholders, because of the
different taxes (capital gains and income tax) and tax
rates borne by different investors.
• A company should choose and maintain one policy
which maximises one group of shareholders' wealth.
Shareholders will then migrate to companies which
operate a policy in line with their needs - this is known
as the clientele effect.
 Cont...
• The changes in the treatment of tax credits in the 1997
Budget has had a major impact on the preferred dividend
policy of pension funds.
• Until then, pension funds were able to claim back tax
credits on dividends received. As a result of the Budget
changes, dividend yield will reduce in significance, as will
the preference for dividends over capital gains by this
particular clientele.
• Ten years on from the 1997 budget, these changes to the
tax treatment of dividends have been shown to have had a
major impact on pension fund valuations and one of the
main reasons for the stopping, in large numbers, of
company "final salary" pension schemes.
Practical aspects of dividend policy
• In practice a company must consider several
factors when determining its dividend policy.
Note that it is the directors who determine
dividend policy.
• It has to match its dividend policy to its clientele,
to prevent a mass buying and selling of its shares.
• If a company faces a takeover, management
might declare an increased dividend as a defense.
Contt...
• The market might perceive the increased
dividend as a sign of improved future profitability
of the company and its share price will rise.
• This makes it more expensive for any potential
takeover bid. In 1996 National Power paid a
special dividend of £1 per share.
• At the time the company was subject to a hostile
takeover bid from a US electricity company.
Cont...
• High dividend payouts reduce the risk that
shareholders may lose all their investment.
• Dividends act as a signal to indicate the future
prospects of the company - a sudden cut in
dividends indicates that the company is
experiencing difficulties, and vice versa for an
increase in dividends.
• The market expects companies in general to
follow industry practice.
 Cont...
• The company should finance as much investment
as possible using retained earnings, to avoid
finance issue costs, and an issue of equity capital
may have an impact on the status quo of
shareholding control and may leave the company
open to a takeover bid.
• The necessity for companies to repatriate
overseas profits.
• The level of profits made and the legal position
regarding the payment of dividends in its country
(or countries) of operation.
What Percentage Dividend Payment to
Make?
• There are a number of different payment options that
a company might consider in the payment of dividend.
• A company may pay a constant and fixed percentage of
profits in dividend payments. Such a constant payment
percentage sends out a clear message to shareholders
about the expected level of performance and it is also
relatively easy and clear to operate.
• One of the main problems with this approach, though,
is that the company may reduce its ability to fund
much needed investment and have to go to the
financial markets when it would perhaps have
preferred to use retained profits.
Cont...
• A company may decide to offer no, or zero,
dividends at all.
• Given that most shareholders would expect a
return on their investment (and this would
certainly include all the major pension funds),
then this approach is unlikely to be popular
and in the long term would not be in the best
interests of the company.
Cont...
• Some companies like, if possible, to pay an increasing
dividend year on year.
• This is good for shareholders generally and should attract
more shareholders (with some subsequent possible effect
on share price).
• It is possible, though, that if a company tries to do this year
on year, it is likely to have a negative impact at some stage
on the company's ability to fund much needed investment.
• It is also likely that if, for good reasons, the company
needed to reduce the rate of dividend, this would have an
adverse effect on the attitudes of both shareholders and
the market generally.
 Approaches to the Level of Dividend
• Three approaches may be identified.
• (a) Dividend covers
• This is the earnings per share divided by the net dividend
per share.
• This indicates the number of times the same dividend could
have been paid on the shares from the current year's
earnings alone.
• One dividend policy is to pay out a fixed dividend per share
each and every year, which could be fixed in either real or
money terms. This is the most common policy, with most
companies going for stable, slightly rising dividends per
share - the "ratchet" dividend policy.
Cont...
• (b)The pay-out ratio
• Pay-out ratio is the relation of dividends paid to ordinary
shareholders to the earnings available to be paid out to
ordinary shareholders. As such, it includes previous
cumulative earnings.
• Another dividend policy is to maintain a constant pay-out
ratio. Naturally the dividend will fluctuate each year
depending on the level of retained earnings and any
movements in reserves.
• This policy is quite rate in listed companies, though many
firms may work towards some notional target pay-out
ratio.
Cont...
• (c)Residualvalue
• A third, less common, dividend policy is to use
retained earnings to fund all projects which show a
positive net present value (NPV) at the firm's
weighted average cost of capital (WACC) and pay out
any remaining funds as dividends.
• This is possibly the most objective dividend policy for
rational investors but the concerns of "signalling"
(see above) often overrule such a common sense
approach.
 TITLE AUTHOR YEAR DATA MODEL RESULTS THEORY
Results suggest that the

Reaction of Stock
Prices to Dividend M AKBAR
79 COMPANIES
LISTED ON KSE
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stock prices to cash
dividends announcements
are insignificant, for stock
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Impact of dividend companies listed
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announcement
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signaling affect prevails in
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organizational stability and
approach Banda 2004 to 2013 regression model
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Bank Dividend Policy Safdar Husain
BANKS listed on Findings reveal that the
and Investment Tahir,
stock impact of investment
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5 2015 exchange/data decisions on the firms Balancing Theory
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taken from 2004 financing decisions depend
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to 2010 on the risk level
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of listed Banks in Kenya Mungami
Dividend pay out policy
and firm financial Kajola,
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from Nigerian listed Adewumi
non financial firms
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kenya from 2006 to Test/Regression N/A
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structure, corporate earnings
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value
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negative and statistically
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with Stock market prices
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panel regression banks pay higher
models was amount of dividends and
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Nadeem
Protection, Creditor 201 5918 banks from 52 the impact of dividends in strong
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Dividend Policies period 1998-2007 of shareholders protection countries.
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amounts. dividend pay out is low.
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THANK YOU