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Chapter 14
Dividend Policy
1 Introduction

Ve, Po

To maximise S/H wealth the Board should establish a dividend policy- the
payment pattern to the equity investors
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Pattern – Be consistent with dividend payments
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g 6 cents per share
E
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The latter
Links into the P o via the dividend valuation model (DVM)

In a perfect capital market, providing the director can invest in project with a positive NPV,
no dividend are required
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(Manufacture dividends)

Dividend irrelevance theory
Modigliani and Miller (M&M) proposed that in a tax-free world, 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
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Assumptions of M&M dividend irrelevancy theory
M&M made a number of simplifying assumptions:
(a) No taxes exist (corporate or personal)
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e
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(c) There are no transactions costs: for example, in issuing new shares, or
taking out a bank loan, or selling shares
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Criticism of M&M dividend irrelevancy theory
There are strong arguments against M&M's view that dividend policy is
irrelevant as a means of affecting shareholders' wealth
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(a) Impact of taxation
Differing rates of taxation on dividends and capital gains can create a
preference for either a high dividend or high earnings retention
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(b) Capital markets are not perfectly efficient
Companies may find that funds are not always available to finance
attractive investments
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(c) Impact of transaction costs
Because of transaction costs on the sale of shares, investors who want
some cash from their investments will prefer to receive dividends rather
than to sell some of their shares to get the cash they want
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Even if management were to provide
them with profit forecasts, these forecasts would not necessarily be
accurate or believable unless backed up with a signal of confidence in
the form of a rising dividend
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This is known as the bird-in-the-hand theory
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- Zero/low dividend
- Investment offer high returns
- Often prefer to avoid debt finance

Mature companies
Mature companies often follow a stabe growth or constant payout policy
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e
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 Liquidity position – (i
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cash, rather than profits is required to pay a dividend
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 Information content/’signaling’ – capital markets tend not to be perfect
markets and in the absence of perfect information a company’s dividend
declaration is seen as an important signal of the future prosperity of the
company
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 Transaction costs – reduce the ‘’manufacturing’’ dividends expected by MM
 What dividends do S/H want (clientele effect)?
 Signaling effect - payment of dividends indicates a healthy company
 Retaining cash is a key source of finance
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 Risk-paying now is safer than promising to pay next year
 Is the dividend within the company law regulations?
Accumulated Realised Profit greater than Accumulated Realised Loss
ARP greater than ARL

4 Alternatives to Cash Dividends

Scrip dividend
A scrip(or share) dividend is an offer for shares in a company
as an alternative to a cash dividend
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Scrip Dividends
Scrip dividend is where a company allows its shareholders to take their
dividends in the form of new shares rather than cash
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 Preservation of cash for reinvestment
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 More shares reduce the company’s gearing and hence increase its
borrowing capacity
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e
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broker’s fees and stamp duty on share purchase
 Shareholders may get a tax advantage if dividends in the form of
shares rather than cash
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It may prevent a takeover or enable a quoted company to
withdraw from the stock market
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I
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Buy back shares at Po and cancel them
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Advantages for the company might include:
 Giving flexibility where a firm’s excess cash flows are thought to be only
temporary
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 Increasing EPS through a reduction in the number of shares in issue
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g
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 Altering capital structure to reduce the cost of capital
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 The company may pay too high a price for the shares
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 Premiums paid are set first against share premium and then against
distributable profits (if against distributable profits, this will reduce future
dividend capacity)
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 Some shareholders may suffer from being taxed on a capital gain following
the purchase of their shares rather than receiving dividend income

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