DIVIDEND POLICIES AND DECISIONS

Dividend policy determines the division of earnings between payments to stock holder’s and re-
investment in the firm. It therefore looks at the following aspects:

i). How much to pay – this encompassed in the four major alternative dividend policies.

 Constant Amount Of Dividend Per Share

 Constant Payout Ratio
 Fixed Dividend Plus Extra
 Residual Dividend Policy

ii) When to pay – paying interim or final dividends

iii) Why dividends are paid – this is explained by the various theories which has to determine
the relevance of dividend payment i.e.:

 Residual dividend theory

 Dividend irrelevance theory (MM)
 Signaling theory
 Bird in hand theory
 Clientele theory
 Agency theory

iv) How to pay: cash or stock dividends.

Importance of Dividend Decisions

Dividends decisions are integral part of a firm’s strategic financing decision. It is therefore a
plan of action adopted by management e.g payment of high dividends means less retained
earnings and the firm may have to go to the market to borrow for investment purposes. This will
increase its gearing level.

Solution to the Dividend Puzzle

A firms dividend decision may have some relevance to the firm’s share value. The managers
therefore requires to formulate an optimal dividend policy which will maximize the wealth of the
shareholders (value of shares).

i) HOW MUCH TO PAY: ALTERNATIVE DIVIDENDS POLICIES

a) Constant payout ratio
This is where the firm will pay a fixed dividend rate e.g. 40% of earnings. The DPS would
therefore fluctuate as the earnings per share changes.

Dividends are directly dependent on the firms earnings ability and if no profits are made no
dividend is paid.
This policy creates uncertainty to ordinary shareholders especially who rely on dividend income
and they might demand a higher required rate of return.

b) Constant amount per share (fixed D.P.S.)

The DPS is fixed in amount irrespective of the earnings level. This creates certainty and is
therefore preferred by shareholders who have a high reliance on dividend income.

It protects the firm from periods of low earnings by fixing, DPS at a low level.

This policy treats all shareholders like preferred shareholders by giving a fixed return. The DPS
could be increased to a higher level if earnings appear relatively permanent and sustainable.

c) Constant DPS plus Extra/Surplus

Under this policy a constant DPS is paid every year. However extra dividends are paid in years
of supernormal earnings.

It gives the firm flexibility to increase dividends when earnings are high and the shareholders are
given a chance to participate in super normal earnings

The extra dividends is given in such a way that it is not perceived as a commitments by the firm
to continue the extra dividend in the future. It is applied by the firms whose earnings are highly
volatile e.g agricultural sector.

d) Residual dividend policy

Under this policy dividend is paid out of earnings left over after investment decisions have been
financed. Dividend will only be paid if there are no profitable investment opportunities
available. The policy is consistent with shareholders wealth maximization.

ii) WHEN TO PAY

Firms pay interim or final dividends. Interim dividends are paid at the middle of the year and are
paid in cash. Final dividends are paid at year end and can be in cash or bonus issue.

iii) DIVIDENDS THEORIES (WHY PAY DIVIDENDS)

The main theories are:

1. Residual dividend theory

Under this theory, a firm will pay dividends from residual earnings i.e. earnings remaining after
all suitable projects with positive NPV has been financed.
It assumes that retained earnings is the best source of long term capital since it is readily
available and cheap. This is because no floatation cash are involved in use of retained earnings
to finance new investments.
Therefore, the first claim on earnings after tax and preference dividends will be a reserve for
financing investments.
Dividend policy is irrelevant and treated as passive variable. It will not affect the value of the
firm. However, investment decisions will.

Advantages of Residual Theory

1. Saving on floatation costs
No need to raise debt or equity capital since there is high retention of earnings which requires no
floatation costs.

2. Avoidance of dilution of ownership

New equity issue would dilute ownership and control. This will be avoided if retention is high.
A high retention policy may enable financing of firms with rapid and high rate of growth.

