Dividend policy

Dividend policy is concerned with financial policies regarding paying cash dividend in the present or paying an increased dividend at a later stage. Whether to issue dividends, and what amount, is determined mainly on the basis of the company's unappropriated profit (excess cash) and influenced by the company's long-term earning power. When cash surplus exists and is not needed by the firm, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program. Practical issues and competing theories are discussed below.

Management considerations

Further information: Corporate finance § Dividend policy

In setting dividend policy, management will typically regard various practical considerations. The decisioning essentially weighs the best use of those resources for the firm - i.e. investment needs and future prospects - but also takes into account shareholders' preferences. Competing theories are discussed in the next section.

As regards the firm: If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, and excess cash surplus is not needed, then management should return some or all of the excess cash to shareholders as dividends. The firm's overall finances and any debt covenants in place will also be of relevance.

As regards shareholders: As a general rule, shareholders of "growth companies" would prefer managers to retain earnings so as to fund future growth internally (or have a share buyback program) whereas shareholders of value or secondary stocks would prefer the management to distribute surplus earnings in the form of cash dividends. Re the former, for example, the thinking is dividend payments, and share price, will be higher in the future, (more than) offsetting the retainment of current earnings. See Clientele effect.

Regarding both: Management must choose the form of the dividend distribution, generally as cash dividends or via a share buyback. Various factors may be taken into consideration: where shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding. Alternatively, some companies will pay "dividends" from stock rather than in cash; see Corporate action.

Relevance of dividend policy

Modigliani-Miller theorem

Main article: Modigliani–Miller theorem

See also: Capital structure § Modigliani–Miller theorem

The Modigliani–Miller theorem states that dividend policy does not influence the value of the firm. The theory, more generally, is framed in the context of capital structure, and states that — in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market — the enterprise value of a firm is unaffected by how that firm is financed: i.e. its value is unaffected by whether the firm is funded by retained earnings, or whether it raises capital by issuing shares or by selling debt.

The dividend decision, relating to both equity financing and retained earnings, is, in turn, value neutral. Here, shareholders are indifferent as to how the firm divides its profits between new investments and dividends. The logic, essentially, is that capital used in paying out dividends will be replaced by new capital raised through issuing shares. The latter will increase the number of shares, diluting earnings, and hence lead to a decline in share price. Thus any increase in firm value because of the dividend payment (e.g. per the Gordon model where value is a function of dividend) will be offset by the decrease in value due to raising new capital.

Lintner's model

John Lintner's dividend policy model is a model theorizing how a publicly traded company sets its dividend policy. The logic is that every company wants to maintain a constant rate of dividend even if the results in a particular period are not up to the mark. The assumption is that investors will prefer to receive a certain dividend payout.

The model states that dividends are paid according to two factors. The first is the net present value of earnings, with higher values indicating higher dividends. The second is the sustainability of earnings; that is, a company may increase its earnings without increasing its dividend payouts until managers are convinced that it will continue to maintain such earnings. The theory was adopted based on observations that many companies will set their long-run target dividends-to-earnings ratios based upon the amount of positive net-present-value projects that they have available.

The model then uses two parameters: the target payout ratio and the rate at which current dividends adjust to that target:

${\begin{aligned}D_{t}&=D_{t-1}+\rho \cdot \left(D_{t}^{*}-D_{t-1}\right)\\&=D_{t-1}+\rho \cdot \left(\tau \cdot E_{t}-D_{t-1}\right)\\&=\rho \cdot \tau \cdot E_{t}+(1-\rho )\cdot D_{t-1}\\&=\rho \cdot D_{t}^{*}+(1-\rho )\cdot D_{t-1}\end{aligned}}$

where:

• $D_{t}$ is the dividend per share at time $t$
• $D_{t-1}$ is the dividend per share at time $(t-1)$, i.e. last year's dividend per share
• $\rho$ is the adjustment rate or the partial adjustment coefficient, with $0\leq \rho \leq 1$
• $D_{t}^{*}$ is the target dividend per share at time $t$, with $D_{t}^{*}=\tau \cdot E_{t}$
• $\tau$ is the target payout ratio on earnings per share (or on free-cash-flow per share), with $0\leq \tau \leq 1$
• $E_{t}$ is the earnings per share (or free cash flow per share) at time $t$

When applying its model to U.S. stocks, Lintner found $\rho \simeq 30\%$ and $\tau \simeq 50\%$.

This is a symmetric model. However in reality the progression of dividends is extremely asymmetric: increases in dividend are usually small and frequent, while decreases (including cutting the dividend altogether) are large and infrequent.

