Dividend policy


Dividend policy, in financial management and corporate finance, is concerned with
the policies regarding dividends;
more specifically paying a cash dividend in the present, as opposed to, presumably, paying an increased dividend at a later stage.
Practical and theoretical considerations will inform this thinking.

Management considerations

In setting dividend policy, management must pay regard to various practical considerations,
often independent of the theory, outlined below.
In general, whether to issue dividends, and what amount, is determined mainly on the basis of the company's unappropriated profit 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.
At the same time, although the decisioning must weigh the best use of those resources for the firm - i.e. investment needs and future prospects - it must also take into account shareholders' preferences, and the relationship with capital markets more broadly.
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.
However, potentially limiting any distribution, the firm's overall finances, liquidity, and legal / debt covenants in place will also be of relevance.
Management may also wish to avoid "unsettling" the capital markets by changing policy abruptly; see below re signaling.
As regards shareholders:
As a general rule, shareholders of "growth companies" would prefer managers to retain earnings so as to fund future growth internally 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, 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

There are several schools of thought on dividends, in particular re their impact on firm value.
A key consideration will be whether there are any tax disadvantages associated with dividends: i.e. dividends attract a higher tax rate as compared, e.g., to capital gains; see dividend tax and.
Here, per the Modigliani–Miller theorem, as below:
if there are no such disadvantages - and companies can raise equity finance cheaply, i.e. can issue stock at low cost - then dividend policy is value neutral;
if dividends suffer a tax disadvantage, then increasing dividends should reduce firm value.
Regardless, but particularly in the second case, other considerations apply; see.

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 will be offset by the decrease in value due to raising new capital.

Gordon model

In contrast to the above, under the dividend discount model, and particularly the “Growth model” of Myron J. Gordon, the value of the firm is explicitly a function of dividends paid.
Here investors are seen to prefer a “bird in the hand”: i.e. dividends are certain as compared to income from future capital gains.
The resultant valuation formula thus returns value as the present value of “all” future dividends:
where: is the current stock price; is the constant growth rate in perpetuity expected for the dividends; is the constant cost of equity capital for that company; is the value of dividends at the end of the first period, which may be substituted with earnings multiplied by a retention ratio.
This formula, essentially, applies a perpetuity formula to the current dividend, set to grow at a sustainable rate. Strictly, it is then to be applied only to “mature “companies. Further, an implication as regards policy, is that dividends are paid only where investors’ required return - i.e. cost of equity, ke - is greater than the company’s sustainable growth rate. Conversely while the company is enjoying growth in excess of other comparable firms then it should not pay dividends, instead, funding its capital requirement with retained profits.

Lintner's model

provides an explicit formula for determining dividend policy;
it is particularly relevant to a publicly traded company.
A key model-assumption is that management will consider two factors in determining the dividend amount, with both indicating higher dividends correspondingly. The first is the net present value of future earnings; the second is the sustainability of these earnings.
At the same time, any policy must recognize that investors will prefer to receive their dividend with certainty, and thus, if possible, management will maintain a constant rate of dividend.
The theory followed the observation that companies often set their long-run dividends-to-earnings target as a function of expected NPV positive "projects".
Expressed as a model, two parameters are considered: the target payout ratio and the rate at which current dividends adjust to that target:
where:
  • is the dividend per share at time
  • is the dividend per share at time, i.e. last year's dividend per share
  • is the adjustment rate or the partial adjustment coefficient, with
  • is the target dividend per share at time, with
  • is the target payout ratio on earnings per share, with
  • is the earnings per share at time
When applying this model to U.S. stocks, Lintner found and.
The above implies some symmetry. However, in reality, the progression of dividends is asymmetric: increases in dividend are usually small and frequent, while decreases are large and infrequent.

Capital structure substitution theory and dividends

The capital structure substitution theory 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 are maximized.
As a corollary, the CSS theory is seen to provide management with 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
should prefer dividends as a means to distribute cash to shareholders, where
  • D is the company's total long-term debt
  • is the company's total equity
  • is the tax rate on capital gains
  • 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 favorable performance of the company's stock in the future.
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.
It has some support in game theory, constituting a form of "signaling game".
Note that the concept of dividend signaling has been 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.