3. Tax position of shareholders

High-income shareholders prefer low dividends to reduce their tax burden on dividends income.
They prefer high retention of earnings which are reinvested, increase share value and they can
gain capital gains which are not taxable in Kenya.

ii) MM Dividend Irrelevance Theory

Was advanced by Modiglian and Miller in 1961. The theory asserts that a firm’s dividend policy
has no effect on its market value and cost of capital.
They argued that the firm’s value is primarily determined by:

 Ability to generate earnings from investments

 Level of business and financial risk

According to MM dividend policy is a passive residue determined by the firm’s need for
investment funds.
It does not matter how the earnings are divided between dividend payment to shareholders and
retention. Therefore, optimal dividend policy does not exist. Since when investment decisions
of the firms are given, dividend decision is a mere detail without any effect on the value of the
firm.

They base on their arguments on the following assumptions:

1. No corporate or personal kites

2. No transaction cost associated with share floatation
3. A firm has an investment policy which is independent of its dividend policy (a fixed
investment policy)
4. Efficient market – all investors have same set of information regarding the future of the
firm
5. No uncertainty – all investors make decisions using the same discounting rate at all time
i.e required rate of return (r) = cost of capital (k).
iii) Bird-in-hand theory
Advanced by John Litner (1962) and furthered by Myron Gordon (1963).
Argues that shareholders are risk averse and prefer certainty. Dividends payments are more
certain than capital gains which rely on demand and supply forces to determine share prices.
Therefore, one bird in hand (certain dividends) is better than two birds in the bush (uncertain
capital gains).
Therefore, a firm paying high dividends (certain) will have higher value since shareholders will
require to use lower discounting rate.
MM argued against the above proposition. They argued that the required rate of return is
independent of dividend policy. They maintained that an investor can realize capital gains
generated by reinvestment of retained earning, if they sell shares.If this is possible, investors
would be indifferent between cash dividends and capital gains.

iv) Information signaling effect theory

Advanced by Stephen Ross in 1977. He argued that in an inefficient market, management can
use dividend policy to signal important information to the market which is only known to
them.

Example – If the management pays high dividends, it signals high expected profits in future to
maintain the high dividend level. This would increase the share price/value and vice versa.

MM attacked this position and suggested that the change in share price following the change in
dividend amount is due to informational content of dividend policy rather than dividend policy
itself.Therefore, dividends are irrelevant if information can be given to the market to all players.
Dividend decisions are relevant in an inefficient market and the higher the dividends, the higher
the value of the firm. The theory is based on the following four assumptions:

1. The sending of signals by the management should be cost effective.

2. The signals should be correlated to observable events (common trend in the market).
3. No company can imitate its competitors in sending the signals.
4. The managers can only send true signals even if they are bad signals. Sending untrue
signals is financially disastrous to the survival of the firm.

v) Tax differential theory

Advanced by Litzenberger and Ramaswamy in 1979

They argued that tax rate on dividends is higher than tax rate on capital gains.Therefore, a firm
that pays high dividends have lower value since shareholders pay more tax on dividends.
Dividend decisions are relevant and the lower the dividend the higher the value of the firm and
vice versa.

Note
In Kenya, dividends attract a withholding tax of 5% which is final and capital gains are tax
exempt.
vi) Clientele effect theory
Advance by Richardson Petit in 1977

It stated that different groups of shareholders (clientele) have different preferences for dividends
depending on their level of income from other sources.

Low income earners prefer high dividends to meet their daily consumption while high income
earners prefer low dividends to avoid payment of more tax. Therefore, when a firm sets a
dividend policy, there’ll be shifting of investors into and out of the firm until an equilibrium is
achieved. Low, income shareholders will shift to firms paying high dividends and high income
shareholders to firms paying low dividends.

At equilibrium, dividend policy will be consistent with clientele of shareholders a firm has.
Dividend decision at equilibrium are irrelevant since they cannot cause any shifting of investors.

vii) Agency theory

The agency problem between shareholders and managers can be resolved by paying high
dividends. If retention is low, managers are required to raise additional equity capital to finance
investment.Each fresh equity issue will expose the managers financing decision to providers of
capital e.g bankers, investors, suppliers etc.Managers will thus engage in activities that are
consistent with maximization of shareholders wealth by making full disclosure of their activities.
This is because they know the firm will be exposed to external parties through external
borrowing. Consequently, Agency costs will be reduced since the firm becomes self-regulating.
Dividend policy will have a beneficial effect on the value of the firm. This is because dividend
policy can be used to reduce agency problem by reducing agency costs.The theory implies that
firms adopting high dividend payout ratio will have a higher due to reduced agency costs.

