Dividend
Distribution of profits to the holders of equity investments in proportion to their holdings of a particular class of capital
Constraints on dividend policy (2)
- Retained earnings
- Covenants
If company choses to retain earnings instead of paying dividend (3)
- Dividend paid in short term will be lower
- Investors compensated for short term sacrifice by higher dividends in the future
- Capital value of shares should increase in line with retentions > producing capital gains
Dividend decision interrelated with
Company’s investment and financing decisions
Dividend policies adopted by companies (5)
- Constant percentage of annual earnings
- Stable growth
- Residual
- Zero
- Special or extra dividend
Type of dividend policy depends on
Stage of lifecycle eg
Young companies > residual policy
Mature > stable growth/ constant
If dividend policies are out of line with the market’s expectations
Appears to produce significant share price reactions
Growth rate of dividends formula
g = rb
g = annual growth rate of dividends r = rate of return on new investments b = proportion of profits that are retained
If next year’s dividend is provided, use
D1
___
(r-g)
If current year dividend provided, use
D0 ( 1 + g)
_________
(r - g)
Dividend declared can be interpreted as
Signal from directors to shareholders about the strength of the underlying project cash flows
Clientele effect
Whereby investors chose to purchase shares based on their individual needs/ requirements (eg if want regular cash payments, chose company who traditionally pays regular dividends instead of potential for high capital gains)
Clientele effect can
Place pressure on management to produce stable and consistent dividend policy
Factors influencing the dividend policy
RELATE
R > Restrictive Covenants E > Expectations of shareholders L > Liquidity A > Attitude to debt T > Tax E > Evaluation by the market
Agency theory
Managers may not always act in the best interest of the shareholders
One way for shareholders to keep control
Insist on relatively high payout ratios > forces the directors to have investment projects scrutinised by external providers
Alternatives to paying a cash dividend > liquidity enhancing alternatives (2)
- Scrip dividend
- Concessions
Scrip dividend
Shareholders are offered bonus shares free of charge as an alternative to cash dividend.
Distributable reserves reduce
Share capital increases
Advantages of scrip dividend (2)
- Preserves cash position
- Creditors of company are provided with additional security because distributable reserves are converted into permanent capital
Disadvantages of scrip dividend (2)
- Earnings per share will decrease as number of shares increases
- Can lead to tax implications for individual investor as capital gains are taxed at different rate from dividend income
Concessions
Can provide concessions to shareholders instead of paying out all or some of dividend eg discount/ free products
Alternatives to paying a cash dividend > liquidity reducing alternative
Share repurchase
Share repurchase advantages (2)
- Fewer shares in issue so earnings per share will increase
- Can prevent unwelcomed takeover bid
Share repurchase disadvantages (2)
- Implies that the company cannot use the funds as effectively as shareholders
- Difficult to find price which is fair to both seller and those shareholders not selling
