DIVIDEND DECISIONS

BY: CPA CHARLES LWANGA WASSWA

0774-666-883
Cont’d
• Retained earnings are the most important single source of finance for
companies, and financial managers should take account of the
proportion of earnings that are retained as opposed to being paid as
dividends.
• The dividends a company pays may be treated as a signal to investors. A
company needs to take account of different clienteles of shareholders in
deciding what dividends to pay.
• For any company, the amount of earnings retained within the business
has a direct impact on the amount of dividends. Profit reinvested as
retained earnings is profit that could have been paid as a dividend.
Cont’d
• A company must restrict its self-financing through retained earnings
because shareholders should be paid a reasonable dividend, in line
with realistic expectations, even if the directors would rather keep the
funds for reinvesting.
• At the same time, a company that is looking for extra funds will not be
expected by investors (such as banks) to pay generous dividends, nor
over-generous salaries to owner-directors.
• The dividend policy of a business affects the total shareholder return
and therefore shareholder wealth
Cont’d
Dividend payments
• Shareholders normally have the power to vote to reduce the size of
the dividend at the Annual General Meeting, but not the power to
increase the dividend.
• The directors of the company are therefore in a strong position with
regard to shareholders when it comes to determining dividend policy.
For practical purposes, shareholders will usually be obliged to accept
the dividend policy that has been decided on by the directors, or
otherwise to sell their shares.
Cont’d
Factors influencing dividend policy
• When deciding on the dividends to pay out to shareholders, one of the main
considerations of the directors will be the amount of earnings they wish to retain to
meet financing needs.
• As well as future financing requirements, the decision on how much of a company's
profits should be retained, and how much paid out to shareholders, will be
influenced by:
• (a) The need to remain profitable. Dividends are paid out of profits, and an
unprofitable company cannot go on indefinitely paying dividends out of retained
profits made in the past.
• (b) The law on distributable profits. Companies legislation may make companies
bound to pay dividends solely out of accumulated net realised profits.
Cont’d
• (c) The Government may impose direct restrictions on the amount of
dividends that companies can pay.
• (d) Any dividend restraints that might be imposed by loan
agreements and covenants. A loan covenant may restrict the amount
of dividends that the company can pay, because this will provide
protection for the lender.
• (e) The effect of inflation. There is also the need to retain some profit
within the business just to maintain its operating capability
unchanged.
Cont’d
• (f) The company's gearing level. If the company wants extra finance, the sources
of funds used should strike a balance between equity and debt finance.
• (g) The company's liquidity position. Dividends are a cash payment, and a
company must have enough cash to pay the dividends it declares.
• (h) The need to repay debt in the near future. The company must have enough
cash to pay debts as they fall due.
• (i) The ease with which the company could raise extra finance from sources other
than retained earnings. Small companies which find it hard to raise finance might
have to rely more heavily on retained earnings than large companies.
Cont’d
Dividends as a signal to investors
• The ultimate objective in any financial management decisions is to maximise
shareholders' wealth.
• This wealth is basically represented by the current market value of the company,
which should largely be determined by the cash flows arising from the
investment decisions taken by management.
• Although the market would like to value shares on the basis of underlying cash
flows on the company's projects, such information is not readily available to
investors.
• But the directors do have this information. The dividend declared can be
interpreted as a signal from directors to shareholders about the strength of
underlying project cash flows.
Cont’d
• Investors usually expect a consistent dividend policy from the company,
with stable dividends each year or, even better, steady dividend growth.
• A large rise or fall in dividends in any year can have a marked effect on
the company's share price.
• Stable dividends or steady dividend growth are usually needed for share
price stability.
• A cut in dividends may be treated by investors as signalling that the
future prospects of the company are weak. Thus the dividend which is
paid acts, possibly without justification, as a signal of the future
prospects of the company.
Cont’d
• The signalling effect of a company's dividend policy may also be used
by management of a company which faces a possible takeover.
• The dividend level might be increased as a defence against the
takeover: investors may take the increased dividend as a signal of
improved future prospects, thus driving the share price higher and
making the company more expensive for a potential bidder to take
over.
Cont’d
Theories of dividend policy
Residual theory
• A 'residual' theory of dividend policy can be summarised as follows.
- If a company can identify projects with positive NPVs, it should invest in
them.
- Only when these investment opportunities are exhausted should
dividends be paid.
• Dividends should therefore be the amount of after-tax profits left over
(the 'residual' amount) after setting aside money to invest in all viable
business opportunities.
Cont’d
Traditional view/Relevancy theory
• The 'traditional' view of dividend policy focuses on the effects of
dividends and dividend expectations on share price.
• The price of a share depends on both current dividends and
expectations of future dividend growth, given shareholders' required
rate of return.
Cont’d
Irrelevancy theory/ Modigliani and Miller (MM) theory
• In contrast to the traditional view, Modigliani and Miller (MM)