How to pay dividends (mode of paying dividends)

1. Cash and Bonus issue
2. Stock split and reverse split
3. Stock repurchase
4. Stock rights/rights issue (to discuss in class)

1. Cash and bonus issue

For a firm to pay cash dividends, it should have adequate liquid funds.
However, under conditions of liquidity and financial constraints, a firm can pay stock dividend
(Bank issue)
Bonus issue involves issue of additional shares for free (instead of cash) to existing shareholders
in their shareholding proportion.
Stock dividend/Bonus issue involves capitalization of retained earnings and does not increase the
wealth of shareholders. This is because R. Earnings is converted into shares.

Advantages of Bonus Issue

a) Tax advantages
Shareholders can sell new shares, and generate cash in form of capital gains which is tax exempt
unlike cash dividends which attract 5% withholding tax which is final

b) Indication of high profits in future:

A Bonus issue, in an inefficient market conveys important information about the future of the
company.
It is declared when management expects increase in earning to offset additional outstanding
shares so that E.P.S is not diluted.

c) Conservation of cash
Bonus issue conserves cash especially if the firm is in liquidity problems.

d) Increase in future dividends

If a firm follows a fixed/constant D.P.S policy, then total future dividend would increase due to
increase in number of shares after bonus issue.

Journal entry in case of bonus issue

Dr. R. Earnings (par value)
Cr. Ordinary share capital (par value)

NB: A firm can also make a script issue where bonus shares are directly from capital reserve.

2. Stock Split and Reverse Split

This is where a block of shares is broken down into smaller units (shares) so that the number of
ordinary shares increases and their respective par value decreases at the stock split factor.

Stock split is meant to make the shares of a company more affordable by low income investors
and increase their liquidity in the market.

Illustration
ABC Company has 1000 ordinary shares of Sh.20 par value and a split of 1:4 i.e one stock is
split into 4. The par value is divided by 4.

1000 stocks x 4 = 4000 shares

par value = 40 = Sh.5
5

Ordinary share capital = 4000 x 5 = Shs.20,000

A reverse split is the opposite of stock split and involves consolidation of shares into bigger units
thereby increasing the par value of the shares. It is meant to attract high income clientele
shareholders. E.g incase of 20,000 shares @ Shs.20 par, they can be consolidated into 10,000
shares of Shs.40 par. I.e. (20,000 x ½) = 10,000 and Sh.20 = x 2 = 40/=

3. Stock Repurchase
The company can also buy back some of its outstanding shares instead of paying cash dividends.
This is known as stock repurchase and shares repurchased, (bought back) are called treasury
Stock. If some outstanding shares are repurchased, fewer shares would remain outstanding.

Assuming repurchase does not adversely affect firm’s earnings, E.P.S. of share would increase.
This would result in an increase in M.P.S. so that capital gain is substituted for dividends.

Advantages of Stock Repurchase

1. It may be seen as a true signal as repurchase may be motivated by management belief that
firm’s shares are undervalued. This is true in inefficient markets.

2. Utilization of idle funds

Companies, which have accumulated cash balances in excess of future investments, might find
share reinvestment scheme a fair method of returning cash to shareholders.
Continuing to carry excess cash may prompt management to invest unwisely as a means of using
excess cash.
Example
A firm may invest surplus cash in an expensive acquisition, transferring value to another group
of shareholders entirely. There is a tendency for more mature firms to continue with investment
plan even when E (K) is lower than cost of capital.

3. Enhanced dividends and E.P.S.

Following a stock repurchase, the number of shares issued would decrease and therefore in
normal circumstances both D.P.S. and E.P.S. would increase in future. However, the increase in
E.P.S is a bookkeeping increase since total earnings remaining constant.

4. Enhanced Share Price

Companies that undertake share repurchase, experience an increase in market price of the shares.
This is partly explained by increase in total earnings having less and/or market signal effect that
shares are under value.

5. Capital structure
A company’s managers may use a share buy back or requirements, as a means of correcting what
they perceive to be an unbalanced capital structure.
If shares are repurchased from cash reserves, equity would be reduced and gearing increased
(assuming debt exists in the capital structure).
Alternatively a company may raise debt to finance a repurchase. Replacing equity with debt can
reduce overall cost of capital due to tax advantage of debt.
6. Employee incentive schemes
Instead of cancelling all shares repurchase, a firm can retain some of the shares for employees
share option or profit sharing schemes.

