BBPW3203 FINANCIAL MANAGEMENT II - WordPress.comBBPW3203 FINANCIAL MANAGEMENT II. Content 4.1 FIRM’S DIVIDEND POLICY 4.2 TYPES OF DIVIDEND POLICIES 4.3 IMPACT OF DIVIDEND POLICY

Topic 4

Dividend Policy

February 2018

BBPW3203 FINANCIAL MANAGEMENT II

Content

4.1 FIRM’S DIVIDEND POLICY

4.2 TYPES OF DIVIDEND POLICIES

4.3 IMPACT OF DIVIDEND POLICY ON A FIRM’S VALUE

• A dividend is defined as the distribution of a firm’s income to its shareholders.

• Dividend policy determines what happens to the value of the firm as the dividend increases (decreases), holding everything else (capital budgeting and borrowing) constant.

• It is a trade-off between retained earnings on one hand and distributing cash to shareholders on the other.

• The amount of dividend payment structure is one of the fundamental decisions that financial managers make because it not only communicates to the market participants but also sends a signal about the prospects of the firm.


• The amount of dividend payment structure is one of the fundamental decisions that financial managers make because it not only communicates to the market participants but also sends a signal about the prospects of the firm.

• It has an important implication for the firm’s value and investment and borrowing decisions.

• Dividends are good pieces of financial system because of their role in determining the stock value.

• The value of the stock is the present value of expected future dividend.

• Therefore, any changes in dividend structure will have a significant impact on the firm’s value.


4.2.1 Constant Payout Ratio Policy

This type of payout policy is very rare among companies.


• This indicates the percentage of ringgit earned for each share that is distributed to shareholders.

• This policy helps firms to establish a certain percentage of earnings to be paid to owners in each dividend per share. However, if the firms’ report losses or earn less, the dividend may be lower or even omitted altogether for a certain period.





4.2.2 Constant Nominal Dividends (Regular Dividends)


• This type of policy postulates that a firm maintains a nominal amount (fixed

ringgit dividend) of dividend irrespective of a firm’s level of income.

• This is also called a regular dividend, which is a level that the board of directors

hopes to maintain in the future.

• However, regular dividend could be increased (decreased) if proven increases

(decreases) in earnings are reported.

• This type of dividend is much sought by investors as this gives a consistent kind

of income to shareholders, hence reducing the uncertainty of their dividend

income.

4.2.3 Special Dividends Payout Policy


• Firms sometimes issue extra or special dividends to their shareholders on certain occasions.

• This is done when the level of earnings are far better than expected in a given period; the firms may pay this additional income as a form of special dividends.

4.2.4 (a) Chronology of Dates of Dividend Payment

• Most firms follow a dividend declaration and payment procedure similar to the outline in Figure 4.1.






4.2.4 (b) Dividend Reinvestment Plans


• In recent years, many firms have established dividend

reinvestment plans.

• Under these plans, shareholders can have their dividends

automatically reinvested in additional shares of the

company’s common stocks.

• There are two types of reinvestment plans.

purchase of existing stocks and purchase of newly issued stocks.

4.2.5 Dividend Payment Decision


• Companies tend to change dividends steadily in response to a sustainable increase in earnings. Cash dividends per year are more stable than earnings.

• Firms tend to pay higher dividends if the firm records higher earnings while lower dividends are paid out if the firm records lower earnings. Therefore, in general firms tend to follow a stable dividend policy.


There are two major schools of thought among finance scholars regarding the effect dividend policy has on a firm’s value.

• the traditionalist view led by M&M who argued that dividend policy does not have a significant impact on the firm’s value; and

• the modernist views of Gordon, David Durand and John Linter who argued that the dividend policy does matter to a firm’s value.


4.3.1 Arguments and Assumptions for Dividend Irrelevant Theory

• The proponents of dividend theory are Merton Miller and

Franco Modigliani (M&M)

• They argued that dividend policy will have no impact on the

value of the firm.

• This is because the value of firm is determined by its basic

earning power and its business risk.

• In other words, M&M argued that the firm’s value mainly

depends on income produced by its assets, not on how this income is split between dividends and retained earnings.



• Therefore, dividend irrelevancy rests on the following arguments:

• If efficient, competitive markets exist, then the M&M dividend irrelevance theory is reasonable given an investment programme and debt policy, the equity portion of the financing may come internally, from retained earnings, or raised externally at low cost in equity markets.

• If earnings exceed the necessary equity funding for the capital budget, the residual can be paid in dividends.

