Dividend policy is concerned with financial policies regarding paying dividend . When cash surplus exists and is not needed by the company, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or share buyback.
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. The dividend policy of a business affects the total shareholder return and therefore shareholder wealth.
Factors influencing dividend policy
The decision on how much of a company’s profits should be retained, and how much paid out to shareholders, will be influenced by:
- The need to remain profitable.
- The law on distributable profits.
- The government may impose direct restrictions on the amount of dividends that companies can pay.
- Any dividend restraints that might be imposed by loan agreements and covenants.
- The effect of inflation, and the need to retain some profit within the business just to maintain its operating capability unchanged.
- 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.
- The company’s liquidity position. Dividends are a cash payment, and a company must have enough cash to pay the dividends it declares.
- The need to repay debt in the near future.
- 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.
- The signalling effect of dividends to shareholders and the financial markets in general.
Theories of dividend policy
- 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 are signal to shareholders. The ‘traditional’ view of dividend policy is to focus 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.
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.
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. As a result of obtaining outside finance instead of using retained earnings: Loss of value in existing shares = Amount of dividend paid
In answer to criticisms that certain shareholders will show a preference either for high dividends or for capital gains, MM argued that if a company pursues a consistent dividend policy, ‘each corporation would tend to attract to itself a clientele consisting of those preferring its particular payout ratio, but one clientele would be entirely as good as another in terms of the valuation it would imply for the firm’.
- BPP, F9 Financial Managment
- Phnom Penh HR