DEFINING DIVIDEND POLICY
Brealey et al
defined dividend policy as “ the trade off between retaining earnings on the
one hand and paying out cash and issuing new shares on the other.” Brealey
et al (1986:417)
DIVIDEND CONTROVERSY
Over the last
century, three schools of thought have emerged over dividend policy.
•
One faction sees dividends as attractive and as a positive influence on
stock prices.
•
A second bloc believes that stock prices are not related to dividend
payout levels.
•
The third group of theories maintains that firm dividend policy is
irrelevant in stock price valuation.
The question
is If dividends are so irrelevant as is being purported by Modigliani and
Miller "Why do corporations pay dividends?" and also, "Why
do investors pay attention to dividends?" Black [1976]
Theories of Dividend Policy
Irrelevance Theory
Modigliani and Miller researched and produced a paper
stating that dividends were irrelevant to share value. They were of the view
that the determinants of value of a share are the availability of projects with
positive NPV’s rather than pattern of dividends paid out by a company to its
shareholders
According to them under
ideal conditions, the value of the firm is unaffected by dividend policy
Argument against MM
preposition
1. If dividends are so
irrelevant "Why do corporations pay dividends?" and also,
"Why do investors pay attention to dividends?" Black [1976]
Argument for MM preposition
1. Dividend policy makes no
difference because it has no effect on either stock prices or the cost of
equity - Black and Scholes (1974),
Bird-in-hand theory
This theory states that dividends are more predictable
than capital gains because managers can stabilize dividends, but cannot control
stock price.
Therefore, dividend payments are safe cash in hand
while the alternative capital gains are at best cash in the bush.
Tax Preference Theory
The theory argued taxes are paid on dividends in the
year they are received while taxes on capital gains do not have to be paid until
the stock is sold. Again taxes on capital gains may be less than on dividends,
which are considered ordinary income. Thus depending on the tax situation of
the investor, investors will prefer that companies retain the earnings and
promote capital appreciation
THE CLIENTELE EFFECT
— Some shareholders may prefer
stocks that do not pay dividends.
— Other shareholders may
prefer stocks that pay a regular dividend.
— Investors will form their
well-diversified portfolios of stocks to have the desired dividend policy.
— All clienteles would prefer
not to be constantly rebalancing their portfolios as firm switch policies.
Rebalancing is expensive due to transactions costs.
Main Factors
Determining Dividend Policy
Dividend turn to be
lower when there are more investment opportunities as the theory suggests.
However, many businesses tend to base their dividend on the profit or earnings
of the most recent year
How dividends are paid
Cash dividend
These are payment of cash by the firm to share holders
Stock dividends
This is the distribution of additional shares to share
holders e.g., right issues
Dividend payout ratio: this is the
fraction of earnings paid out as dividends
Legal limitations on dividend
State laws- help to protect creditors against
excessive payment of dividend
placing of limits on dividend payments
Stock repurchases
Some firms buys back from its share holders
Ex-dividend date – This is the date that determines whether a
shareholder is entitled to dividend payment
Scrip Dividend
This is when a
company allows it share holders to take their dividend in the form of new
shares rather than cash
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