• If the equity capital needed for investment exceeds the internally generated earnings, external equity can be raised inexpensively in financial markets.



• Therefore, dividend irrelevancy rests on the following arguments:

• With efficient markets, it does not matter if earnings are retained and shareholder value is built up via capital gains, or if dividends are paid out as dividends and the equity needed is raised in financial markets.

• The risks that shareholders bear are related to the investment and debt policies, not the dividend policy. Therefore, value of firms is not affected by dividend policy, rather it is affected by the investment policy of the firm.

• An efficient market provides, at fair prices, for transfers in ownership created by shifts in dividend policy. All the while, the total value of the business is unaffected by dividend policy, only investment and debt policy through the tax shield.



The argument for dividend irrelevancy rests on the following assumptions shown in Table 4.2.



The argument for dividend irrelevancy rests on the following assumptions shown in Table 4.2.


4.3.1 (a) Signaling Effect of Dividend

• M&M argued that a firm’s value is not increased by increased dividends, but the firm’s value increases if the increase in dividends signals the presence of high NPV opportunities.

• In markets where there is little information, increased dividends signal increased future cash flows.

• Therefore, dividend policy is a form of communications to the market about future prospects of the firm.


4.3.1 (a) Signaling Effect of Dividend

• Dividend increases send good news about cash flows and earnings and dividend cuts send bad news.

• This is due to the assumption that a high dividend payout policy will be costly to firms that do not have the cash flow to support a higher dividend payout policy.

• Dividend increases signal a company’s good fortune and its manager’s confidence in future cash flows.


4.3.1 (b) Clientele Effect

There are different groups of people who prefer different dividend payout policies.

• For example, retired individuals, pension funds, university lecturers generally prefer cash income. So they will be much better off if they receive higher payout

from earnings.

• While other individuals or groups of people may prefer not to receive current dividend payment, as they do not need current income to support their living and dividends are taxed based on ordinary income. Therefore, they may prefer capital gain for tax reasons.



• If the firm retained relatively higher earnings rather than paying dividends those stockholders who need current income would be disadvantaged. The value of their stocks might be increased because of higher

reinvestment.

• However, these individuals who need current dividends for their living might sell back some of the shares to obtain cash. Hence, selling pressure may result in a drop in stock price. Evidence from several studies suggests that there is in fact a

clientele effect on stock price.

4.3.2 Argument against Dividend Irrelevant Theory


There are a number of reasons that are being put forward to justify that dividends are indeed relevant.

(a) Bird-in-the-hand Theory• The principal conclusion of M&M’s dividend irrelevance theory is

that dividend policy does not affect the required rate of return on equity.

• This conclusion has been hotly debated in academic circles. In particular, Myer Gordon and John Linter and others argued that cost of equity declines as dividend payouts increase because investors are less certain of receiving the capital gain than they are of receiving dividend payments.


(b) Taxes• Removal of the no-tax assumption also makes a difference to

shareholders.• Investors that are in high marginal tax brackets might prefer lower

dividend payouts. • Taxes must be paid on dividends immediately and dividends are

taxed as ordinary income. • If the firm reinvests the capital back into positive NPV

investments, then this should lead to an increase in the stock price.

• Investors can then sell the stocks and realise capital gains that are taxed at a lower rate.


(c) Flotation Costs• If a firm has a high dividend payout, then it will be using its cash to

pay dividends instead of investing in positive NPV projects. • If the firm has positive NPV projects available, it will need to go to

the capital market to raise money for the projects.• There are fees and other costs (flotation costs) associated with

issuing new securities. • If the company had paid a lower dividend and used the cash on

hand for projects, it could have avoided at least some of the flotation costs.

• Therefore, removal of a no flotation cost assumption definitely affects an investment decision and hence a firm’s value.


(c) Flotation Costs• If a firm has a high dividend payout, then it will be using its cash to

pay dividends instead of investing in positive NPV projects. • If the firm has positive NPV projects available, it will need to go to

the capital market to raise money for the projects.• There are fees and other costs (flotation costs) associated with

issuing new securities. • If the company had paid a lower dividend and used the cash on

hand for projects, it could have avoided at least some of the flotation costs.

• Therefore, removal of a no flotation cost assumption definitely affects an investment decision and hence a firm’s value.

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BBPW3203 FINANCIAL MANAGEMENT II - WordPress.comBBPW3203 FINANCIAL MANAGEMENT II. Content 4.1 FIRM’S DIVIDEND POLICY 4.2 TYPES OF DIVIDEND POLICIES 4.3 IMPACT OF DIVIDEND POLICY