Capital structure substitution theory and dividends

The capital structure substitution theory (CSS) describes the relationship between earnings, stock price and capital structure of public companies. The theory is based on the hypothesis that management "manipulates" capital structure such that earnings per share (EPS) are maximized. As a corollary, the CSS theory is seen to provide management with (some) guidance on dividend policy - more directly in fact than other approaches, such as the Walter model and the Gordon model. In fact, CSS reverses the traditional order of cause and effect by implying that company valuation ratios drive dividend policy, and not vice versa.

The theory provides an explanation as to why some companies pay dividends and others do not: When redistributing cash to shareholders, management can typically choose between dividends and share repurchases. In most cases dividends are taxed higher than capital gains, and thus investors - and management - would typically be expected to select a share repurchase. However, for some companies share repurchases lead to a reduction in EPS, and it in those cases the company would select to pay dividends. From the CSS theory, then, it can be derived that debt-free companies should prefer repurchases whereas companies with a debt-equity ratio larger than

${\frac {D}{E_{\text{q}}}}>{\frac {1-T_{\text{C}}}{1-T_{\text{D}}}}-1$

should prefer dividends as a means to distribute cash to shareholders, where

• D is the company's total long-term debt
• $E_{\text{q}}$ is the company's total equity
• $T_{\text{C}}$ is the tax rate on capital gains
• $T_{\text{D}}$ is the tax rate on dividends

Companies may then "target" a dynamic Debt-to-equity ratio.

The CSS theory does not have 'invisible' or 'hidden' parameters such as the equity risk premium, the discount rate, the expected growth rate or expected inflation. As a consequence the theory can be tested in an unambiguous way. Low-valued, high-leverage companies with limited investment opportunities and a high profitability, use dividends as the preferred means to distribute cash to shareholders, as is documented by empirical research.

Dividend signaling hypothesis

The dividend signaling hypothesis posits that a company's announcement of an increase in dividend payouts constitutes an opportunity to signal to the market that the firm is "better off than the average". Increasing a company's dividend payout may then predict (or lead to) favorable performance of the company's stock in the future. (See also Earnings guidance.)

The theory is built on the assumption that, although in a perfect market there is no information asymmetry, in practice the firm's management will be better informed than the market in estimating the true value of the firm. (See Efficient-market hypothesis and Modigliani–Miller theorem.) It has some support in game theory, constituting a form of "signaling game".

Note that the concept of dividend signaling has been widely contested. At the same time, however, the theory is still used by some investors, and is supported by empirical studies showing that a firm's share price may increase significantly upon announcement of dividend increases, despite the cost inherent in the dividend tax.

Walter's model

Walter's model holds that dividend policy is a function of the relationship between the company's return on investment and its cost of equity, and hence also affects the value of the company.

The argument is that capital retained will be invested by the firm in its profitable opportunities, whereas dividends paid to shareholders are invested elsewhere.

Here, the firm's achievable rate of return, r, reflects as its return on equity; while the shareholders' required rate of return is proxied by the firm's cost of equity, or k_e. Thus, if r < k_e then the firm should distribute the profits in the form of dividends; however, if r > k_e then the firm should invest these retained earnings. The model assumes, at least implicitly, that retained earnings are the only source of financing, and that k_e and r are constant (given these, the approach is subject to criticism).

The value of the company, then, may be seen as the present value of the return on investments made from retained earnings, and a theoretical value is then expressed as:

$P={D+r((E-D)/k_{e}) \over {k_{e}}}\,$

where

• P = Market price of the share
• D = Dividend per share
• r = Rate of return on the firm's investments
• k_e = Cost of equity
• E = Earnings per share

Residuals theory of dividends

Under a Residual Dividend policy, dividends are paid out from "spare cash" or excess earnings; this is to be contrasted with a "smoothed" payout policy.

A firm applying a residual dividend policy will evaluate its available investment opportunities to determine required capital expenditure, and in parallel, the amount of equity finance that would be needed for these investments; it will also confirm that the cost of retained earnings is less than the cost of equity capital. If appropriate, it will then use its retained profits to finance capital investments. Finally, if there is any surplus after this financing, then the firm will distribute these residual funds as dividends.

This policy will attract investors who appreciate that the firm is trying to employ its capital optimally; it also delays (or removes) the payment of the secondary tax on dividends. This policy, furthermore, requires fewer new stock issues and hence lower flotation costs.

At the same time, a variable dividend policy may send conflicting signals to investors. It also represents an increased level of risk for investors, as dividend income remains uncertain, and the share price may respond correspondingly. See also Residual income valuation and Retained earnings § Tax implications.

See also

• Clientele effect
• Dividend puzzle
• Look-through earnings
• Dividend payout ratio
• Dividend yield
• Dividend cover

External links

• Dividend Policy by Alex Tajirian
• Corporate Dividend Policy by Henry Servaes (London Business School) and Peter Tufano (Harvard Business School)