proposed that in a perfect capital market, shareholders are indifferent
between dividends and capital gains, and the value of a company is
determined solely by the 'earning power' of its assets and
investments.
Cont’d
• MM argued that if a company with investment opportunities decides
to pay a dividend so that retained earnings are insufficient to finance
all its investments, the shortfall in funds will be made up by obtaining
additional funds from outside sources which might lead to loss of
dividends and capital gain in the future.
Cont’d
The case in favour of the relevance of dividend policy (and against MM's views)
• There are strong arguments against MM's view that dividend policy is
irrelevant as a means of affecting shareholders' wealth.
• (a) Differing rates of taxation on dividends and capital gains can create a
preference among investors for either a high dividend or high earnings
retention (for capital growth).
• (b) Dividend retention should be preferred by companies in a period of capital
rationing.
• (c) Due to imperfect markets and the possible difficulties of selling shares easily
at a fair price, shareholders might need high dividends in order to have funds
to invest in opportunities outside the company.
Cont’d
• (d) Markets are not perfect. Because of transaction costs on the sale of
shares, investors who want some cash from their investments will prefer
to receive dividends rather than to sell some of their shares to get the
cash they want.
• (e) Information available to shareholders is imperfect, and they are not
aware of the future investment plans and expected profits of their
company. Even if management were to provide them with profit
forecasts, these forecasts would not necessarily be accurate or believable.
• (f) Perhaps the strongest argument against the MM view is that
shareholders will tend to prefer a current dividend to future capital gains
(or deferred dividends) because the future is more uncertain.
Cont’d
Scrip dividends
• A scrip dividend is a dividend paid by the issue of additional company
shares, rather than by cash.
• When the directors of a company would prefer to retain funds within the
business but consider that they must pay at least a certain amount of
dividend, they might offer equity shareholders the choice of a cash
dividend or a scrip dividend. Each shareholder would decide separately
which to take.
• With enhanced scrip dividends, the value of the shares offered is much
greater than the cash alternative, giving investors an incentive to choose
the shares.
Cont’d
Advantages of scrip dividends
• (a) They can preserve a company's cash position if a substantial number of
shareholders take up the share option.
• (b) Investors may be able to obtain tax advantages if dividends are in the form of
shares.
• (c) Investors looking to expand their holding can do so without incurring the
transaction costs of buying more shares.
• (d) A small scrip dividend issue will not dilute the share price significantly.
However, if cash is not offered as an alternative, empirical evidence suggests that
the share price will tend to fall.
• (e) A share issue will decrease the company's gearing, and may therefore enhance
its borrowing capacity.
Cont’d
Disadvantages of scrip dividends
• (a) Assuming that dividend per share is maintained or increased, the
total cash paid as a dividend will increase.
• (b) Scrip dividends may be seen as a negative signal by the market ie
the company is experiencing cash flow issues.
Cont’d
Share repurchase/Share buy back
• Purchase by a company of its own shares can take place for various
reasons and must be in accordance with any requirements of legislation.
• In many countries companies have the right to buy back shares from
shareholders who are willing to sell them, subject to certain conditions.
• For a smaller company with few shareholders, the reason for buying
back the company's own shares may be that there is no immediate
willing purchaser at a time when a shareholder wishes to sell shares.
• For a public company, share repurchase could provide a way of
withdrawing from the share market and 'going private'.
Cont’d
• Public companies with a large amount of surplus cash may offer to
repurchase (and then cancel) some shares from its shareholders.
• A reason for this is to find a way of offering cash returns to investors
without increasing dividend payments.
• Higher dividend payments would affect investor expectations about
future dividends and dividend growth, whereas share buybacks would
not affect dividend expectations at all.
• In addition, by reducing the number of shares in issue, the company
should be able to increase the earnings per share (EPS) for the
remaining shares.
Cont’d
Benefits of a share repurchase scheme
• (a) Finding a use for surplus cash, which may be a 'dead asset'.
• (b) Increase in earnings per share through a reduction in the number of shares in
issue. This should lead to a higher share price than would otherwise be the case,
and the company should be able to increase dividend payments on the remaining
shares in issue.
• (c) Increase in gearing. Repurchase of a company's own shares allows debt to be
substituted for equity, so raising gearing. This will be of interest to a company
wanting to increase its gearing without increasing its total long-term funding.
• (d) Readjustment of the company's equity base to more appropriate levels, for a
company whose business is in decline.
• (e) Possibly preventing a takeover or enabling a quoted company to withdraw
from the stock market.
Cont’d
Drawbacks of a share repurchase scheme
• (a) It can be hard to arrive at a price that will be fair both to the
vendors and to any shareholders who are not selling shares to the
company.
• (b) A repurchase of shares could be seen as an admission that the
company cannot make better useof the funds than the shareholders.
• (c) Some shareholders may suffer from being taxed on a capital gain
following the purchase of theirshares rather than receiving dividend
income.
Cont’d

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