7. Reduced take over threat

A share repurchase reduced number of share in operation and also number of ‘weak
shareholders’ i.e shareholders with no strong loyalty to company since repurchase would induce
them to sell.
This helps to reduce threat of a hostile takeover as it makes it difficult for predator company to
gain control. (This is referred as a poison pill) i.e. Co.’s value is reduced because of high
repurchase price, huge cash outflow or borrowing huge long term debt to increase gearing

Disadvantages of stock repurchase

1. High price
A company may find it difficult to repurchase shares at their current value and price paid may be
too high to the detriment of remaining shareholders.

2. Market Signaling
Despite director’s effort at trying to convince markets otherwise, a share repurchase may be
interpreted as a signal suggesting that the company lacks suitable investment opportunities. This
may be interpreted as a sign of management failure.

3. Loss of investment income

The interest that could have been earned from investment of surplus cash is lost.

Factors to consider in paying dividends (factors influencing dividend)

1. Legal rules

a) Net purchase rule

States that dividend may be paid from company’s profit either past or present.
b) Capital impairment rule: prohibits payment of dividends from capital i.e. from
sale of ssets. This is liquidating the firm.
c) Insolvency rule: prohibits payment of dividend when company is insolvent.
Insolvent company is one where assets are less than liabilities. Insolvent
company is one where assets are less than liabilities. In such a case all earnings
and assets of company belong to debt holders and no dividends is paid.

2. Profitability and liquidity

A company’s capacity to pay dividend will be determined primarily by its ability to generate
adequate and stable profits and cash flow.
If the company has liquidity problem, it may be unable to pay cash dividend and result to paying
stock dividend.
3. Taxation position of shareholders
Dividend payment is influenced by tax regime of a country e.g in Kenya cash dividend are
taxable at source, while capital are tax exempt.
The effect of tax differential is to discourage shareholders from wanting high dividends. (This is
explained by tax differential theory).

4. Investment opportunity
Lack of appropriate investment opportunities i.e. those with positive returns (N.P.V.), may
encourage a firm to increase its dividend distribution. If a firm has many investment
opportunities, it will pay low dividends and have high retention.

5. Capital Structure
A company’s management may wish to achieve or restore an optimal capital structure i.e. if they
consider gearing to be too high, they may pay low dividends and allow reserves to accumulate
until a more optimal/appropriate capital structure is restored/achieved.

6. Industrial Practice
Companies will be resistant to deviation from accepted dividend or payment norms within the
industry.

7. Growth Stage
Dividend policy is likely to be influenced by firm’s growth stage e.g a young rapidly growing
firm is likely to have high demand for development finance and therefore may pay low dividend
or a defer dividend payment until company reaches maturity. It will retain high amount.

8. Ownership Structure
A dividend policy may be driven by Time Ownership Structure e.g in small firms where owners
and managers are same, dividend payout are usually low.

However in a large quoted public company dividend payout are significant because the owners
are not the managers. However, the values and preferences of small group of owner managers
would exert more direct influence on dividend policy.

9. Shareholders expectation
Shareholder clientele that have become accustomed to receiving stable and increasing div. Will
expect a similar pattern to continue in the future.

Any sudden reduction or reversal of such a policy is likely to dissatisfy the shareholders and may
result in a fail in share prices.

10. Access to capital markets

Large, well established firms have access to capital markets hence can get funds easily
They pay high dividends thus, unlike small firms which pay low dividends (high retention) due
to limited borrowing capacity.

11. Contractual obligations on debt covenants

They limit the flexibility and amount of dividends to pay e.g. no payment of dividends from
retained earnings.

Dividend ratios
1. Dividend per shares (DPS) = Earnings to ordinary shareholders
Number of ordinary shares

Indicate cash returns received fro every share holder.

2. Dividend yield (DY) = DPS

MPS

Indicate dividend returns for every shilling invested in the firm.

3. Dividend cover = DPS

DPS

Indicate the number of times dividends can be paid out of earnings of shareholders. The higher
the DPS the lower the dividend cover.

4. Dividend Payout Ratio = DPS

EPS

Shows the proportion of Earnings which was paid out as dividends and how much was retained.